Late February is always a prime opportunity for analysts to escape the cold Northeast weather as there are several industrial conferences held in Miami, Florida. While snow was pelting the New York area, the sentiment in Florida wasn’t much warmer as industrial companies remained cautious regarding trade and slower global growth. This is somewhat counter to investor enthusiasm surrounding the sector with the index up over 17% so far this year; well ahead of the broader market averages. At this point we believe talks alone are not enough to drive further outperformance in the sector given raised expectations. The group did get a boost during the conference as specific details were being reported on an outline of what the US-China trade deal could entail. Press reports have cited that negotiators are drawing up a memorandum of understanding on structural issues that include forced technology transfer and cyber theft, intellectual property rights, services, currency, agriculture and non-tariff barriers to trade. There also has been a discussion of the enforcement mechanism for the deal, which is crucial to its lasting success.
Also positive in a deal is that it is likely to include a commitment from China to purchase substantially more US goods such as agricultural and energy products to reduce their trade deficit. The deadline for higher tariffs on Chinese goods was set to kick in on 1 March, but has been delayed by President Trump given the recent progress towards a deal.
Companies at the conferences cited the US as still the strongest market with China slowing further exiting the fourth quarter. Europe is also becoming an increasing concern given the additional slowdown seen in the last few months and Brexit turmoil continuing. The Eurozone manufacturing PMI dropped to a 68-month low in February and is now in contraction territory. While the focus on tariffs has been primarily with China, companies are voicing increasing concern on the proposed auto tariffs that could go into effect on Europe as President Trump has threatened up to 25% tariffs on imported European autos and auto parts. Reports have also cited that the EU would target US companies with tariffs of their own in retaliation for the auto tariffs.
Expectations from most companies were for better earnings growth in the back-half of the year based on lessening margin headwinds, improved demand from a US-China trade deal and easier foreign currency comparisons. More companies have called out labor and transportation costs as a bigger near-term headwind that should lessen as supply chains adjust to current demand. Many suppliers were caught by surprise from better than expected demand in 2018 and have been hiring and training new employees to catch up. Several companies have been using air freight in the near term to get parts. which has been an expensive solution.
On an industry specific basis, the railroads, defense and aerospace companies sounded the most optimistic. Management's main focus at the railroads continues to be on precision scheduling railroading and rightsizing their network costs and fluidity. Rail volumes have been good, but many caution that some of it is a pull forward from trade and is likely to moderate. Defense companies are optimistic for an increased budget for fiscal 2020, given recent press reports, and we should see President Trump's initial budget in March. Investors, however, are still concerned that a lack of a budget agreement from Congress could increase the possibility of a sequester later this year. Aerospace demand also seemed to have good visibility through 2019 given strong backlogs at the OEMs and the likelihood of further production increases as the year progresses.
Machinery companies remained more cautious on average given their larger exposure to tariffs and China-led commodity demand. However, the recent stimulus moves from China and strong credit data have been a positive in that it has boosted commodity prices and ag prices. Finally, airlines had a somewhat weaker tone due to some government-related shutdown weakness and some moderation in prices, especially in Europe corridor. Airlines still see the environment relatively healthy with close-in booking activity doing well, so this recent weakness could be short-lived.
Author: Adam Scheiner, CFA, Industrial and Materials Analyst Americas, UBS Financial Services Inc. (UBS FS)
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