As we approach the regular reporting season there is a level of anticipation. As investors, we can reflect on the quality of the earnings, the outlook for profits and the challenges some sectors and companies are likely to face until the next cycle of earnings announcements. It is the essential report card on corporate Australia.
The July confession period was a little on the light side vs previous confession periods. In part the recent bank royal commission has forced some significant announcements already. You could say there was a pre- confessions period announcement in June. So the current expectation is that we head into the August reporting period with most of the earnings downgrades (market cap adjusted) behind us.
From the outset, and it must be said in very broad terms, the momentum of earnings growth remains robust and this is also reflected with some business conditions and confidence indicators. The repair of corporate profits is now well into the third year following many years of earnings contractions (an earnings recession). That is why the market is currently around their 10-year highs and if you include the dividends, the accumulation index is around all-time highs.
Targets are important to monitor and forecasting is a necessary process. If there are no additional earnings shocks then my forecast for the ASX 200 remains at 6,550 and 6,750 for 30 June 2018 and 31 December 2019 respectively. The target implies a modest capital return before the dividend. Therefore the right bottom-up stock selection process is the key to beating the benchmark.
As with all forecasts, context is important as there are many moving parts. The RBA will need to keep interest rates steady at historic lows as the economy is already seeing tighter lending conditions following various prudential regulatory changes and also post the royal commission lending has slowed. The AUD will need to be at the lower end of the 0.70 band and with a tight labour market some modest wage growth (no signs yet) could be absorbed.
The expectations for the August reporting period imply strong contributions from the resources (commodities, bulks) on the back of good volume growth, energy (price growth), some diversified financials (particularly the ones with non-AUD earnings) and the healthcare sector (who have very lofty valuations). Expectations for bank earnings have been lowered but it still looks too early to be overweight the banks for now.
The significant earnings challenges for the banks (big four and regionals) will continue for some time but they will remain reliable dividend contributors for now with limited upside to earnings growth momentum. It would be difficult to find an active fund manager overweight banks however it is clear the SMSF sector has a long time frame and values the dividend plus franking, more than professional fund managers. The big four banks will simply need to continue the current demerger cycle from the many non-core businesses. That includes any wealth managers, fund managers, insurance businesses that remain. The quicker they do this the better it will be for their net interest margins (NIMs) going forward. Further their cost-to-income ratio’s outside of the core business units remain too high.
As for AMP that needs to be singled out. A disappointment is an understatement. The dividend is no longer reliable and it has all the characteristics of a classic value trap. Telstra is also facing significant challenges as it only has the mobile business that exhibits any potential growth characteristics. They have already cut their distribution and one should expect this trend to continue for now.
The upcoming reporting period will confirm to investors the health of corporate Australia (profits, corporate governance) and if expectations are delivered then current equity valuations can be justified.
CIO | Atlas Capital
Director | Salter Brothers Asset Management (SBAM)