As investors contemplate what slowing growth means for markets, Morgan Stanley Research details which sectors and industries have traditionally been more defensive and where this may be changing.
Defensive classics are sectors and industries that have traditionally held up during challenging market conditions—and a few that even thrive when times get tough.
Although markets have enjoyed one of the longest expansions on record, there is risk of a shift to downturn in the next twelve months. Ahead of any shift, Morgan Stanley Research analyzed nearly 25 years of historical patterns to identify the industries and sectors primed to withstand an equity market downturn. The results aren't always what investors might expect.
“We think this work challenges some of the traditional notions of defensiveness on a few fronts," says Adam Virgadamo, U.S. Equity Strategist and lead author of the recent report, The Defensive Scorecard: U.S. Equities. The report combines historical data and fundamental analysis to assess if what was defensive in the past will continue to be so in the future.
The research team's defensive scorecard evaluated industries and sectors based on three key metrics. The first is defensive performance—how returns fare during times of stress. The next metric is business stability, which assesses factors such as cash flow and sales growth volatility.
Investor income is the final broad metric, with analysts believing that stocks that return cash to shareholders have a larger buffer against price changes. In addition to quantitative screening, the scorecard also considers market trends and fundamental analyst input. The results yielded some expected defensive stalwarts—as well as a few surprises.
The workhorses of this scorecard are what the Research team refers to as “Defensive Classics." These include sectors and industries that have traditionally held up during challenging market conditions—and a few that even thrive when times get tough.
The report classifies the Aerospace and Defense industry as “highly defensive," mainly because of growing Department of Defense budgets and an elevated global threat environment. Other solid defensive classics include Beverages, Health Care Equipment, Utilities, and Integrated Oil and Gas. In many cases, these industries represent products and services that consumers and governments rely on regardless of economic circumstances, or they're bolstered by demographic trends, such as an aging population.
Investors can think of sectors in the “Selective Defensives” category as potential contributors. “They screen as borderline defensive, mostly due to a few stocks or sub-segments," Virgadamo says.
In this category, sectors’ overall performance isn't entirely reliable, often because of new market trends shaking up traditional business practices. Health Care Providers and Services offers a good example. Hesitant to label the entire sector as defensive, the report parsed the more favorable sub-segments. Labs offer a defensive safe haven because their work is well defined and pricing model stable. However, drug supply chain stocks are less so, thanks to increased uncertainty around pricing and other volatile factors.
Specialty Chemicals and Industrial Gases and some specialized REITs—such as those focused on residential and health care projects—may provide similar defensive benefits beyond their sector's general performance.
Some sectors and industries once considered classically defensive may not perform as reliably today.
As an example, the Food Products industry has been considered historically defensive. However, the report found that the industry faces current revenue pressure from changing consumer preferences toward organic and natural items, cost increases from rising freight costs and increased customer service demands. These factors “diminish the industry's defensive nature," the analysts write. Pharmaceuticals is in a similar boat, with its once defensive benefits threatened by unstable prices and an industry shift toward niche disease medicine.
The report notes that no defensive scorecard can be exhaustive since some sub-segments or single stocks can always be more or less defensive, but is a strong start for defensive analysis as investors prepare for any potential shift in market leadership.