The winner takes it all…

What does the latest clutch of European earnings reports tell us? Revenues are under pressure and, whilst earnings are beating expectations, the bar was set very low. European companies still have a ways to go on improving their profitability and there’s certainly potential for all-round improvement. But in this low-growth, disrupted and polarized age, any improvement is unlikely to be shared all-round. Companies will need to do more than just trim the fat to get ahead – and a rising tide won’t float everyone’s earnings boat.

The struggle for growth

One of our on-going themes here has been growth, specifically companies’ struggles to capture the sluggish, unreliable, volatile growth that has epitomized this recovery. The latest European earnings season underlines this scrap, with first quarter revenue results missing expectations by the most in 10 quarters.   On the earnings side, companies are beating expectations. According to Thomson Reuters StarMine data, 61% of Stoxx 600 companies reporting so far have beat profit forecasts, but this is against a pretty low bar. February brought the biggest earnings downgrades in seven years!

If we look at the straight forward forecasts – as opposed to beats or misses against expectations – Goldman Sachs now expects 2016 European earnings per share to decline 2% compared with a previous forecast for 4% growth.

European earnings play catch-up

Where do we go from here? It feels counter intuitive to be cheering on the oil price, but theEuropean vs US earnings current rally – albeit curtailed by the Fed – should give a welcome boost to sector earnings and to inflation, without upsetting economic momentum. As we’ve pondered before, oil can be too cheap. But it’s not all about the macro – self-help arguably has a bigger role to play. It’s clear from this quarter’s trading statements that cost cutting has been a Barclays - US vs European labour costs.pngsignificant factoring in helping European companies to beat profit expectations – and that they have further to go. Our Capital Confidence Barometer shows that executives believe there is further potential to improve margins through cost cutting. A recent report from Barclays concurs, highlighting the disparity between European and US profitability that goes back to the financial crisis – but they think things are starting to change…

“Post-crisis, while U.S. companies were able to maintain pricing and aggressively control labor costs, European companies weren’t. However things have changed recently. European companies are stabilizing pricing, and are now aggressively cutting labor costs, suggesting margin expansion.”

Not enough just to trim the fat

No doubt companies have more fat to trim and this is an integral part of improving earnings; but we think companies will need to look beyond cost cutting to get ahead. M&A certainly on the agenda for companies looking to improve efficiency, especially in sectors like construction where margins have historically been low and there is a significant benefit in economies of scale. Our Capital Confidence Barometer data also shows that innovation and digital technology is high up the list of executives’ priorities. For consumer facing companies especially, increasing demand can make it hard to make cuts without cutting service levels – an anathema in a competitive environment. The focus then falls on technology to make better use of their existing workforce through new forms of customer engagement or the creation of new products and services.

UK Retail sales vs prices.pngThen again, innovation and cost cutting don’t count for much if companies lack pricing power. UK retail sales rose by an impressive 4.2% in April, but retail prices have been falling for many months. This is a faced paced, demanding world in which brands and products can very quickly fall out of favour – think smartphones, PCs, bread….who knows what will be “on-trend” in two years’ time. Companies need to stay nimble and have the flexibility and ability to invest and respond quickly. This doesn’t sound easy on earnings – and it won’t be. European earnings levels will probably rise overall, but there could be a substantial disparity between winners and losers as companies take bigger bets to keep up – and some back the wrong horse.

The charts from Matt King of Citigroup below show how the market is polarizing. Our UK profit warning data reflects this divergent trend between winners and losers. In Q1 2016, 47% of companies issuing a warning had already issued a profit warning in the last 12 months – up from 35% in the same period in 2015.

Polarisation between winners and losers.png

And other complications

In terms of assessing the progress of European earnings, we’re not sure Q2 will give us much of a fix. The UK is a complicating factor this quarter. UK surveys and company statements suggest that whilst the economy hasn’t quite stalled, it’s certainly slowed. How much of this is down to uncertainty – and how well it will bounce back after June 23 is hard to say. The construction and real estate sector would appear to be at the epicentre of concern, given recent corporate statements and surveys – but there is a slowdown across Europe and the precise reasons are hard to unpick amidst global uncertainties

Meanwhile, just to complicate things a little further, the latest Fed minutes have put the cat amongst the pigeons again. On May 6 – less than two weeks ago – markets were indicating a 2% chance of a US rate rise in June. In fact, the Fed Fund Rates weren’t indicating a 2016 rise at all. You might not buy into what these indicators are saying, but they matter because the snap back is painful, for the dollar and all who rely on her, i.e. everyone. And something certainly snapped following Wednesday’s minutes release, which showed that some of the FOMC are minded to raise rates in June. The implied chance of a June hike is now 32%.  The dollar has leapt, meaning recovering commodity prices and EM currencies have all turned south. Oil was testing $50 before yesterday – no more. The dollar index has reversed all of April’s fall, back to late-March levels.

And so we’re back to the Fed-market dance. A hawkish step, brings a market dip, the dollar lunges forward, the Fed steps back, and repeat… If the Fed steps forward on June 15 it would still be a surprise and a whole new set of challenges awaits.


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