US Industrials

US Industrials Equity preferences Chief Investment Office GWM | 12 March 2021 2:07 pm EST Adam Scheiner, CFA, Industrial and Materials Analyst Americas, [email protected] Name Ticker Price Sector view: Moderately preferred Most Preferred In this report Boeing Co. BA 252.00 • Global manufacturing should continue to improve as we CSX Corp. CSX 93.82 move through 2021. Additional stimulus and effective vac- Delta Air Lines Inc. DAL 48.32 cines are critical factors in our outlook. Emerson Electric Co. EMR 91.31 Fortive Corp FTV 68.18 • We favor the aerospace and railroad industries along with Honeywell International Inc. HON 212.50 special situations within capital goods. Kansas City Southern KSU 214.86 • Railroads should see powerful earnings leverage from a Lockheed Martin Corp. LMT 339.73 return to growth. Parker-Hannifin PH 308.27 • Valuations for defense companies are attractive again, but Raytheon Technologies RTX 77.05 await direction from Washington. Stanley Black & Decker SWK 191.98 • Aerospace seeing a rebound that should accelerate with Union Pacific UNP 214.52 more vaccines available. United Airlines UAL 54.06 • Raw materials prices are a concern, but are being offset so United Parcel Service Inc. UPS 167.24 far. Bellwether List 3M Co. MMM 184.57 Strategy: Optimism surrounding the rollout of coronavirus (COV- Caterpillar Inc. CAT 219.76 ID-19) vaccines and a potential global economic rebound have Crane Co. CR 91.78 caused the industrials sector index to outperform the market year Cummins CMI 269.80 to date in 2021. The industrials index has posted a total return of Deere & Co. DE 364.46 7.8% versus 5.2% for the S&P 500 for the year to date through FedEx Corp. FDX 268.49 11 March 2021. General Dynamics Corp. GD 172.67 General Electric Co. GE 12.27 Our equity strategy team currently has a moderately preferred view Huntington Ingalls HII 189.91 on industrials. As economic activity begins to improve, we expect Johnson Controls JCI 61.09 to see a pickup in the manufacturing sentiment, which tends to Lennox International LII 292.62 be a positive driver for the sector. Overall we expect the industrial Norfolk Southern NSC 260.75 recovery to continue into 2021, but it should take some time before Republic Services Inc. RSG 95.20 we get activity back to pre-COVID 19 levels. Areas of potential con- Rockwell Automation, Inc ROK 264.25 cern are any delay in COVID-19 vaccines, higher raw materials, and Southwest Airlines LUV 58.47 global economic weakness. Trane Technologies TT 162.94 Source: Bloomberg, UBS as of 11 March 2021 Our positioning within the sector Our most preferred stocks reflect companies with a combination of Sector Benchmark: S&P Industrials exposure to improving end markets as well as favorable company- specific catalysts such as restructurings, acquisitions and new products. This report has been prepared by UBS Financial Services Inc. (UBS FS). Analyst certification and required disclosures begin on page 46. UBS does and seeks to do business with companies covered in its research reports. As a result, investors should be aware that the firm may have a conflict of interest that could affect the objectivity of this report. Investors should consider this report as only a single factor in making their investment decision. US Industrials | Equity preferences Our subsector preferences are currently Transportation at Most Pre- Fig 1: Industrial stocks have not followed the ferred with Capital Goods and Commercial & Professional Services at rebound in new orders Neutral. Our main industrial themes are e-commerce, energy efficien- cy, automation and restructuring/M&A. Capital Goods: Neutral Within capital goods, we favor select companies with favorable end markets and specific catalysts. We are more selective in the mul- ti-industry and machinery groups due to valuation, but see some attractive company-specific stories that should benefit from restructuring, M&A and superior product portfolio. We believe the aerospace industry still has positive long-term drivers, but will first have to deal Source: Bloomberg, UBS as of 1 March 2021 with the overhang of demand destruction in the wake of COVID-19. Transportation: Most Preferred Improving economic growth combined with renewed cost and profit discipline make this subsector attractive. Both the railroads and airlines are focusing on price versus market share, which should enhance underlying profitability. Precision railroading is having a major positive impact on margins and service efficiencies for the railroad group. Airlines should see a move towards normalization, but only after a successful COVID-19 vaccine is rollout globally. Freight transportation is likely to benefit from economic growth, but will have to manage the disruption in their business caused by the surge in e-commerce activity. Commercial and