I approach investing my own money with a risk-first mindset. In my view, what not to buy is as important as what to invest in. Here is the key stock market sector that I am avoiding in the current UK economic environment.
The bigger picture
The UK economy is facing a number of headwinds. Official data from the Bank of England shows that the inflation rate in the UK is now just over 10%. However, the British Chamber of Commerce expects inflation to peak at 14%!
In simple terms, such high inflation means that consumers have a lot less money to spend on things that are not necessary, like food and shelter, which in turn means lower economic growth going forward.
Meanwhile, the central bank has increased interest rates in order to fight off inflationary forces. However, higher interest rates (or tighter monetary policy) means that the cost of servicing debts goes up. For consumers, this translates into higher mortgage rates, and for businesses it results in bigger debt payments.
Overall, the impact of these macroeconomic developments on the British economy is negative.
During such difficult periods, I want to avoid companies that are not providing necessary goods and services or that are in a weak economic position.
When I look at the FTSE 350 opportunity set today, I see one particular sector that I don’t want in my portfolio.
Discretionary goods and services
Also called consumer cyclicals, as they depend on the business cycle to perform well, consumer discretionary companies provide non-essential items or services that are in high demand when the economy is strong.
As such, when consumer confidence and purchasing power are high, these types of stocks tend to do well. In this category we can include high-end apparel, entertainment, retailers, leisure activities, hotel chains, and even automobiles.
However, when consumers have less money to spend, the primary focus of many people would be to pay the bills: energy, food, mortgages and rents rather than to spend on a new watch, car or computer game.
Consequently, consumer discretionary stocks tend to perform poorly when the economy is facing headwinds, like it is now. Indeed, the FTSE 350 Consumer Discretionary Price index has already declined by c.22% this year, at the time of writing.
When I look at the FTSE 350, the following names come to mind as examples of consumer cyclical stocks I am avoiding right now: JD Sports, Next, Currys and Games Workshop.
What about the long term?
As a long-term investor with a passion for fundamental analysis, I am always conflicted about dismissing stocks based on macroeconomic considerations. However, one think I learned from working for Neil Woodford is that attractive fundamentals must be supported by a positive business case going forward.
Given the above economic environment, I do not see a strong business case for this stock market sector. However, when the data changes, I too shall change my mind.