Machinery

This year's surge in the S&P industrial machinery index is in jeopardy of making a full reversal, because earnings follow-through is not forthcoming. Previous sources of industry support, such as aerospace and automotive demand, are eroding. That is evident in the inability of machinery orders to gain traction, even in countries that have experienced currency weakness. Machinery orders are contracting steeply in Japan and Korea, while German machinery demand is barely growing. It is doubtful that the U.S. can buck this trend, particularly if the U.S. dollar continues to appreciate. Without top-line improvement, factory activity will wane, further undermining machinery productivity growth and profitability. The S&P industrial machinery index remains a high-conviction underweight. The ticker symbols for the stocks in this index are: BLBG: S5INDM - ITW, SWK, IR, PH, FTV, DOV, PNR, XYL, SNA, FLS. bca.uses_in_2016_10_19_002_c1 bca.uses_in_2016_10_19_002_c1

Stocks are flirting with new highs, courtesy of a gradualist Fed and the reduced threat
of incremental near-term U.S. dollar strength.

A playable pair trade opportunity has emerged on the back of shifting capital spending patterns: long communications equipment/short machinery.

On Monday, we downgraded the S&P agricultural chemicals index owing to excess global food supplies, which threaten to dampen prices for a while longer. This also has negative ramifications for heavy equipment and agricultural equipment companies. To make matters worse, other end markets are in even worse shape. Resources companies have neither the financial wherewithal nor incentive to undertake expansion. Free cash flow has plunged in the mining and oil & gas industries, and balance sheets are saddled with debt. Meanwhile, global construction markets are coming off the boil, even prior to any increase in borrowing costs. Both residential and commercial real estate construction growth is decelerating rapidly, suggesting that oversupply has seeped into markets. The bottom line is that the earnings recession in heavy and ag equipment companies will stay intact. Please see Monday's Weekly Report for more details on our downgrade to underweight. The ticker symbols for the stocks in this index are: BLBG: S5CSTF - CAT, PCAR, CMI. bca.uses_in_2016_09_14_002_c1 bca.uses_in_2016_09_14_002_c1

Equities are celebrating domestic economic disappointment rather than re-pricing the risk of ongoing profit struggles. This reinforces that liquidity and share price momentum are still the dominant market forces.

Unlike rails, the S&P industrial machinery index has tested prior relative performance highs even though the global manufacturing sector is still laboring under excess capacity in Asia and weak commodity prices. Relative share price performance has already diverged wildly from oil prices, a rare occurrence, and a re-convergence is probable if profits fall short. While companies have cut inventories and staff to address productivity slippage, there is little top-line relief ahead. U.S. machinery new orders continue to contract and there is no help forthcoming from abroad. Non-U.S. developed economies are struggling. Capital spending is in retreat, based on the contraction in capital goods orders and capital goods imports. Our proxy for global machinery orders, excluding the U.S., is contracting. Consequently, there is little scope for a recovery in machinery output, which is necessary to lift utilization rates and allow the industry to sustainably escape deflation. We put this group on our high-conviction underweight list on Monday. The ticker symbols for the stocks in this index are: BLBG: S5INDM - ITW, SWK, IR, PH, PNR, DOV, SNA, XYL, FLS. bca.uses_in_2016_08_03_002_c1 bca.uses_in_2016_08_03_002_c1

It is dangerous to equate recent equity strength with economic vitality, as history shows that liquidity-fueled equity advances favor non-cyclicals over deep cyclicals. Take profits in gold, buy rails and sell industrial machinery.

Industrial machinery stocks have surged as if China is headed back to double-digit GDP growth and the U.S. dollar is going to reverse all of its recent year's gains. That combined scenario would produce a rebound in sales growth, and allow investors to bet on increased operating leverage. But that is wildly optimistic, especially given that the sales outlook remains murky. Our global machinery new order proxy is contracting. Global machinery exports have also gone ex-growth. Importantly, leading indicators of new orders are bearish. For instance, BCA's Global CapEx Indicator is heralding a contraction in developed country capital formation. That does not bode well for global output growth, and by extension, machinery consumption. Coal and other commodities also provide a good read for future industrial machinery demand. Clearly, coal is warning that machinery new orders will stay punk. Whiffs of reflation in China have supported other commodity prices, but it is premature to extrapolate this liquidity-driven bounce into a demand-driven upturn. Loan demand is still anemic, and machinery stocks have front run any improvement in China's cyclical outlook (bottom panel). Use the rally in the SP& industrial machinery index to downshift to an underweight position.The ticker symbols for the stocks in this index are: BLBG: S5INDM - ITW, SWK, IR, PH, PNR, DOV, SNA, XYL, FLS. bca.uses_in_2016_05_25_002_c1 bca.uses_in_2016_05_25_002_c1  

Fed hawkishness reinforces the need for an imminent profit recovery to justify current valuations. Our Indicators do not signal such an outcome. Stay defensive, and return to an underweight stance in the industrials sector.

There are a number of warning signs that the global and EM equity bounce is unsustainable. The latest episode of housing recovery in China will prove temporary due to still-large imbalances. Overweight Indian stocks: the credit cycle in India is less vulnerable compared to other EMs. However, the outlook for Indian equities in absolute terms is not bullish.