UK second-half 2015 earnings: The trouble with being global - J.P. Morgan Asset Management
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UK second-half 2015 earnings: The trouble with being global

Contributors Alex Dryden, Global Markets Insights Strategy Team
In brief
  • With 285 companies in the FTSE 350 having reported (as of 15 March 2016), we estimate that second-half 2015 earnings per share (EPS) declined by 7.5% year on year (y/y).
  • With 70% of revenues coming from overseas, weaker growth in emerging markets and Europe has combined with a strong pound to hurt earnings. But both growth and currency headwinds now look to be easing.
  • Global growth is expected to slow slightly in 2016, to 3%, but the UK market should benefit more than most from a reduction in US recession fears and signs of stabilisation in China and other emerging market economies.
A closer look at our earnings model

There are a number of unusual features of the UK market that make it more difficult than in the US to track corporate earnings in a timely fashion. One key difference is that the vast majority of UK firms only report on a semi-annual basis, which explains why we will publish our UK earnings report only twice a year.

The main index used for our earnings updates is the FTSE 350 index, which is a combination of the FTSE 100 and FTSE 250 and therefore captures performance of UK large and mid cap companies. The main UK equity benchmark is the FTSE All-Share, which has a full list of 643 stocks and therefore incorporates an additional 300 smaller companies that are outside the FTSE 350. However, since the FTSE 350 represents 96% of the market capitalisation of the FTSE All-Share, we believe this index gives us a broad overview of UK earnings.

UK earnings report

Overall, we estimate that earnings for the FTSE 350 fell by 7.5% (y/y) in the fourth quarter of 2015 (Exhibit 1). Unsurprisingly, the biggest headwinds have come from the energy and materials sectors, which have been battered by falling commodity prices over the last few years.

The FTSE 350 has a 15% exposure to commodity sectors, which have seriously dented UK earnings performance in the last few years
Exhibit 1: FTSE 350 earnings per share growth
Change year on year

Source: Bloomberg, FTSE, HSBC, J.P. Morgan Asset Management; data as of 16 March 2016.

UK equities have been historically viewed as a proxy for global growth due to the international nature of a large percentage of the market’s constituents. The UK is unique in its lack of domestic exposure. As highlighted in Exhibit 2, UK equities source 70% of their revenues from overseas. In the US, 49% of revenues come from overseas, while in Europe the proportion is just 44%.

FTSE 350 companies source 70% of their revenues from overseas
Exhibit 2: UK earnings by region

Source: FactSet, FTSE, J.P. Morgan Asset Management; data as of 16 March 2016.

Global exposure is a double-edged sword

The international nature of the UK stock market exposes investors to two significant factors. One is the potential for a change in the pace of earnings growth at its source. The second factor is the currency translation effect, as companies take their overseas earnings and repatriate them back to the UK. The issue for investors is that these two risks are often positively correlated, meaning that UK equities can be hit doubly hard by a slowdown overseas as both earnings growth in local currency terms and the currency exchange rate fall.

However, the flip side is that UK equity investors can benefit significantly from an improvement in economic growth. We would hope to see this dynamic over the next two years as and when global growth worries start to ebb.

Emerging market (EM) growth is one area that UK investors need to be more alert to than their European and US counterparts. FTSE 350 companies source over 25% of their earnings from emerging markets, compared with just 18% for both the Stoxx 600 and S&P 500. EM economic growth has been sluggish in recent years with EM economies growing 4.5% in 2015, the slowest pace since 2009. This sluggish growth has been a headwind for UK earnings. Fortunately, the outlook for EM economies is brightening, with growth for this year forecasted to bottom at 4.4% before rebounding to 5.1% in 2017.

Investors should also note that the UK market’s headline exposure to emerging markets disguises a significant divergence in the exposure of different sectors. As we highlight in Exhibit 3, some sectors have very little earnings exposure to emerging markets. UK utilities, for example, have no EM exposure and source 73% of their revenues from the UK (see Exhibit 6). This domestic focus, coupled with attractive dividend yields, explains why the utilities sector has been the port of choice for UK equity investors sheltering from the global storm. UK utility firms are up 0.5% year to date, in contrast to the broader FTSE 350, which is down 2%.

