By Michael Wursthorn 

Industrial stocks' strong performance this year has stalled. But some analysts expect the sector to break from its rut if the U.S. and China get around to signing an initial trade truce.

Industrial stocks in the S&P 500 are down 1.4% so far in December, on pace for the sector's first monthly loss since August, after data last week showed manufacturing activity across the U.S. further contracted in November.

Industrial conglomerate Honeywell International Inc. has fallen 2.3% this month, sliding along with Caterpillar Inc., down 1.3%, and United Technologies Corp., off 1.4%, among others.

That dented industrial stocks' recent rally, knocking the sector's gain so far this year down to 25%. And an analyst at UBS Financial Services Inc. says conditions for manufacturers show signs of worsening, exposing companies in the sector to a deeper pullback unless China and the U.S. can reach an accord.

"It appears that customers are still cautious on spending and production and are reducing inventory further," UBS analyst Adam Scheiner wrote in a note to investors Monday. "Trade continues to be the major culprit for the negative business psychology and it is crucial for the industrials and materials sectors that the U.S. and China successfully reach the 'Phase 1' deal in the near term."

Inventory reductions have continued and can be seen in weak rail and freight volumes, Mr. Scheiner added.

Corporate executives, including those at machinery maker Caterpillar, also complained in the fourth quarter that customers continue to curtail spending as trade tensions and economic worries have pushed some companies to hoard cash.

That may mean corporate profit estimates for industrial stocks need to come down further, making it harder for investors to justify further gains in stock prices until earnings pick up again. Analysts estimate a 5% contraction in fourth-quarter profits for industrial manufacturers versus the 5% gain they had forecast in September, according to FactSet.

Still, several investors, convinced the U.S. will eventually resolve its trade issues with China, remain upbeat on industrial stocks. Such an event would likely give an immediate boost to industrial stocks, along with the broader stock market, and help revive business spending, banks said.

The U.S. and China have yet to set a date for the signing of their limited trade deal.

At the same time, valuations remain at appealing levels, analysts say. S&P 500 industrial stocks trade at 16.7 times estimated earnings over the next 12 months, near where they traded before the 2008 financial crisis. And Bank of America adds that industrial stocks trade at a 6% discount to the S&P 500, a level not seen since the industrial earnings recession in 2015 and 2016.

Despite UBS's sour take, the bank expects manufacturers to hit a trough in the next three to six months, then bounce back. And analysts at Bank of America and Jefferies LLC both recommend investors increase their exposure to the sector next year.

Write to Michael Wursthorn at Michael.Wursthorn@wsj.com

 

(END) Dow Jones Newswires

December 09, 2019 17:14 ET (22:14 GMT)

Copyright (c) 2019 Dow Jones & Company, Inc.
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