Rudi’s View: Low Expectations Not Low Enough?

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In this week's Weekly Insights:

-Master & Servants; Bonds vs Equities
-Earnings Forecasts: Low Expectations Not Low Enough?
-Conviction Calls & Best Ideas

By Rudi Filapek-Vandyck, Editor

Master & Servants; Bonds vs Equities

"I used to think that if there was reincarnation, I wanted to come back as the president or the pope or as a .400 baseball hitter. But now I would like to come back as the bond market. You can intimidate everybody."

If your experience is similar to mine, you have been closely watching global stock markets for many years, decades!, but only recently have you started to genuinely appreciate the true meaning of that statement made in the late 1990s by former president Clinton advisor James Carville.

Equities, precious metals and commodities and bonds usually operate in worlds apart from each other, with the occasional, temporary, exception. The stock market is all about corporate profits, so we have been told, and thus bonds are left to those who cannot stomach the risks and volatility of equities, FX and commodities.

Stocks and bonds; it's often seen as an uneasy, even an unnecessary combination. On multiple occasions I have seen faces of equity managers turn grey when asked about what bonds might do in the future. It's simply not in their DNA.

Some six years ago I attended an anniversary event of the 1987 global share markets crash, watching several grey-haired survivors walking off stage after conceding "we still don't know what caused it".

Fingers are usually pointed at programmatic trading programs, but the initial trigger most likely came from German and US bond markets.

The story for the past years is not dissimilar. Most equity indices last year, as well as gold, endured a tough journey in 2022 because bond yields kept rising. Higher bond yields put downward pressure on valuations of most assets, but in particular of quality and long-duration assets trading on high multiples on stock exchanges.

No surprise thus, when bond yields retreated from their peaks in October, this had a positive impact on beaten-down equity markets which promptly started to recover. What has surprised ever since though is equity investors have treated the apparent peak in bond yields as a continuous good news story, even though the reason why bond yields might have peaked may not be good news at all.

As every expert in fixed interest is able to explain, at first bonds are selling (yields rising) because central banks are hiking rates while inflation is rising but then the focus shifts towards the real economy impact of those hikes and bonds start to price-in future rate cuts while economies are losing momentum.

In theory, this is but a straightforward scenario, but in practice it never really is. Every cycle has its specific framework and conditions, and this time the global background does not equal the precedents from the past due to prior lockdowns and stimulus programs, the war in the Ukraine, aging populations, and this new era of technological breakthroughs.

The bond market is far from the only driver for share markets, of course. This is also why its influence often goes unnoticed with investors trained to focus on market sentiment, valuations, momentum indicators, economic signals and profit forecasts, but the bond market remains as omnipotent as ever.

The chart below reveals 2023 has by no means been an exception. Witness how each 'mountain' in US bond yields (ten-year) has coincided with sharp retreats for share prices in September-October, in February and yet again in June-July, while each retreat into the next 'valley' spurred on the next equities rally.

The problem with knowing how this close correlation works is still that forecasting the next move in bond markets is too difficult a task for most of us, including many who follow fixed interest closely, unless, potentially, when the next mountain forms towards the 4% level?

Unless one is convinced we are about to relive the 1970s with persistently elevated levels of inflation, which will need to be priced in by bonds, it is but a fair assumption to make that 4% -or thereabouts- marks the upper level for US bond yields for the current cycle.

Equally important: the path towards inflation returning to an annualised pace of 2% is unlikely to unfold as a straight line throughout the quarters ahead; most likely there'll be bumps and disappointments along the way, almost guaranteeing volatility in bond yields, and thus in equities and other assets, not to mention what might happen if economic indicators genuinely roll over.

With most forecasters and market observers now of the view the underlying trend in inflation is negative, which should keep bond yields anchored towards lower levels too, all of this represents positive news for equity markets that have by now developed the Pavlovian response to rally every time bond yields sag.

If there's one reason as to why equity indices may not revisit the lows from late-2022, this may be why.

But wait a minute, I hear some of you responding, aren't equities blatantly ignoring the risk for economic recession and what that might imply for corporate margins and profitability?

Indeed, they probably are, but underneath the major indices share markets are still extremely polarised and the irony is many of the cheaper priced companies might well be the most vulnerable to a slump in economic momentum, while those who benefit most from falling yields might well be best-equipped to deal with tepid (or negative) economic growth.

Which takes us to the Q2 results season in the US and the upcoming corporate reporting season in Australia. Ultimately, so the adage goes, all roads lead to corporate profits, but it surely isn't the only driver for share markets, certainly not in the short term.

