In today’s Investment Policy Committee (IPC) meeting, we focused on the sector weightings in our portfolio. Industrial stocks were of particular interest. The industrial sector faces several headwinds at this time.
1. Interest Rates
How can low interest rates be a headwind? Our research shows that the relative performance of the Industrial sector is positively correlated to interest rates. The chart below shows this relationship.
As you can see, 10-Year Interest Rate Yield (blue line) and Industrials Index relative to S&P 500 (orange line) move closely together. This may not be immediately intuitive, but the relationship does make sense.
When interest rates rise, that generally means the economic outlook is improving. The Industrial sector is particularly sensitive to economic movements. Therefore, an increase in interest rates indicates an improving economy, which is positive for industrials.
We believe interest rates will remain muted. The industrial sector could underperform over the near-term, as a result.
2. Emerging markets
Many industrial companies have made huge investments in foreign economies, particularly emerging markets. The decline in oil prices has really put a hurt on several foreign nations, particularly Brazil. China’s economy has also slowed, which has not been favorable for the outlook of many industrials.
3. Energy prices
Low commodity prices represent another headwind. Oil prices do not directly impact industrials, however, many of them manufacture supplies for the energy producers. As the investment budgets for energy companies dry up, it means less demand for their suppliers. If oil prices remain low, the energy divisions of many industrials will also suffer.
Currency issues impact the industrial stocks in two ways:
1. Earnings translated back into U.S. dollars are worth 20% less than they were 6 months ago. The market can overlook that, as we will explain more in coming weeks.
2. Industrial companies who sell to foreign nations are much less competitive when the dollar strengthens. That hurts competitiveness of U.S. suppliers.
What does it mean for you?
We continue to like the industrial sector for the long-term, but these headwinds will not go away in the near-term. As a result, we have decided that it is prudent to cut back your exposure to the Industrial sector until these headwinds subside.