Industrial Machinery Stock Outlook - August 2017

The U.S. market showed strength subsequent to the election of President Trump, primarily factoring in his promised pro-growth policies. However, the momentum has stalled following uncertainties looming over policy enactment and implementation.

As far the Industrial Products companies are concerned, the Trump government’s infrastructure improvement plan, if implemented, will boost demand. Also, the sector is seeing improving export demand for its products from foreign nations.

Since the beginning of the year, industrial products stocks have been strong performers, with the sector gaining roughly 9.4%. Among the S&P 500 members, the top five industrial machinery gainers include Roper Technologies, Inc. (ROP), Deere & Company (NYSE:DE) (DE), Stanley Black & Decker (NYSE:SWK), Inc. (SWK), Caterpillar (NYSE:CAT), Inc. (CAT) and Rockwell Automation Inc (NYSE:ROK). (ROK). The poor performers include Flowserve Corp. (FLS), Emerson Electric Company (NYSE:EMR) (EMR) and Eaton Corporation, PLC (ETN).

Industrial production is one of the leading economic indicators for the industrial stocks. It measures the level of output of manufacturing, mining and utilities sectors in a country. A brief discussion on the machinery industry in different nations is given below.

Industrial Machinery - Nation-Wise Description

The United States: The country’s industrial production increased at an annual rate of 4.7% in the second quarter, driven by impressive growth in mining and utilities.

Per the U.S. Census Bureau report, new orders for U.S.-manufactured machinery increased 5.7% in the first half of 2017 led by growth in orders for construction, mining, industrial, material handling and other machineries. Also, the job market showed strength, with the recent data indicating 209,000 new job additions in July. In second-quarter 2017, new job additions averaged 194,333 per month. Unemployment rate declined from 4.4% in June to 4.3% in July.

Citing improvement in economic activities, the Federal Reserve raised its interest rates in June and indicated further rate hikes ahead. This, in turn, will make capital investments more expensive and hence might weigh on businesses for industrial products makers.

Per its Jul 2017 report, the International Monetary Fund (IMF) trimmed its growth projections for the U.S. economy by 20 basis points (bps) to 2.1% for 2017 and 40 bps to 2.1% for 2018 primarily on account of uncertainties surrounding the implementation of governmental policies.

Japan: According to the report from Japan’s Cabinet Office, core machinery orders (an indicator of capital spending by companies in the next six to nine months) decreased 1.4% in first-quarter 2017 while fell nearly 3.1% in April and 3.6% in May.

In second-quarter 2017, total machinery order will likely decline 0.9% while core orders are expected to fall 5.9%. Orders from manufacturing clients will likely fall 1.1% while that from government clients might decline 13.6%.

The country’s economy is struggling with internal issues including low investment levels, unfavorable exchange rates, aging population and a huge public debt. Also, the consumption level has failed to revive to a satisfactory standard since it suffered from a 3% rise in national sales tax in Apr 2015.

In addition, the country is facing weak economic conditions externally. However, efforts to improve wages and hence, demand as well as steps to increase investments domestically might work in the country’s favor in the quarters ahead.

The IMF increased its growth projection for the country by 10 bps to 1.3% for 2017 while it remained stable at 0.6% for 2018.

China: China’s GDP grew 6.9% from the year-earlier period in the second quarter, coming in better than expected. Improvements in infrastructure investment, retail sales and higher exports due to healthy global economy have worked in its favor. In March, the government announced its plan to spend $2 trillion for the development of infrastructure and transportation by 2020. However, tiff with the U.S. economy over trade relationships might dent its growth momentum.

The country’s industrial production increased 7.6% year over year in June on the back of improvement in manufacturing and utilities sectors, offset by weakness in the mining sector. Industrial production in both May and April grew 6.5%.

For 2017, the Chinese government anticipates economy to grow roughly 6.5%. The IMF projects the Chinese economy to grow 6.7% in 2017 and 6.4% in 2018.

India: The country’s industrial production decelerated to 1.7% in May 2017, having expanded 2.8% in the previous month. Production suffered from lower rise in manufacturing output and contractions in mining and quarrying outputs.

Expectations of a strong demand, improved policies and better monsoon conditions are the factors that will influence the country’s growth, going forward. The government is making concerted efforts to turn the country into a prime manufacturing hub for all nations across the world. Apart from boosting the foreign capital inflow in the country, these strategies will improve the domestic job market as well as demand for industrial products. The recent interest rate cut by the central bank, driven by prevailing low inflation rate in the country, will allow accessibility to cheap loans.