Where things might get tricky for equity indices is that, recently, previously close correlations have broken down, suggesting positive investor sentiment is pulling equity prices away from closely correlated drivers including money supply, liquidity, and bond yields. This means corporate results this time around might have to be better than expected, not simply meeting forecasts, in order to keep positive momentum going.

The other big unknown remains whether falling bond yields can continue to provide positive support for equities or whether this changes if/when economic data and corporate profits deteriorate further.

Only one way to find out…

Earnings Forecasts: Low Expectations Not Low Enough?

There's no denying, in the slipstream of more resilient economic data and indicators, corporate profits have equally proven to be more resilient in this cycle than many had thought.

In line with a positive share market interpretation of lower bond yields (see above), this has been one of the pillars underneath a supportive share market story year to date in 2023.

In addition, and this in particular applies to the Australian market, analysts' forecasts are low, and falling, suggesting companies only face a low hurdle in order to meet or beat expectations in August. Consensus has the average EPS growth well below average, with negative growth projected for FY24.

But it never is this simple and there is one important reason as to why the bar seems so low for Australian companies this August and for the year ahead: companies are doing it tough and overall conditions are expected to worsen further, before they can start to recover. Central bank tightening works at considerable delay. The local mortgage cliff has only just started to impact. Supply chain bottlenecks are still a recent memory. Inflation is still a negative factor.

In the US corporate profits have fallen by circa -8% on average over the twelve months past, so there is undeniably a visible recession at the corporate level, it's just not apparent from how major indices have performed to date. Then those indices are carried by only a small group of outperformers, with markets underneath characterised by extreme polarisation.

At the very least, such a set-up suggests a one-size-fits-all, generalised approach might not be the appropriate one for equities this time around. Shares that have experienced a big rally this year might require that companies do better than simply meeting expectations, a fact that applies more to the USA than it does for Australia, but history shows there will be winners and losers at either end of the market.

Before we start digging into the finer details for upcoming releases, let's briefly reflect on what occurred earlier this year during the local February reporting period.

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This year's February results season in Australia took place at the pointy end of a very strong rally from beaten-down levels in late 2022, and it soon became obvious Australian companies had landed in Struggle Street. Corporate results did not shine, on average, and instead provided plenty of reasons for share market momentum to deflate.

As I wrote in early March:

"February wasn't great – not when we zoom in on corporate profits, underlying trends and margins; even the most bullish among the bulls might have to concede as much. February has turned into a thorn in the side for all those forecasters who believe the low is in for markets and a new bull market is taking shape."

The big takeaway from that season, I believed, was that no less than 49% of reporting companies require a pick-up in the second half to meet either their own guidance or market forecasts in August. Investors have since witnessed the return of the annual confession season whereby management teams concede they won't meet targets or expectations.

When we consider the magnitude of that percentage, it is probably half a miracle confession season to date hasn't brought out more warnings and brutal reassessments, but it's good to keep in mind companies are allowed a margin of 15% before they are required to release an official ASX update.

The benign character of confession season thus far can still be explained in multiple ways, including the scenario whereby companies might just keep the disappointment until the day of result release.

On FNArena's number-crunching, more reports disappointed than those that beat forecasts -32.5% versus 29.5%- but equally important; one-in-five companies in February reduced their dividend for shareholders. That twenty percent of dividend reductions is equally a big number.

Ominously, the two sectors that delivered major upside surprises in February were discretionary retailers and REITs – the two sectors that have since suffered the most as downward pressures revealed themselves later on. Equally surprising: CSL ((CSL)) was at the time nominated as having delivered one of the stand-out financial performances in the month, yet four months later management issued a profit warning which has pulled down the share price to a level last seen in early 2022.

All in all, most experts labeled corporate Australia's results at the time as a "mixed bag" and even without a subsequent crisis for regional banks in the US, it was obvious operational results were simply not good enough to support ongoing market enthusiasm, generally speaking.

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Fast forward to mid-July, less than a full month from when the local tsunami hits the ASX, and profit forecasts have been reduced noticeably while the likes of Amcor ((AMC)), CSL, KMD Brands ((KMD)) and others have updated with disappointing numbers and forecasts, but nothing like what was possible in terms of worse case scenarios.

Irrespective of reductions to date, just about every expert across the globe maintains analysts' forecasts are still too generous, both in Australia and elsewhere. It has also been observed profits in Australia yet again appear more vulnerable than elsewhere. Is this because of the high concentration in banks and resources?

This higher vulnerability did inspire global strategists at Citi to put Australia in the Underweight basket. Citi is positive on global share markets with the in-house view anticipating economic recessions and relatively resilient corporate margins and profits, but Australia is considered too weak in realistic prospects to join in Citi's cautious optimism.

