Rudi’s View: Quo Vadis, Corporate Profits?

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In this week's Weekly Insights:

-Quo Vadis, Corporate Profits?
-Conviction Calls
-FNArena Talks

By Rudi Filapek-Vandyck, Editor FNArena

Quo Vadis, Corporate Profits?

Bad things tend to happen when global economic growth dips below 3%. In recent days I have been alerted to this historical observation by multiple economists and market analysts, so I thought it is worthwhile highlighting this point.

GDP forecasts around the globe are in decline, with many a forecast now sitting marginally above 3% for the global economy this year and next. This makes that historical observation potentially even more important.

One key ingredient to those forecasts is, of course, how much central bank tightening needs to occur to bring consumer price inflation back under control.

Truth is, we don't know. Which is why traders, investors and central bankers are all watching the data very closely.

Markets Oversold In May

Global equities had looked technically oversold for a number of weeks, but that interview by Fed Chair Jerome Powell to the Wall Street Journal mid-month had kept a firm lid on overall enthusiasm to start piling back in.

'Don't fight the Fed' has a different meaning this time around.

Investors needed a bit of extra time to fully digest the new Fed narrative. Controlling inflation is now of the uppermost importance (see also further below).

When markets are oversold, the smallest hint of optimism can trigger the next rally. Last week US indices rallied more than 6% to post their best week for the calendar year to date. According to the latest economic data, the all-important US consumer remains eager to spend, even if this means he/she has to dip into savings.

And there are quite a few suggestions that inflation is no longer poised to keep surprising to the upside, despite expectations for higher energy and materials prices in the quarter(s) ahead.

Peak Inflation Anxiety?

Reduced anxiety about inflation in particular might be the most important development in May, if it proves to be accurate. It implies that bond yields might have peaked already, as also shown by the US ten-year yield declining towards 2.75% from 3.10% earlier.

A more relaxed US bond market might allow equity markets to become less volatile, in a general sense, but it will also allow those market segments that had previously de-rated to shift back onto investor radars.

Think bond proxies such as REITs, property developers and infrastructure owners, but also Quality and Defensive Growth stocks that traditionally trade on higher valuation multiples.

In Australia, I note both Carsales ((CAR)) and Goodman Group ((GMG)) shares are back above $20, while the likes of Cochlear ((COH)), NextDC ((NXT)) and IDP Education ((IEL)) are well off their lows.

One cannot argue with 'hope' and it is very likely equity markets will adopt the view that if central bankers can relax more about further momentum for inflation, they don't have to stick with their intentions for aggressive tightening. This reduces the risk for over-tightening, and thus for an economic recession.

Not everybody is on board with this reasoning, as also illustrated by the latest comment from the economics desk at Citi:

"Markets are increasingly reflecting the idea that slowing growth will lead to a more dovish Fed policy rate path. We disagree with this assessment and see risks still balanced toward a more extended period of above-target inflation requiring a further tightening of financial conditions."

I still remain a bit wary myself, not in the least because the Federal Reserve will also embark on Quantitative Tightening (QT), i.e. actively selling bonds. Nobody knows what the impact of additional liquidity withdrawal will look like, but we are going to find out.

Corporate Profits: The Next Concern

In the background of this year's Grand Debate about inflation, interest rates and bond yields, and the impact of it all on housing markets and economies in general, investor focus is already turning towards corporate margins and profits – the next Big Challenge for equities this year.

It is this second challenge that keeps me worried about the outlook for equities.

Simply put: markets have devalued on a normalisation in bond yields, which has pulled down the 'P' in average Price Earnings (PE) ratios. But now we will have to deal with the 'E', earnings (profits), and outside of energy producers and bulk commodities coal and iron ore, the trend has already turned negative – globally.

These are slow-moving processes, and more downside should be expected, if only because inflation is slow-moving too, and multiple challenges remain amidst slower economic momentum.

In the US, where super-margins and super-profits previously combined with outsized gains and valuations, the simple observation is the Q2 reporting season failed to inspire. In about six weeks, US companies start releasing their Q3 financials.

It's going to be interesting, to say the least.

In Australia, we don't have extensive quarterly reporting and the 50-odd, mostly mid-cap companies that report in between February and August are not representative for the bulk of the local share market.

Investors have seen a number of profit warnings coming through, mostly issued by companies of questionable quality or of a relatively small size, bringing home the old truth that smaller companies are more vulnerable to economic challenges.

I do expect to see a lot more "confessions" as the financial year draws to a close and the August reporting season beckons.

