Large cap stocks deliver robust results

Revisions to earnings forecasts for industrial companies have proven far more resilient than recent reporting seasons. However, valuations remain above long run averages, which is tough to justify versus forecast 2017 profit growth of only 7pc, cautious company outlook statements and low levels of capital re-investment. 

Resources stocks duly delivered large anticipated increases in both earnings and dividends in February. With sector balance sheets largely in strong shape, the majors’ rhetoric on how they choose to allocate surplus cashflow is very much directed at sustaining high payout ratios. This is pleasing for shareholders, but also infers that the miners still have poor confidence in the trajectory of commodity prices. The February sell-off in resources (resource stock index - XJR down 3.6pc), despite the shareholder friendly news, is a timely reminder that it is the commodity price outlook, rather than increments of dividend yield, that remain the primary driver of performance for the miners.

Chief Economist Michael Knox warns that while the outlook for the US economy is good, and the outlook for US earnings is even better, the S&P500 is now overvalued versus his modelling. The promise of much lower US corporate tax rates explains a large part of the optimism. However we think that tax reforms are guaranteed a noisy passage through the US Senate and this makes inflated equity markets vulnerable to any disappointment. 

Key company outlook comments and insights point to ‘more of the same’ in terms of challenging economic conditions and pressure points in the economy. It’s a terrific time to be a consumer thanks to intensifying competition in grocery, telco and retailing (including new international entrants). All indications are that the housing cycle has peaked, but high activity levels and pricing are expected to persist for longer than many investors first expected. 

However the benign economic environment is making it tough for corporates to generate material growth in sales and to justify investing capital in their own businesses, contributing to the flat outlook. In the absence of capital investment, we question for how long corporates will continue to be able to eek out profit growth where cost removal, innovation (higher productivity) and lower borrowing costs (which may in fact reverse in the coming year) have probably been larger drivers of growth than sales have.