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Industrial Machinery Stock Outlook - December 2017

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The cyclical nature of industrial machinery demand is benefiting from the synchronized global growth backdrop. The International Monetary Fund (IMF) recently raised its outlook for the global economy, with the financial institution anticipating the world economy to grow 3.6% in 2017. It expects 2.2% rise in advanced economies and 4.6% growth in emerging nations. Global output is projected to increase 3.7% in 2018, including 2% growth for advanced nations and 4.9% improvement for emerging countries.

We believe that continuous advancements in technologies applied in agriculture and mining industries keep demand strong for farming and mining machinery. Moreover, healthy growth in demand for packaged foods and beverages across nations, especially in emerging countries, are significantly increasing the use of highly sophisticated food processing and packaging equipment. Further, need for better infrastructure and residential and non-residential spaces require heavy construction machineries.

Machinery stocks are broadly grouped under Industrial Products, one of the 16 broad Zacks sectors. The sector has performed well, yielding a solid return of 18.3% year to date. This outpaces growth of 16.9% recorded by the S&P 500 and roughly 13.2% by the NYSE Composite.

Among the S&P 500 members, the top five industrial machinery gainers since the beginning of the year include Caterpillar, Inc. (CAT - Free Report) , Stanley Black & Decker, Inc. (SWK - Free Report) , Deere & Company (DE - Free Report) , Roper Technologies, Inc. (ROP - Free Report) and Rockwell Automation Inc. (ROK - Free Report) . The poor performers include Flowserve Corp. (FLS - Free Report) , Emerson Electric Co. (EMR - Free Report) and Eaton Corp., PLC (ETN - Free Report) .

Industrial Machinery: Description

Industrial production is one of the leading economic indicators for industrial machinery stocks. It measures the level of output of manufacturing, mining and utilities sectors in a country. A brief discussion on the machinery industry in different nations is given below.

The United States: The country’s industrial production increased2.9% year over year in October driven by impressive growth in mining, manufacturing and utilities output. In September, industrial production increased 1.6% year over year.

In addition, a few indicators point toward healthy operating conditions in the industry. Per the U.S. Census Bureau report,new orders for U.S.-manufactured machinery increased 6.4% in the first nine months of 2017 led by growth in orders for construction, mining, industrial, material handling and other machineries.

Also, the job market showed strength, with the recent data indicating 261,000 new job additions in October. Average of new job additions in the last three months was 162,000 (accounting for hurricane affects). The unemployment rate dropped 10 basis points (bps) to 4.1%. Also, the country’s GDP has advanced 3% in the July-September quarter.

We believe that implementation of the Trump government’s growth policies, especially the proposed $1 trillion spending on infrastructure improvement, will be a boon for industrial machinery stocks. Other tailwinds are the strengthening housing and commercial construction markets in the country. To continue supporting the growing economy, the Federal Reserve has hiked its interest rates twice this year while another one might be expected in December.

The IMF projects the U.S. economy to grow 2.2% in 2017 and 2.3% in 2018. These estimates represent increase of 10 bps from the previous projection for 2017 and 20 bps for 2018.

Japan: The country’s economy is struggling with internal issues including low investment levels, an aging population and huge public debt.Also, the consumption level has failed to revive to a satisfactory standard since it suffered from a 3% rise in national sales tax in April 2014.

However, strengthening exports driven by rise in automobile and electronic shipments have supported the country’s annualized GDP growth of 1.4% in the third quarter compared with the previous quarter. In addition, we believe that initiatives to improve wages are likely to spur domestic demand as well as steps to increase investments domestically might work in the country’s favor in the quarters ahead.

According to the report from Japan’s Cabinet Office, core machinery orders (an indicator of capital spending by companies in the next six to nine months)increased 4.7% in third-quarter 2017. However, the same is predicted to be quite different in the fourth quarter, with total machinery orders likely to decline 1.9%. Core orders are expected to fall 3.5%, orders from manufacturing clients will likely drop 9.4% and that from government clients might decline 3.3%.

The IMF increased its growth projection for the country by 20 bps to 1.5% for 2017 and by 10 bps to 0.7% for 2018.

China: China’s GDP grew 6.8% from the year-earlier period in the third quarter. However, this improvement was slightly below 6.9% registered in the previous quarter as a rise in retail sales and higher exports were partially offset by weak expansion in infrastructure investments.

The country’s industrial production improved 6.6% year over year in September on the back of improvement in manufacturing and utilities sectors, offset by weakness in the mining sector. Industrial production in October grew 6.2%.

For 2017, the Chinese government anticipates economy to grow roughly 6.5%. We believe that implementation of the government’s plan to spend more than $2 trillion for the development of infrastructure and transportation by 2020 will boost the economy and spur demand for industrial machinery.

The IMF projects the Chinese economy to grow 6.8% in 2017 and 6.5% in 2018, up roughly 10 bps from the respective previous estimates.

India: The country is currently witnessing the after-effects of some major reforms —demonetization and goods and services tax — implemented in the trailing 12 months. These economic decisions along with other strategies to make the country a prime manufacturing hub for all nations across the world are expected to drive its economic growth going forward.

