Rudi’s View: Corporate Profits Will Show The Way

This story features RESMED INC, and other companies. For more info SHARE ANALYSIS: RMD

In this week's Weekly Insights:

-Corporate Profits Will Show The Way
-Conviction Calls
-FNArena Talks

By Rudi Filapek-Vandyck, Editor FNArena

Corporate Profits Will Show The Way

Is the Federal Reserve ready to take its foot off the pedal and hike interest rates at smaller increments?

The strong response that followed the surprisingly "dovish" rate hike from the RBA last week instantaneously shows why investors globally and here in Australia are keen to find out the answer, and the exact timing of the central bank's "pivot".

Most forecasters still think central bank tightening will at least continue until the end of 2022 but a slower pace, a pause maybe, will likely be taken as a positive for risk assets that have had a rough trajectory these past nine months.

Surely, those pesky inflation numbers must peak at some point, and start trending downwards?

Among investors and commentators in the US, this is the debate of the moment. If not next month, then when? Plus: if not to save the US economy from recession next year, maybe then to save the global financial system which is showing up its fragility here and there?

It's this to-ing and fro-ing, switching between hope and disappointment, that has made September the most volatile month in a long while. Measured by daily index movements of at least 1%, September offered 4 positive and 8 such negative days out of a total of 22 trading sessions throughout the month.

October started strongly as hope never genuinely dies, but disappointment has quickly followed.

Most commentators I read don't think Powell & Co are as yet ready to follow the RBA's example, even though system fragility will be on the Fed's radar.

Last week's statement from the RBA suggests Philip Lowe's board is concerned about global stresses and Australian households, but US households carry (a lot) less debt and the Federal Reserve can move a few mountains if it has to if/when the global financial system requires plumbing.

I do think there is a clear and present danger with investors almost solely concentrating on central banks' signals and intentions, at a time when corporate earnings should be on everyone's mind.

Then again, this might change soon, and not necessarily for the better.

US Corporate Earnings In Focus

Corporate earning season in the US for this year's third quarter starts at the end of this week. This time around there have been a number of warnings already the pressure from slowing growth, inflation, higher yields, a stronger US dollar and significant tightening from central banks is starting to make an impact.

Companies including FedEx, Apple, Tesla, AMD and Nike have all disappointed or pre-warned recently, as did Samsung outside of Wall Street. If these early disappointments prove indicative of what lays ahead, investors should expect ongoing bouts of volatility, this time driven by corporate "misses" and downgrades to growth forecasts.

When we zoom in on those forecasts for the current financial year and beyond (see chart below) a rather odd picture emerges: since 2008 only on one occasion has EPS growth for S&P500 companies come out at bang on the long term average of 8%, yet this is exactly what current forecasts imply for this year and the two years ahead.

I think what we are witnessing is a classic example of converging forecasts around a "safe" middle-of-the-road assumption when nobody is quite certain what to make of next year's conditions. In other words: neither the analysts behind those forecasts, nor the business leaders providing them with guidance and input, know how to quantify trends and conditions in a slowing, recessionary environment that has yet to reveal itself.

Yet, by all accounts, the chances for an economic recession in the US, and elsewhere, next year have only increased, and are still increasing. US treasuries have never been inverted to the extent they are today, and for as long as they have to date, without an economic recession following.

Market analysts at Longview Economics pointed out recently the Conference Board's leading indicator for the US economy is currently at a point below zero where it has proven to be a false signal on only four occasions post the 1960s. However, on each of those four occasions the recession was avoided because the Federal Reserve provided support and stimulated economic growth.

This time around the Fed is still tightening, and of the intent of continuing to tighten until there is a clear trend reversal in consumer price inflation.

Let there be no mistake: the narrative that current forecasts are too high and need to be culled over the weeks if not months ahead is by now pretty much generally accepted among Wall Street firms. The big debate that is left is how much leverage-to-the-downside should one account for?

