Hot markets, modified expectations

Feeling hot hot hot!

The UK’s weather has been hotter than Spain (apparently), debt markets –  until last week’s HY wobble – were as hot as 2007 (almost unbelievably), European earnings forecasts are cooling (all too predictably) and US earnings are heating up (artificially?)

Whatever the temperature, it’s never silly season here; but out there in the markets there’s arguably still a detachment from reality, which – as Mr Carney warns – may arrive sooner than expected.

Missing expectations …redux

EY’s latest analysis of UK profit warnings shows the highest number of first half warnings since 2011. UK quoted companies issued 63 profit warnings in Q2 2014 – down by 11 on Q1, but up by nine on the same quarter of 2013 to reach the highest total for second quarter warnings in three years.

Why are profit warnings going up, when the sun is shining over the UK economy? After all, UK GDP rose by 0.8% in Q2 as expected and EY ITEM Club predict 3.1% growth in 2014.

The most obvious reason is accounting 101 – sales are not profits.

Two margin headwinds in particular have increased in strength in 2014. Adverse exchange rates – mainly the rapid increase in sterling – triggered a fifth of H1 profit warnings, up from 3% in 2013. It is primarily a translation issue – at least for the moment – UK export volumes are pretty FX resilient. It is worth noting here that FTSE Support Services companies have issued the most FX warnings – it’s not just manufacturers who do business overseas.

The other main headwind is competition and linked pressure on pricing – cited in around 20% of H1 warnings, versus 7% in 2013. These pressures are obvious in food retail, but it’s a much broader issue. A low level of insolvency means many companies are competing in packed and competitive market place, with lower returns than companies would expect at this point in the cycle.

Add to this a disappointing level of global growth– the IMF lowered its 2014 forecasts again last week – and you have a trickier picture for UK plc than it might look at first glance.

This helps to explain why consensus expectations for the MSCI UK Index fell by 9% in H1 2014; but, still begs the question of why expectations ran so far ahead in the first place. Actually, the real question is why expectations so consistently run ahead. This is the fourth year of downward earnings revisions for Europe, according to Goldman Sachs. Could it be that companies, analysts and economists alike tend to underestimate the challenges of recovery – or is it just an all pervasive over optimism?

As for the outlook, profits are rising modestly, the IMF latest global growth downgrade is for what’s past – rather than what lies ahead – and the UK recovery looks well set. However, there are still reasons to take a fairly sober view on H2: the countdown to monetary tightening, cooling housing market (ex-London), uncertainties of AQR and that high level of global competition and rise in sterling, which are still featuring heavily in a brisk pace of Q3 profit warnings. The fall in consensus earnings is tailing off, but it’s not done just yet.

Trick of the buyback

Over in the US, Q2 earnings season is well underway and beating expectations. However, there is unease. Are these earnings figures too good to be true? How much is the rise in EPS down to the prevalence of share buybacks?

US companies have certainly been buying back shares at a rapid rate – an annualised US$400 billion, or 2.5% of GDP, according to Andrew Smithers. In some cases, companies have used cash, but many others have taken advantage of cheap debt. Andrew Lapthorne of Société Générale calculates that US corporate net debt is now a record $2.3t and the ratio of long-term debt to total assets is close to its 2009 peak.

So, the buyback trend may not have much further to run. Companies will need to rely on their own mettle to improve earnings at some point – a tough task when so much of their fat is already trimmed. Next stop M&A?

UK companies are certainly taking advantage of a window of deal opportunity to get ahead.

Partying like it’s 2007

Do we need more warnings about the disconnection between debt markets and reality and the return to debt dependence? Ok, just one more from S&P:

” We’re increasingly concerned about whether the right companies are benefitting from cheap credit and whether they are using it in the most productive way. While less pronounced in Europe than in the US, current trends all point to erosion in market discipline and a greater reliance on financial engineering to generate returns rather than fundamental growth. Furthermore, greater use of leverage and a growing number of aggressively structured transactions in the European leveraged finance market is reminiscent of some of the excesses of the 2006-2007 boom period.”

Not much more to add to this, other than the long-term risks being stored up in the system and the potential for logjam if ‘yield tourists’ lured by returns into unfamiliar markets want to leave.

Investors normally receive a premium for this lack of liquidity. After all, the price of an asset isn’t what you paid, it’s the price at which you can sell – something that investors don’t appear to have pondered much of late. European high yield debt, liquidity risk premia has halved in the last year and is almost back to pre-crisis lows. However, it’s likely to become more relevant in the next six months. Recent falls in return and rise in outflows hint at the potential for shock..

  • Total return on high-yield debt is down 0.5% in July, after 20 months of monthly gains. (Barclays)
  • Investors pulled $4.8bn from high-yield bond funds last week, the largest weekly outflow for the sector since June 2013 in the midst of taper tantrum (EPFR Global/BoAML)