It is not always easy to spot the next profit warning coming, and many a share price has received quite a shellacking already, for general fears of lower profits or otherwise.

Analysts at UBS recently pointed out commodity-related costs for their universe of companies throughout the Asia-Pacific have gone up by 29% year-to-date.

Conclusion: "With operating leverage fading and the impact of cost increases typically taking three months to feed into margins, the risk to earnings remains substantial at least over the next quarter".

Even more concerning is that UBS has placed Australia in the least favoured basket for the APAC region, suggesting ASX-listed companies are likely to fare worse than those in China, Singapore, Indonesia, Philippines and Malaysia.

Differences in pricing power means some companies are better equipped to deal with rising cost challenges than others. This is why, for example, packaging company Amcor ((AMC)) is trading near an all-time high when energy and commodity prices are running hot on supply constraints.

Unfortunately, the UBS research focuses mostly on companies in China, Japan and elsewhere, with only a small number of ASX-listed names mentioned. Imdex ((IMD)) is seen as a potential candidate for the next profit warning, while a2 Milk ((a2M)), Bega Cheese ((BGA)), Synlait Milk ((SM1)) and KMD Brands ((KMD)) have been nominated as likely beneficiaries for any sustained decline in commodity prices.

Another noteworthy observation relates to the latest global update by Citi which reveals Australia is one of few markets where average EPS growth is forecast to be negative in 2023. The reason is that following a stellar increase in EPS forecasts this year for the Energy and Materials sectors, Citi forecasts have both sectors retreating into negative growth next year.

That'll be the next challenge for investors; assessing for how long exactly may the current favourable environment last for what are, in essence, highly leveraged, cyclical businesses.

Meanwhile, Citi's Bear Market Checklist has improved on the back of lower share prices with only 6 out of 18 components flashing red or amber warning signals. At the end of last calendar year, the score was 8.5 or nearly 50%. Back in October 2007 the score was 13, while in March 2000 the list had 17.5 out of 18 indicators calling Mayday, Mayday!

The market sentiment indicator previously known as Citi's Panic/Euphoria Index, now relabeled as Levkovich Indicator, is not signalling equities are in Panic mode, but the indicator is not that far off, and a long while from the Euphoria that characterised 2021.

Citi's indicator has no bearing on short-term sentiment or market direction but at current level Citi suggests there should be good buying opportunities for investors taking a 12-months view or longer.

Market strategists at Morgan Stanley tend to agree with that assessment. They also believe equity indices are likely to face more downward pressure depending on how much lower corporate profits might fall.

And that, history suggests, is now the most important question of all: quo vadis, corporate profits?

Australian investors might have to wait a little while yet to find out, but the next US corporate results season is only 1.5 months away.

More Reading:

-Don't Fight The Fed: https://www.fnarena.com/index.php/2022/05/26/rudis-view-dont-fight-the-fed/

-Trend Is Turning For Corporate Profits: https://www.fnarena.com/index.php/2022/05/12/trend-is-turning-for-corporate-profits/

-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/

-2022, The Big Adjustment: https://www.fnarena.com/index.php/2022/02/17/rudis-view-2022-the-big-adjustment/

FNArena Corporate Results Monitor:

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

Conviction Calls

It's one of the calls that will generate a lot of attention, both from financial media and from investors the world around.

Goldman Sachs has called the peak in modern battery metals lithium, cobalt and nickel, now forecasting steep falls in prices over the coming two years.

The suggested trajectory in respective prices is different with the analysts projecting a fall-off-the-cliff experience for lithium, a meaty price fall for cobalt and an ongoing rally for nickel into year-end, then followed by a serious correction.

With spot lithium currently priced around US$60,000/tonne, the broker's year-average estimate declines to US$53,982/tonne for 2022, with an average of US$16,372/t penciled in for 2023.

For Cobalt, the current spot price of circa US$87,000/t compares with the broker's year-average estimate of US$78,500/t for 2022, and US$59,500 for 2023.

Nickel is currently priced around US$31,000/t but Goldman Sachs anticipates another rally to US$36,500/t over the rest of the calendar year, with its price averages at US$31,000 and US$30,250/t respectively for this year and next.

The good news is, on Goldman Sachs' projections, the forthcoming deep correction will sow the seeds for the next Super Cycle for these materials, likely to commence by the second half of this decade, with supply struggling more severely to catch up on strong growth in demand.

By 2030, estimated market deficits are around one third for cobalt, more than one fifth (22%) for nickel and 13% for lithium with the broker highlighting these forecasts incorporate active recycling of materials by then.

