Rudi’s Comprehensive August 2022 Review

Feature Stories | Sep 16 2022

A compilation of stories relating to the August 2021 corporate reporting season in Australia, including FNArenas final balance for the season.

Content (in chronological order of publication):

-Quo Vadis, Corporate Profits?
-Not The Bottom, Not The End
-Conviction Calls
-Corporate Profits The Next Challenge
-Reporting Season: Early Signals
-Corporate Earnings: Between Dr Jekyll & Mr Hyde
-Conviction Calls
-August Preview: Curve Balls, Profits & Forecasts
-Conviction Calls
-August Results: First Blood
-When Forecasts Are Too High
-August Delivering More Downgrades And Misses
-What Happened To That Recession?
-August Reports: Closing Remarks
-Conviction Calls
-Conviction Calls

By Rudi Filapek-Vandyck, Editor

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 Checklisthas 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?

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