Before anyone has the wrong idea: Morgan Stanley's conviction remains most economies, including the USA, will escape economic recession, but corporate margins will lose their lockdown premia and thus profits are poised to surprise on the downside, expected to pull equity markets down with them in the process.

As the saying goes: it's complicated.

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With EPS growth hard to come by, and dim-looking prospects for the year ahead, UBS analysts have identified four questions that are likely to colour the upcoming season in Australia:

-Is the consumer crunch now happening?

-Are labour costs beginning to break out?

-Can profit margins be maintained?

-Are interest expenses manageable?

The broker's suspicion is trading updates that often come attached to financial releases might look decidedly 'bleak'. The unemployment rate remains near an historical low. With the average wage bill projected to increase by 10% annualised, corporate costs might feature as a major headache next month.

Shorter-dated bonds have risen significantly in the year past, suggesting companies are poised to report higher-than-expected interest expenses. Profits might feel the pinch both from rising costs and from declining sales, even if companies can keep their margins intact.

Given the subdued macro-outlook and context, UBS's expectations for August are low. "We see the ASX as flush with companies that have promise and opportunities, but upbeat stories are likely to be largely dismissed over the next month. Instead, attention will focus on a decelerating economy, a strained consumer, and the lagged effect from the Reserve Bank's hiking cycle which began a year ago."

Against a background of negative EPS growth locally, current market forecasts are for average 10.9% EPS growth for the world, with 9.8% growth for developed markets and 18.1% for emerging markets. The corresponding number for Australia, as things stand, is negative -3%.

A closer look into the underlying components does reveal Australia's growth prognosis is heavily weighed down by the energy sector, at arm's length followed by still negative forecasts for materials (miners) and financials (in particular: the banks) whereas utilities, healthcare, industrials, IT and communication services all seem poised for strong, above-average growth.

As per always: the devil is in the detail. A heavily bifurcated market is like a knife that cuts both ways. Local strategists at Morgan Stanley already made the point the Australian economy is running on variable speeds, with tighter conditions having the most impact in Victoria. This might add a regional flavour on top of your usual sector and corporate quality qualifications.

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Having said this, the main question at the macro level remains the same: how bad exactly can/will things become?

Market strategists at Macquarie would probably answer that question with Bachman Turner Overdrive's You Aint Seen Nothing Yet. Unlike the meme, it looks like Godot finally arrives in FY24, the strategists declared in this week's preview to the August reporting season.

If Macquarie is correct, investors are drawing the wrong conclusions from resilient markets up to this point. It's a slow-moving process, but this still implies the worst is yet to come. By year-end, predict Macquarie strategists, the consensus FY24 EPS growth forecast will be closer to -10%, implying things will worsen a lot, and rapidly too, in the months ahead.

Macquarie reminds investors in August last year twice as many companies guided below consensus forecasts, which translated into negative share price outcomes. Were this to repeat for defensive and growth companies this year, Macquarie will be ready to start buying their shares.

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Recent optimism in the US seems to be based upon market forecasts stabilising and even spreading out over a slightly larger group of companies. This has been interpreted as an early signal the US recovery is broadening into a broader base of companies.

On current forecasts, American corporate profits are set to trough in Q2, which is the current reporting season over there, with an uptrend to resume from the current quarter onwards.

Plenty of sceptics around to keep overal doubt up. Here's the take from ClearBridge as published by FNArena on Friday:

https://www.fnarena.com/index.php/2023/07/14/bear-market-rally-or-new-bull-emerging/

Sceptics at Morgan Stanley summarised the Bull and Bear cases as follows:

The Bull Case

-Soft landing appears obvious
-Corporate profits 'fine'; rebounding
-Labor markets are strong but not wage inflationary
-Fed rate cuts imminent despite no pause and no cuts forecast until 2024
-Cash on sidelines is too big and impatient
-AI, AI, AI

The Bear Case

-Policy operates with a lag; economy slowing
-Peak company margins unsustainable
-Falling inflation cuts both ways; negative operating leverage
-Recession indicators are screaming
-Regional bank stress has implications for lending standards
-Debt ceiling is source of US$650bn liquidity drain
-The passive indices are overvalued; stock concentration raises idiosyncratic risk
-Rates are not returning to pre-covid lows; the Fed will fight the market

Morgan Stanley's conclusion: "our conviction is not wavering".

One of the key factors that has the strategists attention are inventories, which in multiple sectors currently look bloated, though Morgan Stanley describes them as "extremely elevated" and "a broad-based problem".

The thinking is that with the release of supply chain pressures, and the fall in inflation, coupled with decelerating economic momentum, companies will lose their pricing power at a time when they need to reduce bloated inventories. It doesn't take too much imagination to see how this can quickly escalate into broad-based negative news.

