What Trump's Election Means for Industrials
Defense is likely to be the clearest beneficiary, with a mixed impact for other sectors.
It’s challenging to predict what will happen following the election of Donald Trump as president of the United States, because he may lack the full support of the Republican Congress and may refine his policies as his team gathers information from business and labor leaders, but we can say with confidence that the near-term cone of uncertainty surrounding the performance of many industrial stocks just increased. Trump’s anti-free-trade rhetoric and policy uncertainty has led to an initially weaker U.S. dollar, which combined with talk of infrastructure spending and tax cuts seems to be pushing inflation expectations upward. This could result in U.S.-based manufacturers being more globally competitive against Japanese and European peers. However, increased inflation, expanding debt costs, and the erection of trade barriers could offset enhanced competitiveness through higher costs and faltering global demand.
Across our industrial coverage, U.S. and European defense contractors stand out as winners, while our outlook for other sectors is more mixed. We’re concerned about the impact of slowing trade and air travel hitting transports, aerospace manufacturers, and airlines. While we think the Trans-Pacific Partnership would be a net positive for Japanese automakers, we see the future of U.S. trade policies with Mexico as the key development for U.S. auto names. Heavy-equipment firms, which like automakers are oriented to global markets, should benefit from a weaker dollar, but the prospect of higher debt costs could hurt their financing businesses. For homebuilders, we think the election outcome may actually spur increased consumer confidence for some Americans, and this could provide a housing tailwind. Finally, we don’t see much of an impact on the industrial gas companies we cover; engineering and construction firms might benefit from greater infrastructure spending, an intention Trump highlighted in his acceptance speech, but we take a cautious stance on real increases.
Defense Is the Sector Most Directly Affected
All the U.S. defense companies outperformed the market Nov 9. We think the reduced possibility of a lengthy continuing resolution, the potential for near-term increases in defense spending, and a flight to safety drove these stocks higher as opposed to the potential for significantly faster long-term growth in U.S. defense spending. Earlier this year, we assessed four variables as key drivers for U.S. defense spending: the threat environment, the government’s fiscal health, the defense budget cycle, and politics. At the time, we posited that these factors were flashing green and that U.S. defense budgets were on the cusp of a sustained upturn regardless of the election. Nothing that has transpired since the election has changed this view.
Under a Trump administration, we do think defense budget growth will come in closer to our bull case, which envisions the total Department of Defense budget going above $650 billion in government fiscal year 2019. Moreover, near-term spending could move upward in the current government fiscal year 2017 as a result of an increase in overseas contingency operations funding. The prospect of a continuing resolution running well into next year has also been greatly reduced, and the resulting uncertainties surrounding defense funding and new program starts have also lessened, in our view.
From his policy speeches, we know that Trump advocates higher troop levels, more ships and submarines, and a greater number of fighter aircraft. Regarding specific programs, we think Trump will favor missile defense, where Lockheed Martin (LMT) and Raytheon (RTN) have significant exposure. Trump also appears to favor a robust modernization of the U.S. nuclear triad across programs like the B-21 bomber ( Northrop Grumman (NOC)), Columbus-class submarines ( General Dynamics (GD)), and Ground-Based Strategic Deterrent (to be competed).
We will get a more concrete view of Trump’s defense priorities when his administration issues its first budget request in February 2017, noting that the lead time required to build the DoD’s budget places limitations on the changes a new administration can realistically make. We plan to conduct an analysis of this request and the potential impact on our fair value estimates in the defense space. In addition to budgets and program priorities, Trump has criticized high-profile weapon systems, including the F-35, as largely unnecessary artifacts of special interests. This criticism combined with an already tough contracting environment--witness Lockheed’s recent F-35 pricing negotiations--suggests to us that investors’ positive knee-jerk reaction following the election might need to be tempered a bit.
