FTSE 350 engineering & industrials – Engineering a recovery

The eurozone recession, a drop in German output and weaker growth in China caused panic, yet indicators such as the purchasing managers' index (PMI) do appear to have bottomed out. In fact, in the US and China, the PMI is back above the magic 50 mark – which signals growth territory. But while Europe has stabilised, its manufacturing sector ended 2012 "mired in recession", and any shock to the domestic economy could easily offset rising demand in key export markets.

Analysts at Capital Economics believe the eurozone economy will shrink by 2 per cent this year, far worse than consensus estimates. A Spanish bailout, and instability from Italian elections in the spring, looks likely, and there's a clear danger that the crisis could re-escalate in 2013. German elections in September will toughen chancellor Angela Merkel's stance, too. We're a little more positive and the data are, at least, moving in the right direction.

That said, those with heavy exposure to the continent could be penalised, which puts heat treatment expert Bodycote (BOY) in the spotlight again; almost two-thirds of its business is done there and just under half is pegged to industrial production. Sales momentum has been building, but management admits trading is volatile. Lucrative aerospace work and US demand are therefore crucial.

Of course, China steals the headlines – a sharp pick-up in activity recently has dampened fears of a hard landing – but North America could be the decider. Melrose (MRO), IMI (IMI) and Weir (WEIR) make about a third of sales there – for conglomerate Smiths Group (SMIN) it's more than half. A fierce debate over federal budgets comes to a head early in March, but UK engineers are unlikely to suffer permanent damage and could even benefit from a rare moment of clarity.

Destocking triggered profits warnings late last year and limited order visibility is still hobbling manufacturers. Few were prepared to guess at outcomes for 2013, either, so forecasts are all over the place. While there could be more mileage in this rally, a weighted sector PE ratio of 15 prices in "a lot of optimism", cautions broker N+1 Singer. Many engineers are on near-peak margins, too, and growth is slow. That shouldn't be a problem for Rotork (ROR) and IMI, but do not underestimate the potential for further earnings misses and profit alerts elsewhere.

Not at GKN (GKN), though. True, half its sales are made in Europe, so an economic relapse there won't help matters. But that looks less likely and a lot of bad news from the continental automotive market – one that GKN consistently outperforms – appears priced in. Last summer's acquisition of Volvo Aero, however, is not. Less cyclical, higher-margin aerospace work will generate around 40 per cent of profits and improve visibility, a fact the market chooses to ignore.

Away from the dirt and grime, there are signs of further upside within the packaging sector. It served us well in 2012 – we made an average profit of 15 per cent tipping Mondi (MNDI), RPC (RPC), DS Smith (SMDS) and Rexam (REX) – and we're sticking with them. For Mondi and Smith, big acquisitions and equally large cost savings made the difference, transferring growth from a soggy, cyclical paper industry to inventive packaging and dynamic emerging markets. Further consolidation is inevitable and earnings upgrades are likely, as long as paper prices don't fold.