June Review: Still No Overall Reason To Get Excited, Plus A Quick Take on the ISM
The problem with a blog is that it is often unclear where opinion takes over and facts get left behind. As we start a more formal approach to an Industrials and Basic Industries blog, we have every intention of expressing opinion, but we will try to clearly identify occasions where our opinion is more of a view than an interpretation of the data.
Recently we have written about inventory and we have written about Europe and in our June monthly, published today, we have tried to bring it all together. But what we are really talking about is Industrials and Basic Material production rates, and whether levels that are discounted in earnings estimates and valuations are reasonable. Inventories and Europe are a couple of downside risks to production, but there are others – not least of which is the strength of the US economy itself.
The debate would not be as interesting or as important if the stocks were washed out and trading as if they anticipated weakness, but this is not the case. Valuations are high; in many cases they are discounting an expectation that already high returns are sustainable.
We are cautious because ultimately a large part of the argument comes down to consumer spending; whether it is housing, consumer durables or general retail. While consumer spending is growing in the developing world, it is stalled in the US and declining in Europe. The fixes discussed for Europe do not increase any near-term jobs and they do not put spending money into the hands of the average consumer. The NY Times on Saturday reported on the contraction in Italian consumer spending over the last few months – the story is similar in other countries and we have the added risk that near term spending stimuli go away (Euro 2012 and the 2012 Olympics). Anecdotally, commentators at both the Spain/Portugal and Spain/Italy soccer matches remarked on the limited number of fans at the grounds and empty seats in the stadium (these were the semi-finals and finals of the tournament). The tournament was in Poland and the Ukraine, and in our opinion a more limited number than would have been expected could afford it.
Consumer spending drives demand for basic materials and ultimately many industrial products and without strong, job focused stimulus in both Europe and the US it is hard to see how we get meaningful growth and how profitability in many basic industries remains high.
There is a lot of positive talk about operating leverage – “capacity is underutilized and so demand can grow without the need for more capital – driving strong returns”. Let’s take the other side of that argument for a minute – “operating rates are not high, and if demand falls or even falters, we could see competition step up as companies try to fill capacity”. This would drive pricing and margins down as it has many times in the past.
Valuation in the Basic Materials and Industrials space shows the spectrum of opinion. The Metals and Mining space is discounting the sort of demand slowdown and pricing weakness that we are worried about – so are Commodity Chemicals and Diversified Chemicals. Some parts of the Capital Goods space have seen significant valuation corrections in the last three months (the exception would be those focused on the Agriculture market). While we would argue that Capital Goods valuations have a long way to go to reflect the pessimism discounted in Metals and Commodity Chemicals, there are others that appear much more exposed. Electrical Equipment, Specialty Chemicals, Coatings and Paper are all pricing in a rosy future – much of it anticipating growth in sectors/regions to which the cheaper sectors are equally exposed, such as Europe and US Housing.
The exhibit below is fully explained in our research, but shows all of the sectors we cover except Agricultural Chemicals over-earning relative to history, but extreme variation in values. In theory the points should line up from top left to bottom right, and anything in the top right box is attractive, while sectors in the bottom left are unattractive.
Quick Take on the ISM:
- Overall number indicative of some of the demand weakness that we have discussed in recent research, both on inventories and on Europe.
- Some demand weakness and inventory will have been driven by lower pricing – partly because pricing direction will influence purchasing and forward orders.
- More concerning is customer inventories as in a period of declining prices you would expect customers to shed inventories in anticipation of lower prices later. Inventories rising at the customer level while commodity prices fall is a very concerning sign around consumer spending. Expect customer orders to fall further to reflect lower consumer demand and to get inventories under control.
- Production is down to control inventories and because demand is weaker.
- Inventories higher in June for Electrical Equipment, Machinery, Wood Products – all sectors that look expensive (machinery less so than the others).
- Overall exports fall, but higher in a number of sectors suggesting that both Chemical and Machinery exports were lower – Chemicals (ex-commodity) also looks expensive – big exposure to Europe.
ISM numbers support our more cautious view on manufacturing and demand for basic materials – see our June Monthly – published today.
Expect a more bearish stance from companies as they go through Q2 earnings and Q3/Q4 guidance.
Most exposed from a valuation perspective: