Asset Allocator: September 2015

The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only.

 Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment.

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ASSET ALLOCATOR: September 2015  

30/09/15- Assessing Market Fall out

 

Current market turmoil may be prompted by worries about China – and its demand for commodities – but is the real worry actually much closer to home? Are investor’s in fact spooked less by China’s travails and more by DECLINING corporate profitability in both the UK and the US? If this is the case then the current sell off – from already high valuation multiples – could intensify over the next few months as a series of fairly dreadful earnings numbers emerge. 

Andy Lapthorne, SG’s resident stock market warrior and quant strategist has been sounding the alarm for months now. One of his most recent charts is below, showing the annual change in 12-month forward S&P 500 EPS expectations. Andrew observes that this “series is based on forward consensus expectations and therefore excludes many of the write-downs and exceptional items that are currently pushing down actual reported profits. It is more akin to operational profits and has never been this negative outside of a recession [emphasis added]”.


What’s causing this rapid slowdown in corporate earnings growth? Lapthorne suggests that there is a clear link between US import prices and the relative performance of industrials vs. both the market and, as is shown in the chart below, vs. the consumer sectors. According to Lapthorne “this is intuitive; lower import pricing creates margin pressures in production which is deemed beneficial to the end consumer - cheaper prices, low inflation, low interest rates etc. - but is painful for the producers. The question is how does weaker industrial profitability then feed through to the wider economy?”.

One obvious mechanism is that stock market investor’s will start to fret about declining corporate profitability, volatility will increase and business leaders will start to delay expansion plans.

  


Societe Generale’s Lapthorne has long maintained a cautious stance, so until fairly recently one could argue that his view was perhaps non consensus, even maverick. Not anymore! More and more big banks have been joining the (dismal) chorus in recent months, warning that US profits are under shooting. 

Perhaps the most public dissent has come from US based Goldman Sachs which recently announced that it now sees 2015 earnings by S&P 500 businesses at $114 a share, after predicting $122 in October. The bank reckons that Sales will fall in 2015 for the first time in five years as margins slip and revenue by energy company’s declines. “S&P 500 P/E, which is historically rich, will stay elevated through the remainder of 2015, but will compress when the Fed starts its tightening cycle in December,” a Goldman Sachs team led by strategists Amanda Sneider and David Kostin wrote in the report.

Over here in Europe, global bank HSBC has also recently turned markedly more cautious. A note this week from its equity analysts in the UK suggests that is now “a serious risk that US earnings growth will disappoint on the basis of these economic forecasts. Consensus is for 10% EPS growth in 2016 whereas we forecast only 2%. We are below consensus for 2017 as well. The key area of difference is that we expect margins to be squeezed whereas the consensus is for them to improve. “

According to HSBC “margins are already above average, and we have reached the stage in the economic cycle where wage growth usually begins to rise. Our forecast is for wage growth to rise to 2.5% by 2017, and this is a recipe for margins to be flat to down in our view. We are unlikely to see the improvements in margins envisaged by consensus, 5% next year and 7% in 2017, unless demand is quite a bit stronger than we forecast.”

Moving away from these investment bank estimates, the best way of gauging the aggregate market consensus is to use numbers from US research firm FactSet. Its most recent weekly report for the S&P 500 strikes an equally cautious note declaring that as a result of the downward revisions to earnings estimates, the market expects estimated year-over-year earnings decline for Q3 2015 of      -4.5%, which is higher than the expected decline of -1.0% at the start of the quarter (June 30).

According to FactSet the US “Energy sector is expected to report the largest year over-year decrease in earnings of all ten sectors, while the Telecom Services and Consumer Discretionary sectors are predicted to report the largest earnings growth of all ten sectors for the quarter. The estimated sales decline for Q3 2015 is -3.3%, which is also higher than the estimated year-over-year revenue decline of -2.5% at the start of the quarter. The Energy sector is expected to report the largest year-over-year decrease in sales of all ten sectors, while the Telecom Services and Health Care sectors are expected to report the largest growth in sales of all ten sectors for the quarter. “

Given that many investors are now betting on oil breaching the $40 barrier at some point before the end of the year – Goldman Sachs has it going as low as $20 a barrel – one can only estimate that those declining energy sector profits will carry on tumbling. Looking at future quarters Factset reckons that analysts “do not currently project earnings growth to return until Q4 2015 and revenue growth to return until Q1 2016”.

