Rudi’s View: Corporate Profits – The Next Challenge

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In this week's Weekly Insights:

-Corporate Profits – The Next Challenge
-Conviction Calls

By Rudi Filapek-Vandyck, Editor FNArena

Corporate Profits – The Next Challenge

The first six months of 2022 have not been easy to navigate for investors, but the next challenge might turn out to be just as tricky with analysts forecasts looking too rosy and companies potentially too optimistic about their ability to absorb the many changes happening while also maintaining their profit margin.

While much attention is going out to local retailers and other consumer-related companies, as share prices for the likes of Nick Scali ((NCK)), Super Retail ((SUL)), Temple & Webster ((TPW)) and Wesfamers ((WES)) might have been over-sold (at least for the medium term), one sector that has equally caused a lot of damage to investment portfolios is the local mining sector.

It was not simply a matter of macro-factor selling either as companies including OZ Minerals ((OZL)), St Barbara ((SBM)) and Dacian Gold ((DCN)) fessed up to what should have been on every investor's mind beforehand: miners might have been enjoying strong price rises for their raw products, but those companies in the field are equally users of electricity, diesel, gas, and other commodities, while higher transport costs and staffing problems, not to mention excessive rain on the East Coast and yet another wave of covid infections further add to operational risks.

Sure, the prospects of an economic recession in key countries next year should be on every investor's mind, but what about cost pressures right here, right now?

The team of metals and mining analysts at JP Morgan believes the upcoming reporting season won't be pretty for the sector, with cost inflation accelerating while worker absenteeism remains a problem too.

JP Morgan has now factored in more conservative forecasts, but still, the team is forecasting "the current doom-and-gloom to last through the July/August reporting season (negative news flow) before a more constructive macro backdrop (China reopening) helps support the sector".

More conservative projections have led to reduced valuations and JP Morgan reports the average cut in Net Present Value (NPV) has been -15% across the sector. Only one company received a downgrade in rating; Newcrest Mining ((NCM)) moved to Neutral from Overweight. OZ Minerals, post public shellacking, was upgraded to Overweight from Neutral.

While expecting the weeks ahead might prove a real challenge for investors in the sector, the team at JP Morgan has nominated four sector Top Picks: OZ Minerals, BlueScope Steel ((BSL)), IGO Ltd ((IGO)), and South32 ((S32)).

As Evolution Mining ((EVN)), equally post-shellacking, is now seen trading near five year-lows, this stock has become the broker's most preferred among gold producers.

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The upcoming results season won't simply be an extended line-up of negative corporate confessions, of course. There will be surprises to the upside. Plus some share prices will be seen as having fallen too far, even after releasing disappointing operational numbers.

A recent preview published by stockbroker Morgans on the local gaming sector singled out Jumbo Interactive ((JIN)) as one company that is likely to report strong growth numbers in August, followed by yet another year of strong growth in FY23. The analysts are equally positive about Tabcorp spin-off The Lottery Corp ((TLC)).

While noting Morgans' projections for Jumbo are slightly below market consensus, the company is the only one whose forecasts have not been downgraded ahead of August.

The other companies are BlueBet Holdings ((BBT)), Star Entertainment ((SGR)), Tabcorp Holdings ((TAH)) and The Lottery Corp, as well as Aristocrat Leisure ((ALL)) which does not report in August; the company only just released its six-monthly update in May.

Equally important: with the notable exception of Star Entertainment and Tabcorp, all four other companies are Buy-rated ('Add') at Morgans, with price targets that are double-digit percentages above present share prices (except for Tabcorp).

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One sector that remains on investors' radar are discretionary retailers. The Big Questions that to date remain unresolved:

-have share prices sunk too low?
-is it too early to expect the end of downgrades?
-what if next year proves The Bottom for this sector – how will investors respond in the meantime?

Similar to Morgans on gaming stocks, analysts at Jarden have cut their forecasts for ASX-listed discretionary retailers, many of those reductions are significant, in particular for FY23. But Jarden also suggests a general uptick in consumer confidence can translate into significantly less risk for the sector, which would make share prices look "cheap".

