Bellwether Caterpillar points to continued uncertainty

As the world’s largest manufacturer of heavy industrial equipment, Caterpillar (US:CAT) is seen as a bellwether for the global economy. Serving more than 190 countries and multiple industries, its signature yellow machines are used in everything from housebuilding to mining. Demand for the group’s products is therefore a good indicator of business confidence and the outlook for broader economic activity – if construction companies buy more equipment, it is because they expect to build more things in the near future. As goes Caterpillar, so goes the economy.    

Already squeezed by US-China trade war tensions, Covid-19 has piled on the pressure for Caterpillar – its adjusted EPS plunged by more than 50 per cent in the first half of this year. Despite this backdrop, the shares have surged upwards from their mid-March low as investors bet on a global economic recovery. But recent third quarter earnings may temper those expectations. Adjusted EPS halved year-on-year in the three months to 30 September, to $1.34 (£1.03) reflecting falling sales across all product categories. As companies shy away from purchasing expensive pieces of kit, Caterpillar’s third quarter revenue dropped by 23 per cent to $9.9bn. The decline was led by North America amid less pipeline and road construction and lower demand from the oil and gas industry.

Caterpillar believes demand will improve in the fourth quarter, although the lack of forward guidance speaks to the uncertainty ahead. Construction sales are expected to benefit from an uptick in North American housebuilding which is being encouraged by low interest rates and people seeking more living space. US housing starts rebounded in September, increasing by 1.9 per cent from August to an annual rate of 1.4m units. Permits for new housing also rose by 5.2 per cent, implying that there is further momentum to come. But this must be set against rising Covid-19 cases – which could spark more lockdowns – and labour market turmoil. With 23m people already receiving unemployment benefits, this could increase in the absence of a new coronavirus relief package. At the same time, Caterpillar anticipates commercial construction will remain weak for the rest of the year. Spending on non-residential projects has yet to bounce back and a potential boost from an infrastructure bill hinges on November’s election.

All roads lead to China

The only bright spot in Caterpillar’s results were construction sales in the Asia Pacific, with 14 per cent growth led by China. This momentum is expected to continue as the Chinese government invests in new infrastructure as part of its pandemic recovery plan. China is issuing RMB 3.75 trillion (£428bn) of bonds for local governments to build things like 5G networks and electric vehicle charging stations.

As Chinese construction and industrial activity ramps up, so has its appetite for commodities. Compared to a year earlier, imports of iron ore – which is needed for steel production – increased by 11 per cent in the first nine months of 2020, to 868m tonnes. Meanwhile, copper imports jumped by more than two-fifths over the same time period to 5m tonnes. Coupled with pandemic disruption to miners on the supply side, China’s hankering for copper has sent the price soaring to around $7,000 per tonne.

Much like Caterpillar, the copper price is also considered a bellwether for the global economy. But ‘Doctor Copper’ is only really reflecting the health of one patient right now – China. Beyond its stimulus spending, China is likely stockpiling the red metal for its next five-year plan which is expected to involve copper-intensive green initiatives. The strength of the renminbi versus the dollar also means copper is comparatively cheaper for Chinese buyers right now.

Because China is such a large commodities importer, its buying spree is showing up in another popular barometer. The Baltic Dry Index (BDI) measures the cost of shipping various raw materials and while it is an imprecise science, higher shipping rates can be read as higher demand for raw materials, suggesting manufacturers intend to produce more finished goods. The BDI plunged earlier this year as Covid-19 brought the world to a virtual standstill, but as economies have reopened, it cruised to its highest level in more than a year at the start of October. Still, as with copper, the BDI is largely reflecting strengthening Chinese output as other countries navigate the pandemic storm.

Those looking to the bellwethers for reassurance that the global economic recovery is afoot will likely be disappointed. Indeed, Caterpillar’s shares dropped by just over 3 per cent following its third quarter announcement. The group is holding more inventory than usual, partly to hedge against supply chain disruption, but also in anticipation that demand will pick up at some point. The problem is, it remains unclear when that will be as we wrestle both financial and health crises. What is transparent is that China is currently steaming ahead. As to when the rest of us will catch up is anyone’s guess.