Where is uncertainty hitting hardest?

This week’s Capital Agenda Blog comes from Alan Hudson, Head of UK Restructuring.

In the last year, we’ve been talking about UK companies issuing the highest number of profit warnings since the global financial crisis. But, in our latest analysis, we’ve had to go back even further to find our reference point.

In Q2 2019, we saw the highest percentage of companies warning in a second quarter since 2001, with bellwether sectors like chemicals and construction issuing profit warnings at 18 and even 20-year highs.

How much of this is due to uncertainty, where is uncertainty hitting hardest and what can our profit warning data tell us about what could lie ahead?

A question of trust

We talk a great deal about uncertainty, but arguably we’re really talking about trust. Uncertainty is part of life – it’s part of doing business – but this is well beyond the norm. Near-term risks are exceptionally high. Companies cannot place their trust in economic forecasts or the existence of current trading conditions in even a few months’ time.

EY ITEM Club expects UK GDP to grow by 1.3% in 2019 and 1.5% in 2020, if the UK leaves the EU with a deal. But, they predict growth of just 0.3% in 2020 under a no-deal scenario – which they give a 40% probability, higher than signing a deal (30%) or a further extension (30%).

Brexit isn’t the only issue. The March extension was unexpected and the increasing likelihood of a “no-deal scenario” is the main reason why the UK has multiple economic scenarios. But, Brexit is a symptom of a domestic upheaval, which in turn is part of a shattering of the global political landscape. In addition to Brexit, we’re also awaiting the appointment of a new UK Prime Minister and new spending plans. The trade tussle between the US and China – also a by-product of domestic politics – is also fast moving and unpredictable. Regional tensions are rising – not least in the Middle East.

What makes this even more treacherous is the continuing backdrop of relentless structural change. Whose business model will still be relevant by the end of the next decade – or even next year? This relentless pressure has left many companies struggling to keep-up and vulnerable to adversity — even in benign economic conditions.

Signs of hiatus

If companies and consumers have less trust in the outlook, they may hold back from spending, signing new contracts and making new investments – investment into the UK is also in danger. If this hiatus in activity happens suddenly, without hope of earnings catching up before the end of the financial year, profit warnings inevitably rise.

PW numbers Q2 2019

This is exactly what we’re seeing now. In Q2 2019, 19% of warnings cited Brexit, mostly in terms of the impact of uncertainty and up from the 2% who cited Brexit in Q2 2018. Almost a third of profit warnings cited delayed or cancelled contracts in Q2 2019 – a near ten-year high. Profit warnings increasingly refer to “restructuring costs”, with more companies needing to reshape their businesses to meet a sudden shift in customer behaviour or market conditions.

In short, our broad spread of uncertainty indicators is high and rising.

confidence Q2 2019

Where have the canaries stopped singing?

As the chart below illustrates,  the percentage of companies warning has increased across the economy, only dipping this year in Consumer Services, where warnings were already high. The sectors with the most significant year-on-year increases in profit warnings have the highest reliance on businesses and investor confidence, especially those in the construction and manufacturing supply-chains  with automotive a particular pinch point.

The impact of Brexit uncertainty is also widening. In the last 12 months, companies in 14 FTSE sectors have issued Brexit-themed profit warnings – with five sectors “added” in Q2 2019.

PW sectors Q2 2019

Retail haven’t increased as much as industrial or technology warnings. Although, we are starting to see a bigger pullback in consumer spending, partly on weakening fundamentals, partly on falling confidence. That said, with all eyes on the final quarter, unless sales dip dramatically this summer retailers may hold off warning until they have a clearer view of Christmas spending.

The 18 and 20-year highs respectively in FTSE Chemicals and FTSE Construction & Materials profit warnings are especially concerning. Both sectors are bellwethers, giving us insights into the health and confidence of the economy. Almost every manufactured product has a chemical company somewhere in its supply chain. A spike in warnings from the construction sector can indicate a decline in broader economic confidence and a reluctance to commit to long-term projects – sentiments echoed in our UK Attractiveness Survey. In both sectors, the vast majority of 2019 profit warnings relate back to delayed or cancelled contracts.

Investor flight

This rise in warnings, combined with significant falls in June’s PMI surveys,  makes it feel like we’re experiencing a sea-change in parts of the economy. This point is underlined by a median share price fall of 20.9% in Q2 2019 – the second highest level we’ve recorded and more than the height of the financial crisis.

The biggest increase in first-day share price falls in the last few years has come in Technology, Industrials and Financials — areas that have seen some of the biggest increases in profit warnings over this period, with capital clearly taking note.

The flight to safety is further underlined by the gap between the 7.2% average first-day share price fall for FTSE 100 vs 22.5% on AIM. This is the widest gap since 2008.

SP1Q2 2019

What next?

The number of warnings is at an 11-year second-quarter high. The percentage of companies warning is at an 18-year second quarter high. First day share price falls are at levels we saw in the financial crisis. This is happening at a time when both domestic and global economies are growing – albeit more slowly.

EY Stress Q2 19

As our data – and other economic surveys illustrate –  when business, consumers and investors lose their trust in the outlook, this can stall activity – even in a growing economy.

If confidence rises, business and consumer spending could pick up later in 2019. But, given the complexities of delivering Brexit and other risk factors, a relatively high level of uncertainty is likely to remain for some time – even if a deal is reached.

The escalating threat of a “no-deal” Brexit will add greater costs and uncertainty. The exact impact of “no deal” on profit warnings is almost impossible to model given the large number of scenarios that could play out. But, we’d expect to see a spike and spread of profit warnings, as companies reset their forecasts – especially if we saw significant port disruption and increasing tariff and non-tariff barriers.

This would increase warnings in sectors where warnings have been low thus far, including food producers and food retailers. Consumer spending, which has sustained growth in the last three years, would struggle against this backdrop.

And to come…

In September, we’ll be marking twenty years of EY profit warning analysis by releasing a study that looks at what happens next when companies issue multiple profit warnings. It’s chastening to see how little time companies can have to react when markets turn against them.

Download your copy here to read our full analysis.

View our FTSE Construction & Materials and FTSE Chemicals sector highlights.

Or explore the Profit Warnings Console which provides you with access to over twelve years’ worth of data at the click of a button. Using the console, you can analyse warnings to identify the forces affecting your market to shape your path ahead.