U.S. manufacturing is experiencing decelerating growth rates. That combined with trade conflict, falling automotive sales and surprisingly bad numbers from the purchasing managers index have investors feeling anxious about industrial stocks.
Things don’t look good now, but some on Wall Street think manufacturing will be growing again by the middle of 2020. That is good news, because the market is forward looking and will start to discount higher growth by year-end.
The Institute for Supply Management’s index, commonly known as the PMI, peaked about a year ago—coincidentally around the time the U.S. began implementing tariffs on Chinese goods. The recent 47.8 reading—indicating contraction and the worst since 2009—shook investor confidence further, catalyzing a sharp selloff to start the fourth quarter. The Dow Jones Industrial Average (.DJI) dropped 3.1% over the first two days of October, more than wiping out all second-quarter gains.
It isn’t just the U.S. PMI that is flagging. Global manufacturing weakness is showing up in many places, including at Japanese robot maker Yaskawa Electric (YASKF). The company reported results last week and cut sales guidance.
“We see no positives,” J.P. Morgan analyst Tomohiko Sano wrote in an Oct. 10 research report. “Yaskawa lowered guidance for the fiscal year—ending Feb 2020—and now expects sales to be down 12%—versus down 3% prior.” Yaskawa stock dropped 2.5% the day the company reported results.
Yaskawa generates about 20% of sales in China and sells many so-called short-cycle products—lower-priced, faster-moving products that provide investors a real-time look into the state of industrial demand. Tractors and backhoes from Caterpillar (CAT), on the other hand, are long-cycle products. Customers make one large purchase every few years.
The good news amid all the bad news is the length of the current manufacturing decline. Barclay’s analyst Julian Mitchell looked at historic industrial declines in a Saturday research report. “We are in the third quarter of the current short cycle downturn,” he said. “The average downturn historically lasted six quarters.” But Mitchell believes this downturn will last five quarters and the industrial economy will be growing again by the second quarter of 2020. He likens the current environment to the 2015/2016 industrial downturn. Back then, the U.S. PMI declined for about 15 months, or five quarters.
More growth isn’t the only recent positive for industrial stocks. “Events last week have de-risked [ S&P 500 ] cyclical sectors,” wrote Stifel head of institutional equity strategy Barry Bannister in a Monday research report. “President Trump gave into a mini-deal on trade—as China wanted—the Fed gave in to mini-QE (our term, not theirs).” Bannister thinks fiscal and monetary stimulus benefits cyclical stocks. His “mini-QE” refers to additional liquidity added to calm short-term funding markets.
Though Bannister is positive, risks to the overall economy remain. “We see one of two outcomes—another mid-cycle acceleration or further deceleration into ultimate recession,” Baird analyst Dave Manthey wrote following the Fastenal (FAST) earnings report on Friday. Shares of Fastenal—another short-cycle bellwether—jumped 17% after the company beat Wall Street estimates by 2 cents, a seemingly small amount. “A near perfect storm of better-than-feared [third-quarter] results and coincidentally positive trade headlines sent [the stock] soaring.” Manthey rates shares the equivalent of Hold with a $37 price target, 4% higher than recent levels. The economy keeps him cautious.
The debate about the direction industrial stocks will take for the balance of the year could be settled—for a few weeks, at least—after industrials report earnings over the coming weeks. Railroad CSX (CSX) and Union Pacific (UNP) report third-quarter numbers on Oct. 16 and 17, respectively. The following week, on Oct. 22, industrial conglomerate United Technologies (UTX) reports, followed by heavy-equipment maker Caterpillar on Oct. 23.
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