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Global strategists at Morgan Stanley believe the Bear Market for equities has further to run with a close eye on aggressive central bank tightening and a deteriorating outlook for corporate profits.

Morgan Stanley's preferred setting is now relatively Underweight equities, with Australia left as the sole Overweight allocation because of the ASX's leverage to materials as well as its high dividend yield. The RBA is not as aggressive as the Fed, which feeds into the more defensive narrative of the local economy.

More support is seen from the Australian dollar which, short-term, is expected to fall to US67c and climb back to US70c into 2023.

Morgan Stanley favours Energy, Healthcare and Materials on the ASX over housing linked and consumer-related exposures. Banks have recently been lowered to an underweight position. Value is preferred over Growth.

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Talking about ongoing risks in a Bear Market that doesn't seem near its end by half, last week Greg Galton, director Private Wealth Research at Canaccord Genuity, summarised the key risk for equities as follows:

"If the rate of increases in US inflation drops sharply in coming months, the Fed may at least pause its rate hike plans after June or July. This could avoid recession and might allow equities to at least grow in line with still-positive corporate earnings.

"We are still some months away from a clearer picture on the speed of US disinflation."

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Analysts at Citi seem convinced the market has treated consumer-related equities on the ASX too harshly, instead suggesting the outlook remains relatively robust for household goods throughout the rest of 2022, while momentum in food retailing is "normalising".

Citi used the latest research update to highlight it currently has Buy ratings for Coles ((COL)), Woolworths ((WOW)), Super Retail ((SUL)), Harvey Norman ((HVN)), Beacon Lighting ((BLX)), Nick Scali ((NCK)), Premier Investments ((PMV)), City Chic Collective ((CCX)), Lovisa Holdings ((LOV)), and Michael Hill International ((MHJ)).

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Rising concerns about a global recession have combined with a severe de-rating for ASX-listed technology stocks and sector analysts at Goldman Sachs have directed their focus towards identification of those technology companies that look well-placed to navigate what looks like a much tougher environment ahead.

Free cash flow, balance sheet health and recurring revenues are thus top of the priority list with a minimum market cap of $250m required.

Interestingly, TechnologyOne ((TNE)) came out as the best-positioned among all Buy-rated stocks, however… if we can ignore the current valuations and recommendations then the two best placed companies are Pro Medicus ((PME)) and WiseTech Global ((WTC)), on the broker's analysis.

Because of its high valuation, still, Pro Medicus is Sell-rated by the broker, while WiseTech is currently rated as Neutral.

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Equity strategists at UBS have updated their list of Best Stock Ideas in Australia; essentially those stocks that are believed to represent the broker's team of analysts most and least preferred investment ideas for the 12 months ahead.

Broader picture, UBS retains a preference for so-called late-cycle sectors, as well as companies that should benefit from higher inflation. In addition, the strategists seem convinced the chosen companies will be able to achieve solid earnings growth even as the outlook in general is deteriorating.

Wesfarmers ((WES)) and Qantas Airways ((QAN)) have replaced Harvey Norman ((HVN)) and Brambles ((BXB)) on the most preferred list, whereas growing concern about the cost of doing business for building materials and food producers has led to the inclusion of AdBri ((ABC)) and Inghams Group ((ING)) to the least preferred selection.

That Least Preferred list further includes Charter Hall Long WALE REIT ((CLW)), Insurance Australia Group ((IAG)), Magellan Financial Group ((MFG)), Telstra ((TLS)), and Woolworths ((WOW)).

As far as the list of Most Preferred Best Stock Ideas goes, resources are represented by BHP Group ((BHP)), Northern Star Resources ((NST)), Origin Energy ((ORG)), South32 ((S32)) and Santos ((STO)), while for Financials, UBS has selected Computershare ((CPU)), QBE Insurance ((QBE)) and Westpac ((WBC)).

Other inclusions are Amcor ((AMC)), GUD Holdings ((GUD)), IDP Education ((IEL)), James Hardie Industries ((JHX)), NextDC ((NXT)), Nine Entertainment ((NEC)), Select Harvests ((SHV)), Seven Group Holdings ((SVW)), Stockland ((SGP)), and Treasury Wine Estates ((TWE)).

FNArena Talks

Last week's presentation on the outlook for equities is available via the FNArena Talks section on the website (51 minutes):

https://www.fnarena.com/index.php/fnarena-talks/2022/05/30/2022-outlook-when-cash-is-king/

Subscribers can download the slides via the Special Reports section on the website (scroll down).

(This story was written on Monday 30th 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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