On my drive to work early this week, I heard on the radio that McDonalds reported a decline in earnings. Analysts noted that more people are employed now than 5 years ago, and these people have more money to spend on better fast food options. Chipotle was specifically cited, but here in Rapid City it is clear Five Guys Burgers and Fries would also serve as a good step-up competitor.
It seems to go against what we typically believe, which is the rising economic tide tends to float all boats. But the truth is, when income or employment improves, people give up cheaper products and services for higher quality ones.
Industries that do well when the economy is doing well are known as “cyclical” industries. This harkens back to the business cycle, in which industry as a whole expands to generate positive economic output, and when aggregate output decreases, a recession results.
Some industries can be “more” cyclical than others. Highly cyclical industries include housing, new automobiles, and luxury items. When times are good and people feel they have stable work, they are more willing to spend on big ticket items. Likewise, these industries suffer in a recession since more people find themselves out of work or are less certain about their future.
For other industries, say the sit-down restaurant industry, you will likely see less business, but not as steep of a drop off in demand. People still might find $50 or $60 in their budget to dine out even if the future is murky.
Other industries are described as “non-cyclical.” Take for example healthcare or utilities. While people would wish they could cut the expenses of these items when the economy takes a downturn, the reality is their consumption will likely remain at a relatively steady rate. Most of us will forego several other items before we refuse to pay the heating bill in winter, or before we refuse to get a broken arm fixed.
Then there is the concept of “counter-cyclical” industries. These are businesses which may see additional revenue because of a contracting economy. Think discount retailers and cheap fast food. People will readily buy these products and services in a recession when they can afford less and forego Chipotle or Five Guys. Another good example of a counter-cyclical industry is the foreclosure processing industry. As unfortunate as reality is, when people lose their homes in a recession, more people need to be employed to foreclose on properties.
Knowing how your business member tracts with the economy is important. Cyclical businesses should not struggle during an economic expansion. A cyclical business that is operating marginally during an expanding economy may not be a “going concern” in a recession. On the other hand, if they are struggling because of a recession, there may be reason to believe their performance will improve as the economy improves. Of course, all of this is vice versa for counter-cyclical business.
Understanding the risk of the business cycle requires lenders to know two things: first, where the economy is in the business cycle, and second, how businesses in their portfolio track with the business cycle.