- Interest rate outlook still defines investor and management approaches
- Tourism and retail looking strong despite economic worries
We’ve just exited the main full-year reporting season and it’s clear that the cumulative impact of 14 successive rate hikes will linger for a while longer. Indeed, it appears that central bankers could be forced to delay initial rate cuts until real wage growth moderates to a degree. That seems a tad unfair where UK workers are concerned, given that domestic wage growth lagged many of our principal trading partners in the aftermath of the pandemic. But the Monetary Policy Committee (MPC) seems determined to err on the side of caution. This could cast a pall over earnings and related income prospects, although the preliminary releases indicate that dividend growth from the FTSE top-tier constituents will probably continue to outstrip the mid-caps in 2024.
Across the pond, stronger-than-expected non-farm payrolls data has scaled back expectations that the US Federal Reserve will cut interest rates as early as June. Traders had been pricing in a 25 basis point reduction, although even that modest scenario is receding into the distance due to stubborn US inflation. Nonetheless, the mere expectation over interest rate cuts this year has reduced the difference between the yield on corporate bonds and those of their equivalent US Treasuries. So we have witnessed a marked step-up in the issuance of corporate debt, especially among companies that were able to push their refinancing commitments back.
Unfortunately, not every company had that refinancing option. The impact of the rate hikes is certainly apparent in EY-Parthenon’s latest Profit Warnings report. In total, 294 warnings were issued in 2023, equivalent to nearly one-in-five of all UK-listed companies. Around a third of the warnings issued in the final quarter of the year were from larger public companies, which came in at “double the average rate”. That’s a surprising outcome given that rate sensitivity is generally held to be more acute among small- and medium-sized businesses.
The strain was particularly noticeable in the FTSE retailers sector, while some UK media companies released negative updates in the final quarter of the year, a consequence of reduced marketing and advertising budgets across a range of industries. In terms of media, this usually translates into delayed contracts or decisions on campaigns. Marketing communications group WPP (WPP) has been struggling to drive new business levels to the highs of a decade ago. The group is placing great store in the impact that artificial intelligence (AI) will eventually have on profit margins, but on a like-for-like basis, US revenue less pass-through costs fell by 2.7 per cent in 2023. That’s significant given that the US market is the largest revenue generator, although it’s worth noting that sales from the group’s retail clients recorded the largest negative reading through the year. US technology clients were primarily blamed for last year’s underwhelming performance, but you’re left wondering whether bosses have overestimated the early impact of AI technologies.
Some other companies were faced by what might be termed an “imperfect storm”. It could be said that domestic building supplies companies have provided a revealing insight into how some households reacted to the pandemic restrictions and their eventual cessation. Kingfisher (KGF) – the DIY chain that owns the B&Q and Screwfix brands in the UK – saw net earnings contract by a quarter for its January year-end. The chain certainly derived some benefit from the home improvement boom that followed in the wake of the lockdowns, but a prolonged period of high input inflation and its effect on household budgets have seen sales flatline. Trading at Kingfisher’s French arm, specifically the Castorama DIY chain, also weighed on financial performance last year.
All this points to wavering business confidence and squeezed discretionary budgets, exacerbated by the prevailing rate environment. However, although macroeconomic factors will always have a bearing on financial performance, there are some companies such as fashion retailer Next (NXT) that seem to defy gravity on this score. The group posted a string of earnings upgrades last year, primarily a reflection of management’s proactive stance on inventory management. Indeed, as we’ve seen in the past, those retailers that did post encouraging earnings figures were those that kept discounted sales to a minimum. By contrast, a group such as Diageo (DGE), whose products are not normally prone to demand elasticity when the economy falters, found the going tough in 2023 due to inventory visibility issues in its Latin America and Caribbean market. Operational efficiencies clearly do matter.
The challenge posed to consumer-facing businesses was brought home by recent analysis from accounting firm Mazars, which showed retail insolvencies at a five-year high. Admittedly, the UK high street has witnessed something of a post-Christmas surge in footfall, but net margins in the hospitality and retail industries will come under further pressure due to this month’s rise in the National Living Wage.
It's worth noting that tourism stands as something of an outlier in terms of discretionary spending patterns.