Morgan Stanley doesn't think technology companies will prove immune either.

On the broker's data crunching, inventory-to-sales remains elevated at the S&P1500 level, especially in semiconductors, capital goods, and technology hardware industries.

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In terms of sector outlooks for the ASX, the key questions for the banks remain how bad exactly the impact from the mortgage cliff and household spending pressures can become, and whether this is already accurately reflected in today's share prices?

In contrast, insurers, the other major segment that sits under the general label of Financials, are currently riding the benefits from a prolonged upswing in market conditions, with each of general insurers, health insurers and insurance brokerages enjoying rising forecasts and broad support from sector analysts.

General sentiment for minerals and metals remains contingent on Chinese stimulus, or more accurately: the market's expectations of it, while on the operational side persistently higher costs will put a dent in many a producer's margin. In the energy sector, it's probably not a coincidence the sector laggard, Santos, is now everybody's top pick.

Discretionary retailers face the same investor dilemma as the banks: bad news has to a degree already been priced-in, sector-wide, but is it enough?

The local healthcare sector is singled out as the obvious 'go to' by most strategists given share prices have lagged over quite some time, the industry is packed with robust, high quality business models with international allure and the ability to keep growing during times of economic duress, and market leader CSL has already issued a profit warning, with the subsequent market punishment executed.

All shall be revealed in the six weeks ahead. Strap yourself in. This won't be a relaxing walk in the park.

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FNArena's Results Monitor has kept track of 68 companies that reported financial results post February:

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

The results overall have not been inspiring, though they have equally not been incredibly negative.

Soon we will close this period off and start a new August season monitor. Paying subscribers have access to an archive that dates back to August 2013, including general statistics and individual assessments for each period.

Conviction Calls & Best Ideas

Both strategy teams at Macquarie and UBS continue singing from the same hymn sheet in the lead-in to the August reporting season; defensive sectors that can withstand economic recession remain high on the most preferred wish list.

UBS explains this puts the focus on technology, insurance and healthcare, but also on reliable and stable dividend payers, which includes companies in infrastructure, utilities and insurance sectors.

Macquarie's favouritism for sturdy defensives puts the focus on general insurers, but equally on healthcare, infrastructure and utilities, and telcos.

Technology sector analysts at Goldman Sachs have used yet another sector update to elevate Macquarie Technology ((MAQ)) to the broker's Conviction Buy list with cloud services providers in general preferred over hardware manufacturers in the sector.

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Morningstar's selection of Best Stock Ideas for Australia and New Zealand has seen two amendments recently with the inclusion of car parts distributor Bapcor ((BAP)) and the removal of InvoCare ((IVC)).

The latter is still on the menu of foreign suitors, though Morningstar is not happy with the offer that's on the table. Irrespectively, there are better and cheaper alternatives out there, the stock pickers suggest, including Bapcor.

Other names on the list:

-AGL Energy ((AGL))
-The a2 Milk Co ((A2M))
-Aurizon Holdings ((AZJ))
-Fineos Corp ((FCL))
-Kogan ((KGN))
-Lendlease ((LLC))
-Newcrest Mining ((NCM))
-Santos
-TPG Telecom ((TPG))
-Ventia Services Group ((VNT))
-Westpac Bank ((WBC))
-WiseTech Global ((WTC))

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Over at Wilsons, the selected list of Most Preferred Direct Equities exposures has been enlarged with the addition of South32 ((S32)).

Others that have kept their inclusion:

-APA Group ((APA))
-CSL
-IDP Education ((IEL))
-Mineral Resources ((MIN))

In addition, Wilsons' research also suggests shares in Select Harvests ((SHV)) have been oversold.

The team has also identified a number of long-term structural growth stories whose share prices are offering attractive entry points to what are considered quality companies:

-Aroa Biosurgery ((ARX))
-Lovisa Holdings ((LOV))
-Ridley Corp ((RIC))
-Siteminder ((SDR))
-TechnologyOne ((TNE))
-Tourism Holdings Rentals ((THL))

For those looking for more speculative opportunities, Wilsons has put forward two names:

-Immutep ((IMM))
-Neuren Pharmaceuticals ((NEU))

The latter has gone for a big run prior to the publication of today's update.

For ideas inside the resources sector, Wilsons has its eye on Beach Energy ((BPT)) and Leo Lithium ((LLL)).

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(This story was written on Monday, 17th July, 2023. It was published on the day in the form of an email to paying subscribers, and again on Wednesday as a story on the website).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer 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: contact us via the direct messaging system on the website).

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