Judging from Jarden's revisions in forecasts, the news from upcoming results releases will look a lot less dire from household goods than from companies selling fashion or recreation goods.

Jarden has tried to apply multiple filters to identify which companies in the sector might be great value at present and its screens generated a positive outcome for Woolworths ((WOW)), Flight Centre ((FLT)), Domino's Pizza ((DMP)) and Accent Group ((AX1)).

Those that screened negatively: Harvey Norman ((HVN)), JB Hi-Fi ((JBH)), Nick Scali, Super Retail, and Beacon Lighting Group ((BLX)).

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These are but early attempts in what soon will become an avalanche in analyst updates and revisions ahead of and during the August reporting season in Australia, which is still 2-3 weeks away.

Meanwhile, another quarterly season of corporate reports is about to start in the US. Investors will be glued at their screens to find out whether, as just about everyone assumes, market forecasts need a significant re-set. For Australian investors, freshly emerging trends in the US might be translated onto the ASX.

One additional complication for US markets is the negative impact from a stronger US dollar. As pointed out by Morgan Stanley this week, a simple math on S&P500 earnings is that for every percentage point increase year-on-year, EPS growth is negatively impacted by 0.5x.

Given the USD is currently up by 16% year-on-year, this implies EPS in the US is facing a headwind of -8% just from the currency.

Therefore, concludes Morgan Stanley, the recent rally in stocks is likely to fizzle out before too long.

More Weekly Insights to read:

-Minus 20% https://www.fnarena.com/index.php/2022/07/07/rudis-view-minus-20/

-Quo Vadis, Corporate Profits? https://www.fnarena.com/index.php/2022/06/02/rudis-view-quo-vadis-corporate-profits/

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

Conviction Calls

Albert Edwards became an instant celebrity during the bear market of 2008/09 when his index projections first looked ridiculous, then eerily accurate.

But fame in global finance doesn't stick. Not when the next decade turns into a raging bull market and you're still doing your utmost best to highlight and emphasise the potential negatives.

And that, we should all realise, is Edwards' job at Societe Generale. His often outlandish views do not correspond with his employer's official prognosis – Edwards is specifically employed to offer the 'what if' scenarios, as in: what if the world goes pear-shaped in the year ahead?

That said, Edwards has been reflecting back on the 2008-experience of late, and more specifically how energy and mining stocks held up back then, while the rest of markets got shredded into little pieces, until both sectors too had to give in to the gravity-pull of the GFC bear market.

Thus far, Edwards observes, 2022 is pretty much following the same scenario, with small differences in timing. His conviction thus remains undeterred:

"Soft-landing advocates must now face the overwhelming evidence of economic collapse and extricate their heads from the sand."

The Ukraine war is keeping oil prices elevated for longer, but Edwards predicts it won't change the broader picture in that oil prices too will eventually respond to the severe recession that is coming. His key surprise has been in weakening agricultural commodities. But then again, this simply feeds into his view that energy prices cannot stay where they are.

The Big Surprise over the next six months, Edwards predicts, will be a collapse in global CPI surveys as commodities deflate and a deep recession announces itself. Get prepared for 10-year bond yields returning below 1% is his credo.

"…a cyclical bust awaits and that will feel very much like a full-blown return to deflation."

The simplest of warnings here is that, back in 2008, just about everyone smiled (if not laughed) when hearing about Edwards' predictions early in the year, but six months down the track a general sense of awe had overtaken the initial ridicule.

Was 2008 the one lucky gambit or will 2022 cement Edwards as the one to turn to during bear markets?

The answer, as Bob once sang, is still blowing in the wind…

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Societe Generale's Albert Edwards is not, however, the most bearish of market commentators this year. He's in a very tight contest for that title with the team of strategists at Saxo Bank where the ruling view is the Everything-in-a-Bubble has now well and truly burst.

Our best guess, posits the team, is the S&P500 will ultimately correct some -35% from its peak while the market finding its bottom could take as long as the middle of next year.

"The V-shape recovery will not happen this time and the bear market will likely not exhaust itself until the new generation of investors that went all-in on speculative growth stocks, Ark Invest funds, Tesla and cryptocurrencies have fully capitulated."

