Crispin Murray

Head of Equities

Markets float higher on central bank money

The relatively swift election of Theresa May as British Prime Minister has removed one of more the immediate sources of post-referendum uncertainty; nevertheless, all eyes remain on near term economic data.

On Friday the IHS Markit Purchasing Managers Index (PMI), an indicator of private sector activity, revealed a sharp fall in the UK even as both Europe and the US surprised on the upside. This suggests that fears of a post-Brexit economic slowdown in the UK are coming to fruition.

There is an underlying tension in the markets. On one hand there are the abundant uncertainties born of Brexit and of the upcoming Italian referendum and its implications for the EU. On the other hand lies the therapeutic effects of easy central bank policy designed to counter any stress on capital market liquidity.

Even with Friday’s decent US PMI result, the market is pricing in only one rate hike at best for the remainder of 2016. In this environment, it is central bank support which is dominating and driving markets higher.

With such abundant liquidity seeking yield, significant parts of the market are getting closer to fully-priced territory, which can be seen with Industrials ex-banks trading towards the top end of their 20-year range in terms of 12m forward price-to-earnings valuations.

Such environments are challenging for investors as liquidity can drive markets for long periods of time. What we do know is that in this environment stocks become more vulnerable to disappointment and understanding stock specifics is critical.

This results in some vulnerability as we move into reporting season given that, broadly speaking, valuations do not provide much of a downside cushion should company results disappoint.  At this point we don’t anticipate a disastrous reporting season, although there are few signs of stellar results at an aggregate level either.

As an example, personal care and hygiene company Asaleo Care (AHY) plunged -31.0% on a profit warning ahead of its FY16 result. While the cost headwinds from USD-priced pulp used to make tissues and toilet paper were well known, the company’s plan to pass these costs on via higher prices has been crimped by competitors attacking several of its key product segments.

Discounting at supermarkets, facing their own competitive pressures, also appears to have weighed on AHY’s margins. The net effect is likely to be in the order of -15% to earnings for FY16, with the price fall beyond this reflecting a reversal of the recent re-rating on what was perceived to be a relatively defensive earnings stream.

While we do not see this as a broader harbinger for the earnings season, it is a timely reminder of how severely a disappointed market can react to an earnings miss from highly-rated defensives.

 

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