US industrials companies appear set to benefit from significant US infrastructure spending in the near term. Moreover, US domestic industrial activity may see a limited slowdown amid the war in Ukraine, whereas other countries need to grapple with sanctions on Russia and searching for alternative energy sources. In the longer term, European industrials could see higher demand for renewable energy installations and increasing energy efficiency in buildings, along with increased defense spending.
In the past few weeks, we have seen net outflows from European-domiciled sector ETFs, as heavy selling of financials (mainly European banks) has offset the buying of energy ETFs.1 That trend has slowed in recent days as investors explore other sectors. With sector return dispersion across three and six months at top-percentile levels, sectors remain effective tactical allocation tools.
Overall, investors seem satisfied with buying the US market in light of its relative isolation from the war in Ukraine and its broad economic strength. Within the US, we see a particular opportunity with industrials. The sector is highly correlated to the S&P 500, with a beta of more than 1, and may appeal to investors who want a targeted cyclical and value play on US equities.
So far in 2022, the US industrials sector has outperformed the S&P 500, with the gap widening since the Russian invasion of Ukraine.2
Industrials is a diverse sector, made up of many industry groupings (see Figure 1 for the breakdown of the US sector). The sector lacks any dominant mega cap names and no stock accounts for more than +/- 10% of index performance year to date. This relative lack of idiosyncratic stock risk is notable for investors considering the sector as a vehicle for accessing trends in demand, as detailed below.
Figure 1: Breakdown of US Industrials by Industry (%)
While we see a relatively attractive outlook for many of this sector’s industries, we should caution on the earnings outlook. Previous earnings upgrades for industrials have stalled (along with most sectors). We anticipate margin pressure from increased costs for steel, energy and other commodities, with manufacturers of building products or machinery potentially most affected. Fuel prices will hit airlines in particular. Meanwhile, supply-chain disruptions will push up prices further. The impact on company profits will depend on companies’ ability to pass these costs on.
Focus on aspects of demand
Despite the fear that the growth in economic activity witnessed worldwide in January and February may slow, as the impact of Russian sanctions and dented confidence feed through, we see numerous drivers for the industrials sector, including:
We expect a pick-up in capital expenditure across industries. Coming out of the Q4 results season, corporate cap ex expectations are high.
The US $1 trillion infrastructure bill laid out plans for improvements to roads, bridges, airports, waterways and power infrastructure nationwide, which would require services across the industrials sector.
There is an expected increase in defence spending in Europe (including Germany pledging to go to 2% of GDP). This could boost demand for helicopters, airlift capabilities and missile systems.
There could be an increase in demand for power generation and renewable energy transition projects as countries look to energy security in the future.
Elevated crop prices (led by disruption to wheat and corn from Ukraine and Russia) could extend the cycle and thus drive demand for agricultural machinery.
Demand may rise for mining machinery in response to metals pricing.
Following years of constrained capital expenditures, oil producers are likely to lift demand for drilling equipment, benefiting producers and associated transportation.
Shipping/logistics volumes and pricing are forecast to remain high.
US industrials for now, Europe for longer
US industrials companies appear set to be the direct beneficiaries of the significant US infrastructure spending over the next few years. Meanwhile, US domestic industrial activity may see limited slowdown, whereas other countries need to grapple with Russian sanctions and looking for alternative energy sources. For these reasons, we see the most immediate opportunity in the US industrials sector.
However, in the longer term, there is also an investment case for Europe industrials. Many of the quoted companies in this sector could benefit from higher demand for renewable energy installations and increasing energy efficiency in buildings, especially those companies supplying electrical equipment.
For investors who would like a more diversified approach, the world industrials sector broadens the exposure beyond the US (which accounts for 52% of the world market cap) and Europe (26%) to include Japan (14%), which is the second-largest single-country exposure in the index and offers a variety of well-known engineering companies.
How to access this theme
Investors looking to play the industrials theme can do so with SPDR ETFs. To learn more about these ETFs, and to view full performance histories, please click on the links below to visit their fund pages.
1 Source: Bloomberg Finance L.P., as of 16 March 2022.
2 Source: Bloomberg Finance L.P., as of 16 March 2022.
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