It was to be expected that holidaymakers and other travellers would come back to the fold once the Covid-19 travel restrictions began to lift. Latest figures from the United Nations World Tourism Organization show that numbers were at 88 per cent of pre-pandemic levels through last year and are expected to return to 2019 levels this year. It’s little wonder that the likes of InterContinental Hotels (IHG) and easyJet (EZJ) saw their stock rise through 2023, to say nothing of the stark improvement in the engine aftersales market that buoyed Rolls-Royce (RR.) through the year. Indeed, the Derby-based aerospace group has been the strongest performer among the blue-chip stocks, gaining 179 per cent in value over the past 12 months.
The Rolls-Royce chief executive Tufan Erginbilgic has implemented a comprehensive cost-cutting programme with the aim of driving £400mn-£500mn in efficiency savings, adding to efforts from previous boss Warren East. Management is ahead of schedule on the plan and these actions, together with the marked increase in engine flying hours, gave rise to significant operational leverage benefits, enabling the aerospace engineer to book reported profits of £2.43bn against a loss in the prior year.
The pandemic clearly casts a long shadow, but the harsh medicine doled out by Erginbilgic and his team is having the desired effect. The next step will be to reduce the sizeable debt overhang.
Debt overhang
Naturally, the rise in the cost of capital has had a direct bearing on preliminary figures in the financial sector, although it always pays to dig a little deeper into income statements within this corner of the market – a lot can happen between the gross profit figure and net earnings. Nevertheless, there were some broad commonalities within those FTSE 100 constituents engaged in investment/wealth management.
However, you can only lay so much blame on industry trends. In the case of St James’s Place (STJ), accusations over excess management fees resulted in a £426mn charge on the income statement to cover potential compensation payments. The impairment duly resulted in a swing to a reported earnings loss, even though the group boosted the top line by 45 per cent.
In our most recent coverage, we didn’t reiterate our buy call based on a contrarian perspective, but rather from the somewhat outmoded “special situation” recovery angle. Despite the excess charge controversy, which had been in train for a lengthy period, it’s interesting to note that the group’s advisers won £15.4bn in new business, while client retention was 95.3 per cent for the year. Clearly, the adviser has its acolytes regardless of the cost.
In general, however, it would be fair to say that the sector was hamstrung by outflows from mutual funds and institutional businesses, while the value of managed assets came under pressure through unfavourable revaluations. Given what happened to asset prices during a decade of ultra-loose monetary policy, we shouldn’t be too surprised. Yet, some FTSE 100 companies within the broader financial sphere fared better than others. On release of Phoenix Group’s (PHNX) year-end figures, we noted that it was “well insulated against wider instability in some of its underlying markets”. Despite the shaky backdrop, Phoenix saw a 72 per cent year-on-year increase in new business net fund flows, while total cash generation of £2.02bn outstripped the previously upgraded target rate two years ahead of schedule. It exited 2023 with a Solvency II surplus of £3.9bn on the balance sheet, so management now feels able to institute a “progressive and sustainable” dividend policy. None of this was enough to galvanise the share price through the year, possibly because valuations across the industry are facing increased scrutiny due to changes under the IFRS 17 accounting standard. And as one of the so-called Mansion House Compact, alongside industry peers such as L&G (LGEN) and Aviva (AV.), the fear exists that a proportion of its invested capital could find its way into illiquid assets.
Beyond specific issues, however, there is no denying the centrality of the interest rate trajectory where the UK’s top-tier constituents are concerned. Net earnings were certainly constrained in the UK property sector, with all but one of the companies that reported registering double-digit declines. Obviously, sentiment towards the UK’s leading housebuilders has soured due to an investigation by the Competition and Markets Authority into price collusion, but the steady rise in the base rate had already weighed on valuations, even though contrasting effects are in evidence. Consider that a company such as Unite (UTG) benefited from an increase in annual net rental income, but it was still compelled to take a valuation hit from increases in property yields, again a consequence of higher interest rates.
For investors, the prospective reduction in the base rate is keenly anticipated simply because it will make risk-free assets like cash relatively less attractive. The fact that bond yields have remained erratic has done little to assuage the risk-off attitude, at least on this side of the Atlantic. The UK market remains undervalued compared with overseas rivals, with heavily weighted sectors such as basic materials and financials trading well below their long-term averages. A modest reversion to long-run multiples could see the UK close the gap through 2024, but much still depends on the MPC.
