The industrials sector is leading second quarter growth, with a double digit growth rate of 13.0%. That’s not the headline many investors would expect given the weak operating environment – just this week, the ISM manufacturing index disappointed (though is still in expansionary territory) and construction spending declined for the third consecutive quarter. Oil prices moved into bear market territory and the first read on second quarter GDP was partly weighed down by a reduction in business spending on equipment (the third consecutive quarter of decline). Yet, the industrials sector has the largest beat rate for Q2 earnings and along with other cyclical sectors leads stock performance for the year after, of course, the outsized performance recorded by the high yielding telecommunications and utilities sectors.
It would be natural to assume the industrials beat rate is occurring because the bar was set low for a sector suffering from the weak macro environment. That was not the case as estimates since the start of the year were reduced by less than 70% of the index’s sectors and are now better than expectations were on January 1.
The aerospace and defense industry group dominates the upside surprises for industrials this quarter and even accounted for several guidance raises. We recognize that near-term the growth from industrials may not be sustainable as global growth and end market (oil and gas in particular) concerns are rational and understandable. However, we believe pockets of strength currently exist within aerospace and defense, building products, and industrial conglomerates.
Most importantly, it is our opinion that industrials should at least be on watch as we believe the 2017 earnings outlook could be underestimating the potential for cost cutting to benefit the group and for the upside inherent in any slight upturn in economic activity.