Treasury yields perked up last week, and contrary to what some investors believe, that’s a promising sign for stocks.
The rise suggests the economy is gathering momentum. Wage growth, inflation, manufacturing data, and consumer confidence are also showing signs of strength.
As a result, stockholders may want to rotate out of some of their defensive holdings, which have done well this year, and into cyclical names, say strategists at JPMorgan Chase. They recommend the capital goods, financial, auto, and semiconductor sectors.
Barron’s screened for promising companies in those sectors and found five with below-average valuations and healthy growth prospects: Caterpillar (CAT), KeyCorp (KEY), Parker-Hannifin (PH), BorgWarner (BWA), and Applied Materials (AMAT).
But what about the risk that rising bond yields will tempt shareholders to defect, causing stock valuations to contract?
Not to worry for now. The starting point for yields is so low that the correlation between stocks and bonds has been strongly negative. That is, as investors sell bonds, pushing their yields higher, stocks have tended to rise in response, as they did this past week, because rising yields are read as good news for the economy.
“We expect equities to significantly outperform bonds into year-end,” the JPMorgan strategists wrote last week, noting that the current state of bond yields bodes for a double-digit return for stocks over the next year.
The 10-year Treasury yield has risen to nearly 3.1% from under 2.9% at the end of August. That’s helping ease concerns that as the Federal Reserve raises short-term interest rates, long-dated yields won’t keep up, which can result in something called an inverted yield curve—often a sign that a recession is coming. The JPMorgan strategists contend that a better predictor of recessions is the effective federal funds rate, recently about 1.9%, minus the core inflation rate, 2.2% over the past year. The result is negative, -0.3 percentage points, suggesting that monetary policy is still much more carrot than stick.
If yields keep rising, they say, cyclical and financial stocks would benefit.
And that would be promising for Caterpillar. Barron’s recommended the stock during a two-and-a-half year rise to $161 from $77 before cooling on it early this year (Jan. 6, “With Caterpillar Soaring, It’s Time to Sell”). The stock recently fetched $156, even though earnings estimates have been rising.
One risk facing Caterpillar is that the company could be a fat political target in a trade war. But the business backdrop matters, too, and the company’s retail sales have grown for 18 consecutive months—including by 23% in August versus a year ago—after 51 months of declines. Caterpillar has been able to offset higher costs for steel and other materials with price increases. Equipment-expensing rules, meanwhile, have been sweetened under the tax cuts signed into law by President Donald Trump, providing a tailwind for orders through 2022.
Trade worries have left Caterpillar shares reasonably priced, at 12.5 times projected earnings over the next four quarters, versus a five-year average of 18.4 times. The dividend yield is 2.2%.
Shares of KeyCorp surged 5% this past week, an acknowledgment of how banks stand to benefit from a pickup in yields. A rise in long yields relative to short ones can help lending spreads, and healthy economic conditions bring robust demand for loans. That’s offset a bit by the effect of corporate tax cuts, which have allowed companies to pay off debt.
KeyCorp, whose banking footprint is spread across the West, Midwest and Northeast, expects about 3% loan growth this year, and it has plenty other avenues for growth. One is to continue cross-selling investment banking and commercial services to customers it picked up during a 2016 acquisition of First Niagara Bank.
Another is to reinvest securities from its own portfolio at rising rates; Deutsche Bank analyst Matt O’Connor notes that the company has $1.2 billion to $1.3 billion of securities rolling off each quarter at a blended yield of 2.1%, which can be reinvested at 3.3%. The stock’s dividend yield is 3.3%, after a 42% payment boost in July. Earnings per share are seen rising 27% this year, aided by tax cuts, and 11% next year. Shares trade at 12 times next year’s earnings forecast.
Parker-Hannifin makes filters, motors, pumps, valves, and much more. Its customer base is broadly scattered across industries including power generation, aerospace, commercial building, and mining. The company estimates the total market it goes after is worth $130 billion in yearly sales, which puts its market share at 11%. The goal is to increase earnings per share at 10% a year on revenue gains and margin improvements.
So far, so good: Operating margin has expanded to 13.7% from 11.3% over the past two years, and Wall Street is expecting that figure to top 15% in two years. There is reason to believe management has been too conservative with its financial guidance, says Barclays analyst Julian Mitchell, who initiated coverage of shares in September with an Overweight rating.
In Parker-Hannifin’s fourth fiscal quarter through June, revenue rose 9%, to a record $3.83 billion. But the company’s projected revenue for fiscal 2019 implies 2.3% to 5.1% growth. Either there’s a sharp slowdown coming—with few signs of one now—or that guidance could be a low hurdle.
BorgWarner makes turbochargers, clutches, transmissions and the like for gasoline- and diesel-burning vehicles, and electronics, motors, battery heaters, and other components for electric vehicles. In an investor day presentation last week, management outlined a plan to get to $14 billion in revenue by 2023, from $10.6 billion projected for this year, and noted that the dollar amount of its average content in electric vehicles is expected to be higher than that for combustion ones.
At the same time, the combustion-engine business continues to grow. Whether BorgWarner’s shift to electric vehicles will be a smooth one remains to be seen, but its shares appear priced for low expectations, at 10 times this year’s earnings forecast.
The market for computer memory has slumped, and now orders for equipment used in the manufacture of silicon equipment are dipping, too. Applied Materials says revenue for its October quarter is likely to come in at $3.85 billion to $4.15 billion, and the midpoint of that range implies an 11% decline from the previous quarter.
But barring a broad downturn in the economy, the chip slump looks likely to be shallow and short. Krish Sankar, a Cowen & Company analyst, predicts a rise in overall spending on wafer equipment next year. Last month, he upgraded Applied shares, now down 22% year-to-date, to Outperform from Market Perform.
One thing that will help Applied is a broad product portfolio encompassing memory, logic chips, displays, and more. Recent industry weakness has centered around memory. Another plus for investors weighing the stock is a low valuation. Shares trade at nine times forward earnings projections, versus an average of 14 times over the past five years. Sankar estimates that Applied shares could rise to $62 from just under $40 recently.
That’s based on earnings bottoming during the October quarter at just under $1, or a little below $4 annualized, and Applied deserving to trade at 15 to 16 times trough earnings.
Bond yields, of course, could eventually move high enough to give stocks more competition. But not right away: Goldman Sachs predicts the 10-year Treasury yield will rise only a few tenths of a point more by the end of next year.
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