February offers insights on companies and economies around the world, including the US and China, which are of particular interest this time around. This years’ reporting offered the first real insight as to the impact of the US-China trade war on the largest companies and economies in the world. In this Collection, we hear from Jonathan Moog, Pengana Global Smaller Companies; Peter Rutter, Royal London Asset Management; Warryn Robertson, Lazard Asset Management; Stefan Marcionetti, Magellan Asset Management; and Matt Reynolds, Capital Group. They each share their view on the messages they’re getting from the US’ and China’s earnings seasons.
What we're seeing in the US and China
Jonathan Moog, CIO and Portfolio Manager, Pengana Global Small Companies
Speaking to China first, what we've seen out of China is a real pause in business out of Q3 and Q4. A lot of the companies we chat with were really waiting to see what budgets look like post-Chinese New Year, which is happening right now. Right now, there’s not a lot of solid, long-term information being reported out of China.
A lot of the companies in our portfolio are in ‘wait-and-see’ mode. We are waiting to hear from them post-Chinese New Year when a lot of budgets get reset in China. I think we'll have a little more visibility then if there's been a real economic slowdown there or not.
Right now, most companies have less visibility then they have that they've historically had, but there isn't a definitive path up or down in terms of kind of an economic viewpoint or what's really happening in the market there.
When looking at the U.S., so far what we've seen is a reasonably positive reporting season. I think there's been some sector-specific and company-specific issues, Apple, or anything related to Apple, that type of thing. But overall, I think the general news out of the U.S is probably, in my opinion, been slightly better than expected.
Autos have really started to roll over in a couple different geographies and that informs some of the smaller companies that supply new autos. Small companies sometimes see it first because they tend to be monoline businesses. Their businesses get impacted before a larger company with multiple lines of business starts to notice pain throughout their entire business.
I think that's what we've seen so far in both the USA and China.
Growing signs of rockier times ahead
Peter Rutter, Head of Global Equities, Royal London Asset Management
Recent results in the US and China suggest that the growth rates for the world economy and corporate profits are slowing. For example, whilst the average US company reported a 12% annual increase in earnings for Q4 2018, the level of ‘positive surprise’ in the reported sales and earnings for the quarter was the lowest in any quarter since 2016. On top of this, guidance for Q1 2019 and the full year was fairly weak from many companies such that analysts have since downgraded expectations for Q1 2019 earnings growth from high single digits to -1%. Earnings are now expected to shrink year on year in the USA. Trade wars, currency, higher interest rates, falling oil prices (impacting energy stocks significantly) and cost inflation (wages and transport) are some of the key reasons cited by US corporates for this weaker guidance.
In China, the pattern is somewhat like that observed in the USA although poor momentum around earnings progression has been ongoing for longer with the recent quarter continuing the pattern seen in the last 9 months.
So, what does this signal for us? Well, momentum is weak and there are growing signs of rockier times ahead. Seeing economic and earnings growth stabilise at a lower level or begin to reaccelerate will be key to supporting equity markets at current levels in our view, absent monetary or fiscal stimulus.
How do we cope with this risk and challenge? Our approach is to focus on individual stocks rather than the market. Even in a time of stress, a wonderful aspect of global equity investing is that there are over 3,000 companies in the investible universe. By being focused on identifying superior business models, company strategies, management teams and end market opportunities we can find investments to be optimistic relatively independently of what is happening in the wider market.
Earnings ‘nirvana’ can’t continue forever
For the companies we look at in the US, earnings so far have been a little better than the market anticipated. Often the year begins with ‘euphoria’ and high expectations for company earnings and as the year progresses these estimates are “refined downwards” and investors can be disappointed. This year though, we believe expectations were more reasonable around earnings growth and results have been a little ahead of consensus. However, this shift in earnings expectations is an important issue for investors to consider.
Investors are starting to realise that the company earnings ‘nirvana’ of low interest rates, sales growth, low wage growth and corporate tax cuts cannot continue forever. We are actually even more pessimistic than the market on company earnings in the medium term and believe this is one of the biggest risks facing the global equity market (the other being premium driven multiples driven by below sustainable interest rates).
In our view, for most companies the degree of earnings growth resulting in above normalized margins that has been observed in recent years is unsustainable in the long term. Ultimately, we believe profit margins will decline, either through slower sales growth as GDP growth slows or higher input costs in the form of higher wages and increased funding costs (i.e. rising interest rates).
The concern we have is that the shock of a series of earnings misses after a prolonged period of earnings growth will be a major tipping point in market sentiment.
