This Sector Seems To Be Outperforming Everything Else So Far In 2019

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.

So what could be the downside to all that good news?  First, rising economic growth can result in higher energy costs, which would raise costs for the airlines directly and other industrial areas indirectly. Additionally, there’s the mix in Washington, where economic policies likely have helped to boost growth while also boosting the possibility of trade conflicts—with the Trump administration threatening to tear up NAFTA, while imposing tariffs on steel and aluminum imports, and warning that there may be more to come. With roughly 45% of the sector’s sales coming from overseas (according to data compiled by Strategas Research), trade disputes have the potential to cause a drag on the group. Also, the U.S. economy seems to be distancing itself from the global economy, which we believe has helped to boost the U.S. dollar, making U.S.-made goods more expensive for foreign buyers, and that also could negatively affect some of the industrial sector.

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.