• 3Q 11 was the worst quarter for global equities since 4Q 08; before the 2008-2009 global financial crisis, one has to go back to 3Q 02 to find a worse quarter
• Under popular market convention, Consumer Staples, Utilities, Telecommunication Services and Healthcare are considered defensive sectors, while Information Technology, Consumer Discretionary, Energy, Industrials and Materials are generally considered cyclical sectors
• Financials have traditionally been defensive in nature, but changing profit avenues has increased the cyclical nature of the sector in recent years
• Consumer Staples, Utilities and Telecommunication Services were the most defensive sectors in the quarter while Information Technology surprised by performing largely in-line with Telecommunication Services and Healthcare; Materials, Financials, Industrials and Energy underperformed the general market
• We looked at the 5 best quarters and 5 worst quarters for the global stock market since 1994 to assess the performance of the various sectors over those periods
• As anticipated, the defensive sectors outperformed over the 5 worst quarters since 1994 with a -9.6% average return compared to the -17.9% average for the general market, vindicating their “defensive” billing
• Cyclical sectors delivered a -21.1% average return over the 5 worst quarters, underperforming the market
• For performance over the 5 best quarters, ranking of sectors was not quite as clear cut; sector-specific parameters explained some of the “anomalies” observed in Energy and Telecommunication Services
• Knowledge of whether sectors are cyclical or defensive will enable investors to better position their portfolios, and to identify funds with a more defensive or aggressive positioning to better suit their investment purpose

Global equities returned -17.3% (on a total return basis, in USD terms) in 3Q 11, marking the worst quarter for equities since the 2008-2009 global financial crisis. Prior to that period, one has to look back to 3Q 02 to find a weaker quarter for global equity markets. In this sector update, we look at how the various GICS (Global Industry Classification Standard) sectors have performed under the recent volatile market conditions, with a focus on whether defensive sectors have truly lived up to their “defensive” billing.

Little Correlation with Direction of Overall Economy

Amongst the ten GICS sectors, four are generally considered “defensive” (see Table 1) as their industries have little correlation with the overall direction of the general economy. Demand for goods like healthcare products and consumer staple essentials usually depend little on whether the economy is expanding or in recession, leading to more resilience in the sales and profits for associated companies which ultimately translate to more stable (and resilient) stock prices. Financials have traditionally been considered defensive as lower interest rates in recessions serve to lower borrowing costs for commercial banking operations, allowing profits to be sustained. However, since the repeal of the Glass-Steagall Act in 1999, the line between investment banking and commercial banking activity has blurred, and the prominence of more economic-sensitive investment banking activities within the financial sector has possibly led to a higher correlation of the sector’s performance with the direction of the overall economy.

Defensive Sectors Outperformed in 3Q 11

As of 26 October 2011, only three of the ten GICS sectors (Consumer Staples, Healthcare and Telecommunication Services) were still positive year-to-date (see Table 1), after losses sustained in a 3Q 11 “quarter-pounder”. In a quarter which saw global equities decline by 17.3%, the four defensive sectors (led by Consumer Staples and Utilities) all turned in negative returns, but losses were significantly lower compared to the overall market. Not surprisingly, cyclical sectors like Materials, Financials and Industrials were the worst-performing sectors, returning between -22.5% and -25.7% over the quarter.

Despite its cyclical positioning, Information Technology had a surprisingly strong 3Q 11, with the -10.5% return for the sector just marginally lower than that of Healthcare (-10.2%) and Telecommunication Services (-10%). Apple Inc, a heavyweight in the Information Technology sector (and the largest holding in most Technology funds), actually delivered a positive 13.6% return in 3Q 11, boosting performance of the overall sector.  

Were Defensive Sectors Truly Defensive?

The recent quarter provides a good example of how defensive sectors outperformed more cyclically-positioned ones in down-markets, but to assess if such a relationship holds, further analysis may be required. Also, given their expected resilience in down-markets, should defensive sectors be expected to underperform in a more bullish environment? To test this, we looked at the 5 worst quarters and 5 best quarters for the global stock market since 1994 to assess the performance of the various sectors over both bearish periods, as well as bullish ones.

Defensive Sectors Outperformed Over the 5 Worst Quarters

Between 4Q 94 and 3Q 11, the five worst quarters for global equities were 4Q 08, 3Q 02, 3Q 11, 3Q 08 and 3Q 01, with returns of -22.2%, -18.3%, -17.3%, -16.5% and -15% respectively (see Table 2). As anticipated, the defensive sectors turned in a more resilient performance over these difficult periods and outperformed with a -9.6% average return over the five quarters, compared to the -17.9% average for the general market, vindicating their “defensive” billing. In contrast, the cyclical sectors averaged a -21.1% return over the five worst quarters since 1994.

