The industrial sector is slowing, and industrial stocks will outperform in 2023. While that sentence might qualify as an early contender for the oxymoron of the year, there is a case for industrial stocks like General Electric (GE 0.91%), Boeing (BA 0.61%), and Raytheon Technologies (RTX -0.33%) and others to outperform. Here's why.
What happened in 2022
To understand why the industrial sector can outperform in 2023, it's essential to understand what happened last year. Going into 2022, the general narrative from industrial CEOs was that inflationary pressures and supply chain issues would persist in the first half, giving way to a gradual improvement in the second half.
It didn't happen.
Instead, the cost pressures (from raw materials, component and labor shortages, and logistical challenges) persisted throughout the year. They were worsened by the conflict in Ukraine and extended lockdowns in China driven by that country's zero-COVID policy. As a consequence, company after the company suffered costs that were more than expected.
Here are a few examples. 3M's (MMM 0.57%) management started the year forecasting raw material/logistics headwinds of $350 million to $450 million for the full year, only to end the third quarter forecasting $750 million to $850 million.
Raytheon Technologies' management reduced its defense businesses' earnings outlook for 2022 due to lack of materials and labor shortfalls. Its Pratt & Whitney division (aircraft engines) and the aerospace industry, in general, are struggling to overcome a lack of titanium structural castings after sanctions were applied on Russia.
Earlier in the year, Raytheon CEO Greg Hayes said: "Typically, we get about 75% to 80% of those folks come back from layoff. In this case, what we're seeing in our supply chain is only about 25% of the people are coming back."
Boeing CEO Dave Calhoun highlighted the ongoing supply chain issues, component shortages, and labor issues that are making it hard to ramp up airplane production, notably for its 737 MAX, which has a backlog of more than 3,500 orders.
GE's management expected its renewable energy business to lose $500 million to $700 million in 2022 but is now forecasting a whopping $2 billion loss. GE Renewable Energy is executing on orders won in a lower-inflation environment, and so is having to absorb dramatically increased costs. Major turbine manufacturers Siemens Gamesa (GCTAY) and Vestas (VWDRY 2.82%) lost money in 2022.
It's different this time
Conditions turned out to be worse than expected going into 2022, but there are some key differences in 2023.
First, many industrial companies have pushed through price increases; their full impact on cash flow and earnings won't be seen until 2023. For example, GE Renewable Energy, Vestas, and Siemens Gamesa have all pushed through price hikes for new orders. That will help profitability and cash flow in 2023 as they start using the inventory bought at high prices in 2022.
Indeed, 3M chief financial officer CFO Monish Patolawala has already told investors that "we believe manufacturing and supply chain operations are our greatest opportunity to reduce costs and increase productivity to drive improvement in operating margin performance [in 2023]."
Second, Patolawala's point highlights that the industrial sector will be lapping raw-material and supply cost increases from last year. There are already clear signs of deflation in the system. The Thomson Reuters CoreCommodity CRB Index, a weighted index of 19 commodities, is still relatively high, but it appears to have moderated.
Data by YCharts.
Third, higher interest rates will likely moderate raw material prices and supply chain issues (less demand on the system) and ease the labor-availability issues that Raytheon and Boeing management have both attested to.
Industrial sector stocks for 2023
All told, issues with raw material costs, supply chains, logistics, and labor should ease in 2023. That's good news for profit margins and for companies struggling to deliver on orders.
It should now be easier for industrial companies with large backlogs and strong order books -- like Raytheon, Boeing, and General Electric -- to retain and hire skilled workers. A deep recession will be bad news for everyone, but barring that, many stocks in the industrial sector look set for an excellent year.