Consumer spending in China on the way down
Stefan Marcionetti, Portfolio Manager, Magellan Asset Management
Recent company results showed the US economy is still strong while they gave a mixed view of China. Economy-wide bellwether stocks such as Visa and Mastercard, which give a broad reading of consumer spending, showed steady trends from their US businesses, but their cross-border volumes weakened marginally in early 2019. Wage pressures were again cited by a number of large US employers, another indication that the US economy is robust.
The results hinted that Chinese consumer spending is weakening. Apple had a rare miss on its earnings guidance due to lower-than-expected iPhone sales in China. The company blamed macro weakness and consumer caution as the reasons. The total Chinese smartphone market was also weak in the latter part of 2018. However, luxury and beauty brands such as LVMH, L’Oréal and Estée Lauder reported strong growth from China.
The big global advertising platforms, Google (Alphabet) and Facebook, reported consistent revenue growth. Given the economic sensitivity of advertising, this suggests the global economy is healthy.
While recent reports from many large global businesses have been generally robust, they weren’t the primary driver of the sharp rebound in global stock markets in early 2019. The change to the outlook for US interest rates was the reason for the rebound in sentiment. Concerns about higher US rates eased when the Federal Reserve shifted to a more neutral stance in January from a previous bias to raise rates and said it might alter the pace of shrinking its balance sheet, whereas previously it was doing this on a pre-set course.
Divergent fortunes for the two global powerhouses
As the two largest economies in the world, a slowdown in corporate earnings in the US and China would clearly have meaningful investment implications. Although the International Monetary Fund (IMF) recently revised down its global growth forecast for 2019 and 2020 partly because of the negative effects of tariff increases by the United States and China, we note that this deceleration may be just a normalisation or a reversal to a trend level of growth.
US: slowdown but no signs of recession
The US experienced rapid growth coupled with a synchronised global recovery in 2017. Markets were mostly anticipating a normalisation due to late cycle effects in early 2018. The interest rate trajectory was moderate, with the US Federal Reserve (Fed) looking poised to tighten monetary conditions. However, a sudden late cycle fiscal impulse and trade tensions upset that trajectory and we witnessed capital flowing back into the US when perhaps that capital should have been moving into Europe and emerging markets. Fed rhetoric since the beginning of 2019 has been dovish as a result.
Fast forward a year, and the biggest concern for investors in recent months has been the slowdown in the US. While we do not anticipate a slowdown in the US of recessionary proportions, it is worth noting that most global macroeconomic indicators – industrial production, purchasing managers index (PMI), trade – do point to the US slowing back to growth levels that we were seeing prior to the tax impulse. Importantly, although the profit effects of the one-time repatriation tax may wear off this year, there is no imminent threat from the effects of the lowered corporate tax rate (from 35% to 27%). With the next national election not until 2020, that would be the earliest that we may see any change in tax laws even if the size of the federal budget deficit in the US continues to grow. That said, as the level of economic activity in the US stabilises, we anticipate a stabilisation in other economies as well.
China: further weakening expected
China is in a tricky position. The recent release of fourth-quarter 2018 results show weakness in the small and medium-sized enterprises (SME) sector. Bottom up company fundamentals still look acceptable with domestic orders still growing at 5% year-on-year (yoy), but capital expenditure is gradually fading, and we also note that export orders are now contracting. SMEs are the beating heart of China’s manufacturing sector. Large portions of the economy are now slowing – led by manufacturing – in a coordinated fashion: housing, exports, the consumer, business confidence. Although the services PMIs, which typically lags the cycle look better, manufacturing PMIs are clearly weakening. There are still some who believe in a Chinese recovery story, but our local team on the ground in Beijing notes that the trade war is having a meaningfully negative effect.
Our economists remain cautious on China, even as the market holds out hope about its current stimulus efforts. Our analysis shows that infrastructure spending growth seen mostly at the city level should pick up in 2019, but that it is unlikely to be significant in reviving supply chains, nor anywhere near stimulus levels witnessed 2015-16.
Political and policy risk to remain elevated; anticipate global synchronisation of central bank policy
The current slowdown is synchronised compared to the 2015-2016 slowdown, where global growth trajectories were divergent. This implies that major central banks are likely to adopt a globally synchronised approach, especially with the potential of a further slowdown in China. At this stage, we expect major central bank activity to reflect a pause on tightening rather than the next step of a return to easing.
To reiterate, we do not necessarily think that the recessionary pressures loom large for the US given current financial conditions but concede that risks to global growth remain. However, an escalation of trade tensions beyond those already incorporated in forecasts remains a key source of risk to our outlook. A range of triggers beyond escalating trade tensions could spark a further deterioration in risk sentiment with adverse growth implications, especially given the high levels of public and private debt. These potential triggers include a “no-deal” Brexit and a greater-than-envisaged slowdown in China.
Instead, the main shared policy priority is for countries to cooperate and resolve their trade disagreements and the resulting policy/political uncertainty.