Was 2017 as good as it gets?

An interesting start to 2018 …

By any measure, it has been an eventful start to 2018. In the first quarter we have witnessed some of the biggest equity market swings this decade, watched as trade and geopolitical tensions heighten and experienced a series of UK restructurings. Together these events already make it feel like a very different type of year. Global growth prospects remain good but the risks have clearly intensified. Though tax reform in the USA might provide some additional short-term stimulus, there is a possibility that momentum in the world economy is just starting to ease off. 

… is a challenge to stability …

The headline findings from EY’s latest Profit Warnings report (with thanks for the insight from my colleague Kirsten Tomkins) suggest a reasonable stable corporate outlook – UK quoted companies issued 73 profit warnings in Q1 2018, matching the four year rolling average, two fewer than the same quarter of 2017 and 10% less than the previous quarter.

The headline M&A results for the same time period tell a similar story of reasonable economic health. UK M&A totalled $120bn and 681 deals, more than twice the overall value of transactions in Q4 2017 ($51bn, 586 deals). However, domestic and outbound values were similar to the first quarter of 2017 and the real change was the surge in the value of inbound deals, up from $6bn in the last quarter of 2017 to $67bn in Q1 this year. This surge was driven by one large deal and so we will need more time to be sure what the M&A data is telling us.

Beneath the headlines, it appears that the sense of stability may be illusory - an increasing number of sectors are undergoing structural change and volatility has returned to capital markets after an extended period of uncommon calm. Brexit is the most visible example of a relatively uncertain political environment but there are other political uncertainties that could impact businesses. There are a great number of moving parts to 2018 - and companies will need their wits about them to keep up.

… with more high street blues …

UK quoted companies issued 73 profit warnings in Q1 2018, matching the four year rolling average, two fewer than the same quarter of 2017 and 10% less than the previous quarter. But if the headline figure suggests an ordinary quarter, this was anything but.

What makes this quarter extraordinary is the seven-year high in profit warnings from FTSE Consumer Services sectors – led by retail. I have written before about the perfect storm facing retail with online shopping, a squeeze on consumer spending, increased labour costs, higher import costs and a rise in business all impacting performance. These numbers illustrate the point with the FTSE sectors issuing the most profit warnings in Q1 2018 being General Retailers (13), Support Services (10), Software & Computer Services (6), and Travel & Leisure (5).

These numbers mean that almost a fifth of FTSE General Retailers warned in Q1 2018 alone. In addition, a fifth of FTSE Travel & Leisure companies have warned in the year-to-date. Most warnings came from the Restaurants & Bars sub-sector, where a quarter of companies warned.

… and FTSE SmallCap stocks feel the strain …

The highest number of profit warnings from FTSE SmallCap companies since the financial crisis – and their prevalence in consumer-facing sectors - underlines the pressure on the domestic economy.

Profit warnings from FTSE SmallCap companies have risen dramatically in the last six months, hitting 20 in Q1 2018 - well ahead of the four-year average of 12. 

There’s a strong link with the other major trend in profit warnings - the strain on the consumer economy. FTSE General Retailers by far lead the table of FTSE SmallCap warnings. Indeed, FTSE SmallCap constituents made up 47% of FTSE General Retailer’s warnings in the last 12 months, compared to just 18% in 2016.  

Smaller companies tend to be more susceptible to rapid economic change and missteps due to their size and position in the supply chain. But this recent rise also stems from the index’s higher exposure to higher import and labour costs in the domestic economy, with 45% of warnings citing pricing pressures in Q1 2018, compared with 27% elsewhere.

… and future earnings are under pressure …

As a result of the economic challenges identified above, earnings expectations have been subdued in the last six months. This may limit profit warnings across all indices this spring – even though there is a slightly brighter consumer outlook. However, any economic improvement will be marginal and increasing global uncertainties could delay investment decisions, hindering contract reliant sectors and keeping warnings ahead of last year’s record-breaking trough.

… making for an interesting 2018.

These are unprecedented times for the UK economy with Brexit a major unknown. While the economy has been stable if sluggish, there are clear differences in performance across industries. As the economy develops over the course of the year the impacts of changes will vary by sector. Careful monitoring and analysis will be required to manage risks and identify opportunities.

View the full EY Profit Warnings analysis

@MarkGregoryEY

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