Saxo is preparing for inflation to remain structurally high, for yet another crisis in Europe, as the world of crypto-assets is facing a Big Clean Up, likely resulting in much stricter regulation (than otherwise would have occurred), while a come-back for fossil fuels is sending clean energy commodities "off the rails".

Industrial commodities will go into hibernation, to be awoken again later on as the global economy is facing an L-shaped recovery trajectory. Saxo refers to prior bear markets of 1970s, 2000 and 2007 and the fact after each of those, economies took around four years to recover.

Saxo says companies to own this time around are energy producers and quality industrials that pay a dividend, with strong earnings and cash flows to sustain those dividends while fending off the pressure from higher rates, wage inflation and additional inflationary pressures.

The key conclusion to draw from Saxo Bank versus Edwards is there can be multiple scenarios to potentially push this year's bear market onto much lower levels.

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Shifting towards the here and now on equity markets, David Rosenberg of Rosenberg Research (I've mentioned him before) remains steadfast in his view that what is occurring in July is simply a short-term relief rally/bounce from heavily oversold conditions.

Best to leave this uptrend to shorter-term traders, suggests Rosenberg, as investors should treat it as a counter-movement inside an overall downtrend.

Rosenberg continues to preach investment portfolios should be conservative and defensive with the Federal Reserve over-estimating real strength in the US economy. Soon Powel & Co will be forced to pause in their tightening process, albeit it will be too late to avoid a recession, remains Rosenberg's view.

Inflation will be replaced by another period of deflation, with much lower bond yields, if Rosenberg's predictions prove correct.

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Tim Toohey, Yarra Capital Management's Head of Macro and Strategy, offers a glimpse of optimism in that he still anticipates a challenging third quarter for equity markets this year, but Q4 might bring along the "line in the sand" when quities might enjoy the early beginnings of a genuine rebound.

Toohey's time schedule is based upon a number of assumptions:

-The Fed will stop tightening around September as economic data deteriorate

-Falling commodity prices and bloated inventories will soon have US inflation starting to surprise to the downside

-The RBA too will complete its tightening cycle before year-end, at around 2.35% and while Australia should avoid a recession, growth next year will be scant

The silver lining for markets, suggests Toohey, is that interest rates will likely be lower than what the bond market is currently pricing.

"September-October should be the time to re-enter and take advantage of some relatively indiscriminate selling in quality equity names."

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Strategists at UBS remain steadfast in their prediction that earnings forecasts are not only too high, the process of re-adjustment to a much tougher environment will last until (at least) February next year.

Meanwhile, investors are advised to take a much more defensive stance with UBS guiding towards companies that should outperform in times when inflation is high and interest rates rising, while the growth outlook is decelerating.

UBS's selection of Best Ideas has been expanded with Metcash ((MTS)), Transurban ((TCL)) and TPG Telecom ((TPG)), as well as ANZ Bank ((ANZ)) and Steadfast Group ((SDF)), plus lithium miner IGO ((IGO)).

Stocks that have been removed from the list are Northern Star Resources ((NST)) and South32 ((S32)), Westpac ((WBC)), GUD Holdings ((GUD)), Nine Entertainment ((NEC) and Select Harvests ((SHV)).

Have kept their inclusion: BHP Group ((BHP)), Origin Energy ((ORG)) and Santos ((STO)) for Resources exposure; Computershare ((CPU)) and QBE Insurance ((QBE)) in Financials; and Amcor ((AMC)), IDP Education ((IEL)), James Hardie ((JHX)), NextDC ((NXT)), Qantas Airways ((QAN)), Seven Group Holdings ((SVW)), Stockland ((SGP)), Treasury Wine Estates ((TWE)), and Wesfarmers ((WES)).

UBS's Best Ideas also comes with a Least Preferred section, which saw the removal of Inghams Group ((ING)), Telstra ((TLS)) and Woolworths ((WOW)) and the fresh inclusion of Harvey Norman ((HVN)), InvoCare ((IVC)) and Macquarie Group ((MQG)).

Those who've kept their Least Preferred status are Adbri ((ABC)), Charter Hall Long WALE REIT ((CLW)), Insurance Australia Group ((IAG)), and Magellan Financial Group ((MFG)).

