Industrials
A playable pair trade opportunity has emerged on the back of shifting capital spending patterns: long communications equipment/short machinery.
China's industrial sector is showing signs of regained strength. Odds of immediate fresh stimulus measures have declined, but Fed tightening will not become a serious policy constraint for the PBoC. Chinese stocks will not be immune in a broader global selloff, but the risk-return profile of this asset class is still favorable. Expect H shares to grind higher, albeit with increased volatility.
On Monday, we downgraded the S&P agricultural chemicals index owing to excess global food supplies, which threaten to dampen prices for a while longer. This also has negative ramifications for heavy equipment and agricultural equipment companies. To make matters worse, other end markets are in even worse shape. Resources companies have neither the financial wherewithal nor incentive to undertake expansion. Free cash flow has plunged in the mining and oil & gas industries, and balance sheets are saddled with debt. Meanwhile, global construction markets are coming off the boil, even prior to any increase in borrowing costs. Both residential and commercial real estate construction growth is decelerating rapidly, suggesting that oversupply has seeped into markets. The bottom line is that the earnings recession in heavy and ag equipment companies will stay intact. Please see Monday's Weekly Report for more details on our downgrade to underweight. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI.
Equities are celebrating domestic economic disappointment rather than re-pricing the risk of ongoing profit struggles. This reinforces that liquidity and share price momentum are still the dominant market forces.
The S&P air freight & logistics index has been in a long relative performance funk, during which time valuations have been squeezed down to very attractive levels at a time when fundamentals should begin to improve. Business sales are rising relative to inventory. The top panel shows that when inventories are falling relative to GDP, it provides a tailwind to relative performance. Tight inventories intensify the need for rapid delivery services to ensure optimal supply chain management. When inventories are plentiful, there is less need for high-priced, just-in-time, air freight services. Thus, the rundown in inventories is a positive sign for future revenue growth. Even emerging markets are likely to contribute. Asian manufacturing inventories are being depleted, heralding an improvement in Asian air freight growth. Nevertheless, it is important to keep expectations in check, because deleveraging, protectionist/anti-globalization sentiment and low productivity growth globally will cap global trade growth potential. Still, burgeoning online retail sales growth is a boon for package delivery. While some large retailers may take delivery in-house, spillover onto traditional carriers is inevitable. The latest surge in online sales bodes well for an end to industry deflation. We upgraded this group to overweight, please see yesterday's Special Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5AIRFX - UPS, FDX, CHRW, EXPD.
In a Special Report published yesterday, we showed that the transport relative performance bear market and valuation squeeze had already matched what has typically occurred during a recession. Consequently, any stabilization in underlying drivers of global trade could produce a positive share price outcome. Evidence supports the view that the long slump in world export growth is ending. Export volume growth in many emerging countries has climbed back into positive territory. These regions have been the epicenter of global goods production. Global export price deflation has eased, suggesting that some sort of new equilibrium has been established. Importantly, an inventory restocking phase could provide a fillip to overall export growth. Inventories have been rundown in the U.S. and other developed countries, while inventory-to-sales ratios in a number of developing countries have also rolled over. Inventory cycles are fleeting, and investment decisions should key off of overall final demand, but at current valuations, even small amounts of good news could lift the sector. Against a backdrop of productivity and profit margin resilience, the likelihood of a playable advance in the transport sector has increased, particularly in the S&P air freight index. The ticker symbols for the stocks in this index are: BLBG: S5TRAN - UNP, UPS, FDX, DAL, NSC, CSX, LUV, AAL, UAL, KSU, CHRW, EXPD, ALK, JBHT, R.
Transport stocks have discounted a recession, trading below trough bear market relative valuations. That is too cheap given signs of stabilization in global export growth.
Unlike rails, the S&P industrial machinery index has tested prior relative performance highs even though the global manufacturing sector is still laboring under excess capacity in Asia and weak commodity prices. Relative share price performance has already diverged wildly from oil prices, a rare occurrence, and a re-convergence is probable if profits fall short. While companies have cut inventories and staff to address productivity slippage, there is little top-line relief ahead. U.S. machinery new orders continue to contract and there is no help forthcoming from abroad. Non-U.S. developed economies are struggling. Capital spending is in retreat, based on the contraction in capital goods orders and capital goods imports. Our proxy for global machinery orders, excluding the U.S., is contracting. Consequently, there is little scope for a recovery in machinery output, which is necessary to lift utilization rates and allow the industry to sustainably escape deflation. We put this group on our high-conviction underweight list on Monday. The ticker symbols for the stocks in this index are: BLBG: S5INDM - ITW, SWK, IR, PH, PNR, DOV, SNA, XYL, FLS.
Investors looking for a lower risk vehicle to participate in broad equity market strength than from chasing momentum driven areas with dubious fundamentals need look no further than the S&P rail index. Expectations have been crushed and valuations are on the cheap side of neutral. While rail freight is currently in a funk, leading indicators have perked up, particularly for the largest category, intermodal. The latter largely reflects the transportation of consumer goods. Thus, the surge in personal bank loans, strength in trucking tonnage and port traffic all bode well for a recovery in freight in the coming quarters. Against a backdrop of steep cost cutting, any stabilization in top-line performance should have an immediate positive impact on the bottom line. We upgraded to overweight in Monday's Weekly Report. The ticker symbols for the stocks in this index are: BLBG: S5RAIL: CSX, KSU, NSC, UNP.
It is dangerous to equate recent equity strength with economic vitality, as history shows that liquidity-fueled equity advances favor non-cyclicals over deep cyclicals. Take profits in gold, buy rails and sell industrial machinery.