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A Dark Cloud Is Looming Over Chemical Stocks

June 25, 2023
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A Dark Cloud Is Looming Over Chemical Stocks
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A series of profit warnings from chemical companies in June, citing weak demand and tough pricing conditions, raises concerns about potential implications for the broader industrial and cyclical complex.
As China’s economic revival shows signs of stalling, economists from major institutions, including Goldman Sachs, HSBC, Citi, and Nomura, have revised their GDP growth forecasts lower for 2023, causing uncertainty for globally linked earnings prospects.
Troubles have also expanded into the packaging sector with profit warnings issued, and there is skepticism about the possibility of a soft economic landing without significant impact on profits, labor, or credit, especially considering the ongoing monetary tightening.

Warnings from the chemical sector on the outlook for earnings are piling up — just as worrying signs about global demand and economic growth begin to multiply across the board.

June has proved a bad month for chemical producers, with four European companies warning about their profit outlook for the rest of the year. This week, Lanxess joined Croda, K+S and Victrex in preparing investors for the impact of weak demand, tougher pricing, or destocking by customers. In the US, Cabot blamed softer global demand as it ditched its full-year forecast.

Whether the worsening outlook for chemicals is a warning for the broader industrial or cyclical complex isn’t yet clear. But without substantial stimulus in China or signs that demand is picking up, caution could be warranted — especially at a time when optimistic investors have pushed their positioning in stocks back to elevated levels. 

Industrial shares are usually closely correlated with chemicals and account for nearly 14% of the Stoxx 600, the largest sector weight in the European benchmark after health care. More broadly, economically driven cyclicals are about two-thirds of the market. Their earnings prospects are heavily linked to global growth, which has been driven by China for the past few years. But the Asian giant’s revival is faltering. In the past week, economists at Goldman Sachs, HSBC, Citi and Nomura are among those to have revised their China GDP growth forecasts lower for 2023, doubting that stimulus from Beijing could turn the tide.

“Expectations have been too high about what China will be able to do on stimulus, as the Chinese government is more constrained compared to previous cycles relative to kick-starting the economy through just cutting interest rates or lowering reserve requirements for banks,” says Peter Garnry, head of equity strategy at Saxo Bank A/S.

Valuations remain a concern. The latest drop in chemical stocks has taken the premium on the sector’s price-to-earnings ratio over the broader European market back to its 10-year average of about 19%, after peaking at 40% last year. Industrials are still trading near a similar record premium of 40%, double the 10-year average.

In another worrying sign, troubles are expanding into the packaging sector, with Mayr-Melnhof Karton becoming the latest European company from the sector to issue a profit warning. This follows other paper and pulp sector warnings from companies including Billerud AB, UPM-Kymmene, and Stora Enso.

European cyclicals have brushed off weak macro-economic forecasts and surveys, thanks to hard data like GDP figures, which have held up well so far this year. Hopes of a soft landing and a peak in yields have supported stocks, while receding inflation has also helped.

Still, other overall macro-economic readings give a less positive picture. Manufacturing PMIs remain in the doldrums, in sharp contrast with the expansion in services data this year. A debate rages over how this gap will close, with UBS strategists Gerry Fowler and Sutanya Chedda contending that services activity will be dragged lower.

“European services new orders PMIs reversed quite sharply in May,” the UBS strategist say. “If this is a sign of emerging weakness in services demand, it could lead to more sector correlation and equity downside.”

“The main disconnect that the market will need to grapple with revolves around the hopes of a soft landing, without much pain to profits, labor or credit, but at the same time the expectation that inflation will come down quickly,” says Vincent Rennella, Silex Investment Managers’ head of equity strategy, who is keeping his defensive stock allocation. “How can the consensus think that the worst of pressures is behind us, when the impact of monetary tightening historically worked with a lag, especially with a Fed that has not even stopped hiking?”

By Michael Msika, Bloomberg markets live reporter and strategist via Zerohedge.com

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