Industrials stocks held up better than feared during the second quarter earnings season despite overall growth and earnings guidance that was worse than expected. Going into the quarter we believed that management's guidance was largely too aggressive which would result in earnings misses and guidance cuts for the back half of this year (see our blog dated 12 July 2019, Entering a Confession Period). This has largely played out as expected, but it appears the growth slowdown has spread out to other areas such as discrete automation, upstream oil/gas, food and beverage, and short cycle industrials. Auto and electronics still remain the weakest verticals and saw no improvement during the quarter. The second quarter also exited on a low note with June the weakest month as cited from a majority of firms that reported and which necessitated the resetting of expectations for the rest 2019.

The big question currently is if this latest cut to earnings is enough. If the global economy continues to slow we would expect that this cut will not be the last. Furthermore, 2020 earnings expectations are also likely to be lowered based on the weaker growth now forecast for the second half of this year. All this adds up to a sector that should struggle to outperform given the slowing trends with valuations that are not significantly depressed. On a positive note, any visibility on a bottoming of economic trends in the US and abroad would be a significant benefit and likely lead to valuation expansion for the sector as a recovery is seen in the near-term. Under this scenario, the more cyclical areas of machinery, electrical equipment and cap goods would benefit the most. Any trade deal between the US and China would also be significant positive at this point, but the outlook is increasingly deteriorating on this front.

Trade tariff escalation is a material negative for the sector. President Trump's announcement of a 10% tariff on an additional USD 300 billion in additional exports starting 1 September from China marks an escalation in the over a year long trade battle between the US and China. Much of the disagreement in the talks appears to stem from China's unwillingness to make concessions in areas such as intellectual property protections from theft and forced transfer that the US views as necessary in any truce. China has also not gone ahead with the additional purchase of agricultural products that President Trump sees essential to any trade deal. As it increasingly appears that China is content with the current situation for now and is working on stimulus to improve their economy, that could make a trade truce more difficult to reach in the near term.

While industrials are less directly exposed to the additional tariffs (list 4) announced last week, they would be indirectly impacted by any slower economic growth. This is appearing more likely as the additional tariffs will hit consumer goods which could hurt the general economic cycle. Many companies in the sector have already attributed some of the recent sales slowdown to uncertainty caused by the accelerating tariffs. This has caused customers to hold lower levels of inventory than normal due to the lack of visibility on the trade structure going forward. Shifting supply chains are also having a near-term disruption on demand. We are concerned that the longer that the trade uncertainty drags on, it could begin to negatively impact capital spending and longer-cycle markets. Trade tensions are also on the rise with Europe as President Trump has threatened to impose tariffs on France as well as additional tariffs on European autos and auto parts.

Short cycle trends have not yet bottomed. Revenue organic growth during the quarter for the multi-industrials fell to 1%-2%; a pronounced slowdown from over 4% last quarter. It is also likely that 3Q growth will slow further given the sequentially decelerating growth throughout the quarter, weaker global PMIs and the continued currency headwind. Short cycle industries have been hit harder in areas of auto, machinery, semis/ electronics and distributors. This has caused some of the more cyclical exposed companies to guide to negative growth over the next quarter. Global stimulus could help stabilize and reverse the recent sector weakness, but it usually takes a few quarters to have an impact. As we are only two quarters into this slowing trend, we think it is likely still somewhat early to expect improving sales in the near term.

We see the strongest trends in the sector remaining in the aerospace and defense industries. Defense stocks finally rebounded on strong second quarter earnings as opposed to sell offs over the last few earnings reports. Top line growth for the group remains strong and accelerated for several companies with revenue growth of 7% for the group which ranked near the top of the sector for the quarter. Book to bill levels were strong at above 1, which should lead to further strong growth in coming quarters. We see the recent budget deal as favorable in that it should also take some uncertainty off the table for the next two years of avoiding any harmful sequesters or budget cuts.

Aerospace also remains the standout in the sector as revenues continue to be boosted by strong after market activity that has more than offset the grounding of the 737 Max. This helped exposed companies raise estimates for this year which was counter to most of the sector. Organic growth was a standout at over 9%-11% for the average aerospace company. Demand for air travel has remained strong, which should bode well for the industry over the medium-term. Airline companies also reported strong top line trends aided by the Max grounding and still strong global demand. However, the additional supply from the potential return of the Max to service over the next six months is a risk to airline ticket pricing in the near-term.

Author:

Adam Scheiner, CFA, Industrial and Materials Analyst Americas, UBS Financial Services Inc. (UBS FS)

This report has been prepared by UBS Financial Services Inc. (UBS FS). Please see important disclaimers and disclosures at the end of the document.

Appendix

UBS Chief Investment Office's ("CIO") investment views are prepared and published by the Global Wealth Management business of UBS Switzerland AG (regulated by FINMA in Switzerland) or its affiliates ("UBS"). The investment views have been prepared in accordance with legal requirements designed to promote the independence of investment research.

