Are earnings expectations 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.

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.

****

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.

****

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 Ansell (ANN), 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.

****

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.

****

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.

****

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 overall doubt up. 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.

****

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.

FNArena offers impartial, independent share market commentary and analysis, on top of proprietary tools, data and applications, for self-managing and self-researching investors. The service can be trialed at (VIEW LINK)