Looking abroad, European and Asian allies may rethink their security arrangements with the U.S. under a Trump presidency. Trump has called for increases in defense spending from NATO countries and appears open to greater militarization across the Asia-Pacific region. We are convinced that our existing growth forecast for European defense budgets coupled with significant Asia-Pacific defense spending increases continues to be correct. These spending shifts should open more revenue growth opportunities for domestic defense contractors in Europe and Asia while also creating more international opportunities for U.S. firms. Unsurprisingly, European defense names like BAE Systems (BAESY) and Leonardo (LDO) (Finmeccanica) were up strongly following the U.S. election.
Global Trade Actions Could Ding Commercial Aerospace
Across the commercial aerospace sector, our outlook is a bit less sanguine than in defense. Shares of the two large commercial aircraft manufacturers, Boeing (BA) and Airbus (AIR), increased following the election. However, we’re a bit concerned that Trump’s tough trade rhetoric might translate into action and create headwinds for global trade and air travel demand. This could crimp new aircraft orders and potentially lead to deferrals or cancellations. Wide-body planes like the B787, B777, and A350, which were already facing a soft market, could suffer disproportionately, in our view.
In addition to these broader trends, Trump has criticized Boeing’s recently announced plans to open a Chinese 737 completion, and we think Boeing’s Chinese orders--China accounts for an estimated 20% of the company’s commercial aircraft backlog in units--may be vulnerable. While it would be nearly impossible for the Chinese to satisfy demand solely through more domestically produced C919 aircraft, we could envision a scenario where the Chinese react to tougher U.S. trade policies by funneling more narrow-body orders to Comac, China’s national champion, and favoring Airbus’ aircraft over Boeing’s. Plans to sell Boeing and Airbus aircraft to Iran--the European firm uses American content, which means it requires U.S. approval--will surely be subject to increased scrutiny. Boeing and Airbus Iran orders stand at about 100 aircraft each, including some much-needed 777 orders for Boeing. Aerospace suppliers we cover such as Spirit Aerosystems (SPR) (aerostructures), Safran (SAF) (engines), United Technologies (UTX) (systems and engines), Transdigm (TDG) (components), and Rockwell Collins (COL) (avionics) will probably be buffeted by the same winds as Boeing and Airbus should these risks materialize. However, given the recurring revenue streams they enjoy, aftermarket players like Transdigm and the engine manufacturers could exhibit more resiliency than the airframe and aerostructure producers.
Airlines also face the possibility of a more protectionist world with increasingly restrictive borders, which can curb air travel demand. Under such a scenario, passenger traffic, which has been running slightly above its historical growth rate recently, could fall below its long-term trend line. The International Air Transport Association recently forecast a downside case of 2.5% compound annual growth over the next 20 years versus a base case of 3.7%; the possibility of its downside case has increased. Given the capacity expansion ongoing across airlines coupled with fare weakness and the removal of the fuel price tailwind going into 2017, we think a Trump presidency only adds to an already long list of uncertainties for airline stocks. Legacy U.S. carriers like United (UAL), Delta (DAL), and American (AAL), which operate flights on lucrative international routes, could be disproportionately affected by international trade barriers, should these materialize. On the other hand, we think U.S. carrier complaints of unfair competitive practices from Middle Eastern airlines might find a more receptive ear from a Trump administration, which could help protect their international routes.
Mixed Bag for Diversified Industrials
Trading in U.S.-based diversified industrials has been mixed but trending positive as the market digests Trump’s plans to boost the domestic economy from within by easing corporate taxation and protecting American jobs, while keeping a watchful eye on global trade agreements. Given their longer-term competitive advantages that we believe will outlast a Trump presidency, we intend to keep wide-moat United Technologies and Emerson Electric (EMR) on our industrials Best Ideas list.
Companies like General Electric (GE), United Technologies, 3M (MMM), Emerson, and Parker Hannifin (PH) have deep-rooted, century-long histories as American employers, and such companies are likely to benefit if Trump’s policies support an industrial renaissance on U.S. soil. In addition, with Trump calling for corporate taxation reform, we envision the potential for corporate tax breaks to be awarded to companies that invest in U.S.-based manufacturing capacity and research and development. We call out Ametek (AME), 3M, and Roper Technologies (ROP) as companies whose 10-year effective tax rates (low 30s) average higher than peers (low to mid-20s). Fewer dollars flowing toward cash taxes will free up capital for these companies to reinvest in operations.
