Earnings downgrades set to test share prices

Earnings estimates are likely to be revised down during reporting season with potentially negative implications for companies that can’t show enough light at the end of the tunnel.

Expectations on the pace of US monetary policy normalisation and their impact on global markets could remain a driving force.

Earnings estimates are expected to be revised down during reporting season, with potentially negative implications for companies that can’t show enough light at the end of the tunnel.

However, as reporting ramps up this week, strategists are divided on whether such downgrades alone will be big enough to knock the overall sharemarket after its recent downward ­correction.

Expectations on the pace of US monetary policy normalisation and their impact on global markets could remain the driving force with the Fed expected to end quantitative easing and start raising rates next month.

Monday’s intraday rebound in ANZ after it fell 5.4 per cent to a 12-month low of $26.57 on a profit warning in its trading update showed how stocks can bounce when companies project improvement.

ANZ shares closed down 1.9 per cent on Monday at $26.57.

Australian earnings are set to be downgraded further, but fear of a collapse in corporate profit margins are overblown, according to UBS equity strategist Richard Schellbach.

“With this profit season capturing the Omicron lockdown months of December and January, we expect the skew towards downgrades to continue throughout February,” he said.

Moreover, this reporting season looked set to be a “minefield” in terms of how rising input costs and supply chain bottlenecks ­affected profit margins.

Adding to the complication is the fact that the economy was hit with an enforced pause in December and January due to the Omicron wave.

A modest downgrade over the last six months to 2021-22 earnings was initially driven via cuts to large miners and banks.

Despite this, the outlook for profits had looked strong, with upward revisions outnumbering downward revisions up in ­December.

“Since then momentum has faded, and with this profit season capturing the Omicron lockdown months of December and January, further slippage should be expected,” Mr Schellbach said.

Miners have been downgraded the most since the start of the year, as the negative impact from volume cuts and wage pressures overwhelm the recent strength seen in commodity prices.

Mr Schellbach noted that the consensus for earnings growth of 13 per cent for 2021-22 is set to be gradually downgraded, with a final number likely to be about 9 per cent.

But while that would represent a “deceleration from last year’s breakneck speed”, it would still be “noticeably above trend”, and fear of a collapse in corporate profit margins was “overblown”.

“We note that this solid but ­decelerating earnings growth trajectory was the standard experience from prior periods which were two years on from an earnings recession, such as 2003, 2011 and 2018,” he said.

Still, the risks appear “meaningful” for certain companies, as investors focused on how companies were dealing with supply chain bottlenecks, how they were managing labour cost issues, and when they expected a resumption of activity levels back to “normal”.

Labour cost burdens provided a guide as to where these vulnerabilities lay, with the financials and gaming & leisure sectors looking to be most at risk, Mr Schellbach added.

Similarly, Morgan Stanley’s Chris Nicol warned of Omicron disruption and the impacts from cost push inflation, supply-chain friction and labour supply short­ages. “The impacts from continued Covid-related trading disruption are not immaterial for equity markets,” Mr Nicol said.

“In real time, the consequences of Covid continue with a focus on mobility, consumption and disruption over the key Christmas trading period and to start 2022 to feature heavily in interim result commentary.”

While supply-chain friction and emerging wage pressures are “clear and present obstacles to growth”, scrutiny of the duration of disruption and its impact on margins is set to increase.

And in Mr Nicol’s view, it was not necessarily “in the price” despite a 6.4 per cent fall in the sharemarket last month and its first correction since early 2020.

While expectations of disruption to trade and risk to earnings had risen, Mr Nicol warned that earnings estimates were relatively stale and the bottom-up margin assumptions appeared to factor little of this impact, with outer-year forecasts showing elevated margin outcomes versus pre-Covid history.

“In our experience, earnings downgrades driven by margin resets carry share price reactions often deeper and more sustained,” he said.

Moreover, the last six months of lockdown effects had been larger and cost push pressures had been more persistent than forward expectations suggest.

“Supply-chain friction and tight labour availability were key emerging issues well before the Omicron variant came into the frame,” Mr Nicol said. “What is clear in recent update com­mentary is that inventory levels have been affected and the shift from just in time to just in case is upon us.”

Unseasonable weather had compounded fresh supply-chain issues and the ability for bricks-and-mortar retailers to not only open for the same amount of hours pre-Covid, but at a similar cost per head, was proving problematic.

“The lead and lag effects will be well on display and at the very least some profit margin stress testing should be the order of the day and, while some revenue ­impacts may be tolerated, the scrutiny on margin trends versus still-elevated expectations is a factor to watch,” Mr Nicol said.

He also noted that expectations for earnings momentum had continued to fade.

His models suggest a likely trough in the expected 2021-22 earnings per share growth rate of 8-10 per cent versus 13.1 per cent now, with cyclical industrials in the firing line.

Interestingly, earnings estimates for the 2023 and 2024 financial years are for low-single-digit percentage growth, with pressure expected from commodity forecasts and industrials expected to do the heavy lifting.

But Mr Nicol said this expectation “rubs against the near-term pressure we expect in interim ­results for this cohort and the likely pressure on margins versus ­expectations”.