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Cyclical and non-cyclical stocks
26 Nov 2020

During the last five years, the Maltese economy experienced an upward trajectory in its GDP growth with a long-term average of around four per cent. Despite a more challenging global environment in 2019, the domestic economy continued to register a vigorous rate of economic expansion. The GDP growth in 2019 was 4.4 per cent, from 7.3 per cent in 2018, which is still above the long-term average.

This expansion in GDP was mainly driven by domestic demand, particularly government consumption and gross fixed capital formation, while private consumption also had a positive impact. Against this backdrop the Malta Stock Exchange Total Return Index has surged close to 16 per cent from January 2016 to December 2019.

As we moved into the new year the mammoth impact of the COVID-19 pandemic had the inevitable toll on growth expectations. In March 2020, the European Central Bank staff macroeconomic projections were already envisaging much muted GDP growth in the first half of the year, followed by a possible improvement in the last six months of 2020. Undeniably, uncertainty surrounding the outbreak of COVID-19 implied a negative shock to the economy.

Actual figures during late August showed that the Maltese economy shrank 16.2 per cent year-on-year (y-o-y) in the second quarter of 2020, the biggest contraction ever, due to the coronavirus crisis. It follows an upward revised 1.4 per cent y-o-y gain in the first three months of 2020. This was due to widespread contractions across all main sectors of the economy, with declines in household consumption and fixed investment.

Recently published International Monetary Fund data for Malta now shows that GDP for 2020 is expected to contract by 7.9 per cent, as opposed to the 2.8 per cent contraction previously forecast during April 2020. The Euro Area GDP contraction is expected to be 8.1 per cent for 2020, and thus Malta is still expected to contract slight below the EU average.

Understanding and analysing this data as soon as it is published is important as it will provide a good understanding in which cycle the economy is in. This will allow investors to rebalance their portfolio in such a way to reflect the economic trajectory.

"Recently published data for Malta now shows that GDP for 2020 is expected to contract by 7.9 per cent."

Many investment managers commonly segregate stocks and equities into cyclical and non-cyclical equities. Generally, a cyclical stock is directly affected by the economic business cycle. In an economic boom, it is normal that spending and investment patterns increase within an economy, which have a spiral effect, where people start to spend more with the result that companies are more profitable.

So a cyclical stock tends to give better returns when the economy grows and is affected negatively in an economic downturn. Conversely, a non-cyclical stock is considered as a defensive stock and is less sensitive to the performance of the economy.

We recently tested the performance of cyclical and non-cyclical stocks on the Maltese market. This was done by creating two segregated portfolios of the securities listed on the MSE, each of which composed exclusively of either cyclicals and non-cyclicals securities.

We noticed that in the last five years up till the third quarter of 2019 the cyclical portfolio outperformed the non-cyclical securities. This reflects the strong economic momentum of the Maltese economy in this timespan.

From the last quarter of 2019, evidently, this analysis also captured the transition of the non-cyclical equity portfolio outperformance when compared with the cyclical equity portfolio.

This was emanating from the fact that during the first half of 2019, albeit GDP figures annual growth was still in an upward trajectory, they had been moving more closely to the long-term average of four per cent.

So this shift in sentiment brought also a sector rotation from those considered as cyclical equities, much like hospitality and leisure sector and financial sector companies to other sectors which are considered of a more non-cyclical nature, such as communication and technology sectors.

So shifting between equities within different sectors that might have different behaviours is an important consideration in the risk management framework of investors. Sometimes, local investors tend to invest in those equities that have an inclination to distribute dividends, with little consideration to the different sectorial exposures that one might be building up in the process.

Although it is important that equity investors seek companies that provide returns to shareholders, given the extraordinary period we are living at the moment, dividends are not the ultimate objective one should consider when investing in equities.

One of the key concepts in the management of mutual funds is to ensure that a portfolio is adequately diversified, and such economic factors should be taken into consideration for the benefit of ultimate beneficiary shareholder. This will also protect investors should a particular sectorial downturn occur.

The author and the company have obtained the information contained in this article from sources they believe to be reliable but they have not independently verified the information contained herein and therefore its accuracy cannot be guaranteed. The author and the company make no guarantees, representations or warranties and accept no responsibility or liability as to the accuracy or completeness of the information contained in the article.

Clayton Scicluna, Portofolio manager, BOV Asset Management Ltd

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