Chemicals

Chemicals: play less defense now and seek opportunities to add risk as the year progresses – Recession or not, we expect chemical stocks to remain volatile in 2023 as the sun continues to set on the cycle and earnings ebb for many commodity chemical companies in particular. Looking toward the horizon though, a “red sky at night” augurs smoother sailing conditions ahead. Come spring, we would expect elevated inventory levels to be rationalized, so risk to consensus estimates could become more symmetric, particularly if China were to regain its footing after what looks to be a choppy start to 2023. By that time we will have also lapped the initial hike in the Fed funds rate in March 2022, which is typically a good omen for both absolute and relative sector performance. In this context, investors may not wish to “play offense” immediately, but we argue that the luxury of “playing defense” has become more expensive. For example, industrial gases – a classic late-cycle haven – performed quite well through 4Q22 to the point where premium multiples now leave less room for error in our opinion. Likewise, disinflation beneficiaries like coatings stocks continue to make sense thematically, but here too the “price of admission” has increased with all four coatings producers in our coverage having outperformed handily in 4Q22. Meanwhile, our analysis suggests that the market has already priced in a majority of prospective cost relief, while certain sources of volume risk remain among construction- and industrial-linked markets for example. As a result, we advocate a patient approach in seeking greater risk and return in 2023+. In general, we prefer chemical stocks that offer inexpensive normalized trading multiples relative to structural growth prospects, irrespective of cyclical profile. We’re looking for opportunities to re-deploy capital into (1) specialty chemical growth stocks trading at a reasonable price; and (2) commodity-linked names that feature some combination of (A) strong cash flow; (B) cleaner balance sheets; and (C) limited prospective growth in supply. In terms of recent incremental changes, we upgraded shares of lithium producers ALB and LTHM in early January after sharp pullbacks, and downgraded shares of APD given more limited upside to our target after a torrid run in 4Q22. Our top pick overall at this juncture is Livent (LTHM).