Machinery & Industrials

Despite the significant equity market rally off the March lows, we still see a challenging global economic backdrop and a less than robust environment for the Machinery sector.

As foreign economies deal with weaker exports to the U.S and Europe, industrial customers are cutting back on capital spending. Equipment orders are decelerating in almost every end-market -- from machines used in construction, infrastructure, agriculture to base metal projects.

There are several data points that help to paint the picture of a sharply deteriorating global economic backdrop. Japan's core machine orders did rise 1.4% in February, but on a y-o-y basis orders were down 30.1%. Orders have fallen in 9 of the last 14 months. What's more, according to the cabinet office in Japan, overseas orders fell 22.9% in February.

While a manufacturing survey conducted by the cabinet office indicated core orders would rise 4.1% in the first quarter of 2009, we think this forecast may prove to be too optimistic. We would not be surprised to see core orders decline in each quarter of 2009. Also, in February, Japanese industrial production fell 9.4%. Exports fell 49.4%.

Also, according to the VDMA machine makers association, German plant and machinery orders fell a massive 49% in February compared to the same period a year ago, with export orders down 50% and domestic demand down 45%.  Given that February exports fell 23%, we were not surprised to see German industrial production decline 20.6% in February compared to same period of last year.

Germany was not alone. Italy saw February output decline 20.7% and Greece saw output decline 4.6%. In fact, the whole euro region saw January industrial production fall 17.3%.

The domestic picture appears to be no brighter. Total industrial production fell 1.4% in February, following a decline of 1.8% in January and a decline of 2.4% in December. If one only looks at manufacturing output, the picture is even worse, with a 0.7% monthly decline following declines of 2.7% and 2.9% in January and December, respectively. On a year-over-year basis, manufacturing output is down 13.1%.

Capacity Utilization also fell sharply in February, down to 70.9% from 71.9% in January for the overall index. A year ago, the country’s factories, power plants and mines were working at 80.7% of capacity, which is just about in line with the long-term average (1972-2008) of 80.9%. Even worse, capacity utilization for manufacturing dropped to 67.4% from 67.9% in January and from 78.5% a year ago.

When looking at the global macro backdrop for industrial production and machinery orders amid weaker U.S consumption, we expect a continued slowdown in capital spending.

OPPORTUNITIES

While the credit crunch and slower economic growth dampens private sector spending, fiscal expenditures appear ready to play a counter-cyclical role. China announced a rather large stimulus package in November. In early April, Japan proposed a $150 billion stimulus program, which if approved would equate to almost 3% of GDP.

Also, the U.S Congress passed a stimulus package that President Obama signed on Tuesday, February 17, 2009.  The bill contains money that will flow into infrastructure spending.  The only issue is the timeframe of the spending.  For example, according to CBO estimates, of the $27.5 billion in the budget for highway spending (Title XII - Transportation and Housing and Urban Development Highway Construction), $9.625 billion will be spent by the end of FY2010. This equates to 35% in the first two (FY) years and the remaining portion realized through the (FY) years 2011-2016.

Amid the current, global economic slowdown, there may be a silver lining. Central bankers have gone from raising interest rates and fighting inflation to slashing rates and flooding the system with liquidity. Specifically, the U.S Federal Reserve has engaged in quantitative easing.  Just recently, the FED announced it would spend over $1 trillion to buy mortgages-backed securities, agency debt, and Treasury securities.

In our view, these monetary conditions have helped to put a bid into commodity prices. We would become more constructive on commodity stocks, such as Freeport McMoRan (FCX - Analyst Report), on signs reflation measures were sustainable into 2010.

WEAKNESSES

We remain cautious on the U.S residential construction (& related) space. In our view, there is still too much existing and new home inventory to justify a new up-cycle in starts, which partially impacts the order flow of machinery companies that sell or lease equipment to the homebuilders.

On the demand side, the combination of a weaker U.S labor market and low consumer confidence readings does not appear to add to the pool of available homebuyers. On the subject of lower mortgage rates, we think it will lead to a greater amount of refinance activity than it will new home sales purchases.