Paving the way for industrials and materials?

Commodity prices, late-cycle trends, and politics offer potential for defense and infrastructure spending.

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After a sluggish 2015, the industrials and materials sectors have bounced back this year on the strength of recovering commodity prices. The outlook remains strong, says Tobias Welo, manager of Fidelity® Select Industrials (FCYIX), in part because of the likelihood of increased funding for defense and infrastructure projects.

2015 was a challenging year for industrials and materials stocks. Where do the sectors stand today?

Welo: Both sectors underperformed the S&P 500 Index in 2015, hurt by negative earnings revisions that generally were created by a commodity recession. The drop in oil prices led the slump, but a continuing decline in mining and agriculture companies also contributed to it.

Industrials and materials have outperformed the market through October in 2016. Earnings revisions went from negative in 2015 to more or less unchanged this year, while commodity prices improved. For example, oil bottomed in January and February at less than $30 a barrel but now is pushing past $50. Many other commodity prices, including iron ore, coal and gold, have risen as well. Those improvements have essentially put a halt to downward earnings trends, and the affected stocks have outperformed expectations.

What could that mean for 2017?

Welo: I think the conditions are in place for industrials and materials to outperform the market in 2017, with earnings growth going from flat to positive. I expect commodity prices to continue coming off their troughs, which should help a lot of sub-industries in the industrials and materials sectors that are levered to the commodity cycle.

Commodity prices aren’t the only reason I’m pretty optimistic about next year. Another is the election. Both candidates have expressed a more hawkish view on defense than the current administration and appear more constructive toward infrastructure spending. So I think the implications appear favorable for industrials and materials stocks, regardless of the outcome of the election.

On the international front, China will hold elections in November 2017. That means we can expect a lot of government spending to make sure that everything in that economy is performing well. So I expect to see continued, relatively stable and solid growth in China over the next year or so, helping to maintain demand for industrials and materials companies products.

My optimism for industrials and materials comes at a time when the consumer side is slowing down a bit. This dynamic is typical of the late stages of the economic cycle, when the economy isn’t shrinking but is starting to grow more slowly. The consumer side of industrials and materials is powered by replacement cycles. There are a certain number of people who need to buy cars, air conditioners, refrigerators, and so on. Seven years into this recovery, most of them have taken care of those items.

You mentioned defense spending. What is your outlook for the defense industry?

Welo: Defense is a simple story to tell. This year, the United States had its first increase in defense spending since 2010. Going forward, I expect increased attention on defense spending due to a couple of reasons: terrorism, which has escalated over the last several years, and also increased geopolitical concerns about China and Russia.

More important for these stocks, spending is shifting from purchasing military consumables, like ammunition and missiles, to addressing basic equipment needs. The government has allowed equipment to age over the last 10 to 20 years and there is more of a focus now on modernizing equipment. For example, there’s the B-21 bomber, an $80 billion-plus project over 10 years won by Northrop; there’s a new ballistic submarine program with General Dynamics for $120 billion over 15 years; and a new nuclear weapons program should be forthcoming.

Defense spending usually never goes down a lot and never goes up a lot, but it’s a big number. We were flat to down 2% over the last several years, but over the next couple years we could be flat to up 3%. Changes in defense spending are like turning a battleship—it turns slowly, but it sure makes a difference. With numbers this large, small percentage increases have a big impact.

Which companies could benefit from higher defense spending?

Welo: Lockheed, Northrop, Raytheon, Boeing, and General Dynamics have historically been the prime players. Lockheed, Northrup and Raytheon are almost 100% defense, so they have tended to benefit disproportionately from a larger defense budget. Boeing, UTC, Honeywell, and General Dynamics are not pure plays, but they have a good portion of their business in defense—in the neighborhood of 20% or more. Then there are some mid‐cap players who may be suppliers to the prime companies. In total, the number of defense contractors is less than 20. So it’s a small universe, but it’s bigger than just the prime five.

What are the prospects for infrastructure spending?

Welo: The average age of infrastructure is at a record high in this country. Meanwhile, fixed-asset investment as a percentage of GDP is below the long-term trend line, and miles driven are at an all-time high. This combination means that we’re driving more on the same set of aging roads and bridges.

This situation could be setting up long, steady growth in infrastructure. The highway bill of 2005 was a five-year bill, worth about $57 billion of spending per year, and then we had a two-year bill at only $52 billion a year. Last year Congress approved a new five-year bill for $61 billion a year. That may sound like a small increase, but it will be very meaningful going forward. It’s similar to defense spending: The numbers are large, so relatively small increases over time can have a big impact.

Moreover, 28 states have increased infrastructure funding over the past two years, which comes on top of federal spending. And we’re seeing increasing political support for infrastructure funding, at both the state and federal levels. In the presidential election, both candidates have called for increases in infrastructure spending. So in either case, as long as these campaign promises translate to actions in office, we see potential for increased infrastructure spending in the coming years.

Is there anything that could derail defense and infrastructure spending in the short-term?

Welo: Public infrastructure usually does well later in the business cycle because public purse strings aren’t as tight as they are in the first years after a recession, especially at the state level. As you get later in the cycle, you have stronger tax receipts and the budget situation usually improves, so spending improves. That’s what we’re just starting to see.

These are big, long-cycle projects, and they will continue even if another slowdown hits. Once you’ve taken a bridge out, you have to put it back. The fact that we’ve got a five-year highway bill and a two-year defense bill the last couple of years is a big deal, especially because it came in an environment where there was a lot of political acrimony within Congress and also between Congress and the president.

I think the main risk in the longer run is Congressional stalemate. The economy may weaken, but multiyear funding is still set. So the fundamental question is about incremental funding, and the good news there is that the presidential election has teed up more focus on it.

Learn more

  • Tobias Welo manages Fidelity Select Materials Portfolio®(FSDPX), Fidelity Select Industrials Portfolio® (FCYIX), and Fidelity Select Defense and Aerospace Portfolio® (FSDAX).
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