FYI | Jun 17 2008
By Chris Shaw
The combination of falling real interest rates and lower inflation has been a good one for corporate profitability globally, Macquarie pointing out corporate earnings growth has been in an uptrend for the past 25 years.
But with times getting tougher the broker sees profitability as likely to decline if current economic conditions persist, leading it to question whether this would simply be part of the cycle or is it in fact a signal the uptrend has finished?
In the broker’s view it is reasonably clear the fundamentals that supported higher corporate earnings in past years are certainly weakening, as consumer demand is declining, input costs continue to increase and corporate funding is becoming more difficult to obtain. In Asia there is also the likelihood of slower export growth and earnings thanks to a weakening in US demand growth.
The other factor impacting on the outlook is inflation, as higher prices for fuel and food and other commodities are having an effect on profitability as firms are finding it tougher to pass on these higher costs. The exception appears to be those economies with a strong resources base such as Australia, New Zealand and South Africa, with the broker seeing these countries as continuing to benefit to some extent at least from higher commodity prices.
Politics may also play a role in the outlook for earnings as with inflationary pressures on the increase the broker sees scope for governments to be on the lookout for signs of wage earners feeling the combined pinch of higher food and fuel costs, as such second-round inflation effects are also likely to impact on the level of corporate earnings growth in the longer-term.
Inflation pressures are also expected to signal the end of easy monetary policy and this too will weigh on profitability, the current Australian experience being a prime example of this. As a result, the broker suggests there are signs the current downtrend in profitability could in fact be longer-lasting rather than simply part of a natural cycle.
Looking at different countries in detail the broker suggests profits at US companies this year and going forward will depend largely on the ability to push through price increases to offset higher input costs. This may bring some associated volume pressures in some industries, while concern over wages and pushes for further protectionism are likely to be issues for some time to come. As a result it appears to the broker corporate profits actually peaked in the US in 2006.
The European Union nations also appear to be dealing with an increase in political problems such as the level of wages, while inflation is also a growing threat and is likely to result in tighter monetary policy sooner rather than later. Such an outcome is expected to see profitability trend down in coming years.
In Japan the issue in recent months has been a fall in profitability despite solid levels of capacity utilisation, the broker putting this down to higher input costs. With conditions expected to worsen rather than improve in coming quarters falls in capacity utilisation are expected, which would push down profitability.
For Asia ex-Japan the issue in the broker’s view is how much will economic growth decline on the back of a weaker global economy and how much will this drag down corporate earnings. It sees those countries with greater exposure to the tech and industrial sectors as most at risk, which implies Taiwan, Korea and Singapore. In contrast, strong domestic demand in countries such as Malaysia, Indonesia and Thailand mean they appear less exposed to any slowdown.
Conditions in China seem to be holding up relatively well, the broker putting this down to the government policy of shielding the broader economy by squeezing margins for state-owned companies in the utility and refining sectors. As well, strong domestic demand supports a continuation of relatively strong growth.
Assuming such an outcome in China occurs then South Africa should be relatively insulated from any significant slowdown in the broker’s view as commodity markets will remain strong and this will support South African corporate earnings. There will be some sectors affected though, the broker pointing to the retail, bank and food production sectors as most exposed to earnings downgrades as disposable income levels soften.
In Australia the broker expects wages as a proportion of GDP will continue to fall, meaning corporate profitability should continue to rise on the back of still strong commodity prices. Outside the mining sector though the picture is not as pretty, with a strengthening currency and higher interest rates to keep the pressure on the transport and manufacturing sectors in particular.
It is a similar story for domestically oriented sectors in New Zealand as cost pressures and a falling wealth effect from declines in the housing market crimp both demand and corporate earnings, the only possible bright spot in the broker’s view being a possible easing of labour market pressures.