That said, over the past decade, most diversified industrials have relied heavily on selling capital goods outside the country to take advantage of above-average growth rates in developing economies. Companies such as GE, United Technologies, Honeywell (HON), and Emerson all derive more than half of sales outside the U.S. and have invested heavily in global operating footprints for decades in order to maximize labor, manufacturing, and supply chain efficiencies in support of these businesses. Moreover, protectionist trade policies could backfire as other countries reciprocate and enact tariffs on U.S.-made goods. Already, we’ve heard from companies like Emerson and Honeywell that China, with its burgeoning industrial landscape and growing middle class, prefers to buy from China first, Russia second, and the U.S. as a last resort. This could exacerbate the slowdown in sales that the U.S. industrial peer group has recently faced.
However, if Trump succeeds in revitalizing the American industrial economy, we see a derivative play in U.S. hazardous waste. US Ecology (ECOL) and Clean Harbors (CLH) in particular have suffered the ill effects of volume contraction due to weakening U.S. manufacturing activity and, most recently, the slowdown in U.S.-based oil and gas production. Should the industrial economy roar back to life, we expect both companies to benefit from more regular waste pickup from large manufacturing customers. This activity supports higher-quality, recurring revenue streams, as opposed to the unpredictable project-based work these companies have been relying on lately.
Transportation Could See Roadblocks
Trump’s potential protectionism implies some potential negatives for transports. We encourage investors to focus on fundamentals and the staggering barriers to entry many transports enjoy and use wild gyrations in sentiment as potential buying opportunities for high-quality companies. Given Trump’s criticism of the North American Free Trade Agreement and the TPP, his election has already caused declines across railroad names, especially those serving Mexico via NAFTA such as Kansas City Southern (KSU) and Union Pacific (UNP), as well as potential TPP beneficiaries FedEx (FDX) and UPS (UPS). Of more concern are the international freight forwarders we cover, which would see their top-line growth hindered if global trade declines. A minor winner could be trucking, should hours-of-service regulations be relaxed to prior standards under a more conservative administration, but we view this as even odds now and maintain our current margin expectations.
The small Class I railroad, Kansas City Southern, wins 40%-50% of its revenue from its Mexican operations year after year and benefits tremendously from cross-border trade between Mexico and the U.S. Already around 35% of revenue, cross-border freight is also the growth engine for the rail, via both intermodal containers and auto manufacturing. Autos would perhaps be most affected by Trump’s negotiations, and autos were about 10% of revenue for both KCS and Union Pacific. KCS serves 11 auto plants in Mexico and more are under construction. Union Pacific actually has the greater Mexican exposure. It wins about 10% of its massive top line (we project $19.7 billion in 2016 versus KCS’ $2.3 billion total) hauling freight to and from Mexico, and much of this is auto parts, automobiles, grain, and food. In fact, half of UP’s auto carloads are from Mexico.
Turning to heavy equipment, a weaker dollar would be a positive for sales and for operating margins at all the heavy equipment manufacturers and the industrial distributors that largely serve them. The possibility of increasing debt costs makes us concerned about the balance sheets at HD Supply (HDS) and some of the companies with big captive finance subsidiaries like Caterpillar (CAT) and Deere (DE), which will probably experience some net interest margin compression on existing and new loan receivables. Naturally, greater infrastructure investment would benefit Cat, because its equipment is used in building roads and bridges.