Yet it’s all not completely bad news, with most analysts looking for record level EPS to resume in Q4 2015. According to Factset “analysts also expect net profit margins for the 2nd half of 2015 to be below the levels reported for Q2 2015 (based on per-share estimates). The forward 12-month P/E ratio is now 15.2, which is still above the 5-year and 10-year averages. During the upcoming week, 4 S&P 500 companies are scheduled to report results for the third quarter. “

This optimism may or may not be misplaced, but for now investors have to cope with a hard fact – profits are falling faster than expected. The chart below from US economist Edward Yardeni in his weekly chart pack tells the story simply and elegantly – EPS growth based on consensus estimates is and has been falling markedly.

 


And just in case you thought the UK was exempt from this brewing crisis, consider a report this week from UK based stockbroking firm The Share Centre. They’ve just released numbers that suggest that dividend cover for the FTSE 350 index fell to 1.2 times in the year to the end of March, down from 1.5 times a year ago and its lowest level since the third quarter of 2009 when it stood at just 0.7 times.

The key finding though was that this decline in dividend cover was a result of plunging profits among the UK's 350 largest companies, which fell to £102.8 billion in the year to March 2015, down from £119.6 billion in the previous year and representing a slide of more than 14 per cent.

Conversely, The Share Centre says that FTSE 350 dividend payments have risen to £83.1 billion, up from £79.9 billion a year ago. As a result, dividend coverage ratios have been put under pressure.

Commenting on the fall, Helal Miah, research investment analyst from The Share Centre, says: 'Profits among the country's largest companies have been repeatedly knocked by a slew of global headwinds and sector specific difficulties.

'Commodity price falls, currency swings, slowing global growth and, most recently, supermarket price wars have hit profitability in the FTSE 100. In turn, dividend cover has been stretched, with the majority of companies maintaining or expanding their payouts to shareholders, despite margins being squeezed.'

Seven out of 10 of the sectors analysed by The Share Centre saw their dividend cover ratios fall over the past year. The two worst affected were the consumer services group, which includes supermarkets, and the oil and gas sectors.

The bottom line? My own sense is that this growing pessimism about corporate earnings might be a tiny bit overdone although I’d also concede that these fears may intensify in the immediate near term. For me the key driver is the sudden and continuing decline in oil prices. I don’t see any respite for at least the next few months, with oil prices heading even lower, hitting energy sector profitability hard. 

But the positive effects of this sharp move downwards may eventually start to feed through into the US economy in 2016. As the resources sector continues its remorseless downsizing, its weighting within the key indices will shrink fast. Sectors that benefit from lower energy prices will conversely expand fast, picking up the slack and pushing developed word economies forward in early 2016 again. But unfortunately this may all be a bit too late for US equities which were already pretty much priced for perfection before the China storm hit markets. 

Another chart again from Yardeni above shows that the forward PE ratio for the S&P 500 though lower than recent highs is still some way of ‘fair value’. My guess is that we need another 10% push down to get to those fair values for US stocks. 

But the potential good news is that Europe generally represents much better value, with earnings upgrades on their way (bar Volkswagen of course) and central bank policy much more accommodating. If my hunch is right, European markets might be on the receiving end of renewed US interest over the next year, which should in turn help to underwrite a continent wide stock market recovery.  

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The content of Asset Allocator is provided by David Stevenson, an independent financial journalist. The views expressed in this page are those of David Stevenson only, and Societe Generale takes no responsibility for his views. The views expressed are David Stevenson's views as of the date of publication only. Neither David Stevenson nor Societe Generale accepts any liability arising from investment decisions you may make for your own account. This material is intended to give general information only and is not to be construed as investment advice. The investments mentioned may not be suitable for everybody and you should ensure that you fully understand the investment you intend to make before making an investment. Links to external websites are not operated by or affiliated with Societe Generale. While we aim to point you to useful external websites, we cannot be responsible for their content or accuracy. Societe Generale takes  responsibility for the views expressed on any external websites or any liability arising from investment decisions you may make. You should seek professional advice if any of the content of this page is unclear.

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