What Lies Ahead for the Industrials Sector?

Key Points:

• While storm clouds may be on the horizon, particularly in Europe, the bigger fallout has not yet reached the industrial sector.
• The knock-on effects of energy and the Russia-Ukraine conflict remain unclear and difficult to determine moving forward.
• Supply chain stability is generally improving, and post-pandemic normality is expected by 2023 in many sectors.
• Cautious optimism exists as a result of healthy balance sheets propped up by backlogs and unwavering demand.
• Price increases are expected to offset soaring costs and the impact of inflation.

Preparing for an economic future wrought with uncertainty is no easy feat. Yet, there is cautious optimism that - in some areas - the resilience of the industrial sector will counteract a gloomy economic outlook.

At RBC Capital Markets’ Global Industrials Conference, company executives from a cross-section of industries remained heavily focused on impacts from macro headwinds and spoke with investors on a range of topics from the impact of the European energy crisis and Russia’s invasion of Ukraine to the pace of supply chain recovery in a post-pandemic world.

Europe is weakening

Common consensus throughout the conference centered on the struggles in Europe. The combined Russia-Ukraine conflict, energy crisis and rapidly rising cost of living has turned Europe into a weaker geographic location - particularly for the industrials end market.

Energy is a key concern, as the real long-term impact of the crisis has not yet been felt. The issue is mostly out of companies’ control and could have serious implications for production and supply. Despite seeing little disruption so far this year, the risk clearly skews to the downside. Interestingly, US-based suppliers are set to see an upswing with less exposure to potential energy inflation and other cost pressures; the US continues to be perceived as a comparatively stable alternative.

While the conflict in Ukraine has caused significant disruption in energy and food production, it may offer potential upside to the defense sector in international sales in 2023-24. Combine this with expected increases in defense budgets and opportunities in aerospace for small, unmanned aircraft systems, and the sector could see additional gains.

Pricing power is a tale of two sides

Cost headwinds are expected to continue through 2023 across a broad spectrum of the industrials sector. Despite pockets of raw material deflation, rising energy costs, elevated logistics costs, and labor headwinds, should ensure that cost pressures remain elevated.

There are two sides to the coin as it relates to pricing impacts. On the one hand, commercial companies in areas like business services have aggressively raised pricing while maintaining high retention rates. Rising inflation and rising prices could set the stage for noteworthy margin expansion opportunities.

On the other hand, in areas such as homebuilding and building products, there is a mixed story. Builders are reducing prices and increasing incentives in some instances as they contend with a softening of demand, which makes price increases more challenging to introduce. Predicting how the markets will react to continued rising prices will be key to future industrial sector investment.

Is supply chain stabilization on the up?

There is a general trend towards supply chain improvement across multiple sectors right now, as the impacts of COVID-19 subsides and recovery continues. This loosening of supply chains is easing pressure and helping to rapidly balance inventory positions. It is possible that total normalization may arrive during 2023. In the defense space, for example, 70% of the suppliers indicated that supply chains were stable at Q2 2022 levels and 30% relayed slight improvements to delays.

Despite this, choppiness and instability remains and is causing production schedule disruption.  A lack of component parts is still acting as a gating factor to the rates of production of commercial aircraft, while supply chain headwinds such as freight and port constraints remain problematic. There is a trend toward stability, but expect downside pressure to continue into 2023 across some industries.

Defined by demand and resilience

Confidence in the future success of the industrial sector is reliant on factors impacting revenue generation. As a result of the pandemic, elevated inflation and supply chain complications, many companies are benefiting from record backlogs and strong pricing. Fulfilling existing orders is currently ensuring businesses face no income break.

Many in the industrial sector are facing an uncertain economic future from a relatively strong position. Healthy balance sheets, longer-term contracts and the pricing opportunities brought about by inflation are contributing to a modestly resilient outlook for the sector.Demand for industrial products and services is strong overall, but may waver in some instances. Pockets of weakness are springing up in Europe and China, while slow housing activity and a severe slowdown in builder orders must be considered. In contrast, commercial air travel continues to improve toward pre-pandemic levels, providing higher expectations for the aftermarket. For business services and electrical equipment, demand has remained solid or increased.

While the outlook for the industrial sector remains mixed, the overall takeaways from the conference revolved around demand resilience and supply chain improvement. Set that against a backdrop of market volatility and economic instability, and this makes the case for cautious optimism.