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An ETF for a Stronger Manufacturing Sector

Slowly and steadily, industrial demand is continuing unabated, both in the U.S. and, surprisingly, in Europe.

Robert Goldsborough, 12/27/2013

Morningstar's Take
The United States industrials sector continues to benefit from a slow and steady expansion. In November 2013, the manufacturing ISM report showed growing economic activity in the manufacturing sector for the sixth consecutive month, with across-the-board strength. The headline number is the manufacturing Purchasing Managers' Index number, which hit 57.3 in November, a gain from October's reading of 56.4 and its highest level in the past year. (Any reading above 50 indicates that the manufacturing economy is generally expanding.) And over the past 12 months, the PMI figure has been above 50 for all but one month.

We would caution investors from taking too much away from any one-month (or even two-month) reading. The reason is that if the 57.3 PMI for November is annualized, it would correspond to a 4.7% increase in real GDP. That's a level at which few believe the U.S. economy is capable of growing anytime soon. However, even averaging monthly PMI figures across the past 12 months results in a robust reading of 53.4.

For investors interested in a diversified basket of U.S. industrials-sector companies, we recommend the exchange-traded fund Vanguard Industrials ETF VIS. The main subsectors covered in this fund are aerospace and defense firms, industrial conglomerates, industrial machinery companies, and manufacturers of construction and farming machinery and heavy trucks.

Many of VIS' holdings have significant sales outside of the U.S., giving this fund some exposure to global growth trends. At the same time, the U.S. industrials sector is exposed to a meaningful amount of cyclicality. That cyclicality, coupled with a narrow sector focus, make this fund more volatile than other, broader ETFs. Over the past five years, this fund's volatility of return has been 22.0% compared with 15.8% for the S&P 500. This above-average volatility is partly attributable to the industrial sector's cyclicality.

The ETF also has the lowest expense ratio of any large and liquid U.S. industrials ETF. It's suitable as a tactical investment, only for the satellite portion of a diversified portfolio.

Fundamental View
As indicated above, sentiment indicators remain high across the board in the industrials sector. Morningstar's equity analysts have noted that companies have adjusted nicely to the current growth environment and largely have been delivering healthy profitability. Despite the U.S. government shutdown, industrial demand--in the form of PMI numbers--has remained strong in the U.S. and, surprisingly, in Europe. In fact, Europe's PMI reading recently pushed over 50 for a sustained period, led by the British service sector. The recovery in Europe and the strength in the U.S. have been offset a bit by the impact of moderating Chinese growth on industrial companies.

Given their impact on the U.S. housing market, the specter of rising interest rates is a concern and is something that investors in industrials companies should watch closely.  Housing demand remains generally strong, but rising interest rates tempered demand in the summer of 2013, and a labor shortage further exacerbated matters, lengthening build times. That said, in late 2013, the housing sector has rebounded nicely, with strong growth in homebuilding permits (fueled in part by multiunit residential projects in the Sunbelt) and a battery of other rosy housing reports. Despite these strong results, it's worth noting that the homebuilding sector actually has meaningfully underperformed both the S&P 500 Index and this ETF in 2013, likely because investors are looking ahead and anticipating further rate increases. As a result, while interest rates may rise in 2014 as many are predicting, it's not certain that such increases would meaningfully hurt the housing industry. Depending upon the magnitude of interest-rate hikes, it's possible that those increases already have been priced in to companies' share prices.

Overall, Morningstar's equity analysts expect industrial production to continue to grow at a steady pace--likely in the low single digits--driven by conglomerates, housing, and auto production. Our analysts remain concerned about durable-goods orders and emerging markets. If nonresidential (commercial) construction finally turns a corner, we would expect later-cycle capital goods manufacturers held in this ETF such as Emerson Electric EMRCaterpillar CAT, and Parker Hannifin  PH to benefit. If the international picture strengthens, we would expect transport and logistics firms such as Expeditors EXPDC.H. Robinson CHRWUnited Parcel Service UPS, and FedEx FDX to benefit.

Robert Goldsborough is an ETF Analyst at Morningstar.
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