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The Outlook for Three Key Industries

Following recent turbulance, global equity markets are likely to remain volatile as the new year gets underway. U.S. economic growth and corporate earnings remain strong, but rising interest rates, political turmoil in Europe and rancorous trade negotiations with China have muddied the investment picture. With those crosscurrents in mind, three Capital Group analysts offer their thoughts on how the industries they cover might fare in 2019 and beyond.

Technology

Even the most promising industries run into headwinds eventually, and that’s been the case for technology companies lately. Surging earnings and a multiyear rally made tech seem impervious to outside forces. The fallacy of that perception became clear when embarrassing disclosures about the industry’s cavalier approach to safeguarding customers’ personal data led to heightened scrutiny and fear of new government regulation. The near-term outlook was clouded further as uncertainty about trade policies and the direction of the global economy threatened to dent companies’ prodigious growth rates.

Tech stocks may remain under pressure early in 2019 as investors wait for clarity on these issues, says Irfan Furniturewala, a Capital Group technology analyst. But the sector’s long-term prospects are as bright as ever, with the digital innovations that have ricocheted through society likely to continue. “As incredible as the creations to this point have been, we are just touching the surface in terms of what is possible,” Furniturewala insists.

His enthusiasm stems partly from the fact that the founders who launched many of today’s leading tech companies are still at the helm. Entrepreneurs have a unique vision and relentless drive that typical CEOs, for all their management skills, simply can’t match. Another positive factor, Furniturewala says, is the popularity of “app” stores, such as those run by Apple and Google. These electronic marketplaces make it possible for entrepreneurs with limited resources to cheaply distribute their products, allowing cutting-edge creations to find wide audiences and ensuring an ongoing pipeline of digital innovation.

“These are people who were previously excluded because they may not have had the right qualifications or couldn’t get their foot in the door of the right companies,” Furniturewala observes. “App stores provide a way for their creativity and entrepreneurial zest to be unleashed.”

In the near term, the biggest uncertainty for tech companies is the specter of regulation. It’s understandable that government oversight must catch up to the industry’s breakneck growth, and though any new rules are unlikely to be onerous, they may remain a temporary drag on the sector, Furniturewala says. Tech stocks could come under further pressure if the U.S. trade furor with China deepens or if the global economy loses significant traction.

On the bright side, valuations have declined as share prices have throttled back, making them attractive for investors with three- to five-year time horizons. “There is risk in the near term, but the industry’s long-run prospects are encouraging,” Furniturewala says.

Automation

One of the more notable trends of recent years has been the push by manufacturers to automate production lines to reduce costs and boost efficiency. This dynamic has been especially pronounced in China, where companies are eager to improve quality control and match the productivity of rivals in the U.S. and elsewhere.

This created significant demand for factory automation equipment such as advanced sensors and highly precise measuring devices. Many of these components are produced by a relative handful of Japanese companies whose share prices surged as global economic growth, coupled with unchecked enthusiasm for robotics and other futuristic technologies, caused order volumes to skyrocket. In some cases, equipment buyers loaded up on inventory well before the parts were needed for fear of shortages in the future.

However, this sector is highly sensitive to shifts in economic and market conditions, and factory automation stocks stumbled in 2018 as order volumes pulled back from their furious pace. Softer demand from Asia, particularly in troubled sectors such as auto production, and overall weakness in corporate capital expenditures contributed to the order slowdown.

“Twelve months ago, investors were euphoric, and now it’s been a complete 180-degree turn,” says Kohei Higashi, a Capital Group analyst who follows Japanese automation companies.

Nonetheless, the long-term outlook remains very positive, according to Higashi. China must invest heavily in automation over the next decade to remain competitive with international rivals, he says. Wages are rising across the country, forcing Chinese manufacturers to rely on technology to maintain profit margins.

“Chinese manufacturers have a lot of room to improve productivity,” Higashi observes. “There could be a lot of demand for the companies that supply automation equipment.”

Aerospace

The expansion of the middle class in the emerging world is showing up in many ways, with one of the clearest being the swelling popularity of air travel. Rising incomes have helped a growing number of people in China and other emerging markets secure footholds in the middle class. And just as their counterparts in the U.S. and Europe did decades earlier, the consumer class is splurging on vacations to previously out-of-the-way locales.

This dynamic has been a boon to aircraft manufacturers and components suppliers that make everything from jet engines to passenger seats. According to Capital Group aerospace analyst Keiko McKibben, the favorable conditions show few signs of slowing anytime soon.

“The backdrop for commercial aerospace is incredibly strong,” McKibben notes. “There’s been robust demand for air travel, not only in the emerging markets and China but in developed markets as well.”

Several factors bode well for aerospace companies. A steady rise in passenger traffic has led to an above-average backlog of orders for new planes. The aerospace industry is on solid financial footing, with ample free cash flow. And there is less risk that the current boom will give way to a bust, as has happened in the past. Airlines used to ramp up orders when the economy was humming only to scale them back drastically when conditions changed. However, low fuel prices, jam-packed airplanes and better management have boosted the bottom line for the airline industry and reduced the odds of a sudden drop-off in orders. Beyond that, aircraft manufacturers themselves have shown greater discipline in managing the supply of new planes rolling off their production lines.

Of course, a sharp recession would undoubtedly take a bite out of travel and reduce demand for new planes. The risk of a full-blown trade war between the U.S. and China is another variable. But air travel in China is on course to continue growing, with the country projected to become the largest domestic travel market by the end of the next decade.

“This is an economically sensitive business, and stocks could easily overreact to concerns about a slowdown,” McKibben says. “But the long-term outlook appears to be very favorable.”

The above article originally appeared in the Winter 2019 issue of Quarterly Insights magazine.