2018 Year-End Letter, Part 3: Sectors: Financials and Industrials

In the following we highlight what we view to be the key fundamental considerations for the financials and industrials sectors (U.S.) going forward:

Financials:

Perhaps the best news going for the economy is the presently very healthy condition of the U.S. banking sector.

These highlights from Deloitte's 2019 outlook on the industry sum things up nicely:

The global banking system is not only bigger and more profitable but also more resilient than at any time in the last 10 years. According to The Banker’s Top 1000 World Banks Ranking for 2018, total assets reached $124 trillion, while return on assets (ROA) stood at 0.90 percent. Similarly, tier 1 capital ratio as a proportion of assets rose to 6.7 percent, significantly higher than in 2008.

Total assets in the United States reached a peak of $17.5 trillion. Capital levels are up as well, with average tier 1 capital ratio standing at 13.14 percent. Return on equity (ROE) for the industry is at a post-crisis high of 11.83 percent. Efficiency ratios also are at their best. Similarly, on other metrics, such as nonperforming loans and number of failed institutions, the US banking industry is robust.

There may be no better time than now to reimagine transformation. Economic fundamentals are stronger than at any time in the last decade. The regulatory climate is not going to get any more challenging. And, technologies to enable transformation are not only getting more powerful but also more readily accessible, easily implementable, and economical than before.

Indeed, there appears to be a new kind of promise in the banking industry.

Yet they remind banks that economies don't grow forever, and to not fall prey to the complacency that had them leading the way into the Great Recession of 2008:

We urge banks not to become complacent. The economic/credit cycle is bound to turn at some point. Use recent fortunes to invest wisely, and pursue change with clarity and conviction.

The only problem I have with Deloitte's assessment is with the following:

"Economic fundamentals are stronger than at any time in the last decade."

"The regulatory climate is not going to get any more challenging."

As for "economic fundamentals", while our assessment is that they're still decent (and, thus, supportive of both commercial and consumer banking services going forward), they're not nearly as strong as they were just a year ago. Of course, to view it in reverse -- as a healthy economy requires a healthy banking sector -- the present state of banking in the U.S. is supportive of commercial and consumer activity going forward.

And as for the regulatory climate not growing more challenging; while it may be true that any rollback of 2017's deregulating will be difficult at best, make no mistake, the new balance of power shakeup on Capitol Hill means that, at a minimum, the industry is about to face a stern rhetorical backlash.

As for financial sector stocks, they're -- to say the least -- attractive. 

The sector currently trades at 11.4 times next year's projected earnings and 1.9 times book value, making them -- per standard metrics -- by far the cheapest sector.

Bottom Line: The overall health of the sector, the still positive economic setup, still low interest rates (if the economy is indeed okay, rates will continue to inch higher, benefiting bank margins), efficiencies to be gained (read technology) going forward, and remarkably cheap valuations has us feeling comfortable with maintaining a top sector weighting for financials going forward.

Industrials:

If I had to pick what for me was the most frustrating sector to watch in 2018, industrials would vie for the top spot with materials. 

In last year's letter I cited infrastructure spending as my #1 reason for liking the sector. Here's what I wrote:

1. Infrastructure Spending: While much of the world is already heavily engaged in infrastructure investment, the U.S. looks to be just beginning. We were touting these prospects months before last year's election (when the ultimate outcome was not something we were anticipating), as the Democrats were pounding the table every bit as hard as, if not harder than, the Republicans on the need for infrastructure investment in the U.S.. Thus, passing an aggressive infrastructure spending package will likely be a relatively easy win for the Administration in 2018. 

As it turned out, while there was indeed talk within the White House about a massive infrastructure program, by the time August rolled around it became an after-midterm priority. Now it's a 2019 issue.

The good news regarding infrastructure going forward is that this one has been every bit as much, if not more, the Democrat's baby.

Here's a Reuters headline on November 7th:

Democrats to push for big infrastructure bill with 'real money' in 2019

That would be bullish for industrials!

My other 2018 frustration impacting industrials was of course the trade issues (I want to say with China, but you'd be hard pressed to find a single major trading partner with whom we didn't have an issue with at one point or another during the year). I expressed my concern in last year's letter:   emphasis mine...

6. Protectionism: Now, combine a potentially higher trending dollar with higher barriers to international trade (which has, thus far -- notable exception(s) aside -- been more rhetoric than realty) and we'll have a combination that could ultimately put our bullish thesis to the test.

Sadly, since then, the line between rhetoric and reality has been severely blurred! And boy did it every "put our bullish thesis to the test"!!

The good news, the bad news, and the potential good news for industrials: The good news for the sector is that, along with the overall healthy state of the U.S. economy, the odds of a major U.S. infrastructure program happening in 2019 are high. However, that by itself is in no way enough to counter the damage that a protracted trade war will inflict, if that's where we end up. In fact, such a scenario will -- I promise you -- not spare even the U.S. economy, which, therefore, would be very bad news across all of the cyclical sectors. 

Thankfully, the news around trade has improved markedly of late with regard to China. The next few weeks will be very telling as the two sit down for some serious negotiations. The most recent commentary from both sides suggests that the parties understand the severe macro risk to both if they can't come to a solution (and soon!). 

With regard to our relationship to the rest of the world, recent news isn't as constructive. As I type the Trans-Pacific Partnership (TPP) -- now titled the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (CPTPP) -- is now in effect. Originally the U.S. was the top dog in that arrangement. As it stands, in that removing the U.S. from the agreement was one of the President's very first strokes of the pen, we're out. In exiting the agreement the President promised that we'll end up with better bilateral agreements with all of our partners, which I suppose sounds interesting (not sure what it means in terms of U.S. leadership going forward), but we to this point haven't made much progress in that regard. Japan, however, has. While being one of the ultimately 11 beneficiaries of the CPTPP, Japan will also enjoy the fruits of a what has been deemed "the largest bilateral trade deal ever"  ; a huge tariff-eliminating agreement with the EU signed this summer.

Japan's Prime Minister Abe's comment below speaks to the risk to the U.S. of its own current stance on trade:

“The EU and Japan showed an undeterred determination to lead the world as flag-bearers for free trade”

At one point earlier in 2018 the President did mention that he'd be willing to join the CPTPP after renegotiating the terms; although I haven't heard anything since. I can tell you this, if indeed Washington could see its way to a friendlier dialogue with our trading partners, and to reestablishing the U.S. as the flag-bearer for global trade, the equity market (not to mention the economy) would -- across the board -- benefit exponentially.

In terms of valuation: Industrials presently trade at an attractive 14.9 times next year's earnings (the forward p/e was at 19.7 a year ago), and 4.2 times book (vs 4.8 a year ago).

Bottom Line: Given the still decent economic backdrop, the prospects for a U.S. infrastructure bill, the likelihood for improved trade sentiment (particularly with China) going forward, and attractive valuations, we'll maintain our 15% of equities target to the industrial sector, for the time being...

Our commentary on remaining sectors to follow...