By Michael Sayers
Every year, we ask our credit and equity analysts about the fundamentals for the companies they analyse. We focus on the underlying business conditions that determine companies’ successes and struggles; their ability to evolve and grow, but also the hurdles they face and the threats to their competitiveness over time.
The result is a temperature check on geographies and sectors that is built entirely from the bottom up, offering a view of the outlook for the corporate sector, derived from our analysts’ direct conversations with CEOs, CFOs, and division heads of the companies they cover.
The results of this year’s survey point to a maturing cycle with rising risk and an increasingly complex investment climate. Our analysts see increased weakness in company fundamentals overall and are generally less optimistic or more pessimistic than last year, which comes in all the key indicators across the survey.
On balance, industry returns are now expected to slide a little from last year as management confidence is predicted to ease, capital expenditure is likely to be cut further and dividend expectations are adjusted significantly in energy, materials and utilities.
Overall, analysts expect leverage to remain at last year’s levels but this masks a divergence that sees rising levels in EMEA, Latin America and the US driven by the energy and commodity sectors’ woes. This reflects the regions’ balance sheet health: on average now seen as about right in Europe and the US but stretched in EMEA and Latin America.
Innovation, Consumers and Financials Stand-out
All of this points to a supply-side adjustment in the ‘old economy’ which is clearly reflected in our analysts’ predictions. However, this broad-brush picture tells only part of the story. We still see pockets of strength in other sectors, underpinned by three key trends. The first of these is innovation.
Few sectors appear immune to the effects of new technologies, inventions, discoveries and business models and the disruptive impact these can have on pricing power and market share; but the most affected are IT and healthcare. The fortunes of those who can capture innovation will contrast starkly with those left behind, creating many exciting opportunities for investors who can identify the winners of such upheaval at an early stage.
The second encouraging theme is the emergence of the developed markets’ consumer as the engine of growth. Consumers’ purchasing power benefits from low energy prices, low inflation overall, supportive housing markets, wage growth (even if very subdued) and recovering labour markets. Consequently, management confidence in both consumer staples and discretionary goods has turned neutral; our analysts no longer predict falling confidence like they did last year and generally predict more hiring than in other sectors except IT. Returns in consumer staples are likely to rise on pricing power and demand growth, and discretionary analysts tell us that CEOs regard demand growth as the main source of earnings growth. Strong balance sheets and modest cuts in capital expenditure mean there is sufficient room for dividends to be maintained or raised.
The final sector theme that stands out is financials. This sector is changing for the better under the influence of belt tightening and regulatory nudging, resulting in stronger balance sheets and lower leverage. This comes through in the survey findings. Nonetheless, it is important to recognise that financials still face some important risks, including a softer growth and inflation outlook, various forms of exposure to the energy sector, and lower bond market liquidity. Not surprisingly, regulation is also expected to remain a significant factor but as it encourages firms to increase their capital buffers, this can support returns in the medium term.
So what does all this mean for investors? Growth is becoming scarcer and it is clear that investors will need to be more selective. In this environment, research into the winners and the losers of innovation and disruption across all sectors will be crucial.
Michael Sayers is director of research at Fidelity International
