Industrial sector worry: How bad is going to get?

Jeffrey R. Immelt, chairman and chief executive of General Electric leads a discussion with business leaders at an Ecomagination news conference at Universal Studios in Los Angeles, California May 24, 2007.

BOSTON (Reuters) - For once, when top U.S. industrials report their earnings over the next two weeks, Wall Street will not be asking "What have you done for me lately?"

Investors will fixate on another question, namely: "How bad is it going to get?"

General Electric Co (GE.N) has already warned that third-quarter profit could tumble as much as 14 percent as a result of trouble at its huge finance arm. Beyond that, shareholders expect solid profit growth from manufacturers including United Technologies Corp (UTX.N) and 3M Co (MMM.N).

But given the collapse of the credit markets over the past month, merely solid third-quarter performances are not going to soothe jittery investors.

The turmoil triggered a $700 billion U.S. government bailout of the financial industry and an unprecedented move by the Federal Reserve to start buying short-term corporate debt to keep businesses functioning. On Wednesday, central banks around the world cut interest rates in unison in a bid to limit the economic damage.

"You only had about two weeks of the recent crisis that will be reflected in the current quarter, so it will be all about the outlook," said Matt Collins, capital-goods analyst at Edward Jones in St. Louis.

Following GE's late September warning and Illinois Tool Works Inc's (ITW.N) Tuesday forecast cut, what investors want to know is how bad next year is going to be.

"What are you seeing from customers, what are your order trends," will be the main questions, said Peter Sorrentino, portfolio manager at Huntington Asset Advisors in Cincinnati, which manages about $6.5 billion in assets and holds GE, United Tech and Honeywell International Inc (HON.N).

In a sign of how the slowing economy could cut demand for heavy equipment, aluminum producer Alcoa Inc (AA.N) said on Tuesday it was halting all "noncritical" capital products after its third-quarter profit fell by half.

DOLLAR, PRICING KEY WORRIES

For the first half of 2008, U.S. industrials' growth was boosted by strong demand outside the United States, as a weak dollar inflated the value of foreign revenue and profit.

Now that the dollar has rebounded from its lows that tailwind is gone.

"With the dollar having found its bottom, the issue is going to be if pricing is going to hold," Huntington's Sorrentino said. "If we're seeing weak volume and weak pricing, that's going to lead to a significant raft of downward pressures."

Investors are also keeping an eye on easing energy and commodity prices. While the decline in the cost of oil will take away one of the major margin pressures that manufacturers have dealt with for the past few years, it could prompt customers to demand lower prices at a time when they are also cutting back on their order volumes.

"Most industrials have raised prices pretty aggressively over the last couple of years," said Collins, of Edward Jones. "In the face of a global economic slowdown, while you're seeing the commodity costs pull back, at the same time customers will pull back."

Barclays Capital cut its outlook on the capital-goods sector to "neutral" from "positive" last week, slashing its target prices on 14 companies and saying the credit crunch would mean a prolonged period of slow growth.

STOCKS ALREADY PUNISHED

On the bullish side, industrial shares have already been beaten down pretty badly, suggesting the sector may be due for a rally.

The Standard & Poor's capital goods industry index .GSPIC is down about 39 percent so far this year, a steeper drop than the 31 percent fall of the broad Standard & Poor's 500 index .SPX and the 28 percent slide of the Dow Jones industrial average .DJI.

"If history is any guide, whenever we get into an over-sold position of this magnitude, we always experience a sharp (20 percent-plus) rally," Deutsche Bank analyst Nigel Coe wrote in a research note. "Therefore, we believe short-term risk/reward lies to the upside."

(Additional reporting by Helen Chernikoff in New York; Editing by Derek Caney)