The art of reading tea leaves

Economic and financial implications of Q1 Earnings

Sebastién Galy, Sr. Macro Strategist at Nordea Asset Management

Q1 Earnings: With thin profit margins in the retail sector, some inflation is likely to rear its head in the coming months courtesy of a strong labour market. This should eventually translate into one or two hikes though very few expect these in 2019.

Implications: A mild inflationary pressure would reprice the US Treasury curve to some extent, hence our preference for flexible fixed income. Future gyrations, especially versus Emerging Markets, are likely to be transient as we reach the top of the tightening cycle.

•Economic and financial implications of Q1 earnings

Bottoms-up earnings analysis shows mature sectors forced to innovate and cut costs where they can, but higher minimum wages as well as a sometimes-tight labor market still compress profit margins a bit. However, the bulk of the compression in profit margins and revenues is actually in Energy and IT, likely a function of a global slowdown for the latter as 60% of revenue is generated abroad. Energy is harder to explain with buoyant oil prices. Given an expected rebound in global growth, or at least a Chinese one, some of the margins compression and revenues in the IT sector should reverse.

One important detail is that health care input costs have been on a downtrend courtesy, in part, of muted wage growth in this sector. This means that the weak PPI inflation transmits into a weak PCE subcomponent — a feature that will ostensibly persist.

Finally, the earning season has a decent chance of beating weak expectations and it seems that for now companies are not really dumping bad news in Q1. While inflation may be dampened by a slew of effects, including healthcare, the combination of higher wages and thin profit margins in Consumer Discretionary and Staples means that inflation passthrough is increasingly more likely than not if the labor market stays tight.

•Earnings analysis in detail

Profit margins can be analyzed at the level of the national (NIPA) accounts and quarterly earnings. These represent only traded companies and hence are a biased view on the whole. If wages and interest cost increase faster than inflation, earnings may be compressed if consumption is not boosted enough by higher wages. NIPA corporate profits have been falling from high levels suggesting that companies have healthy cash flows and hence the ability to borrow to invest.

According to Factset, blended Earnings growth is estimated at -3.9% in Q1. Earnings and revenue growth declines are driven primarily by Energy and Information Technology. Currencies were mentioned the most, followed by labour costs, in a sample of 25 companies; mentions of higher minimum wage and a tight labor market were rife. Markedly absent were mentions of automation, which would spur investments. Profit margins are the highest by far in real estate and have declined a tad across sectors, particularly in IT. Competitive pressures are likely to intensify in the consumer discretionary, consumer staples and energy sectors.

Consumer discretionary stocks like Amazon are displacing competition from brick and mortars. Amazon is expanding to high-end groceries with Wholefoods. McDonalds is, in part, a set of cost optimized commodity futures overlaid with currency risk. The company is most likely focused on increasing sales of products with the highest margin, e.g. with pork inflation in China; chicken or beef may be an alternative in the low margin business. Nike has a higher profit margin in a mature sector. As the company is exposed to currency swings, it can hedge based on fairly reasonable assumption; overall 23% of this sector rates as high yield compared with 6% for consumer staples.

Coca-Cola and Kraft Heinz represent consumer stables. Both are in a mature sector with a complex set of commodity and currency futures/forwards, low margins, changing consumer tastes and nimble new entrants. To generate the yield investors seek, much of the gains have to come via cost cutting and, in some cases, mergers. Kraft Heinz, the product of an M&A, reduced leverage amid lower pricing power, changing tastes and smaller more agile producers. Coca-Cola had weak expectations for this quarter, blaming currency volatility and tax changes for depressing earnings last quarter.

Conclusion
Competition is acute in mature sectors leading some to innovate and win. With the advantage of high earnings, high growth sectors can infiltrate more mature sectors displacing demand and forcing innovation and cost cutting. The more investors reward a stream of dividends from mature sectors the higher the pressure to cut costs. These mechanisms are deflationary. However, as the labour market tightens, inflationary pressure and competition for personnel, even in mature sectors, are compounded by sometimes higher minimum wages.

About Nordea Asset Management

Nordea Asset Management (NAM, AuM 204.8bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM 282.6bn EUR*). NAM offers European and global investors’ exposure to a broad set of investment funds. We serve a wide range of clients and distributors which include banks, asset managers, independent financial advisors and insurance companies.

Nordea Asset Management has a presence in Cologne, Copenhagen, Frankfurt, Helsinki, London, Luxembourg, Madrid, Milan, New York, Oslo, Paris, Santiago de Chile, Singapore, Stockholm, Vienna and Zurich. Nordea’s local presence goes hand in hand with the objective of being accessible and offering the best service to clients.

Nordea’s success is based on a sustainable and unique multi-boutique approach that combines the expertise of specialised internal boutiques with exclusive external competences allowing us to deliver alpha in a stable way for the benefit of our clients. NAM solutions cover all asset classes from fixed income and equity to multi asset solutions, and manage local and European as well as US, global and emerging market products.

*Source: Nordea Investment Funds, S.A., 31.12.2018

 

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