The Fed shifts on inflation – What does it mean?
The Fed unveiled a revision to its monetary policy, allowing for higher inflation to help support the labor market. We believe this action could keep interest rates low for years.
During the past few months, U.S. industrials have dramatically underperformed compared to the overall market in a way not seen since the tech bubble. Historically, U.S. industrials have been steady when compared to the overall market because of the sectors diversity. This is compared to international industrials, which have fared slightly better when compared to the overall international markets.
What has caused the divergence between performance of domestic and international relative to their respective markets?
Trey: Broadly, the U.S. market is doing better and has recovered more quickly than international markets because of the technology sector’s dominance within the U.S. As a result, U.S. industrials have lagged the U.S. market, whereas international industrials are faring better since technology performance isn’t as large of a factor for industrial markets.
Additionally, aerospace and defense is a much larger weighting in the U.S. equity market versus international equity markets, and these are areas facing significant headwinds. Commercial aerospace is pricing in a more severe structural impairment from COVID-19 than any other area within industrials. Therefore, negative earnings revisions in the U.S. have been more substantial.
Lastly, international industrials are seen as a higher quality sector than the entire international market. International markets are physically much closer to the recovery in China, which has been staggering. Additionally, the European Union reopening from COVID-19-driven closures has gone more smoothly than in U.S., which has helped from a confidence perspective.
What is your view on maintaining exposure to industrials in the current environment?
Trey: We are most comfortable staying balanced within our industrials exposure. The sector is fairly diversified, so we don’t believe it is wise to chase a stock completely based on one trend or another, like an election, the COVID-19 pandemic or inflation.
That said, some important questions remain: Will people ever work from the office again? Will people travel like they used to? Will every manufacturer try to move its factories and supply chains to its own domestic market?
We believe these are issues that will have a material effect on the industrials sector. Although there will be changes, we believe many of this these issues will normalize.
Talk about the various subsectors within industrials and how they’re positioned within the current environment.
Aerospace: it has underperformed more than any of the industrial subsectors. Passenger air traffic was down 90% in May. However, we want to maintain exposure to this area. Pre-COVID-19, this is an area that had grown 1.5-2.0-times gross domestic product for decades. It’s amazing to see that 80% of the world’s population still hasn’t been on a plane. When things normalize, this is a space that won’t be completely left behind. Although some major aerospace players had issues not related to, there are a handful of companies in which we can get exposure to the recovery in aerospace without risking too much on one company’s specific problems.
Defense: this is a universe that has historically had good stocks with solid cash flows. However, we believe defense budgets may likely shrink regardless of who wins the U.S. presidential election. This is an area in which we have been reducing exposure for the past couple of years.
Multi-industrials and machinery: it includes more classically cyclical names. We continue to focus on names in which we can find long-term conviction regardless of near-term question marks. Nearly every end-market is in a cyclical trough. There are some names within electrical equipment that may benefit from recovery as well as secular move to electrification. Within HVAC, construction and mining and equipment, we’ve seen many of these companies operate much more efficiently than we have in the past.
Construction projects globally have recovered well since it bottomed out in April/May. Looking at hourly usage reports, activity has picked up to near Pre-COVID-19 levels. The bigger question boils down to whether there is enough of a backlog of projects or new projects, to replace the finished jobs in 2021. That said, we are positive on mining as it relates to construction companies. We’ve had a multi-year downturn with excess equipment, but we believe select construction companies with sizable mining exposure may benefit from rebound in commodity prices.
Past performance is no guarantee of future results. This information is not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through July 13, 2020, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This information is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.
Risk Factors: Investing involves risk and the potential to lose principal. Fixed-income securities are subject to interest rate risk and, as such, the value of such securities may fall as interest rates rise. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets.
The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. In addition, the impact of infectious illnesses in emerging market countries may be greater due to generally less established healthcare systems. Public health crises caused by the COVID-19 outbreak may exacerbate other pre-existing political, social and economic risks in certain countries or globally. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.