Key Points:
- The industrial sector represents much of the core of the American economy, but has struggled to gain much traction.
- The diversity of companies in the group makes it somewhat more difficult to make strong pronouncements on the sector.
- Investors should continue to hold a neutral position in industrials, but for those more tactical investors, digging into specific industries may yield opportunities.
The yin and yang of industrials
The industrial sector has gotten a lot of attention since the 2016 election, and for good reason. The economy was a major factor discussed during the campaign season, and the victorious party made hay with the idea that tax cuts would boost economic growth and infrastructure and defense spending would increase. With such industries as defense, railroads, airlines and manufacturing equipment, it may seem that the industrial sector would stand to benefit from such development. And we did see a corporate tax cut that is still being digested, while economic growth seems to have ticked higher, according to readings from the Bureau of Economic Analysis, yet the industrials sector has underperformed the market modestly over the last 12 months. Why?
Industrials struggling to gain traction
And capex spending plans are elevated.
But wait, you may be saying—part of the tax reform package was a large incentive to bring money back to the United States that was held overseas, i.e., repatriation. And on its face, we believe that should help. But there is still uncertainty regarding how much money will actually come back and what companies are going to do with it. According to Strategas, roughly $2.6 trillion is held overseas, with estimates that around $1.7 trillion of that will be brought back relatively soon—yet companies have announced plans for only $465 billion of that money, and there may be more share-buyback and dividend-raising plans than had been hoped for by those bullish on the industrial sector.
Guns or butter?
OK, you may be saying, but what about aerospace and defense? As the biggest industry in the sector (according to data from S&P) and with geopolitical risks elevated and a Republican, pro-defense mix in Washington, surely that can push the sector higher. In fact, aerospace and defense is the second-best-performing industry in industrials over the past 12 months. And there is a tailwind, as Ned Davis Research reports that defense spending tends to grow twice as fast under Republican presidents as Democrat presidents.
But how much money does that leave in the budget for infrastructure spending that many industrial investors seemed to be hoping for? Meanwhile, raised geopolitical tensions aren’t likely to have a positive impact on business spending plans, which could result in capex spending delays. And with midterm elections not too far off, whether defense spending will continue to grow could depend on which party keeps or gains control of Congress.
Picking through the maze
So what should investors do? For most investors, our suggestion for the present is to keep a market weighting on the sector, with broad exposure that will likely offer benefits to offset negatives that may come with the same development. For those investors who want to be more aggressive, we believe there are some potential opportunities within the sector that may be worth investigating for some more targeted investments. But for those investors, we continue to recommend an overall market weighting to the entire sector, so if they decide to overweight a specific industry they likely would need to pare back other areas of the group. The industrial sector is challenging, representing a broad swath of our American economy, and for now those challenges result in a roughly balanced view in our mind, and a market perform rating.
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