According to the IMF, the country is projected to grow 7.2% in 2017 and 7.7% in 2018.

Brazil: Political uncertainties continue to loom large over Brazil’s economy and are mainly responsible for the countries’ below investment grade ratings. Private investments are low while inadequate infrastructure and still high unemployment rate are making the economy more lackluster.

Strong efforts are being made to revive the economy. In July this year, interest rate was trimmed 100 bps by the countries’ Central Bank, this being its seventh consecutive rate cut since Oct 2016. Also, inflation has eased over the past few months. Per the data available, industrial production in the country was flat in Jun 2017 compared with the previous month while showed expansion of 1.2% in May and 1.3% in April.

The IMF expects the country’s output to grow 0.3% in 2017, reflecting a 10 bps increase from the previous forecast. However, growth projection for 2018 has been cut 40 bps to 1.3%.

Eurozone: Per the available data, industrial production in the Eurozone improved 1.3% in May from the prior month and rose 4% year over year. In April, industrial production inched up 0.3% from the previous month. The unemployment rate was 9.1% in June versus 9.2% in the previous month.

The IMF predicts output growth in Euro Area to be 1.9% in 2017, up 20 bps from the previous forecasts and grow 1.7% in 2018.

Industry Ranking

Machinery stocks are broadly grouped under the Industrial Products, one of the 16 broad Zacks sectors. The Zacks sectors comprise 265 industries that are ranked on the basis of earnings outlook of constituent companies in each industry. As a rule, we put our X industries (all 265 of them) into two groups: the top half (i.e., industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank).

Over the last 10 years, using a one week rebalance, the top half beat the bottom half by a factor of more than two to one. (To learn more visit: About Zacks Industry Rank).

The machinery industry comprises stocks that primarily deals with manufacturing and supplying farm equipments (currently such stocks collectively carry Zacks Industry Rank of 19), construction and mining equipment (ranked 19), industrial electronics (ranked 96), electrical products (ranked 117), thermal products (ranked 53), material handling products (ranked 53), printing equipment for industrial use (ranked 117) and industrial tools and equipment, and providing related services are collectively ranked 117.

Going by the Zacks rule, we see that machinery sub-industries fall in the top half. These sub-industries can be of interest to investors seeking exposure in the machinery industry.

Performance and Earnings Trend of the Sector

Per the Earnings Preview dated Aug 4, the earnings season has unfolded well. As of that date, roughly 420 of S&P 500 companies reported results for the April-June quarter, with 74.3% beating earnings estimates and 68.3% surpassing revenue projections.

Of Industrial Products stocks, roughly 91.7% reported results til Aug 4. Earnings beat recorded as of that date was 68.2% while revenue beat was 54.5%.

In the quarter, the market is anticipated to perform well, witnessing earnings and sales growth of 10% and 5.1%, respectively over the year-ago quarter. Seeing the results so far and the favorable operating conditions, we believe that the overall performance of the Industrial Products sector will be encouraging.

Conclusion

The IMF anticipates the world economy to grow 3.5% in 2017. It expects 2% rise in advanced economies and 4.6% growth in emerging nations. Global output is projected to increase 3.6% in 2018, including 1.9% growth for advanced nations and 4.8% improvement for emerging countries.

We believe that policies encouraging better trade relations, increase in infrastructural investments, job creation and high consumer-end demand might accelerate growth in the U.S. economy. This, in turn, will prove beneficial for industrial machinery stocks. It will be interesting to watch the activities of companies, with at least $20 billion market capitalization, including Caterpillar, Inc., ABB Ltd. (ABB), Illinois Tool Works Inc (NYSE:ITW) (ITW), Parker-Hannifin Corp. (PH), Ingersoll-Rand PLC (IR) and Rockwell Automation.

In the S&P 500 group, a major machinery company is Caterpillar. It has a market capitalization of $67.58 billion and currently sports a Zacks Rank #1 (Strong Buy). In the next three to five years, the company’s earnings are predicted to grow 9.50%.

Earnings of Deere & Company are predicted to grow 9.17%. It currently has $41.50 billion market capitalization and Zacks Rank #2 (Buy). The company’s long-term growth prospects seem bright on the back of increasing population, rising living standards, investments in new products and expansion in unexplored geographies.