Takeaways: UK companies are issuing more profit warnings now than 2014. It would be easy to blame election stutters, sterling or oil prices, but the struggle to forecast isn’t new. Volatility, price pressure and disruptive influences have proved to be a troubling mix in this recovery – especially when costs are already cut to the bone. Hence, this week we’re thinking about forecasting and unpicking earnings expectations. And what about the timing of the next correction? A forecasting task fraught with difficulty….but what about 2017?
“The trouble with our times is that the future isn’t what it used to be”. The quote comes from 1930s, or thereabouts and our troubles might be different; but it still resonates in a fast moving world where it looks like a number of companies are struggling to stay on the front foot.
Our analysis shows that UK profit warnings rose year-on-year last quarter and are still running ahead in Q2. There are three obvious ‘culprits’: general election uncertainty, the oil price shock and adverse currency movements. All of which we could write off as temporary effects. However, discounting individual reasons can turn into a ‘Monty Python analysis’… apart from the impact of the election, oil prices and adverse currency moves… etc. There is always something. Perhaps these days there are more ‘somethings’ – or companies are more vulnerable to them. Which is why is can be helpful to think in terms of weather and climate.
Every quarter we see adverse ‘weather’ – potentially temporary setbacks. However, weather is of course influenced by climate and a company’s ability to withstand shocks is also linked to the nature of the corporate climate and how well it has adapted to changes. In terms of growth, the current climate might look favourable with fair economic winds. However, there is undoubtedly still a volatile global backdrop, with a constant rewriting of the global growth and risk map that is disrupting company plans. The shape of this recovery, with low levels of insolvency, also has left many sectors with overcapacity and intense competition that has pushed pricing pressures along the supply chain. ‘Disruptive’ new entrants and technologies have added to the competitive tension and need for constant investment to keep up.
This all leaves many companies with profits under pressure and little room for error –especially when costs are already cut to the bone. The drop in crude prices has put oil companies in the spotlight; but they’ve been under cost cutting pressure for years – affecting their suppliers. Uncertainty and pricing pressures have been pressing on the contract-dependent construction and support services companies, who are now contending with rising wage costs. Retailers are under constant pricing pressure and yet need to invest to keep up with disruptive new entrants and technologies to maintain dwindling customer loyalty.
It’s not that change is new. But, to push our weather metaphor to the limit, there is a faster jet stream that is pulling new disruptive trends through quicker.
What does this mean for companies? Forecasting the ‘weather’ is more difficult. Companies that can flex their business models, cost base and strategies – i.e. those most capable of adapting to ‘climate’ change and show the greatest resilience to adversity will fair best. Many businesses will need to rethink their forecasting, creating more agile, risk-based models that allow for scenario analysis. This is especially applicable to UK listed companies required to make viability statements to comply with the new FRC Corporate Governance code.
So where next for earnings? To paraphrase the White Queen: ‘it’s possible to read six different things before breakfast’. Much of the variation stems from the wide gap between reality and expectation. The reality of Eurozone operating profits is that they’ve fallen to post-Lehman levels over the last twelve months. However, earnings expectations are heading to the stars (along with M&A activity) due to a good growth story: weak currency, cheap debt, an improving economy. There’s a weak story too, if investors focused on the Eurozone debt universe, limited fiscal reform and the ongoing Greek saga. However, there is a window for improvement and high operating leverage means that profits could rise quickly.
As the FT points out this week, even taking this into account, Eurozone assets no longer look cheap. However, US companies – whilst currently beating earnings expectations –may struggle to push on from here. According to the Economist, the US market is around 35% above its 2007 high but earnings per share are only up 20% – even with a significant boost from buybacks. Most of the cost cutting is done and outlook is mixed. The fall in Q1 US GDP growth might be snow related, but it was still considerably below forecasts that took snow into account. The dollar is hurting. These earnings ‘beats’ came against a backdrop of much reduced expectations – Q1 earnings are actually expected to end 1.5% down year-on-year.
UK expectations have recovered somewhat in 2015, but it still looks like a tough year to navigate. The disappointing first estimate of Q1 2015 UK GDP could be revised upwards, A clear election result may provide a summer boost. But, we come back to those pressures on margins and forecasting difficulties. Earnings improvements are not guaranteed in this recovery. Which is why we expect companies will continue to rejig their portfolios, re-allocating capital to stay on the right side of the economic success line. It’s this challenge that we see driving M&A activity higher in 2015. There will be great opportunities for those who can call it right.
It’s a curious leap to from M&A boom to potential market bust. But market corrections– like death and taxes – are one of life’s few certainties. The only speculation really is where and when.
On the where, HY bonds have caught our attention a few times, given the amount of money flooding in as the exits shrink. The trigger that pushes investors to the exit won’t necessarily be huge rise in defaults. Deutsche Bank research shows how the default rate has shrunk considerably since 2002 – excepting a spike in 2009. They put this down to banks’ confidence and willingness to extend debt. (Perhaps because returns are so low elsewhere?) This this lowers spreads, helps companies to rollover debt and lowers defaults. So far so good – but what if confidence shifts? The herd mentality of markets means this can come quickly and devastatingly.
Deutsche believes that the willingness of banks to lend depends on the shape of the yield curve—the difference between the rates available on short- and long-term debt. When the gap is wide, banks earn a good return lending to companies. But as the gap narrows, they lose their enthusiasm for lending. Their chart suggests that there is a lag of around 30 months before this fall in confidence translates into more defaults – so mid-2017, although perhaps sooner for Europe. The graph doesn’t imply a large spike in defaults, but the potential drop in confidence may be enough to spark an exit.
Of course anyone predicting the next crash runs the risk of sounding like Chicken Licken (Chicken Little for our younger readers). How can the sky possibly fall in while central banks are propping it up? However, we’re starting to look ahead in the M&A market and things may slow here, at least, in 2016. More on that next week.