The U.S. industrial sector is an interesting creature. It is often outshone—or maybe “eclipsed” is the more appropriate word this week—by the other stars in the ferment of the stock market. The information technology, finance and consumer discretionary sectors all tend to get a lot of attention when the economy is doing well, as it is now.
But there are good reasons not to overlook the industrial sector. It’s true that the stars haven’t completely aligned for industrials—a lot of potentially beneficial policy issues remain unresolved—but the companies in this sector still have a lot going for them.
A diverse lot
The first thing to note about the industrial sector is that it is very diverse. It includes manufacturers and distributors of capital goods such as aerospace and defense, building products, electrical equipment and machinery. It also includes providers of services including construction, engineering, printing and transportation—that includes airlines, railroads, trucking and shipping.
In other words, it touches just virtually every part of the U.S. economy. Just think about it: Where would the ecommerce giants be without the shipping business? Or the automakers from the consumer discretionary sector without the without the heavy equipment makers? Or utilities without the generator makers? Or the military without the defense industry?
In that sense, it might seem like an investment in the industrial sector is a smart way to get all-in-one exposure to the economy’s operating system. Unfortunately, it’s not that clear cut.
The industrial sector is full of interesting paradoxes. The sector’s diversity can be a source of both strength and weakness, at least when it comes to making a definitive ruling about its prospects. Some businesses respond better to certain economic factors than others, and different kinds of industrial companies thrive at different points in the economic cycle.
“It can be difficult to get the entire group moving in the same direction, making it somewhat difficult for us to make an outperform or underperform call on the entire group,” says Brad Sorensen, managing director of Market and Sector Analysis for the Schwab Center for Financial Research. Even though past performance is no indication of future results, “according to Ned Davis Research, the industrial sector has historically benefitted from such things as better consumer confidence, rising oil prices and better commodity prices—some of which we’re seeing signs of as consumer confidence remains high and iron ore and copper prices have risen in recent months.”
Fuel prices have fallen from their recent peak, but this isn’t necessarily a problem. Whereas higher fuel prices have tended to aid the group in general, they can also raise costs for airlines and trucking companies.
So, given the potential for nuance in the industrials sector, how have these stocks been performing?
“The group received a jolt following the election on hopes that the Trump administration, with a Republican Congress, would be able to push through a major infrastructure package,” Brad says. “However, as hopes of near-term stimulus faded, the group has lost some enthusiasm and has traded just slightly below the overall market’s returns year to date.”
“But that market action tells us a lot about what kind of factors could push industrial performance forward—better economic growth translating into more spending on transportation, building, traveling, etc.,” he adds.
Increased infrastructure spending, of course, would be a big one. On the face of it, this might seem like an area for optimism, as both major political parties appear to agree on the need to invest more in the kind of infrastructure projects that would benefit the industrial sector. The rancor in Washington makes it difficult to be too optimistic though.
Other factors to consider:
- Help from overseas. The industrial sector gets roughly 45% of its sales from foreign sources, according to Standard & Poor’s.1 This could be a source of strength as global growth has shown signs of improving. Markit surveys have shown a continued expansion in manufacturing worldwide,2 and the Organization for Economic Cooperation and Development leading economic indicator has been rising.3 Meanwhile, the U.S. dollar’s recent decline could help boost the value of overseas earnings.
- Defense spending. Strategas Research has reported that defense spending is growing at its fastest pace since 2011,4 while the recent escalation in geopolitical tensions could facilitate even greater military spending, both here and abroad.
- Accommodative monetary policy. Excluding the Federal Reserve, which has been raising rates, central banks throughout much of the developed world are maintaining accommodative policies aimed at stimulating economic activity. Additionally, on the fiscal side, countries are considering undoing some of their more stringent austerity-related policies, which could help to boost economic activity and demand for industrial goods.
What to do
Overall, we believe it’s important to have some exposure to each of the 11 sectors in the S&P 500 Index, and to keep it within a reasonable range—say, a few percentage points—of the market weighting (about 10% for the industrial sector). Although the industrial sector’s prospects aren’t totally clear, we still think investors who haven’t already done so should bring their allocations up to the market weight in case the situation changes.
1Standard & Poor’s data as of 6/30/2017.
2Markit data as of 8/1/2017.
3OECD data as of 8/8/2017.
4Strategas Research data as of 8/2017.
What You Can Do Next
- Changing economic conditions can affect how each component of your portfolio performs. It’s impossible to predict which one will be the top performer in any given year—that’s why diversification is so important. Want to talk about your portfolio? Call our investment professionals at 800-355-2162.
Watch Schwab experts discuss other market and economic topics in the Schwab Market Snapshot.