What Is Consumer Discretionary?
Consumer discretionary is a term for classifying goods and services that are considered non-essential by consumers, but desirable if their available income is sufficient to purchase them. Examples of consumer discretionary products can include durable goods, high-end apparel, entertainment, leisure activities, and automobiles.
Companies that supply these types of goods and services are usually either called consumer discretionaries or consumer cyclicals.
- Consumer discretionary is a sector classification of non-essential consumer goods and services watched by analysts and investors.
- Consumers tend to spend more on consumer discretionary products in economic growth phases, which are usually characterized by higher disposable income.
- Consumer discretionary can be contrasted with consumer staples, which is a classification for companies considered to produce daily necessities.
Understanding Consumer Discretionary
The purchase of consumer discretionary products is often discussed in comparison with its counterpart: consumer staples. Both product classifications are influenced by cycles of the economy. In general, when the economy is strong, consumers earn more and spend more on consumer discretionary products. On the other hand, when an economy is in contractionary phases, consumers usually earn less and focus their spending more on consumer staples, also referred to as consumer defensive.
Economic cycles have a big influence on earnings power and consumer spending in an economy. There are four stages of an economic cycle, defined as expansion, peak, contraction, and trough. A growing economy—expansion to peak—is usually characterized by stronger earnings for businesses and consumers paired with more spending. A contracting economy—contraction to trough—generally has the opposite effect.
When an economy is growing, it is usually expected that its consumers would have more disposable income to spend on discretionary items and less concern over saving for tough times. This leads to a greater demand for consumer discretionary products.
Alternatively, in a poor economy, consumers are more likely to forego the purchases of non-essential consumer discretionary products in favor of adding to their savings. These consumers, however, still need to buy basic household items such as toilet paper, paper towels, food, beverages, and gas, all of which are considered consumer staples.
Consumer Discretionary and Economic Indicators
There are several economic indicators that help economists to determine the state of an economy. These indicators are also important for predicting the potential trends for both the consumer discretionary and consumer staples classifications.
Typically, gross domestic product (GDP) is the number one metric for analyzing an economy. When GDP is growing, it indicates a growing economy willing to spend more. Conversely, when GDP is decreasing, it is an indication of contraction and the need for greater spending prudence.
Consumer confidence can also be relevant. In a weakening economy, consumer confidence typically declines, causing consumers to tighten their belts by postponing vacations and the purchases of non-essential products, such as high-end retail, big-screen televisions, or expensive new cars. The reduced demand for consumer discretionary is usually a precursor to lower sales for the companies that produce these products, which can lead to worsening economic conditions and more contraction.
The shares of consumer discretionary companies tend to lead a general stock market decline at the beginning of a contraction.
The Bureau of Economic Analysis (BEA) releases a monthly report on personal income and outlays, which is also combined with the Federal Reserve’s (Fed) closely followed Personal Consumption Expenditures Index for measuring inflation. In growth phases, personal income and personal spending will typically show increases, leading to more spending on consumer discretionary products. During contractions, meanwhile, personal income and personal spending are usually lower.
Interest rates can also be an interesting metric to follow during all types of economic cycles. Typically, the Federal Open Market Committee (FOMC) and fixed income markets, in general, will usually see rising interest rates in growth phases and falling interest rates in contractions. Interest rates can be a big factor for companies who tap the credit markets for business funding. Monetary policy usually seeks to lower interest rates in contractionary phases to help business stimulus.
Other monthly indicators closely followed to predict consumer discretionary trends may include the following:
- Retail sales
- Non-farm payrolls
- Unemployment levels
- Labor market hours
- Labor market earnings
- Manufacturing activity
- Services activity
- Home sales
- Building construction activity
Investing Strategies: Discretionaries vs. Staples
When an economy is growing, nearly all sectors will see stock value increases. This is helped by increasing profits and more disposable consumer income. Growth phases usually make investing in equities much more attractive. Often, when signs of economic recovery begin to appear, consumer discretionary stocks will lead a stock market recovery.
In contrast, when an economy is contracting, investors are more likely to turn to consumer staples stocks, as well as other lower-risk investments, such as corporate bonds and Treasuries. These types of investments provide even more safety, while still generating some viable returns.
Many investors like to take their bets through sector exchange-traded funds (ETFs) throughout all types of economic cycles. These funds can limit risks through broadened diversification, while still allowing for the concentration of investment positions. In the consumer discretionary and consumer staples categories, State Street Global Advisors offers two of the market’s top options.
The Consumer Discretionary Select Sector SPDR Fund (XLY) includes the S&P 500’s consumer discretionary stocks. Its top holdings, as of August 2020, were the following:
- Amazon (AMZN)
- Home Depot (HD)
- McDonald's (MCD)
- NIKE (NKE)
- Lowe's (LOW)
The Consumer Staples Select Sector SPDR Fund (XLP) includes the S&P 500’s consumer staples stocks. Its top holdings, as of August 2020, were the following:
- Procter & Gamble (PG)
- PepsiCo Inc. (PEP)
- Walmart (WMT)
- Coca-Cola (KO)
- Mondelez (MDLZ)
These ETFs can be good investment options to consider when seeking to navigate through different types of economic cycles.