Signs of stabilisation in emerging markets should help FTSE 350 stocks
Exhibit 3: Emerging market exposure by sector

Source: FactSet, FTSE, J.P. Morgan Asset Management; data as of 16 March 2016.

On the currency front, the international exposure of the UK market means that UK equity investors are vulnerable to swings in international currency markets and a strengthening pound. From 2013 to the summer of 2015 the pound appreciated 21% on a trade-weighted basis, as expectations for UK interest rate rises began to mount. But the mood has now changed dramatically, with the pound down 7% since the end of November 2015 as expectations of higher interest rates recede and investors focus on the possibility that the UK might leave the European Union (EU). The pound may reverse some of its recent weakness if the UK electorate opts to remain part of the EU. However, the country’s significant current account deficit - 4% of GDP in the third quarter of 2015 - is likely to prevent the pound from recovering all the ground that it has lost, at least relative to the US dollar.

The international headwinds facing UK equities, particularly those large cap firms with significant overseas exposure, have damaged valuations. As highlighted in Exhibit 4, the price-to-book ratio for FTSE 100 firms is at its lowest point since 2012. However, currency headwinds look to be fading and although growth overseas is still challenging, the outlook is improving and this should help large cap firms over the coming months.

Large cap valuations are looking attractive after the recent sell-off
Exhibit 4: Price-to-book ratio for FTSE 100

Source: FactSet, FTSE, J.P. Morgan Asset Management; data as of 16 March 2016.

The changing face of the FTSE

Historically, UK equity benchmarks have been considered a proxy for the global commodity cycle, given their heavy exposure to that sector. However, as we highlight in Exhibit 5, the weighting of commodity sectors in the FTSE 350 index has fallen sharply in the last eight years. At the end of 2015, energy and materials accounted for just 15% of the index - down from 34% in mid-2008.

As the influence of commodity sectors has waned, the weighting of consumer-oriented sectors - consumer staples and consumer discretionary - has risen. In 2008, these two sectors accounted for just 18% of the market cap of FTSE All-Share. Today they make up 32% of the index.

The commodity sector is not the only area that has shrunk in recent years. The financial sector was 31% of the index in 2006, but now makes up just 21%
Exhibit 5: Market weight in the FTSE 350

Source: FactSet, FTSE, J.P. Morgan Asset Management. *Consumer-orientated sectors include consumer goods and consumer services. **Commodity sectors include energy and materials. Data as of 16 March 2016

These changes in index composition have had important implications for active UK equity managers, as we described in our previous bulletin, A fresh take on UK equities1. With the correct decision to underweight commodity sectors, UK fund managers could have outperformed the index significantly. Whether this continues to be true in future remains to be seen.

We do know that the significant shift away from energy and materials and towards more consumer-oriented sectors means that many investors need to re-think their long-held view of UK equity benchmarks. As we highlight in Exhibit 6, consumer sectors in the UK are more exposed to the domestic economy than the commodity firms that they share an index with.

There is a significant divergence between sectors exposure to the UK economy
Exhibit 6: Revenue sourced from the UK
% of overall revenue

Source: FactSet, FTSE, J.P. Morgan Asset Management; data as of 16 March 2016.

Investment implications
  • A weakening pound and stabilising growth prospects overseas should help lift UK earnings growth over the coming quarters, particularly for large firms with international exposure.
  • UK equity indices are changing in nature and investors should consider re-evaluating their long-held beliefs about the nature of the UK market. Commodity sectors have a much smaller weighting in the FTSE indices than they did a decade ago and have been replaced with consumer-oriented industries that have more exposure to the UK economy.
  • There has been a significant dispersion in earnings and performance across FTSE sectors in recent years. With this dispersion likely to continue in the months ahead, active management will remain the key to avoid potential pitfalls and take advantage of sector differences.

1 Market Insights: A fresh take on UK equities, Alex Dryden, J.P. Morgan Asset Management, November 2015

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