Industrial Machinery Stock Outlook - April 2018

Accelerating growth of the global economy, from 3.2% in 2016 to 3.7% in 2017, had been a propeller for many countries, both advanced and emerging, including the United States. Over the two years (2016-2017), the country's major stock indexes - S&P 500, Dow Jones Industrial Average and Nasdaq - have surged 30.8%, 41.9% and 37.9%, respectively. Its Gross Domestic Product (GDP) expanded roughly 1.5% in 2016 and 2.3% in 2017.

The International Monetary Fund's (IMF) growth projections are also encouraging. In its January 2018 report, the IMF predicted that the global output will expand 3.9% in both 2018 and 2019. The U.S. economy is projected to grow 2.7% in 2018 and 2.5% in 2019. These estimates reflect an improvement of 0.4% for 2018 and 0.6% for 2019 from its earlier growth forecasts.

Our in-house projections indicate roughly 18% growth in earnings and a 5.6% increase in revenues for the S&P 500 companies in 2018. The earnings projection compares favorably with a growth rate of 9.7% recorded in 2017.

We believe that advancement in the global economy and a strengthening domestic market will prove beneficial for demand of industrial machinery. Technological advancement in agriculture and mining industries will require upgraded farming and mining machineries, while growth in demand for packaged foods and beverages across nations will raise need for highly sophisticated food processing and packaging equipment. Further, the need for better infrastructure and residential and non-residential spaces will raise the demand for heavy construction machinery.

Industrial production is one of the leading economic indicators for industrial machinery stocks. It measures the level of output of manufacturing, mining and utilities sectors in a country. A brief discussion on the machinery industry in different nations is given below.

Industrial Machinery by Nation

The United States: Many factors are currently working in favor of industrial machinery companies here. Encouraging job data, with an unemployment rate of 4.1% in February versus 4.7% in the year-ago month, infrastructural improvement plans of the government and strengthening housing markets are some tailwinds.

Some other key economic indicators are pointing toward healthy operating conditions in the industry. The country's industrial production grew 4.4% year over year in February. This marked the highest increase on a year-over-year basis since March 2011. Mining sector expanded 9.7%, utilities 10.5% and manufacturing 2.5%.

Also, new orders for U.S.-manufactured machinery in January 2018 grew 11.4% year over year while the ISM Purchasing Managers' Index or manufacturing index for February expanded 1.7 percentage points from the previous month. The improvement in the ISM Purchasing Managers' Index suggests expanding economic activities in the manufacturing sector - the key highlights being healthier business conditions, favorable export orders and production, solid backlog and employment growth.

Also, the implementation of the Tax Cut and Jobs Act in December 2017 lowered taxes for many corporations, enabling them to invest the free resources in growth projects. However, the government's tariff imposition on import of steel and aluminum jolted the market somewhat, with fears of possible increase in competitive threats from international players, hike in production costs and retaliatory measures by affected nations.

Japan: The country's economy is still struggling with internal issues, including an aging population and a huge public debt.However, strengthening exports driven by a rise in automobile shipments, improvements in domestic demand induced by healthy growth in private investments and improving employment and wage rates will be beneficial. The country's GDP grew 1.5% year over year in the fourth quarter of 2017 while registering a 0.5% rise over the previous quarter.

According to the report from Japan's Cabinet Office, core machinery orders ( an indicator of capital spending by companies in the next six to nine months ) increased 8.2% in January 2018. However, this is predicted to decline 1.5% in the first quarter of 2018 while total machinery orders are predicted to fall 6.9%.

The IMF increased its growth projection for the country by 50 basis points (bps) to 1.2% for 2018 and by 10 bps to 0.9% for 2019.

China: China's GDP grew 6.8% year over year in the fourth quarter of 2017 while it expanded 6.9% in 2017, higher than the government's target of 6.5%. Healthy export demand, flexible property market and rising manufacturing activities were the prime growth drivers.

The country's industrial production improved 7.2% year over year in both January and February 2018. Electricity, gas and water production as well as manufacturing sectors flourished while the mining recovered during the period.

For 2018, the government of China anticipates economy to grow roughly 6.5%. We believe that robust investment for the development of infrastructure and transportation will boost the economy and spur demand for industrial machinery. Also, the country's efforts to lower its debt burden will be advantageous. However, the possibilities of a trade war with the United States, triggered by its imposition of tariffs on steel and aluminium, might be a concerning factor for the both the countries' trade relations.

The IMF projects economy of China to grow 6.6% in 2018 and 6.4% in 2019, up roughly 10 bps from the respective previous estimates.

India: The country's major economic decisions - including demonetization and goods and services tax - along with other strategies to make the country a prime manufacturing hub for all nations across the world are expected to drive its economic growth. Also, favorable domestic job market, low interest rates allowing easy accessibility to cheap loans, infrastructure investments, healthy export demand and better monsoon conditions are additional factors that can make the country a favorable investment destination.

