Assistant Portfolio Manager David Chung discusses how long-term themes affecting the industrials sector could be amplified as we face a changing economic environment.

Key Takeaways

  • Markets are adapting to the pressures of a changing environment marked by rising inflation, shifting fiscal and monetary policy and geopolitical tension heightened by the Russia/Ukraine war.
  • As a result, long-term trends affecting the industrials sector ‒ increased reliance on defense technology, the reorganization of supply chains, re-shoring and industrial automation ‒ have come into focus.
  • It is our belief that select themes not only remain intact but may also be amplified by the complexities shaping markets today.

The pressures of an environment in flux ‒ persistent inflation, shifting fiscal and monetary policy and evolving geopolitics ‒ have become front and center for markets this year, with significant economic consequences. The effects have been especially pronounced within the industrials sector.

The current state of the sector

Prior to the Russia/Ukraine war, labor supply, inflation and supply chain disruption were already impacting manufacturing in general. Absenteeism, a higher-than-normal quits rate and early retirements have plagued labor supply since the beginning of the pandemic, placing inflationary pressure on wages and, ultimately, prices for many goods. Ongoing COVID lockdowns, particularly in China, have had a significant impact on global supply chains as factories are shut down, constraining supplies. Component shortages continue, with semiconductor chips, which are used in an increasing array of goods, just now beginning to show some progress after a particularly troublesome streak.

The Russia/Ukraine war has added yet another level of disruption, with commodities prices spiking as the conflict chokes off supply and the West reconsiders its reliance on Russian raw materials. Some of the most visible areas have been in oil and natural gas, but Russia is also a major supplier of industrial metals such as nickel, steel and aluminium.

Companies have been affected as economies decouple from Russia, with auto suppliers and manufacturers as prime examples. Russian palladium is critical in the production of catalytic converters for automobiles and Ukraine is an important supplier of automotive wire harnesses. The auto industry is not only grappling with these supply chain effects and reduced production, but also with a general risk-off market environment. Recent dynamics have raised concerns that higher inflation and lower consumer confidence could reduce demand, and the industry may not benefit from positive trends such as the general waning of COVID and recovery in electronic component availability.

Companies may look to pass along any further cost increases to the consumer, but the question of how long inflation can persist before demand collapses remains. Excess savings and generally strong markets have positioned both consumers and corporations with strong balance sheets. There is some concern, though, that despite excess savings during the pandemic, we will start to see the limits of pricing, especially in competitive markets.

Seeds of optimism

Clearly, the Russia/Ukraine war has muddled an already complex economic situation. We are mindful that sanctions and destruction in the region could have lasting inflation implications. That said, the core industrial economy feels like it can muscle through expected Federal Reserve (Fed) tightening and the conflict in Ukraine, barring a serious escalation or nuclear situation. The most recent manufacturing output data (as measured by the Purchasing Managers’ Index) shows robust activity and respondents’ sentiments remain optimistic. Low inventory levels for capital goods require restocking, which should support demand.

We are also beginning to see some easing in raw material supply, and with respect to component shortages, many businesses are predicting improvement in the second half of 2022. Regarding labor supply constraints, many companies are now seeing the lowest employee absenteeism since last summer as the Omicron-variant wave has subsided. Recent COVID lockdowns in China may lead to further logistics and supply challenges but the driver shortage and hiring situation is improving. From an individual company level, though, management teams have generally been bullish on underlying demand trends in their respective businesses, despite acknowledging that the operating environment remains difficult.

Strengthening long-term themes

As we have written in the past, defense technology, automation and the reorganization of supply chains are central themes that can drive long-term growth for the industrials sector. The market developments taking shape now, which we believe will have long-lasting consequences, only serve to reinforce our belief in these themes.

For instance, the past quarter has certainly highlighted the importance of the defense industry. The proposed FY 2023 U.S. Department of Defense (DoD) budget is strong at $773 billion, representing a roughly a 4.1% increase from 2022. Amid ongoing debate, and with mid-term elections on the horizon, the defense budget could increase even further. At the same time, all indications point to increased demand from European Union states looking to bolster their defenses in the face of a more tangible threat from Russia. With COVID restrictions ending and DoD facilities reopening, select defense companies could begin to secure more contracts, which could lead to stronger outyear growth.

We believe that we are in the early innings of a sustained growth period for industrial automation. Structural wage inflation from qualified labor shortages and increasing labor costs will likely lead to more automation, particularly on factory floors. At the same time, geopolitical disruption has only served to accelerate companies’ push to solidify their supply chains and re-shore and near-shore manufacturing operations.

In conclusion, we are faced with a volatile environment being shaped by factors that will reach across the industrials sector. In our view, industrials companies with strong balance sheets and sustainable competitive advantages that are also connected to these strengthening themes may offer investors opportunities for long-term growth.

 

Monetary policy: The policies of a central bank, aimed at influencing the level of inflation and growth in an economy. It includes controlling interest rates and the supply of money.

Purchasing Managers’ Index: The Purchasing Managers' Index (PMI) is an early indicator of the economic health of the manufacturing sector within an economy. The index is based on five indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

Industrial industries can be significantly affected by general economic trends, changes in consumer sentiment, commodity prices, government regulation, import controls, and worldwide competition, and can be subject to liability for environmental damage and safety.

Volatility measures risk using the dispersion of returns for a given investment.