Rudy’s View: Trend Is Turning For Corporate Profits

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In this week's Weekly Insights:

-Trend Is Turning For Corporate Profits
-No Weekly Insights Next Week
-FNArena Talks
-AusbizTV

By Rudi Filapek-Vandyck, Editor FNArena

Trend Is Turning For Corporate Profits

First came the bond market rout, because the Federal Reserve conceded it had waited too long to tackle inflation and thus portfolios globally needed a major reset.

Cue the January sell-off which in particular hit yesteryear's champion performers, i.e. technology, growth, quality and low-volatility defensives.

The Fed's about-face also triggered the worst performance for bonds… ever? Arguably, with all major US equity indices down double-digits year-to-date, a bear market is unfolding for both bonds and equities which is exactly what happened back in 1994.

Back then, the Federal Reserve was equally in accelerated tightening mode to combat too-high inflation.

Once the Fed was done, and inflation had been tamed, there followed no recession and equity markets globally embarked on a strong up-trend that would only be interrupted by a hedge fund debacle (LTCM) and the Asian currency crisis, until the TMT/Nasdaq bubble burst in March 2000.

Equity investors and commentators are by default optimistic and positive, so many will be counting on a repeat of the post-1994 era, which is possible, though not a guarantee.

Either way, first markets have to shrug off the tail-end of this year's bond market abyss and inflation scare; meanwhile the focus already is shifting to the consequences of accelerated central bank tightening, which might well end with the next economic recession. Consumers are now leveraged to low rates and housing is an important driver for most economies.

Within this context, it's probably not wise to focus on current corporate earnings reports or still firm looking economic data and indicators. Accelerated rate hikes in the US combined with quantitative tightening (= reduced liquidity) amounts to what could well turn out to be the biggest leap in tightening ever undertaken by any central bank in such a short period.

This is the true meaning of "aggressive tightening", a policy-stance that has become necessary in 2022 because inflation is (way) too high for comfort, and central bankers have by now lost confidence it will deflate by natural forces alone.

The scenario only few are willing to talk about in the world of equities is that if inflation now sticks around for longer, the only way to bring it back down to acceptable level is through economic contraction, i.e. a recession.

It may yet take a while before investors can confidently assess whether a US recession can be avoided, or not, but shorter-term the focus is shifting to the deteriorating outlook for corporate profits, on the back of stubborn inflation, slowing growth and still plenty of interruptions and sectorial headwinds.

The US leading the way?

In the US, more than anywhere else, business leaders have refined the art of beating market expectations. In just about every single reporting season, and they have four each year, the aggregated statistics are stunningly good. The current season over there is no exception with all 11 sectors beating consensus forecasts thus far.

Despite the market's scepticism, and various harsh punishments in case of major disappointments, the consensus EPS forecast for this year has actually risen by circa 4% since the start of April. At face value, this has created an odd schism between weak share prices and bearish market sentiment whereas corporate profits are actually better-than-expected and forecasts in aggregate are still rising.

But don't be fooled by what the situation looks like on the surface. More experienced market analysts warn there is a lot of smoke and mirrors happening and recent, in-depth analysis by BofA Securities suggests the running season instead is shaping up as a turning point in trend, for the worse.

Take the energy sector out of the calculation, says BofA, and the underlying trend is already slightly negative. On BofA statistics, both ratios for companies providing forward guidance and for analyst revisions to earnings are running at their lowest level since the second quarter of 2020 – at the height of the then freshly-arrived covid pandemic.

BofA has developed its own natural language processing (NLP) analysis which reads earnings calls transcripts while measuring overall sentiment via the language used by corporate leaders.

This proprietary piece of insight equally suggests the underlying trend is back to where it was in Q2 of 2020. On a year-to-year basis, report the analysts, this season's plummeting NLP sentiment score marks the biggest drop outside of the GFC and covid recessions.

History shows such a sharp deterioration in sentiment indicates US earnings growth is about to get a lot worse – not something that is currently assumed in analysts' forecasts, including BofA's. And equity markets tend to follow corporate earnings, both during up-trends as well as when the trend deteriorates.

BofA analysts have identified two important covid demand reversals taking place this reporting season: a rapid shift from big ticket items such as housing and autos -sensitive to rising rates- towards services, while earnings forecasts for the technology sector are now fully reversing the positive pull-forward from covid over the past two years.

Further adding to the analysts' scepticism about market forecasts is the fact that, historically, forecasts tend to start each calendar year on an optimistic note and then, in aggregate, decline as the year progresses.

This year, however, forecasts for both 2022 and 2023 have kept rising while macro conditions are arguably becoming more challenging.

BofA's 2022 year-end fair value target for the S&P500 is 4368 (the index closed at 3991 on Monday).

Inflation Is Real, Finds Corporate Australia

Last week, 103 ASX-listed companies presented at the annual Macquarie Conference and analysts report inflation made a come-back as the key common factor most cited by company representatives.

A year ago, report Macquarie analysts, a quarter of presenters mentioned rising costs. This year just about everyone talked about costs and inflation, also on the back of tight labour markets and covid-related absenteeism.

Macquarie also noted a big gap: while most companies seem comfortable they can pass on cost increases, investors are more sceptical about it. Witness, for example, share prices for most discretionary retailers this year.

Strategy-wise, Macquarie is most comfortable holding shares in beneficiaries of higher rates, like Computershare ((CPU)), or in companies that posses contract-based pricing power, such as Transurban ((TCL)), while producers of commodities with strong cash flows, covid recovery plays and defensives on reasonable valuations are also included.