TPP Won’t Matter for Autos, but NAFTA Does
Many automotive stocks declined the morning after the election. We think selling for now is due to massive uncertainty regarding what Trump will do on a variety of policies, and we will not be changing our auto fair value estimates on indiscriminate selling until we have more clarity on specific policies. If Trump succeeds in his anti-free-trade agenda, then we’d assume prices on all vehicles would go up over time, even for Detroit Three vehicles, because they import their electronics content. We do not expect auto stocks to move a lot on TPP news. TPP would be favorable to Japanese automakers because the agreement allows them to source over half a vehicle from non-TPP nations, such as China, and sell it in the U.S. tariff-free. Should TPP fail to pass, it would be negative for Japanese automakers selling in the U.S., but regardless of trade agreements, firms must offer great product. Toyota TM has been making Tundra pickups in the U.S. for over a decade to avoid the 25% U.S. tariff on trucks, but that has not meaningfully hurt the Detroit Three’s dominance in the full-size pickup segment. TPP or no TPP, Japan is likely to remain effectively closed to American automakers, and the Japanese original-equipment manufacturers have a big share lead in many Southeast Asian markets that a trade agreement is unlikely to change.
In contrast to TPP, abolishing NAFTA would be bad for every major automaker because every major automaker uses Mexico, not only to import into the U.S. but also to export to Europe and South America. If production moves to the U.S. from Mexico this would increase production costs, which would decrease profits, hurt consumers who pay more for vehicles, and could make a dent in the U.S. automakers’ market share.
Policy Details Required for More-Certain Housing Outlook
In the months leading up to the election, housing data mostly remained quite strong, even though political and economic uncertainties typically hurt home sales. However, we have mixed thoughts on the near-term impact the election may have on housing. We think the related uncertainty and market volatility could damp near-term home sales. That said, per the Fannie Mae Home Purchase Sentiment Index survey conducted before the election, more than half of Americans surveyed believe the U.S. economy was headed in the wrong direction. We see the election results as a mandate for change in Washington and may spur increased confidence in some Americans, which could act as a tailwind for housing.
At this time, we are not materially updating our housing forecast; we will review the longer-term impact the election may have on housing fundamentals as more policy details emerge from the Trump administration. On one hand, we are optimistic that new economic policies will spur key drivers of housing demand, such as wage growth and consumer confidence. On the other hand, homebuilders are currently facing labor shortages, and we think this could be exacerbated by stricter immigration policies and increased national infrastructure spending, which would further increase demand for construction labor.
One modest positive of simply passing the event of the election is a reduction in uncertainty that many customers may feel before approving major capital projects. Because energy remains an important end market for the industrial gas and engineering and construction industries, a Trump administration that more strongly encourages domestic energy exploration would probably provide incremental benefits to both. In his acceptance speech, Trump emphasized infrastructure spending; while he may face challenges from his own party, and much of the highway bill has already been set for 2015-20, we do think engineering and construction names would benefit from a potential increase in infrastructure spending.
Trump is likely to push to lower nominal U.S. corporate income tax rates closer to levels in other advanced economies to dissuade companies from relocating overseas, shifting incremental investment there, or creating tax inversions. A Republican Congress may agree to reduce the tax avoidance motivation for firms to develop operations outside the U.S. Many industrials pay taxes in many jurisdictions, but the U.S. typically has the greatest statutory rate among developed nations. Reducing U.S. statutory rates would probably decrease cash taxes and increase value for most companies we cover, chiefly those with U.S. concentration, such as transports, waste haulers, industrial distributors, U.S. airlines, and homebuilders. Presently, we consider it too speculative to grant credit for this possibility.
All this is quite speculative, of course, given Trump’s vagaries and newness. Many industrials have performed well in terms of profitability during the past couple of years of reduced energy activity and a rail freight recession, but weak demand has challenged top-line and earnings expansion. We take this opportunity to highlight our current Best Ideas: Airbus, Alfa Laval (ALFA), Carpenter Technology (CRS), Emerson, Fiat (FCAU), General Motors (GM), Safran, Stericycle (SRCL), United Technologies, and Wesco International (WCC).
Keith Schoonmaker has a position in the following securities mentioned above: GM. Find out about Morningstar’s editorial policies.