Investors should brace themselves for more profit warnings in 2017.
This isn't simply because economic growth will slow this year: economists expect an expansion of only 1.2 per cent this year after 2 per cent growth last. Nor is it just because there's danger of a squeeze upon the profit margins of firms that don't export much.
It's also because economic slowdowns affect the distribution of growth rates across companies. As the macroeconomy weakens, corporate growth becomes more negatively skewed, so that a disproportionate number of firms do badly.
This was first pointed out by Paul Geroski and Paul Gregg in a study of the 1990-91 recession in the UK. They showed that just 10 per cent of firms accounted for 84 per cent of the drop in profits then. However, a recent paper by Nick Bloom of Stanford University and Fatih Guvenen and Sergio Salgado at the University of Minnesota shows that much the same is true around the world. They studied corporate sales growth in 44 countries between 1986 and 2013 and found that "periods of low economic activity are characterised by an increase in the probability of very large negative shocks at the firm level".
A weaker economy doesn't just mean that the average firm does less well. It also means that more firms do worse than average, with a few doing very badly, indeed. "Tail risk is an intrinsic part of the business cycle", says Professor Bloom. This suggests that if UK growth does slow as economists expect, then we should see a disproportionate number of profit warnings.
Worse still, these are largely unpredictable. Geroski and Gregg showed that it was almost impossible to predict the victims of the 1990-91 recession because many were doing well in the run-up to it. And Professor Bloom and colleagues show that share returns also become more negatively skewed in downturns. This suggests that investors do not see bad news coming and so don't discount it in advance: if they did, the distribution of equity returns wouldn't change over the business cycle.
All this suggests that 2017 will be a tough year for stock-pickers even if the overall market does well. This is because a disproportionate number of firms might do badly, with a few suffering very much - sufficiently so to damage even a reasonably diversified portfolio. Stock-pickers will, in effect, be fishing in barren waters.
There is, however, a big piece of good news here. If economic forecasters are right (yes, that's a big if), global economic growth will actually pick up this year: the OECD foresees faster growth in both developed and emerging markets in 2017. If the pattern discovered by Professor Bloom and colleagues continues, this points corporate growth becoming positively skewed, which will make life easier for pickers of global stocks.
This has two implications. One is that profit warnings might be more likely for smaller domestically-oriented UK stocks than for globalised ones. The other is that actively-managed funds who choose from global equities have a better chance of doing well this year than those funds who confine themselves to UK stocks.
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Chris blogs at http://stumblingandmumbling.typepad.com