A favorable domestic job market, low interest rates allowing easy accessibility to cheap loans, infrastructure investments, healthy export demand and better monsoon conditions are additional factors that can make the country a favorable investment destination.

The country’s industrial production decelerated to 3.8% in September 2017, having expanded 4.5% in the previous month. Production suffered from weakness in mining and electricity outputs. In the first half of fiscal 2017 (ended September), industrial production expanded 2.5% year over year.

According to the IMF, the country is projected to grow 6.7% in 2017 and 7.4% in 2018, down roughly 50 bps and 30 bps from the respective previous estimates.

Brazil: One of the major road blocks for the Brazilian economy are the political uncertainties which have gripped the nation, somewhat jeopardizing its growth opportunities. Corruption charges against its president are believed to be one of the reasons behind the country’s poor investment grade ratings. Moreover, low private investments, inadequate infrastructure and still a high unemployment rate of 12.4% are other major hurdles.

Partially negating the impact of these aspects, growth in export demand and efforts to implement a new pension reform targeting the curbing of public debt are currently strengthening hopes of a turnaround in the Brazilian economy. Also, falling inflation have prompted the countries’ Central Bank to ease interest rates. Notably, the interest rate has been lowered by 75 bps in October, this being its ninth consecutive rate cut since October 2016.

In addition, the country’s industrial production has been encouraging since the beginning of the year. Per the latest data, industrial production in September grew 2.6% from the year-ago comparable month.

The IMF expects the country’s output to grow 0.7% in 2017, reflecting a 40 bps increase from the previous forecast. Also, growth projection for 2018 has been increased by 20 bps to 1.5%.

Eurozone: The region, amidst all the political uncertainties, is showing slight improvement in export demand and labor markets. The region’s GDP has improved 2.5% year over year in third-quarter 2017 while industrial production has improved 3.3% year over year in September. The unemployment rate at September end was 8.9% versus 9% at the end of the previous month.

The region’s GDP when compared with the previous quarter inched up 0.6% versus 0.7% recorded in the second quarter. Industrial production, on a month-on-month basis, fell 0.6% in September.

The IMF increased output growth estimates by 20 bps both for 2017 and 2018 to 2.1% and 1.9%, respectively.

Sector and Industry Ranking

Of the 16 Zacks sector, Industrial Products is currently in the top 25%, holding the fourth position. The Zacks sectors comprise 265 industries that are ranked on the basis of earnings outlook of constituent companies in each industry. As a rule, we put our X industries (all 265 of them) into two groups: the top half (i.e., industries with the best average Zacks Rank) and the bottom half (the industries with the worst average Zacks Rank).

Over the last 10 years, using a one-week rebalance, the top half beat the bottom half by a factor of more than two to one. (To learn more visit: About Zacks Industry Rank)

The machinery industry comprises stocks that primarily deals with manufacturing and supplying farm equipment (currently such stocks collectively carry Zacks Industry Rankof 17), construction and mining equipment (ranked 5), industrial electronics (ranked 186), electrical products (ranked 115), thermal products (ranked 28), material handling products (ranked 28), printing equipment for industrial use (ranked 115), industrial tools and providing related services (ranked 20) and companies serving general industrial purposes are ranked 62.

Going by the Zacks rule, we see that machinery sub-industries, except for one, fall in the top half. These sub-industries can be of interest to investors seeking exposure in the machinery industry.

Performance and Earnings Trend of the Sector

Per the Zacks Earnings Trends report dated Nov 16, roughly 470 of S&P 500 companies reported results for the July-September quarter, with 72.3% beating earnings estimates and 66.5% surpassing revenue projections.

Of the Industrial Products stocks, roughly 95.8% reported results til Nov 16. Earnings grew 16.7% year over year, with roughly 65.2% companies beating estimates. Revenues improved 2.9%, with a sales beat of 69.6%.

In the quarter, the S&P 500 companies collectively are projected to deliver earnings growth of 6.5% and sales growth of 5.8%. Seeing the results so far and the favorable operating conditions, we believe that the overall performance of the Industrial Products sector will be encouraging. Earnings for industrial stocks are projected to grow 18.7% while sales to increase 4.5%.

Our Take

It will be interesting to watch the activities of companies, with at least $20 billion market capitalization, including Caterpillar, Inc., ABB Ltd. (ABB - Free Report) , Illinois Tool Works Inc. (ITW - Free Report) , Parker-Hannifin Corp. (PH - Free Report) , Ingersoll-Rand PLC (IR - Free Report) and Stanley Black & Decker, Inc.

In the S&P 500 group, a major machinery company is Caterpillar. It has a market capitalization of $82.7 billion and currently sports a Zacks Rank #1 (Strong Buy). In the next three to five years, the company’s earnings are predicted to grow 10.3%.

Earnings for Deere & Company are predicted to grow 8%. It currently has $48 billion market capitalization and Zacks Rank of #1.The company’s long-term growth prospects seem bright on the back of increasing population, rising living standards, investments in new products and expansion in unexplored geographies.

Internal requirements as well as export orders play a key role in determining the demand for industrial machineries in any country. We believe that efforts to improve trade relations across nations will be a boon for machinery companies. Also, increase in infrastructural investments, job creation and high consumer-end demand will help in accelerating growth.

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