Generic investment research – Risk information:

This publication is for your information only and is not intended as an offer, or a solicitation of an offer, to buy or sell any investment or other specific product. The analysis contained herein does not constitute a personal recommendation or take into account the particular investment objectives, investment strategies, financial situation and needs of any specific recipient. It is based on numerous assumptions. Different assumptions could result in materially different results. Certain services and products are subject to legal restrictions and cannot be offered worldwide on an unrestricted basis and/or may not be eligible for sale to all investors. All information and opinions expressed in this document were obtained from sources believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to its accuracy or completeness (other than disclosures relating to UBS). All information and opinions as well as any forecasts, estimates and market prices indicated are current as of the date of this report, and are subject to change without notice. Opinions expressed herein may differ or be contrary to those expressed by other business areas or divisions of UBS as a result of using different assumptions and/or criteria. In no circumstances may this document or any of the information (including any forecast, value, index or other calculated amount ("Values")) be used for any of the following purposes (i) valuation or accounting purposes; (ii) to determine the amounts due or payable, the price or the value of any financial instrument or financial contract; or (iii) to measure the performance of any financial instrument including, without limitation, for the purpose of tracking the return or performance of any Value or of defining the asset allocation of portfolio or of computing performance fees. By receiving this document and the information you will be deemed to represent and warrant to UBS that you will not use this document or otherwise rely on any of the information for any of the above purposes. UBS and any of its directors or employees may be entitled at any time to hold long or short positions in investment instruments referred to herein, carry out transactions involving relevant investment instruments in the capacity of principal or agent, or provide any other services or have officers, who serve as directors, either to/for the issuer, the investment instrument itself or to/for any company commercially or financially affiliated to such issuers. At any time, investment decisions (including whether to buy, sell or hold securities) made by UBS and its employees may differ from or be contrary to the opinions expressed in UBS research publications. Some investments may not be readily realizable since the market in the securities is illiquid and therefore valuing the investment and identifying the risk to which you are exposed may be difficult to quantify. UBS relies on information barriers to control the flow of information contained in one or more areas within UBS, into other areas, units, divisions or affiliates of UBS. Futures and options trading is not suitable for every investor as there is a substantial risk of loss, and losses in excess of an initial investment may occur. Past performance of an investment is no guarantee for its future performance. Additional information will be made available upon request. Some investments may be subject to sudden and large falls in value and on realization you may receive back less than you invested or may be required to pay more. Changes in foreign exchange rates may have an adverse effect on the price, value or income of an investment. The analyst(s) responsible for the preparation of this report may interact with trading desk personnel, sales personnel and other constituencies for the purpose of gathering, synthesizing and interpreting market information. Tax treatment depends on the individual circumstances and may be subject to change in the future. UBS does not provide legal or tax advice and makes no representations as to the tax treatment of assets or the investment returns thereon both in general or with reference to specific client's circumstances and needs. We are of necessity unable to take into account the particular investment objectives, financial situation and needs of our individual clients and we would recommend that you take financial and/or tax advice as to the implications (including tax) of investing in any of the products mentioned herein.

This material may not be reproduced or copies circulated without prior authority of UBS. Unless otherwise agreed in writing UBS expressly prohibits the distribution and transfer of this material to third parties for any reason. UBS accepts no liability whatsoever for any claims or lawsuits from any third parties arising from the use or distribution of this material. This report is for distribution only under such circumstances as may be permitted by applicable law. For information on the ways in which CIO manages conflicts and maintains independence of its investment views and publication offering, and research and rating methodologies, please visit www.ubs.com/research.

Additional information on the relevant authors of this publication and other CIO publication(s) referenced in this report; and copies of any past reports on this topic; are available upon request from your client advisor.

Important Information about Sustainable Investing Strategies: Incorporating environmental, social and governance (ESG) factors or Sustainable Investing considerations may inhibit the portfolio manager’s ability to participate in certain investment opportunities that otherwise would be consistent with its investment objective and other principal investment strategies. The returns on a portfolio consisting primarily of ESG or sustainable investments may be lower than a portfolio where such factors are not considered by the portfolio manager. Because sustainability criteria can exclude some investments, investors may not be able to take advantage of the same opportunities or market trends as investors that do not use such criteria. Companies may not necessarily meet high performance standards on all aspects of ESG or sustainable investing issues; there is also no guarantee that any company will meet expectations in connection with corporate responsibility, sustainability, and/or impact performance.

Distributed to US persons by UBS Financial Services Inc. or UBS Securities LLC, subsidiaries of UBS AG. UBS Switzerland AG, UBS Europe SE, UBS Bank, S.A., UBS Brasil Administradora de Valores Mobiliarios Ltda, UBS Asesores Mexico, S.A. de C.V., UBS Securities Japan Co., Ltd, UBS Wealth Management Israel Ltd and UBS Menkul Degerler AS are affiliates of UBS AG. UBS Financial Services Incorporated of Puerto Rico is a subsidiary of UBS Financial Services Inc. UBS Financial Services Inc. accepts responsibility for the content of a report prepared by a non-US affiliate when it distributes reports to US persons. All transactions by a US person in the securities mentioned in this report should be effected through a US-registered broker dealer affiliated with UBS, and not through a non-US affiliate. The contents of this report have not been and will not be approved by any securities or investment authority in the United States or elsewhere. UBS Financial Services Inc. is not acting as a municipal advisor to any municipal entity or obligated person within the meaning of Section 15B of the Securities Exchange Act (the "Municipal Advisor Rule") and the opinions or views contained herein are not intended to be, and do not constitute, advice within the meaning of the Municipal Advisor Rule.

External Asset Managers / External Financial Consultants: In case this research or publication is provided to an External Asset Manager or an External Financial Consultant, UBS expressly prohibits that it is redistributed by the External Asset Manager or the External Financial Consultant and is made available to their clients and/or third parties. For country disclosures, click here.