Is -10% enough? Or should it be -15%? More maybe?

One complicating matter is that US indices are still very dependent on what happens next with the so-called Megacaps of Alphabet, Meta, Tesla, Microsoft etc. This part of the market still hasn't fully caught up with the rest to the downside. History suggests this is likely still to happen.

The other observation from history is that if earnings forecasts are being reduced by a noticeable magnitude, share prices usually follow suit. This is why the more bearish marketwatchers believe US indices can still have -10%-15% downside from current levels.

Australian Corporate Earnings In Focus

With a few exceptions of ResMed ((RMD)), Amcor ((AMC)) and the like -companies with a prime listing in the US- Australian investors usually only have an opportunity to catch up with updated corporate details every six months.

There's a trend towards keeping market guidance for the AGM.

This year, investors will be paying more attention than usual given the general uncertainties, and the early signals coming from the US.

The second half of October is stacked with AGMs from the likes of Brambles ((BXB)), Cochlear ((COH)), Reliance Worldwide ((RWC)), Treasury Wine Estates ((TWE)), Whitehaven Coal ((WHC)), and Woolworths ((WOW)).

Then the AGM train moves on throughout November.

In between, miners and energy companies release their quarterly updates while out-of-normal-season reporters release their financials, including the banks, Square ((SQ2)), Xero ((XRO)), GrainCorp ((GNC)), Nufarm ((NUF)), Incitec Pivot ((IPL)) and TechnologyOne ((TNE)).

There will be a lot more to analyse and to digest than simply the next reading on topline and underlying inflation numbers.

In Australia, a different picture has emerged from falling analysts forecasts for corporate profits with an anticipated big deceleration from very high growth in FY22 (the year past) only leaving circa 5% growth for FY23, amidst ongoing further downgrades, and virtually no growth for FY24 and FY25.

At least, such is the apparent outlook at face value.

But in a market that is heavily weighted towards BHP Group ((BHP)) and other cyclicals, plus the banks, any up- or downtrends for those sectors have an outsized impact on the general averages.

In simple terms: energy remains the big stand-out this year, not only in share price performances but earnings estimates across the sector are still on the rise, which further supports share prices for the likes of Woodside Energy ((WDS)) and Santos ((STO)) (more so for exposures to gas than to crude oil).

FY23 is expected to still be a strong year for the sector, which up to a point masks underlying weakness elsewhere. But after FY23, forecasts for energy producers are expected to deflate from cycle-peak levels. For the Materials sector, which largely combines all the mining companies and their contractors, 2022 is expected to be the peak of the cycle.

Interestingly, JP Morgan's monthly data on local funds managers revealed money flowed out of the Materials sector in August and into cash and defensives. Notable positive moves were registered in favour of Macquarie Group ((MQG)), Computershare ((CPU)) and James Hardie ((JHX)) while Aristocrat Leisure ((ALL)) and Coles ((COL)) lost a few friends during the season.

Most forecasts for Australian banks suggest moderate growth beyond the current year, but positive regardless. Both economists and the local bond market do not foresee economic contraction for Australia next year, simply tepid growth instead.

Irrespective of general sector moves, investors always need to bear in mind that individual companies do not necessarily follow the general trend. In all likelihood, the gap between those who can continue performing and those who cannot will only widen in the year ahead, creating a market place of 'winners' and 'losers', polarising performances inside diversified investment portfolios.

Among resources, this year has created a fresh dynamic whereby buyers of natural gas and thermal coal are literally held captive because of limited supply, suggesting elevated prices are here to stay for longer. Within the context of 2022's bear market conditions, investors have happily treated companies leveraged to these themes as this year's New Defensives.

Should we add in sectors such as lithium, uranium, maybe some of the agricultural segments too? What about crude oil post OPEC-Plus supply cuts? Silver? Nickel?

Those are some of the debates being fought in the background right now. Economic recessions tend to always surprise to the downside as far as demand is concerned, but war, China, and specific sector-related conditions can potentially create their own recession-proof dynamic.