Did defensive sectors underperform in bullish markets?

While defensive sectors did in fact outperform over the five worst quarters, how did these sectors fare under a more bullish market environment? In our analysis period (between 4Q 94 and 3Q 11), the five best quarters for global equities were 2Q 09, 4Q 98, 3Q 09, 2Q 03 and 4Q 99 which saw global equities deliver returns of 22.4%, 20.6%, 18%, 17.5% and 17% respectively (see Table 3).  

General Outperformance Of Cyclical Sectors Under Bullish Conditions

Unlike the performance over the worst 5 quarters which saw a more distinct segregation of cyclical and defensive sectors, the 5 best quarters threw up a more mixed picture. On average, cyclical sectors did deliver a stronger average return (19.8%), marginally higher than the 19.1% average return for global equities and surpassing the 13.2% average return for defensive sectors. However, Energy (cyclical) ended up with the poorest average return, while Telecommunication Services (defensive) delivered a relatively strong 20.5% average return despite its defensive billing.

Sector-Specific Fundamentals At Work

A closer examination of returns for the energy sector indicates that the relatively poor 4Q 98 performance coincided with a substantial -25.3% decline in the price of oil over the quarter, which explains why the Energy sector underperformed despite the general market rising by a hefty 20.6% over the same period. Also, the hefty 32.1% return for Telecommunication Services equities in 4Q 99 coincided with the later stages of the technology-fuelled bubble, where telecommunication stocks were part of the TMT (Technology, Media, Telecommunications) sector which saw immense investor demand, allowing Telecommunication Services equities to trade to lofty valuations of over 30X earnings.

Again, sector-specific conditions are at play to explain the reasons behind the apparent higher volatility for Telecommunication Services stocks (see Table 4). By stripping out the period of the Tech-bubble boom (and subsequent bust), the 8-year annualised volatility for the Telecommunication Services sector reduces to 15.4% (down from 18.9%), lower than that of global equities on the whole.

Investing with Defensive/Cyclical Sectors

Our study of sector-specific performance over the five best and five worst quarters (since 1994) of the global stock market indicates outperformance of defensive sectors in difficult periods of the stock market, while cyclical sectors generally delivered a stronger return in bullish quarters. Baring sector-specific conditions (sector overvaluation, industry-specific changes in legislation etc.) which will be expected to weigh more heavily on a particular sector’s performance, historical data suggests that defensive sectors will continue to outperform in weak quarters for the overall equity market, but deliver poorer relative returns in strong quarters. These observations are reinforced by the fundamental differences in industry nature: cyclical sectors are more leveraged on the economy cycle, allowing for stronger profits to be generated in economic upswings but are impacted more in downturns, whereas defensive sectors are less correlated to the general economy and are less affected in recessions, but benefit less when a strong economic expansion is underway. 

How then can an investor use this information? In turbulent market conditions, investors can select more defensive sector funds to be included in the supplementary portfolio to reduce overall portfolio volatility. In strong up-markets, investors may then wish to switch supplementary exposure to more cyclical segments of the equity market to benefit from stronger potential upside. In addition to portfolio positioning, knowing whether sectors are cyclical or defensive in nature will help investors select a suitable fund. By comparing sector exposures (from the fund’s factsheet), investors can assess if a fund manager has positioned the portfolio more defensively or more aggressively compared to its peers. Not surprisingly, funds like the First State Regional China Fund or First State GEM Leaders which had actively taken on a more defensive sector positioning (via a higher allocation to Consumer Staples) going into 3Q 11 actually outperformed both peers and the benchmark so far this year (see Which Defensively-Positioned Funds Outperformed?).

The following is a selection (non-exhaustive) of sector-focused funds available on the platform:

Defensive Sectors
Healthcare: United Global Healthcare Fund, Fidelity Glb Health Care EUR, AB Int Health Care-A SGD, LionGlobal Hthcare Invt-A
Utilities: BNPPL1 Eq World Utilities EUR
Telecommunication Services: United Global Telecoms Fund

Cyclical Sectors
Consumer Discretionary: Amundi Glb Luxury & Lifestyle SGD
Materials/Energy: BNPPL1 Eq World Materials EUR, First State Glb Resources, United Global Resources Fund, JPM Global Natural Resources (SGD) A (acc), BNPPL1 Eq World Energy USD
Financials: Fidelity Glb Fin Serv EUR, United Global Capital Fund, BNPPL1 Eq World Finance EUR
Information Technology: Henderson Global Technology, Aberdeen Global Technology, Fidelity Glb Technology EUR, PRU Global Technology Fund, United Global Technology Fund

See Also:
A Star Pick In This Five-Star Regional Market
Which Defensively-Positioned Funds Outperformed?