First effects of global economic slowdown become apparent

Better than expected. Despite facing many adverse factors, US companies report respectable figures for the fourth quarter. Looking forward, however, profit expectations are likely to be overoptimistic. Which challenges will US businesses face this year? And what does that mean for investors in equities?

The worst December since the 1930s, the best January since 1987. And the positive trend for US equity markets continued in February. Although the US Federal Reserve (Fed) caused strong price drops at the end of 2018 with its ninth key interest rate hike, it was also responsible for an upturn on the equity markets in January. The central bank under Jerome Powell signalled that, if required, it would suspend the tightening of its monetary policy, and might even support the economy with stimulating measures. In other words, a policy U-turn!

Gloomier picture for global economy

The course taken by the Fed in future will generally be more closely linked to economic data than in recent times. At global level, the economic picture has been rather gloomy lately. Many leading indicators, such as the Asian and European purchasing managers’ indices, have weakened. In particular, the trade dispute between the US and China is having an adverse effect by slowing down global trade. The leading indicators in the US had also deteriorated slightly in recent months, albeit from a high level, but have lately stabilised again. The US economy is certainly in better shape than the eurozone. The weakening of global trade has much less impact on the US economy, due to its much stronger domestic focus, and the willingness of US consumers to spend remains high. There are also still some positive effects from Trump’s tax reform. But overall it is time to consider when the upturn in the US is likely to come to an end, as the economic cycle has reached a mature phase.

That is the current environment in which US companies are operating. The situation inside the firms is evident from their reports for the fourth quarter of 2018. Some US companies with international operations are being affected by the weak growth environment. This resulted in weak figures from companies such as construction equipment manufacturer Caterpillar or chemicals giant DowDuPont, and the outlook is not very encouraging, causing share prices to fall. There are concerns about the activities of US companies in China, where economic data is weakening and the trade dispute is raging. Consumer spending in China remains an important driver, however, with a positive impact on US manufacturers of luxury goods, clothing companies and providers of medical equipment.

Focus on tech giants

The US reporting season was always going to focus on the technology giants, as the index heavyweights came under a lot of pressure in the fourth quarter of 2018. After some difficult months, Apple’s figures managed to convince investors. Following a profit warning at the start of January, the iPhone manufacturer was able to slightly exceed the lowered expectations of analysts. It succeeded in sketching out a future path beyond the faltering iPhone. The reports from the other three technology giants were mixed. While Facebook shares reacted with a price leap to revenues and profits that exceeded expectations, online retailer Amazon was subject to cautious forecasts and suffered a negative price reaction due to losses in its international business and concerns about rising costs. Software manufacturer Microsoft, currently once again the largest company in the world based on market capitalisation, presented figures that seemed fairly mixed at first glance – slightly below revenue expectations, but with slightly higher than expected profits. However, Microsoft’s most important growth driver, its cloud business, continues to perform very well. The IT company is also a major beneficiary from digitalisation.

It could have been worse

Overall, the reporting season for the fourth quarter of 2018 is looking pretty respectable, even if profits have fallen in absolute terms. Around two thirds of the companies in the S&P 500 Index were able to exceed analysts’ revenue and profit expectations. Looking at the track record, however, these are rather modest results. Sell-offs in the fourth quarter of 2018 made market participants sceptical, so that in many cases simply meeting the analysts’ estimates led to positive price reactions.

Many analysts had revised their estimates down ahead of the reporting season. That is evident from the profit revisions, of which there were many, particularly in December. That may sound dramatic at first, but it needs to be kept in mind that Trump’s economic stimulus had caused a significant upward distortion of the indicator in recent months. The estimates were gradually adjusted upwards at the start of the reporting season. The indicator is now at a level that can be considered as ‘normal’ for the current stage of the economy.

Selection is key

Let’s not delude ourselves: the era of ever-rising corporate profits is now over. That much is already evident in the fourth quarter reports. Profits are likely to keep falling in the first quarter of 2019. Analysts are expecting profit growth of six per cent for 2019, which may be a little on the high side. But we are still expecting moderate profit growth in 2019. On the one hand, special factors, such as the tax stimulus, are coming to an end in 2019, the outlook for the global economy is getting gloomier, and companies’ costs are rising, for example because they are having to pay higher wages. On the other hand, the US economy remains robust, with many companies focusing on their home market, making them impervious to fluctuations in global trade, and there should be added support from the more gradual raising of interest rates by the Fed. In this environment, there may well be a considerable spread between strong and weak companies. It is therefore important to find the best equities, based on careful selection, and to structure portfolios to ensure they generate the best possible return under the given circumstances. This approach offers opportunities even within the return to normality.

 

As at: 22 February 2018.