Industrials

Resource Demand Elevates CAT Results Resource Demand Elevates CAT Results Overweight Caterpillar, the global trade bellwether, reported results yesterday that beat expectations despite sell-side pessimism that global softness had not been priced in to the stock. Of particular note was the resilience in resource demand that was the source of both revenue and profit outperformance as volume and price gains outweighed tariff-driven input cost increases and FX headwinds. The stock’s reaction to the earnings beat was muted as investors focused on management commentary that aggressive competition would result in market share losses in China. Nevertheless, the credit easing-driven rebound in Chinese construction/infrastructure spending growth should more than offset this headwind. We remain focused on the sector’s core performance drivers. The CRB raw industrials index, which moves in lockstep with the S&P CMHT index, has been ticking up recently and continues to positively diverge from the CMHT’s relative performance (second panel). In particular, the recent spike in energy prices will likely provide a robust lever for relative share prices as energy development projects take off (third panel). Bottom Line: Solid end-demand should deliver outsized profit gains while the still-outstanding catalyst from a positive resolution of the China/U.S. trade tussle stands to lift S&P CMHT share prices. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR.  

Airline Demand Is Soaring Airline Demand Is Soaring Overweight With a pickup in oil prices in general and jet fuel prices in particular, a logical inference would be a decline in airlines’ earnings power (second panel). However, the revenue side of the equation has proven much more resilient than anticipated, a result of industry discipline reflected in constrained capacity growth combined with elevated consumer confidence. The upshot is that consumers have been willing to part with greater shares of their wallets in order to fly (third panel). Much of this is reflected in Delta’s results yesterday. The company lifted their full-year guidance on the back of outstanding customer demand driving unit revenues higher, combined with single-digit capacity growth. While it is worth cautioning that DAL does not face the same 737 MAX grounding issues as peers LUV, UAL and AAL, we believe the exceptional fare environment is a tide that lifts all boats. Accordingly, we expect earnings in the S&P airlines index to continue to significantly outpace the broad market (bottom panel), particularly once the transitory 737 MAX grounding issue is resolved. Stay overweight. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, UAL, AAL and ALK.   ​​​​​​​

Rail Shipments Are Still Falling Rail Shipments Are Still Falling Underweight We downgraded the S&P railroads index to underweight last month based on falling rail traffic leading railroad pricing power down from its recent highs. Last week’s release of traffic data showed further deterioration in volumes, the fundamental driver of pricing power, confirming our bearish thesis. Only four of the 20 commodity categories tracked by the Association of American Railroads (AAR) saw volumes increase last month and virtually all of this was petroleum products which itself is likely only a temporary gain, owing to easing in pipeline bottlenecks later this year. Overall traffic fell a stunning 5.2% from the same period last year (third panel). The Cass Freight Shipments Index too has recently rolled over, a likely precursor to a fall in the Expenditures component of the index, and predicting that railroad pricing challenges are in the early stages (second panel). Meanwhile, sector leverage ratios are at their highest level in a decade as railroads have retooled their capital structure to increase buybacks at the expense of the balance sheet, adding a new level of risk to the industry (bottom panel). Bottom Line: Valuations in the S&P railroads index have overstated earnings power and understated equity risk premia; stay underweight. The ticker symbols for the stocks in this index are: BLBG: S5RAIL - UNP, CSX, NSC, KSU. ​​​​​​​

The Bottom Is Behind Construction Machinery The Bottom Is Behind Construction Machinery Overweight Caterpillar and, by virtue of its relative dominance, the S&P construction machinery & heavy truck (CMHT) index were at the front of the news cycle this week as an analyst downgraded CAT based on a belief that global growth had collapsed. The market largely ignored the report and both CAT and the S&P CMHT index have continued their outperformance since the late-October trough, when we reiterated our overweight recommendation in our Daily Sector Insight report titled “A Buying Opportunity In Construction Machinery”. The signals from the indicators we track imply that the “global growth collapse” is both late and overstated. The CRB raw industrials index, which moves in lockstep with the S&P CMHT index’s relative performance, unsurprisingly showed weakness at the end of 2018 but has since recovered (second panel). Further, the global credit impulse, an excellent leading indicator of relative profitability, has ticked up into positive territory after sending a weakening signal in 2018 and implies a resumption of profit outperformance (third panel). The combination of positive relative sales growth and still-tepid share price action has taken the relative valuation to levels not seen since the 2015-16 manufacturing recession (bottom panel), which marks an exceptionally affordable entry point, particularly for investors seeking to gain exposure to a China/U.S. trade tussle resolution. We continue to think such buying opportunities are rare and reiterate our overweight recommendation. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, CMI, PCAR.

Conglomerates Have Been Rerating Conglomerates Have Been Rerating Overweight (Downgrade Alert) Last fall we felt all of the shoes had dropped in the S&P industrial conglomerates index: industrial conglomerate stalwart GE had cut their dividend to a token to $0.01 per share following awful guidance and the other key constituent members, MMM and HON, noted tariffs and trade wars factoring heavily in their own respective guidance cuts. The market had moved to a deeply negative position with valuations at post-GFC lows which we took as a contrarily positive signal that sentiment had moved too far and we upgraded the index to overweight based on valuations. Our call was somewhat early; GE took another month to reach a 20-yr low. However, since then the index has been smartly outperforming the broad market as GE has surged nearly 50% from the bottom and our expectation of a rerating has largely panned out (second and bottom panels). Bottom Line: With a valuation rerating underway, our contrarian thesis is weakening and we are compelled to add a downgrade alert. We believe this heavily international index would be a key beneficiary of easing in the U.S./China trade tussle which we anticipate to be the catalyst to execute our downgrade alert. The ticker symbols for the stocks in this index are: BLBG: S5INDCX - GE, MMM, HON, ROP.  

A Rare Opportunity In Defense Stocks A Rare Opportunity In Defense Stocks Overweight Though the pure-play BCA defense index has retreated somewhat from the mid-2018 highs, our thesis remains solidly on the offensive. As a reminder, we have been overweight the pure-play BCA defense index since late-2015 and our strategy has been to add exposure on any meaningful pullbacks and keep this index as a structural overweight within the GICS1 S&P industrials index; we believe the current environment is an excellent opportunity to increase exposure. The timing of the current pullback is curious as it has occurred simultaneous to the rapid increase in defense outlays (second panel). Importantly, the CBO projects this level of spending to persist, even without a wartime buildup, as the upgrade of the military remains a core Trump administration policy goal. Considering the relative price of defense stocks is at roughly the same level as it was immediately before the 2016 election (top panel), little of this largesse appears to be priced in. The key offset to our bullish thesis was that valuations in the defense sector were high. However, that negative has evaporated along with the sector’s premium valuation since the beginning of 2019 (bottom panel). Accordingly, we reiterate our overweight recommendation. The ticker symbols for the stocks in the BCA defense index are: LMT, LLL, NOC, GD and RTN.