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Although evidence of short cycle recovery suggests an industrials renaissance, investors should be wary of overpaying for growth.
Shares in SKF, the world’s largest ball bearing producer, are closely watched as a surrogate indicator of industrial activity worldwide. Its products feed into goods that range from dishwashers to cars, wind turbines and power transmission systems, making SKF a bellwether of global manufacturing.
A pick-up in the company’s share price in early 2017 - ahead of a significant uptick in its turnover - reflected expectations of an imminent industrial rebound.
“Last autumn, we started to see improvements in the purchasing managers’ indices, and not just in the US,” says Max Burns, Senior Industrials Analyst at Aviva Investors. “We have seen this trend follow through in 2017: the data has been the best for many years, in the US, euro area, China and the rest of the world. The indices are really strong lead indicators for a short cycle recovery – for industrial components or products that might be bought and replaced within about a year.”
Figure 1: Global Manufacturing Purchasing Managers’ Indices signal an industrial renaissance
Based on past experience, this suggests organic sales growth might start to come through more widely in the industrial sector later in 2017. First quarter releases from SKF and other bellwether stocks, including component producer Schneider Electric, robotics and power specialist ABB and industrial conglomerate General Electric (GE), have reinforced that view – all with positive revenue trends, tending to surprise on the upside.
A number of stand out results have been driven by momentum from Asia. Sandvik, a producer of mining equipment, highlighted a Chinese tailwind, with sales up 31 per cent year-on-year. ABB’s ‘Robotics and Motion’ division saw Chinese orders increase 13 per cent in the first quarter of 2017, and construction equipment company Caterpillar also mentioned a step-up in Asian demand.
The question now is how far the short cycle rebound will spill into longer-cycle end markets, particularly in three important capital intensive areas – mining, power generation and offshore oil and gas. Although Caterpillar suggested markets strengthening in mining and heavy duty construction for the first time in years, Burns believes that sales have been largely replacement-driven so far; not led by a need for equipment for use on greenfield sites.
Significantly, there has been little positive corporate commentary about momentum in oil and gas. Global capital expenditure in the sector was estimated to be around $200 billion in 2016, less than half the level incurred two years previously. In many cases, producers are not looking to re-ignite large scale capex programs with oil trading around $50 a barrel. Around $1.5 trillion of once-planned investment is not thought to be viable at this level.
Long road to recovery?
One key to any long cycle recovery will be the extent to which demand reignites in emerging markets. “Increasingly, China and wider emerging markets are the most important drivers of the global recovery,” says Maulshree Saroliya, Macro Strategist at Aviva Investors. “Global trade indicators have bounced back strongly over the last 12 months, and China and emerging markets tend to benefit more from global trade growth than the US, given their relatively higher dependence on trade.”
Although Chinese growth fell to a multi-year trough in 2016, on-the-ground reports suggest the economy is improving again and that the authorities are ready to step in to increase fiscal support if necessary. Together, Saroliya believes the collective momentum from emerging markets and Europe is “strong and clear”, and greater than that from the US. Significantly, this broad pickup in demand has helped dampen fears about persistent supply side problems, such as disappointing productivity growth.
“The global economic recovery now looks like it’s for real,” wrote researchers at the Brookings Institution in April. “The advanced economies are settling to a reasonable growth path and the fast-growing emerging market economies such as China and India have gotten through a rocky period. Its indicators of economic activity (Figure 2 below) and confidence are both improving strongly, although challenged by ’undercurrents of political and policy uncertainty’.”
Figure 2: Tracking the Global Economic Recovery
Brookings Institution Real Activity Index
Valuations of US industrials at highest level for almost a decade
With the macro environment strengthening, the forward price-earnings ratios of some industrial stocks are close to their highest levels for ten years. Some companies with international exposure to the resources industries, construction and energy markets reached 31 times 2017 earnings, before falling back in the second quarter. Value seems to be in short supply, and Burns is cautious about extrapolating a multi-year industrial earnings acceleration solely on the heels of a short-cycle rebound.
Figure 3: US Industrial forward price/earnings ratios price in cyclical recovery
In contrast, the earnings outlook is less opaque among select global defence contractors. Today’s deep political undercurrents and the combination of ‘hot’ and ‘cold’ war has triggered an uptick in defence spending, after five years of contraction. Military activity is under way in the Middle East, while tensions with North Korea have notably spiked in recent months. Elsewhere, Russia and the Ukraine, China and Taiwan, India and neighbouring Pakistan are all jostling for position, among others.
In this environment, the United Arab Emirates, Saudi Arabia, India, South Korea, Japan and China plan significant upgrades of military hardware. The US, which accounts for one third of global military spending, is planning to increase spending on procurement by more than five per cent annually, and more than six per cent annually on operations and maintenance, over the next two years. That is more modest than initially envisaged by the Trump administration (see Figure 4 below), but still a marked acceleration.
Figure 4: Trump initially planned a significant increase in defence expenditure, exceeding current spending caps
Meanwhile, the US is actively campaigning for other NATO members to focus on their defence budgets. Only a minority - including Greece, France and Estonia - currently spend the guideline two per cent of GDP on defence. According to Lockheed Martin, producer of the stealth F-35 Joint Strike Fighter aircraft, agreement to do so (however unlikely that now seems) could inject another $100 billion of spending across the NATO alliance.
Figure 5: NATO: 2016 defence spending as a percentage of GDP
“There are currently strong political drivers supporting the defence sector, and the stocks have distinctive characteristics”, says Burns. “The winners of large scale government contracts benefit from multi-year budgets, agreed in advance, with a high degree of earnings visibility. They are unusual in that regard.”
Furthermore, Burns believes some concerns over margin pressure may have been overstated. Although US President Trump suggested that he plans to save ‘billions’ on procurement costs, contracts tend to be tight and, in reality, some of the cost ‘cuts’ announced may have already been factored into longer-term analyses. For this reason, Burns prefers European defence stocks over their American peers, as the market may still underappreciate their fundamentals.
Against the unsettled global backdrop, the three year outlook for defence contractors with proprietary products and backlogs of orders is improving. Sales, cash flow and earnings upgrades from the likes of Lockheed Martin and security specialist Rheinmetall are side effects of current instability. Strikingly, there is no continent where the main impetus is towards cutting military expenditure. This is in sharp contrast to prospects in other end markets – in autos, for example, where both the US and European markets look close to their respective peaks; or energy, where global oil and gas capex is expected to decline yet again in 2017. But whether the industrials renaissance becomes deeply embedded, meshing with the upturn in the defence cycle, will depend on a still-uncertain long-cycle recovery.
1. Aviva Investors’ analysis of Q1 2017 earnings announcements from Sandvik Group, ABB, Caterpillar. Source: Aviva Investors, as at April 2017
2. Includes capital spending in oil development and production but excludes spending on exploration. Source: McKinsey & Company. Oil production capex: is a rebound in sight? As at August 2016
3. Source: Chatham House. Navigating the New Normal, as at January 2016
4. Source: Brookings Institution. Update to TIGER: Tracking Indexes for the Global Economic Recovery, as at April 2017
5. Source: Bloomberg, as at 9 February 2017
6: Source: Deloitte, 2017 Global Aerospace and Defence Sector Outlook
7. Bernstein, as at 2 May 2017
8. Source: Senate Armed Services Committee FY 2018-FY 2022 Defense Budget
9. Source: NATO, as cited in Defense One, as at 29 July 2016
10. Source: Bloomberg, as at 19 December 2016
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