Season of mists and reality checks
Last week brought a familiar September market swoon, including a 15-month low for the FTSE and the highest spread between high-yield and investment bonds since July 2013. Risk appetites – if not completely unwinding – are becoming more discerning.
Consequently, there’s a tentative mood as we approach the new month data deluge. So far, an upgrade to UK Q2 GDP, contrasting German retail and employment data, so-so Japanese figures, slightly disappointing Chinese PMI numbers and falling Eurozone inflation add up to mixed start to the week. Still to come are yet more PMI numbers for the Eurozone, UK and US; interest rate decisions from London and Brussels; with the grand finale of US non-farm payrolls on Friday.
With markets mindful of global unrest and watchful for interest rate rises, data has a small ‘Goldilocks’ optimum range in which it can boost prices. Not so hot for the US and UK that it threatens to bring forward interest rate rises, just cool enough to raise the prospect of Eurozone QE, but not so cold that it puts recovery in doubt. News that the US economy grew at the fastest pace since 2011 hit equities last week. So typical of the topsy-turvy, carnivalesque, ‘world turned upside down’ loose monetary environment that will be tough to right.
Why is autumn so often a difficult season in the markets? Perhaps because it’s the back to reality, post summer period, when boards, markets and investors return to their desks and ask whether the year will meet their expectations? So often it doesn’t, to the point where it’s worth questioning whether forecasting of earnings has become endemically over-optimistic.
According to Goldman Sachs, years with negative European earnings revisions outnumber those with positive revisions by a factor of 2:1 since 1989. The recent trend has been especially striking, with negative revisions in every year from 2011. Are overly positive forecasts and the recent peak in profit warnings symptoms of deeper problems? The rise in profit warnings in 2014, in particular, looks so incongruous next to strong GDP growth that we need to ask if there is something else afoot. Could it be that business and forecasting models are struggling to keep up with economic changes and shifts in industry dynamics?
We believe so. Economic growth isn’t a panacea for what ails many companies. The relatively benign nature of the cycle has left markets with overcapacity, intense competition and wafer thin margins – all of which leaves little room for error. Companies are also wrestling with the way the internet is reshaping B2B and B2C relationships. Meanwhile the all-important UK consumer remains rather ‘austere’, having discovered the joys of discounting and the limitations of a slow wage growth recovery – more of which below. Of course there’s also a stronger pound and a tougher geopolitical backdrop to contend with; although these too could also arguably be filed under ‘long-term trends’. Companies cannot passively hope for the rising economic tide to float their boat. Without an appreciation of the changing economic and industry dynamics, companies – and analysts – will struggle to forecast accurately.
Nowhere is the need to adapt more obvious right now than in retail – a sector well used to changing fortunes and fashions, but which is the midst of a generational change in spending patterns.
The EY ITEM Club’s latest special report on consumer spending highlights the new economic challenges. Over the past two years, a steady upturn in consumer spending has supported the wider economic recovery. However, in early 2014 consumer spending was still below its early-2008 peak. Forecast average growth of just 2.4% between 2015 and 2020, will be well below the 3.7% recorded in the decade before the financial crisis. The principle reason for this drawn out fall in spending is the UK consumer’s ‘lost decade’ of real wage growth. Even by 2017, real individual take-home pay will still be less than in 2008. More people than ever have jobs, boosting the collective spending power of UK households. But on average, each household has less real income to spend.
So, economic upturn alone isn’t going to restore retailer fortunes. Spending will rise – shifting back to discretionary items as consumers feel more confident – but previous levels of consumption are unfeasible in this climate. To capture a larger slice of a smaller pie, retailers need the flexibility, ingenuity and focus to match rapid changes in consumer behaviour and meet their need for value and the desire for convenience. Maintaining margins and forecasting earnings whilst meeting these kaleidoscopic needs presents another challenge.
It’s the debt…..
The 16th Geneva Report on the World Economy asks ‘Deleveraging, What Deleveraging? ‘
“Global debt-to-GDP is breaking new highs in ways that hinder recovery in mature economies and threaten new crisis in emerging nations – especially China….…the policy path to less volatile debt dynamics is a narrow one, and it is already clear that developed economies must expect prolonged low growth or another crisis along the way.”
It’s a topic covered here before, but worth emphasising again, that despite impressions to the contrary, the world has not yet begun to deleverage. Financial sector debt has fallen and household debts have stabilised across developed economies. However developed economy public sector debt continues to rise rapidly, along with private debt in emerging markets. Thus, global debt-to-GDP is still rising – 160% in 2001, 200% in 2009 and 215% in 2013 – creating immediate problems and a tough legacy.
Today’s problems are most obvious in Eurozone periphery, still “vulnerable due to the complexity of their crisis and the inadequacies of the mix and sequence of policy responses.” Deleveraging and slower nominal growth are in many cases interacting in a vicious loop, they argue, with the latter “making the deleveraging process harder and the former exacerbating the economic slowdown”.
The authors are also concerned about the build-up of emerging market risk, especially in China. They’re alarmed about interest rate rises and believe that equilibrium real interest rate – that is, the interest rate compatible with full employment – is will remain at historically low levels. An opinion voiced by a number of central bankers, including Mr Carney. Low growth, low inflation, low interest rates? A very different world.