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Traditionally, analysts at Bell Potter select their top picks for the year ahead at the conclusion of each financial year. This year, it has to be said, the selected Stock Picks for FY23 show a remarkable absence of large cap companies.

Is Bell Potter trying to outperform the Big Bear through small cap champions? Or is this merely a reflection of the broker's belief that, twelve months out, the local share market shall be back in full bull market mode?

Bell Potter's selections traditionally are done sector by sector, so here goes the list for FY23:

-Listed Investment Companies; L1 Long Short Fund ((LSF)), PM Capital Global Opportunities Fund ((PGF)), and WAM Alternative Assets ((WMA))

-Agricultrure and Fast Moving Consumer Goods; Select Harvests, Costa Group ((CGC)), and Nufarm ((NUF))

-Technology; TechnologyOne ((TNE)), Life360 ((360)), and Nitro Software ((NTO))

-Diversified Financials; Perpetual ((PPT)) and Pendal Group ((PDL))

-Industrials; IPD Group ((IPG)), DGL Group ((DGL)), Pentanet Ltd ((5GG)), Cluey ((CLU)) and Ai-Media Technologies ((AIM))

-Healthcare: Telix Pharmaceuticals ((TLX)), Paradigm Biopharmaceuticals ((PAR)), Avita Medical ((AVH)), Immutep ((IMM)), Lumos Diagnostics ((LDX)), Aroa Biosurgery ((ARX)), and Pacific Edge ((PEB))

-Base Metals & Gold; Aeris Resources ((AIS)), Nickel Mines ((NIC)), and Capricorn Metals ((CMM))

-Energy; Beach Energy ((BPT)), Strike Energy ((STX)), and Boss Energy ((BOE))

-Strategic Minerals; Liontown Resources ((LTR)), Alpha HPA ((A4N)), and Arafura Resources ((ARU))

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Technology analysts at JP Morgan have repeated their preference for Xero ((XRO)) -Top Pick for the sector- while Hub24 ((HUB)) remains their least preferred stock in the Australian sector for the second half of 2022.

Technology stocks that are currently Overweight-rated at JP Morgan are Altium ((ALU)), Bravura Solutions ((BVS)), Iress ((IRE)), NextDC, Superloop ((SLC)), Tyro Payments ((TYR)), WiseTech Global ((WTC)); all in addition to Xero, of course.

A recent sector update by Goldman Sachs analysts had them highlighting positive views for Xero and Megaport ((MP1)).

JP Morgan's Top Pick among Emerging Companies remains Iress while the Bottom Pick (least preferred) remains Flight Centre ((FLT)).

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A warning from MFS Portfolio Manager and Global Investment Strategist, Robert M. Almeida, Jr.; while it has become popular by today's Finance Commentariat to predict future outcomes through historic parallels and averages (the average bear market lasts, the average return from the bottom, etc), ultimately it is the degree of prior excess that will determine the outlook for today's equity markets.

"The length of the business cycle is irrelevant. What matters is the level of excess and the magnitude of the needed rebalancing process. That determines how much further we may still have to fall."

Almeida is worried about corporate margins in the face of obvious revenue and cost input pressures.

"Companies are telling investors they can maintain historically high profit margins despite rising recession risks and rapidly rising costs. History suggests otherwise."

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Wilsons' Focus List is Overweight Energy, copper and EV materials, Neutral on gold and Underweight iron ore. Exposure to these themes runs via BHP Group, Santos, Woodside Energy ((WDS)), OZ Minerals ((OZL)), Northern Star, and Allkem ((AKE)).

Banks are equally Overweighted with exposure to National Australia Bank ((NAB)), Westpac, ANZ Bank, and Judo Bank ((JDO)).

Exposure to Cyclical Value comes with Qantas Airways, Seven Group Holdings, and Tabcorp Holdings.

For Quality Cyclicals, the list includes Macquarie Group ((MQG)) and James Hardie ((JHX)).

For Structural Growth, included are Aristocrat Leisure, Goodman Group ((GMG)), Seek ((SEK)), and Pinnacle Investment Management Group ((PNI)).

