Earnings: Dilemmas, divergence and disquiet…..
Takeaways: Last night the Fed played down the dollar’s impact on the US economy, but its rise is certainly the hottest topic on Wall Street. Janet Yellen’s dovish tone has taken Euro parity off the table for now, but policy divergences will keep the greenback strong. Meanwhile, European earnings expectations are moving rapidly higher, buoyed by the Euro’s fall, cheap oil and policy support. Private Equity is making hay, using this window to sell off assets at record rates – after all, Eurozone realities may bite again soon. It’s a good time to divest, although rising asset prices create an obvious flipside and currency volatility is complicating deals, even before the Fed really changes its tune. It is still a volatile world – enough to challenge earnings expectations again in 2015 – but uncertainty isn’t the only earnings concern. There is disquiet over sustainability. When the cost cutting and buybacks are done, can companies keep the earnings show on the road?
The Fed has walked another tightrope. Removing the world ‘patient’ effectively starts the countdown to the first increase in interest rates since June 2006; but caution elsewhere in the statement -and some ‘dovish’ dots – suggest the pace of increase will be slower than previously forecast. The dollar has eased back, but now the gun has been fired, better data could easily strengthen it again. At some point it will sink in that we’re on the road to the first US rate increase in nine years.
(If you need context….In June 2006, Sven Goran Eriksson is leading England to another glorious World Cup failure, George W Bush is just about to shout ‘Yo Blair, US house prices are at their peak…along with subprime mortgage lending….)
Last night, Janet Yellen played down the impact of the dollar’s rise on the US recovery. The Fed has other reasons to be ‘patient’ – for want of a better word. Just over a week ago, non-farm payroll numbers smashed estimates. However, retail sales unexpectedly dropped in February, making the last three months the worst in the sector since 2009. House building activity fell by 17% in February, steeper than forecast. Cue doubts over the positive effects of cheap oil, although this data is, of course, backward looking and being viewed through a snow storm.
However, currency pain has been the theme of the US earnings season. Foreign exchange swings cost North American companies almost $19bn in revenue in the fourth quarter, according to consulting firm FiREapps – up four-fold on the previous quarter. This is the flip side to the M&A and debt advantage – a hit to export competitiveness and the translation of foreign earnings. Around 25% of S&P 500 sales are generated abroad – over 50% in the technology, energy and materials sectors. The dollar isn’t the only factor, but it’s the most visible and US earnings forecasts for 2015 have fallen from 8.1% at the start of 2015 to below 2%, according to Thomson Reuters.
This may be an overreaction, but if the dollar moves close to parity again it will be hard for the Fed to ignore, given the further currency advantage it might be handing to the its competitors.
Meanwhile, earnings expectations in continental Europe have risen with pretty much the same haste as the US fall. According to Société Générale, earnings for the Stoxx Europe 600 are forecast to rise by 9.5% in 2015 (excluding banks). Analysts are still downgrading more EPS estimates than they upgrade, both in Eurozone and the United States. However, the pace of downgrades in the Euro area is slowing more rapidly, inspiring even faster inflows into Eurozone assets as confidence increases. Rising asset prices, falling yields is the strengthening story.
This vote of confidence comes after what looks like a dreadful results season for the Stoxx Europe 600, where earnings fell by 4% in the final quarter. However, investors clearly see the region at an inflexion point. There is no doubt that continental Europe isn’t cured – that debt burden hasn’t gone anywhere. However, a weak Euro makes Eurozone equities attractive and investors will hope for earnings outperformance once the currency export benefit and advantage of cheap oil kick in – possibly later in 2015 due to hedging. A 10% drop in the value of the euro translates into a c.6-8% rise in European profits. Given that the c.15% fall in the single currency so far in 2015, that equates to a 9-12% boost – a strong draw. The Europe’s STOXX 600 benchmark has risen by over 16% since the start of 2015 while the S&P 500 has struggled to gain ground.
How long will this last? With debt and labour market constraints limiting on the pace of domestic and external demand growth, our latest Eurozone Survey shows that economic growth could stall by 2017 – assuming regional stability. That’s getting a slightly bigger assumption as Greece pushes its creditors for new concessions and there is increasing talk of credit controls. Private Equity houses are clearly making the best use of this window, with a rapid increase in exit numbers in 2015.. We expect companies to follow, with a strong focus on adjusting portfolios. Preparation and timing, as ever, are vital.. Funding is cheap, but valuations are rising. Currency issues are also creeping into the deal equation, due to exceptional levels of volatility.
Where is the UK in this equation? The chart above and EY’s profit warning data shows UK companies have struggled to meet earnings expectations in this recovery, particularly in the last year. UK profit warnings hit a six year high in 2014, despite respondents to our Capital Confidence Barometer expressing increased earnings confidence. Sterling’s rapid rise certainly took companies by surprise, particularly hurting the FTSE 100, where 60% of sales come from overseas. The significant representation of natural resources companies has also latterly reduced expectations.
The recent uptick in forecasts comes as sterling has weakened against the dollar – although not the euro – and oil prices appear to have found a floor. However, one of the biggest drivers of UK profit warnings in the last year has the relentless pressure on margins. The economy is clearly growing strongly – as the OBR confirms today – but translating sales growth into earnings growth isn’t going to be easy in this environment.
Hence the growing disquiet over earnings sustainability. According to the FT,, US earnings growth has exceeded revenue growth in every quarter – bar one – since the global financial crisis. This rise in earnings has been driven by cost savings (cheap labour and credit) and from buybacks. Both are diminishing in their potency. UK earnings growth hasn’t shown the same ability to outstrip sales, but given acute margin pressures, there is a strong focus on future earnings levels. In UK food retail in particular, investors are being asked to reset their expectations.
It is still a competitive, volatile and difficult environment out there. Companies will need to fight hard to create a distinctive, adaptable and resilient business that can create ‘real’ earnings growth.