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Industry Outlook

We believe that during the Apr–Jun ‘16 quarter macro headwinds, including unfavorable foreign currency movements and weak economic conditions in some developed and developing nations, played spoilsport for many industrial stocks. However, the impacts of such adversities are believed to have ebbed compared with the previous quarter. Toward the end of the second quarter, the United Kingdom decided to exit the European Union, adding to the existing concerns in the global economy.

Per a Jul 2016 report, the International Monetary Fund (“IMF”) has lowered its world economic outlook by 0.1% for both 2016 and 2017 to 3.1% and 3.4%, respectively. Economic growth forecasts for advanced economies have been lowered by 0.1% for 2016 and by 0.2% for 2017, while the same for the emerging economies remained unchanged.

Industrial Machinery—Nation-wise Description

One of the leading economic indicators for the industrial stocks is industrial production, which 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 in the second quarter fell roughly 1% year over year, while easing to a decline of 0.5% in July. The initial month of the third quarter recorded growth in utilities and manufacturing output, offset by weak mining activities.       

Job market showed weakness in the second quarter, evident from an average jobs addition of 153,000 per month, down from 209,000 in the preceding quarter. In July, jobs addition was 255,000, while the unemployment rate was 4.9%. In addition, unfavorable foreign currency movements and economic uncertainties worldwide led to weak export demand for the U.S.-manufactured machinery.

According to the U.S. Census Bureau, export demands for U.S. machinery declined 5.7% year over year in the first half of 2016. A 12.4% decline was recorded in shipments of farm machinery; while construction and mining machinery saw 23.1% and 45.8% fall, respectively. The exception was a 4.2% increase in shipments of industrial machinery. New machinery orders were down 5.3%, while order backlog decreased 7.7%.

The IMF has reduced its growth projections for the U.S. economy by 20 basis points (bps) to 2.2% for 2016, while it reiterated 2.5% growth projection for 2017.

Japan: The country’s economy is struggling with internal issues including low investment levels, unfavorable exchange rates, aging population and a huge public debt. Also, consumption level has failed to revive to a satisfactory level since it suffered from a 3% rise in national sales tax in Apr 2015. In addition, the country is facing adversities of weak economic conditions externally.

According to the report from Japan’s Cabinet Office, core machinery orders fell nearly 9.2% in second-quarter 2016 as against growth of 6.7% in the previous quarter. The fall in core machinery orders has triggered concerns over the future of capital investments by companies.

Orders from manufacturing clients declined 13.4%, while the same from the government clients fell 13.3%. The agency predicts core machinery orders to grow 5.2% in third-quarter 2016, while total machinery order is expected to increase 4.3%.

The IMF lowered its growth projection for the country by 20 bps to 0.3% for 2016 while increasing it by 20 bps to 0.1% for 2017.

China: In second-quarter 2016, China’s GDP grew 1.8% sequentially, above 1.2% growth recorded in the previous quarter, while on a year-over-year basis, the same advanced 6.7%. Though the country is still struggling with capital outflows and forex issues, a slight improvement in infrastructure investment and higher oil prices have worked in the country’s favor.

In July, the country’s industrial production increased 6% year over year, slightly below 6.2% in June and flat compared with May. The increase was driven by an improvement in manufacturing and utilities sectors, offset by weakness in the mining sector. In July, the country’s exports decreased 4.4%, while imports dropped 12.5%.

The IMF projects the Chinese economy to grow by 6.6% in 2016, up 10 bps from the previous projection, while it expects 6.2% growth in 2017.

India:The country’sindustrial production in Jun 2016 increased 2.1% year over year. Expectations of a strong demand, improved policies and better monsoon conditions are factors that will influence the country’s growth, going forward. The government is making concerted efforts to turn the country into a prime manufacturing hub for all nations across the world.

Apart from boosting the foreign capital inflow in the country, these strategies will improve the domestic job markets as well as demand for industrial products. According to the IMF, the country is projected to grow 7.4% in both 2016 and 2017.

Brazil:For 2016, the country projects a gloomy outlookas a result of low private investments and inadequate infrastructure. The country’s unemployment rate increased to 11.3% in second-quarter 2016, up from 10.9% recorded in the quarter-ending Mar 2016. Also available data reveals that the country’s industrial production fell 6% year over year in June.

The IMF predicts the country’s output to decline by 3.3% in 2016, but improve to 0.5% in 2017. The recovery is dependent on foreign direct investments and expansion of industries like tourism, steel and electricity.

Eurozone: Industrial production in the Eurozone rose by 0.6% month over month in Jun 2016, while inched up 40 bps year over year. The unemployment rate was high at 10.1% in Jun 2016, but stable compared with the previous month.

The IMF predicts output growth in Euro Area to be 1.6% in 2016 and 1.4% in 2017.

Zacks Industry Rank

According to the Zacks Industry classification, Machinery is broadly grouped under Industrial Products, one of the 16 broad Zacks sectors. The Zacks sectors comprise 265 industries that are ranked on the basis of the earnings outlook of constituent companies in each industry. To learn more visit: About Zacks Industry Rank

As a rule, the top 50% of all Zacks industries outperform the bottom half by a wide margin. Going by this, industries with Zacks Industry Rank of 132 and lower would fall in the top half, while those with Zacks Industry Rank of 133 and higher would be in the bottom half.

The machinery industry is sub-divided into nine industries at the expanded level: machine tools and related products, construction and mining, electrical utilities, electrical, farm, general industries, material handling, print trading and thermal processing.

Earnings Trend of the Sector

As of Aug 19, all of industrial products stocks (accounting for 2% of the S&P 500 index’s total market capitalization) in the S&P 500 Group reported results for the Apr-Jun 2016 quarter, recording a decline of 1.5% in earnings and 5.6% in revenue.

Moreover, results of all S&P 500 companies released till Aug 19 showed a 3.2% fall in earnings with a meager 0.1% rise in revenues. With conditions unlikely to improve, earnings for the S&P 500 companies are projected to fall 3.1% and revenues to decrease by 0.4%.

Conclusion

We believe the prevalent uncertainties in the global economy will be a drag on the industrial sector. However, the much-needed relief might come from governmental policies inducing better trade relations, increased infrastructural investments, job creation and high consumer-end demand.  

Until such broader improvements materialize, stocks with high investment rankings might interest investors seeking exposure in the machinery industry. In the S&P 500 group, machinery company Illinois Tool Works Inc. (ITW - Free Report) , with a market capitalization of $42.5 billion, has strong earnings growth potential of roughly 8.8% over the next five years. Another industrial company, Avery Dennison Corporation (AVY - Free Report) -- with $6.9 billion market capitalization -- offers roughly 10% earnings growth potential. Both these stocks currently carry a Zacks Rank #2 (Buy).

Among the non-S&P 500 billion-dollar stocks in the machinery industry, Zebra Technologies Corp. (ZBRA - Free Report) sports a Zacks Rank #1 (Strong Buy) and offers 9% earnings growth potential over the next five years while Tennant Company (TNC - Free Report) , with a Zacks Rank #1, is expected to post earnings growth of 11%. EnerSys (ENS - Free Report) , with a Zacks Rank #2, is anticipated to have earnings growth of 13% over the next five years.