At least that's what part of the investment community is banking on this year.

Elsewhere, there's an argument to be made that supermarket owners Coles and Woolworths have not played their usual defensive role this year, instead showing elevated volatility and poor protection to the downside. One of possible explanations is that both are battling inflationary inputs, which erodes their potential growth this year, and possibly for longer.

An equally valid explanation is that of market positioning with local fund managers shifting towards the sector earlier in the year, which quickly created a crowded positioning a la CSL ((CSL)) back in 2020.

Because of relatively premium valuations, I believe rising bond yields have had a larger-than-normal impact as well.

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The message for investors from all of the above, I believe is: pay attention to the macro-context and dynamics, but focus on individual companies, their specific strengths and weaknesses, as that will prove the determining factor in the year ahead.

Conviction Calls

Small cap specialists at JP Morgan have nominated GUD Holdings ((GUD)) as their Top Pick, firmly believing the recovery management at the car parts company is anticipating will materialise in FY23 and FY24.

On the other end, profit warning tragic Appen ((APX)) is now the Bottom Pick (least preferred) following yet another disappointing market update. JP Morgan analysts see ongoing pressure on margins and earnings, with limited visibility on the pipeline.

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Strategy update by Wilsons:

"Our base case remains that inflation will fade over the coming months as transitory pressures normalise, which should see bond yields at least stabilise and support equity valuations.

"Stubborn inflation, interest rate hikes, geopolitical instability, and softening housing markets are some of the key risks to global and domestic economies at present."

Within this context, UBS sticks by its forecast inflation will drop sharply next year, which should see central banks, including the RBA locally, deliver rate cuts in the second half of 2023.

Back to Wilsons, where managers of the Focus Portfolio are looking for earnings resilience to weather out tougher times economically and operationally.

Options included are:

-Quality Defensives: Cleanaway Waste Management ((CWY)), ResMed, CSL, The Lottery Corp ((TLC)) and Telstra ((TLS))

-Quality Cyclicals: James Hardie, Macquarie Group, Nine Entertainment ((NEC))

-Mega-trends of Energy Transition, New Infrastructure and Global Re-Opening, including Cleanaway, Telstra and NextDC ((NXT)), Qantas ((QAN)), Tabcorp ((TAH)) and Aristocrat Leisure, as well as BHP Group, OZ Minerals ((OZL)), Santos, Woodside Energy and Allkem ((AKE)).

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Last month, Morningstar removed G8 Education ((GEM)) from its selection of Best Stock Ideas on the ASX.

Ex-G8 Education, the list contains the following 13 Best Ideas:

-a2 Milk ((A2M))
-AGL Energy ((AGL))
-Aurizon Holdings ((AZJ))
-Brambles
-InvoCare ((IVC))
-Fineos Corp ((FCL))
-Kogan ((KGN))
-Lendlease Group ((LLC))
-Magellan Financial Group ((MFG))
-Newcrest Mining ((NCM))
-TPG Telecom ((TPG))
-Westpac ((WBC))
-WiseTech Global ((WTC))

Shares in G8 Education did not manage a sharp rally in September and their removal follows the research transfer to a new analyst at Morningstar. Clearly, the previous analyst in charge had been too optimistic, as also illustrated by the fact that fair value for the company since the switch has nearly halved to $1.10 (from $2 prior).

Morningstar: "With wages rising quickly and government funding likely to boost demand for childcare workers, we no longer believe increased revenue will translate into outsize [sic] profit gains."

FNArena Talks

The charming Philip Muscatello interviewed me last week for his regular podcast Shares For Beginners. We discussed the pros and cons of Price-Earnings (PE) ratios:

https://www.sharesforbeginners.com/blog/fnarena

(36 minutes, audio only)

(This story was written on Monday, 10 October, 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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– The AUD and the Australian Share Market (which stocks benefit from a weaker AUD, and which ones don't?)
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