The country's industrial production grew 7.5% year over year in January 2018 versus a 7.1% gain recorded in December. Manufacturing output expanded 8.7%, electricity production jumped 7.6% while mere 0.1% growth was registered in mining.

According to the IMF, the country is projected to grow 7.4% in 2018 and 7.8% in 2019.

Brazil: The country is grappling with uncertainties on the political front that has over time adversely affected the country's growth opportunities. General elections are due this October with high probability of abandoned initiatives to reform the country's pension system becoming a major topic of discussion. Moreover, inadequate infrastructure and a still high unemployment rate of 12.6% (in three months ended February 2018) are other major hurdles.

Partially negating these, growth in export demand, strengthening spending in the housing markets and rise in consumer confidence are currently strengthening hopes of a turnaround in the Brazilian economy. Also, falling inflation has prompted the country's Central Bank to ease interest rates. Notably, the interest rate has been lowered 25 bps in March 2018, this being its 10th consecutive rate cut since 2017. The country's GDP in 2017 grew 1% after 3.5% decline in both 2015 and 2016 and is predicted to grow 3% in 2018.

In addition, the country's industrial production has been encouraging, with year-over-year growth of 5.7% recorded for January 2018. This compares favorably with 4.5% growth in December 2017 and 4.7% in November 2017.

The IMF expects the country's output to grow 1.9% in 2018, reflecting a 40 bps increase from the previous forecast. Also, growth projections for 2019 have been increased 10 bps to 2.1%.

Eurozone: The region, amidst all the political uncertainties, is showing improvements in export demand and labor markets. The region's GDP improved 2.7% year over year in fourth-quarter 2017 while advanced 2.3% in 2017. Industrial production improved 2.7% year over year in January 2018.

The unemployment rate was 8.6% in January 2018, down from 9.6% in the year-ago month but stable compared with December.

The IMF raised output growth estimates by 30 bps both for 2018 and 2019 to 2.2% and 2%, respectively.

Sector and Industry Ranking

Industrial machinery stocks are broadly grouped under Industrial Products , one of the 16 broad Zacks sectors. It currently occupies the second position in the Zacks sectors list.

Of the 265 industries comprising the Zacks sectors, those in the top half (i.e., industries with the best average Zacks Rank) have higher chances of beating the bottom half (i.e., the industries with the worst average Zacks Rank). (To learn more visit: About Zacks Industry Rank )

We believe that investors keen on exposure to industrial machinery companies have reasons to rejoice. Machinery industries with their positions are as follows: electrical products is in the top 2% of the 265 industries while construction and mining equipment is in the top 6%, farm equipment in the top 36% and thermal products in the top 49%.

Also, companies dealing in electronics are in the top 15%, material handling products in the top 5%, industrial tools and providing related services is in the top 29% and companies serving general industrial purposes are in the 42%. However, companies dealing in printing equipment for industrial use are in the bottom half at 95%.

Performance and Earnings Trend of the Sector

In the past five years, the Industrial Products sector has yielded a solid 35.4% return.

In the fourth quarter of 2017, earnings of Industrial Products grew 34.8% year over year, while revenues improved 14.5%. The earnings and sales growth was above 19.6% growth in earnings and 4.8% rise in revenues in the third quarter.

Our in-house projections, published in the Earnings Trends report dated Mar 23, indicate roughly 19.6% growth in earnings and 8.2% increase in revenues of Industrial Products sector in 2018. Margins are likely to expand roughly 1%. Growth for earnings and margins is higher than 18.7% and 0.46%, respectively, recorded in 2017, while that for revenues is below 2017-figure of 12.9%.

In the next three to five years, earnings of the Industrial Products sector are projected to grow 10.7%.

Our Take

I nternal requirements as well as export orders play a key role in determining the demand for industrial machineries in any country. We believe that efforts to improve trade relations across nations will be a boon for machinery companies. Also, increase in infrastructural investments, job creation and high consumer-end demand will help in further accelerating growth.

It will be interesting to watch the activities of industrial machinery companies, with at least $20 billion market capitalization, including Caterpillar Inc. (CAT), ABB Ltd. (ABB), Illinois Tool Works Inc. (ITW), Deere & Company (DE), Parker-Hannifin Corp. (PH), Ingersoll-Rand PLC (IR) and Stanley Black & Decker, Inc. (SWK).

In the S&P 500 group, a major machinery company is Catected to grow 12%. Earnings of Deere & Company are predicted to rise 5.67%. The company's long-term growth prospects seem bright on the back of increasing population, rising living standards, investments in new products and expansion in unexplored geographies.Illinois Tool Works' earnings are projected to grow 10.10% in the next three to five years.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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