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.
4. Competitiveness
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.
