These stalwarts look cheap, and they could benefit from a boost in business spending.
Economic cycles usually play out according to a loosely defined sequential cadence. The depth and duration of each cycle differ considerably over decades, but the sequence of when segments of the domestic economy (loosely defined as consumption, production, and investment) progress through each phase of the cycle is relatively consistent. As we digest second-quarter earnings and study the macro indicators, it's quite apparent that the production-centric section of economy, while still firmly in rebound mode, is bumping up against some headwinds, and that investment-centric names are just starting to heat up.
The Consumer is the Canary in the Coal Mine
Generally speaking, early signs of trouble in the U.S. economy typically show up at the consumer level. Comprising more than two-thirds of overall output, the spending behavior of consumers holds huge sway on the direction of GDP. Once the consumer goes south, production of any goods he or she is no longer buying quickly follows.
Added to the decline in consumption is usually an inventory reduction throughout the entire chain, as retailers, distributors, and everybody in between prepare for more difficult times by emptying their shelves and back rooms. This inventory effect assures that swings in production are much larger than movements in consumption. Though the offshoring of much production to low-cost overseas regions has dampened the effect, it hasn't eliminated it by any stretch.
Finally, as profits shrivel, managers' appetites for repairing or upgrading plants deteriorate such that overall business investment usually declines by an even greater magnitude than production. Yet, the lack of investment is a sure way to lose competitiveness, so when confidence recovers, investment usually returns with a vengeance. This dynamic makes capital spending by far the most volatile of the three segments described above. The same phenomena usually play out on the way up, as consumer spending bottoms first, and the other two categories follow suit in sequential fashion, with industrial production bottoming slightly before investment.
Looking Around, Thinking Ahead
Where, then, does the U.S. economy stand in the current cycle? What can we expect from diversified industrial names over the coming quarters? Though driven by a severe contraction in credit availability, the great recession of 2008 and 2009 generally played out according to script, albeit with some distortions due to the malaise in homebuilding. While consumer spending started to decline sequentially in the first quarter of 2008--just after industrial production began to slide in the fourth quarter of 2007--business investment (capital spending excluding residential structures) actually improved sequentially through the second quarter of 2008, only to plummet shortly thereafter. Personal consumption expenditures bottomed by the second quarter of 2009, at around 2.4% below peak levels, in inflation-adjusted terms. Industrial production also hit bottom during the second quarter of 2009, at nearly 15% below peak levels, while business investment bottomed at more than 20% below peak in the fourth quarter of 2009.
Though one wouldn't know it from various gloomy media accounts, real consumer spending as measured by the highly inclusive personal consumption expenditure figures--published by the government--is within a percentage point of its all-time high. The current 1.6% year-over-year growth rate isn't quite what we'd like to see, but consumer expenditures are, in fact, growing. Industrial production, on the other hand, sits roughly half way between its bottom and its 2007 high. Meanwhile, investment is only 5.5% above its 2009 low, and still about 17% below its recent highs.
The takeaway is that investors should expect names with significant exposure to investment-centric markets to post exceptional results. Anything related to business spending is likely to enjoy a material boost over the next several quarters.
But, we urge caution: The current prices of many diversified names already incorporate a rosy outlook.