Professional Services: Neutral This small subsector includes a diverse set of mostly US-centric companies such as waste management, employment and data services. As a large number of companies in the sector are US focused they received a large benefit from corporate tax reform. The environmen- tal waste companies are attractive stories longer term, in our view, that should benefit from increased industrial activity as well as higher inflation. However, being still relatively early in the economic recovery may cause these stocks to be more market performers in the near term. The group would be more defensive in any economic pullback. Industrials environment should continue to improve with stimulus and successful vaccine Industrial stocks have begun to outperform the market again as we are getting closer to our two main catalysts of vaccines and stimulus. The recent approval of the Johnson and Johnson vaccine should continue to boost industrial stocks as investors begin to see the end of the pandemic and a return to more normal activity. While it could still take years for activity and travel fully return to pre-COVID levels, stocks tend to discount a recovery from the bottom much faster than fundamentals. For this reason, we believe airlines and the aerospace group are an attractive way to play this recovery at this time. Vaccines should also help drive rotation to the industrial group that has not kept up with new orders and fundamentals recently (Fig. 1). This catchup to fundamentals should also lead to moderate outperformance over the next six to nine months. CIO GWM 12 March 2021 2 US Industrials | Equity preferences The new order reading of the PMI has remained strong at 64.8 and Fig 2: Low inventories could trigger a restocking should lead to increased revenues in the months to come and is a good indicator of industrial stock performance in the near term. Any movement on an infrastructure stimulus bill would also be a boost for sector performance. Business inventories also now seem below normal relative to sales (Fig 2). This could set up a restocking impact to benefit industrial revenues if demand continues to improve in the months ahead. Further stimulus should help keep US PMIs in expansion territory. PMIs in the major economies still remain in healthy expansion Source: UBS, Bloomberg and ISM territory after their rebound last year from the COVID-19 pandemic. The US in particular remains at strong levels of over 60 on the ISM Index (Fig. 3). The high level of the US PMI is causing some peak Fig 3: Global Activity remains at growth levels fears of a near term pullback possible from high levels, but we believe reopening and stimulus should keep the economy firmly in expansion We remain optimistic on moderate outperformance for industrials given the stocks have lagged and already did not reflect the recent PMI surge as being sustainable. The Biden administration is making further stimulus a high priority with a USD 1.9 trillion dollar package just passing the House and Senate. Stimulus is vital as a bridge to a wide rollout of vaccines. As the economic conditions get back to more normal during 2021 we would expect price to earnings multiples to compress some- Source: Federal Reserve Board, Caixin Global, Factset and UBS what as is usually the case when moving later into a recovery. This should be offset though by continued strong earnings growth that we believe is likely to exceed expectations given accelerating revenues Fig 4: Sales growth should turn positive in 4Q and increased leverage from cost containment is an offset that should allow the group to moderately outperform in 2021. With sales and orders still having not yet turned to positive growth, we believe it is still early to call for a peak in the sector. We expect sales growth to turn positive for most of the sector in 1Q and accelerate thereafter on easy comps with last year's pandemic (Fig 4). Most companies noted that December was the strongest month of the year for orders with continued momentum into Janu- ary. We continue to prefer the transports and aerospace industries that have pulled back recently and select machinery companies that Source: UBS and company reports should rebound once we get better visibility on stimulus and vaccine roll-out in the months to come. This In the capital goods area we remain focused on companies with more self help In the capital goods area we remain focused on companies with more to aid growth. In this vein we like Parker self help to aid growth. In this vein we like Fortive (M&A), Stan- Hannifin (margin growth), Fortive ley Black and Decker (margins and M&A) and Emerson Electric (M&A), Stanley Black and Decker (margins and M&A) and Emerson Electric (restructuring and energy rebound). (restructuring and energy rebound).

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