Stocks mentioned for the latter three segments include South32 ((S32)), CSL ((CSL)), Dexus ((DXS)), and Amcor ((AMC)).

Market segments now facing headwinds include lower interest rate beneficiaries (housing, autos, discretionary retail), covid beneficiaries and so-called higher beta stocks, including cyclicals, small caps and stocks with no earnings.

Many Reasons To Sell

Australia has its own out-of-season corporate results season running and thus far, it has to be pointed out, the numbers don't look too bad, even though we are talking about a small parcel of companies only (17 up until last Friday).

So far a large majority of reports has either beaten (41%) or met (35%) analysts' forecasts, including the household names of National Australia Bank and Premier Investments ((PMV)), joined by Westpac ((WBC)) on Monday, and resources-related WH Soul Pattinson ((SOL)), Gold Road Resources ((GOR)), and New Hope Corp ((NHC)).

See also FNArena's Corporate Results Monitor: 

https://www.fnarena.com/index.php/reporting_season/

Outside of the 40-odd companies that traditionally release financials in between February and August, there is a growing tendency for ASX-listed companies to release quarterly updates, which only adds to the broader insights available to investors. Here two negative observations stand out: confession season is back in Australia, with a vengeance, plus investors will not hesitate to punish, and to punish immediately and hard.

Last Friday, quarterly releases by News Corp ((NWS)) and REA Group ((REA)), as well as the half-yearly financials reported by Macquarie Group ((MQG)), all disappointed. On Monday, share prices are down -16%, -11% and -10% respectively.

The carnage has been a lot worse for the likes of ARB Corp ((ARB)), Atomos ((AMS)), BWX ((BWX)), Corporate Travel Management ((CTD)), EML Payments ((EML)), Inghams Group ((ING)), Janus Henderson ((JHG)), Pointsbet Holdings ((PBH)), Tyro Payments ((TYR)) and many, many others.

The thesis that smaller cap companies are more likely to struggle when put under pressure is certainly receiving a lot of affirmations in Australia this quarter, while trends of higher input costs, ongoing supply chain challenges and technology companies giving up all their covid-related benefits are equally all too apparent too.

Offsetting these ultra-negative experiences have been rather positive and affirmative market updates by the likes of AdBri ((ABC)), Eclipx Group ((ECX)), Lovisa Holdings ((LOV)), MA Financial Group ((MAF)), nib Holdings ((NHF)), Orora ((ORA)), QBE Insurance ((QBE)), Super Retail ((SUL)), and Vicinity Centres ((VCX)).

It is not too difficult to establish many of the positive updates were delivered by companies that were previously lagging or suffering from covid impacts. Alas, with macro factors remaining dominant, and liquidity in general remaining an issue, not all positive market updates are rewarded via a good old fashioned share price rally, plus not all initial rallies stick.

I have been warning since late March for the rising risk of disappointing market updates and profit warnings ahead of the August results season, but the confluence of such a diverse set of factors impacting on market sentiment and share prices has made it practically impossible to avoid any form of portfolio damage.

Add the moribund performance of gold bullion, and the only asset that has truly retained its value over the past months is cash. I suspect this might well remain the case until we see a genuine market capitulation, or the Federal Reserve and other central banks refrain from their aggressive tightening intentions.

Up until such turning point, investors better tread carefully because the ASX looks like a minefield these days, and it's pretty much impossible to predict where the next disappointment might come from.

Short-term damage doesn't necessarily destroy the longer-term investment thesis, but it surely can hurt in the immediate.

Looks A Lot Like 1994

In further confirmation that optimism in equity markets is directly linked-in with a much more benign path for central bank tightening than bond markets are implying, UBS analysts have repeated their positive view for Australian equities by year-end.

This view is based on the in-house conviction that the RBA will cease hiking the cash rate well before all those aggressive forecasts we all get to read in daily newspapers and elsewhere come to fruition. It's simple, argues UBS, hike interest rates in line with the current bond market and thou shalt crash local housing.

Does anyone out there want that to happen? Certainly the RBA does not.

UBS thinks the RBA will not hike beyond 1.60%, which translates into 25bp follow-up moves in each of June, July and August, then a pause, and two more hikes in November and February next year. In case stronger-for-longer inflation requires more hikes, it won't be long before the RBA will be forced to start cutting rates, predicts UBS.

Elsewhere, UBS analysts have come to the conclusion that 2022 is following the script of 1994 when accelerated tightening from the US Fed caused a big reset for global bonds.

Australian equities, at the index level, lost -10% that year. Mining and Energy sectors outperformed the broader market back then, as they have thus far in 2022.

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 More to read:

-A Bear Market Anomaly That Confuses

https://www.fnarena.com/index.php/2022/05/05/rudis-view-a-bear-market-anomaly-that-confuses/

-Peter's Portfolio Reviewed:

https://www.fnarena.com/index.php/2022/04/13/rudis-view-peters-portfolio-reviewed/

-Double Your Protection:

https://www.fnarena.com/index.php/2022/03/17/rudis-view-double-your-protection/

No Weekly Insights Next Week

Weekly Insights takes a short break next week and will resume the following week.

FNArena Talks

Video of my recent Zoom presentation to members of University of the Third Age (U3A) in Toowoomba is now available to all:

https://www.fnarena.com/index.php/fnarena-talks/2022/05/05/2022-exploiting-the-post-pandemic-recovery/

AusbizTV

I am scheduled to appear on AusbizTV's The Call on Tuesday, midday-1pm:

https://www.ausbiz.com.au/

(This story was written on Monday 9th May, 2022. It was published on the day in the form of an email to paying subscribers, and again on Thursday as a story on the website).

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via the direct messaging system on the website).

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