Secular Trends to Balance Weaker Macro for US Industrials

Fitch Ratings-New York-19 September 2022: Slower global economic growth, including looming US recession risk, will pressure sales and margins for diversified industrials and capital goods companies in 2023, although near-term operations will benefit from pent-up demand, Fitch Ratings says. Companies aligned with secular growth trends have greater cushion to absorb weaker demand, while short-cycle manufacturers and those with limited headroom in key credit protection metrics have higher risk for negative rating actions. Sector financial performance faces growing pressure in 2023 due to slower economic growth and geopolitical tensions. Fitch recently cut its global GDP forecasts due to the European gas crisis, more rapid global monetary policy tightening and a significantly weaker outlook in China. We now expect world growth to slow to 2.4% in 2022 and 1.7% in 2023, lowered by 0.5pp and 1.0pp, respectively, from June. We lowered US growth by 1.2pp to 1.7% in 2022 and by 1.0pp to 0.5% in 2023, and a mild recession in 2023 is now our base case US economic forecast. Adequate sector cash balances, FCF and high backlog-driven profits mitigate cyclical downturn risk. Leverage for Fitch-rated issuers in the sector remains moderate at just above 2x debt/EBITDA following improved earnings and debt repayment that reversed pandemic-related leverage increases. The impact of a cyclical downturn is likely to be uneven across the sector. Fitch’s base case ratings projections generally assume midsingle-digit revenue growth in 2023, driven by higher prices. Supply chain issues have constrained sales volumes, but the associated backlog is likely to provide a cushion in the event of a recession. Companies with exposure to cyclical end markets, such as Kennametal (BBB/Stable), are more vulnerable to an economic downturn. Conversely, companies with exposure to secular growth trends, including increasing electrification and use of digital technology, should outperform over the near to medium term. Examples include Carrier Global (BBB-/Stable), Honeywell (A/Stable), Eaton (BBB+/Stable) and Hubbell (A-/Stable). These companies have the market knowledge and technical expertise to capitalize on secular trends by developing new technologies for electrification, autonomous vehicles, analytics and connectivity. EBITDA margins largely recovered to pre-pandemic levels in 2021 and should remain relatively steady going forward. Companies generally succeeded in raising prices to pass through cost increases, although sometimes with a lag that temporarily pressured margins. Most issuers have shown greater operating discipline during the last two years, which should moderate margin declines in a downturn. The potential for reshoring more production could increase costs and weigh on margins longer term, although sector activity has been muted so far. We expect improved FCF from working capital when supply constraints ease and issuers reduce defensive inventory purchases. However, we believe inventories may stabilize as companies seek ways to protect operations against future disruptions. Diversifying suppliers, re-engineering products and selectively reshoring manufacturing are other measures. M&A and share buybacks comprised more than half of the sector’s operating cash flow in recent years, and we see some risk that acquisitions could accelerate if a weak economy reduces current, high valuations. However, liquidity for higher-rated issuers generally remains solid and we expect most companies to adjust spending for actual cash flow and the business cycle, as most have done historically. Still, debt-funded acquisitions are a credit concern that drove leverage higher for some issuers, including Parker Hannifin (BBB+/Negative). We expect these companies to use FCF to reduce leverage during the next two years. However, they currently have limited headroom to navigate weaker economic growth against our negative rating sensitivities. Contacts: Eric Ause, CFA Senior Director, US Corporates +1 312 606-2302 Fitch Ratings, Inc. One North Wacker Drive Chicago, IL 60606 Yee Man Chin Senior Director, US Corporates +1 647 800-9142 Dino Kritikos Managing Director, US Corporates +1 312 368-3150 Stephen Boyd, CFA Senior Director, Fitch Wire +1 212 908-9153 Media Relations: Elizabeth Fogerty, New York, Tel: +1 212 908 0526, Email: elizabeth.fogerty@thefitchgroup.com The above article originally appeared as a post on the Fitch Wire credit market commentary page. The original article can be accessed at www.fitchratings.com . All opinions expressed are those of Fitch Ratings. 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