• Wealth Management

Is It Time for Industrials to Shine?

The long-lagging sector could be on the verge of late cycle gains as production accelerates off recent depressed levels.

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With the stock market hovering around all-time peaks, it’s natural for investors to seek pockets of relative value. One of those pockets of value may be in the industrials sector.

With a 10-year return of 106%, industrials have long lagged other cyclical sectors, behind consumer discretionary, up 189%, and technology, up 161%. At 17.6 times fiscal 2018 earnings, industrials trade at a slight premium to technology and discount to consumer discretionary, while remaining in-line with the broader market.

A Constructive Setup

At a recent Morgan Stanley & Co. conference, management teams cited a number of factors which bode well for industrials including a strengthening mergers-and-acquisitions (M&A) pipeline, the 9% year-to-date decline in the U.S. dollar and a strong industrial demand backdrop globally, particularly in China. Subsectors that seem to be inflecting positively from these factors include aerospace, which benefits from robust global airline traffic, and trucking and logistics, which could see improved pricing due to a near-term reduction in capacity.

Another factor which could bolster industrials is the potential for a tax cut which could help domestically focused industrial companies and the possibility of an infrastructure bill, which could bolster investment in areas such as electrical and highway infrastructures. Additionally, any clarity regarding these proposals could spur more M&A activity in the sector.

The recent hurricanes are also likely to trigger a large rebuilding effort during the next 12 months, which should drive demand for industrial materials, logistics and machinery.

An Extended Acceleration

Recently, Morgan Stanley & Co. policy strategist Michael Zezas noted that a tax reform bill could be delayed until the first half of next year. If so, it could serve to extend recent industrial acceleration by providing a lift just as the impact from hurricane related construction and the weak dollar start to fade.

Mike Wilson, Morgan Stanley & Co.’s chief U.S. equity strategist, is overweight industrials as he calls for a late-cycle, pro-cyclical rally. While industrials have given up much of their post-election gains, he notes that continued earnings acceleration—supported by an improving capital spending environment—provides a constructive background.

A Historical Precedent

History also suggests that it may be a good time for industrials. In late 2014, oil prices dropped some 60%, and industrials followed as production contracted sharply. The last time we saw a similar crash in oil that led to an industrial slowdown, but not a broader economic recession, was in 1985-1986, when crude fell 64%. Growth in industrial production bottomed in July 1985, at which point it accelerated into November 1987. If we align the troughs of industrial production in July 1985 and December 2015, it suggests accelerating industrial activity for at least the next six months.

 

History Suggests a Pickup in Industrial Production

Source: Bloomberg, Morgan Stanley Wealth Management as of Sept 25, 2017

Interestingly, when we review the industrial components in the Dow Jones Industrial Average from 1986, we find they averaged an approximate 20% return from a similar point post-trough in this expansion. Given the tailwinds and catalysts, we think industrials may be on the verge of a similar revaluation today as production accelerates off of depressed levels.

A word of caution: This historical analogy directly preceded the 1987 stock market crash. That said, given the current global synchronous economic recovery is supported by robust earnings growth, we don’t see the same market conditions today. We think this presents an opportunity to take advantage of a late cycle environment which has historically rewarded pro-cyclical sectors. With this backdrop, we think there are still significant gains to be had in industrials.

Note: This article first appeared in the October 2017 edition of “On the Markets,” a publication of the Global Investment Committee, which is available on request. For more information, talk with your Morgan Stanley Financial Advisor, or find one using the locator below.

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