Xero and Telix Pharmaceuticals ((TLX)) represent the High Growth segment for the local market while Quality Defensives include CSL ((CSL)), Insurance Australia Group, Telstra, HomeCo Healthcare and Wellness REIT ((HCW)), Lottery Corp ((TLC)), and Cleanaway Waste Management ((CWY)).

There's always room for the one Hidden Value punt and in Wilsons' case, that one remains with News Corp ((NWS)).

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Software has now become a 'Value' proposition on the ASX, argue Jules Cooper and Josh Goodwill, sector analysts at Shaw and Partners. Their portfolio of stocks under coverage currently consists of 17 ASX-listed companies, of which only three are not Buy-rated.

Both WiseTech Global and Pushpay Holdings ((PPH)) have a Hold rating, while the duo continues its dislike for Iress, rating it a Sell with no upside on the horizon.

Most preferred sector exposures are Whispir ((WSP)), Gentrack Group ((GTK)), Keypath Education International ((KED)), Elmo Software ((ELO)), and ReadyTech Holdings ((RDY)).

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It's probably a sign of the general caution that has crept into the financial community's mindset when both authors of an optimistic share market review, albeit from a technical analysis perspective, go out of their way to not seem too positive about the market's outlook.

And so it is that the July strategy update for US equities by Canaccord Genuity expresses the belief that "a bottom" might be in for US markets, but it might not be "the bottom".

For what it is worth, "a bottom" traditionally stems from too negative sentiment (oversold conditions) while the authors suggest it will require a change from the Federal Reserve for investors to look through the upcoming weakness in the economy and corporate profits before US markets can rally from "the bottom" during this year's bear market.

Alas, Canaccord sees inflation decelerating, but also remaining at a level too high during the second half of 2022, which means the Federal Reserve will stay in tightening mode, irrespective of the slowdown in global economic growth.

Real liquidity, as measured by Canaccord through M2 money growth plus equity and bond mutual funds and ETFs, minus industrial production growth rates, has now dropped to a level that historically has been associated with an economic recession, points out the July strategy report.

Going all the way back to the 1970s, today's reading has never been as far into negative territory as… during the 1970s.

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Two trends have become impossible to ignore among this year's share market analysts and strategists:

-a growing acceptance that economic recessions are on the horizon
-short-term optimism that share markets, at least for now, might be poised for more relief and further potential upside

Both trends have been combined in Longview Economics' most recent strategy update in which Chief Market Strategist Chris Watling expresses his optimism for global equities on a 1-4 months timeframe.

That optimism, it turns out, is based on Longview's in-house technical modeling, as well as on the observation that lower prices for energy and commodities should be a positive for technology stocks and the broader outlook for inflation and economies.

In addition, the technology sector has just experienced its worst de-rating in 40 years, which, history suggests, should feed into at least a prolonged recovery rally, if not a fresh bull market, argues Watling.

The bad news stretches beyond the current rally for equity markets, as Longview has now joined the experts who believe an economic recession has pretty much become unavoidable.

Like so many other sophisticated market analysts, Watling is paying close attention to global liquidity, which seems to have peaked in April and money supply is since contracting rather rapidly.

On current trajectory, points out Watling, and if the Fed doesn’t pivot quickly, money is becoming too tight for the US economy, at a level of growth which has historically led to recessions in the following year.

As pointed out in the chart below, a reading of between 60-70 on the Longview Liquidity Indicator suggests a high risk for economic recession in the US. The latest reading surged beyond 70.

"All of which suggests that the likelihood of a recession in 2023 is growing (and is now more likely than not, i.e. >50% probability). If correct, then as has been widely discussed, earnings for 2023 are too high (consensus is for S&P500 earnings growth of 9.1% in 2023 and 8.6% in 2024). In recessions, forward consensus earnings typically fall by between 16% and 40%."

More Weekly Insights to read:

-Balancing Between Opportunity & Risks: https://www.fnarena.com/index.php/2022/06/30/rudis-view-balancing-between-opportunity-risks/

-Not the Bottom, Not The End: https://www.fnarena.com/index.php/2022/06/23/rudis-view-not-the-bottom-not-the-end/

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

(This story was written on Monday 11th July, 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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