Five things to look out for this earnings season

When it comes to unpredictability, it’s been a while since markets have had to deal with so many unknowns – China, Russia, recession risks, rising interest rates, and supply chain shocks.

So, with earnings season once again looming on the horizon, what can we expect?

Here are a few themes:

Yes, expect the unexpected

The AFR thinks we should expect the unexpected. It cites research from Morgan Stanley’s Chris Nichol, who examines the consensus earnings estimates of ASX-listed companies and argues that many of them are due for an update.

According to Nicol, the median time since companies in the ASX 300 updated their earnings estimates is 48 days, and market earnings continue to carry near term downside risk because “margin forecasts have remained static and in many cases above pre-COVID norms”.

In fact, the AFR reports that there are 45 companies in the ASX 300 that have not updated their earnings estimates in the last 81 to 90 days, and while this would not ordinarily matter, the current climate of economic uncertainty is making it harder for analysts to predict where the upcoming earnings season will land.

‘Excuseflation’ vs the RBA

Speaking of economic uncertainty, the Reserve Bank of Australia’s fight against inflation and its impact on consumer spending will likely be a driving economic theme this earnings season.

The RBA has now raised rates a whopping 12 times since May 2022 and is expected to keep hiking until 2024. It’s the most aggressive rate-hiking cycle since the 1980s, and there is evidence that the hikes are finally starting to have an impact.

While consumer spending increased by a stronger than expected 0.7 per cent in May, retail spending has softened considerably in the past year, and economists consider the figure to be an anomaly rather than a sign of resurgent spending. This fall in retail spending will likely eat into profit margins of ASX-listed companies that are dependent on consumer spending.

While companies might previously have been wary of raising prices for fear of losing market share, the economic volatility of the post-Covid years has given them a built in excuse for price hikes – a phenomenon that Bloomberg has termed “excuseflation”. For many poorer Australians, however, the rising cost of living has already reached crisis proportions, and companies will need to be careful about how they communicate their profit margins, lest they be accused of profiteering.

The inevitable cost-cutting

Which brings us to the ‘R’ word. No, not recession but redundancies.

With Australia’s unemployment rate hovering at a steady 3.6 per cent, and the RBA determined to do whatever it takes to take the heat out of the economy, redundancies are likely to be inevitable.

For anyone who follows the news, it’s no secret that technology companies that over-hired during the pandemic have already started self-correcting. But it’s not just tech sector employees that are feeling the pain, with redundancies coming in from the financial, industrial, and media and entertainment sectors as well.

Companies facing tough questions from shareholders about debt and capital management will inevitably look to hiring freezes and staff redundancies as obvious ways to cut costs.

But there’s redundancies and then there’s redundancies.

Publicly declaring that you’re going to fire 80 per cent of your workforce to become more “hardcore” is a sure way to alienate everyone from customers to future employees. It will also raise obvious questions about the quality of your company’s product and leave it extremely vulnerable to competition.

On the other hand, managing your redundancy announcements with grace will help ensure that employees part ways on good terms, protecting both your brand and your product.

Impact of China’s stalled re-opening

 It’s not just the potential for a hot war in our backyard that has investors worried about China. The world’s second largest economy has helped to power the global economy for the past 30 years, and JP Morgan predicted that its post-Covid re-opening in January of this year would add a full percentage point of GDP to the Australian economy.

But the re-opening has been tepid, and with China’s youth unemployment rate hitting a record high of 20.4 per cent earlier this year, the world’s second largest economy has now installed a new, Western-trained central banker in a bid to try and reboot its economy.

For Australian companies in the energy, materials, industrial, and agricultural sectors that are dependent on serving the growing Chinese middle class, this means that any expectations they might have had of a post-Covid China boom will now have to be written down.

The return of active managers

The RBA’s hiking rate cycle also means that liquidity is harder to come by, and shareholders will be more stringent in examining their investments.

The AFR cites Barrenjoey’s Chief Economist Jo Masters, who argues that the rate hikes have created a two-speed economy in Australia. While mortgage holders are tightening their belts to make their repayments, retirees who already own their property outright are continuing to drive consumption with their spending.

This two speed economy means that company performance will vary greatly, depending on how they generate their revenue. While the construction, commercial property, and residential property sectors are expected to struggle, sectors that are dependent on tourism, education, and the energy transition are likely to prosper.

Valuations matter a lot more in the current environment, and investors can no longer afford to set and forget. The uncertain economic environment means that active managers and stock pickers are back in vogue, and companies can expect more questions about their liquidity buffers, how they are managing costs, and how they intend to provide a steady return on investment for their shareholders.