UK profit warnings on the rise, are the markets right to be worried about the economic outlook?

Summer seems a long way away.
As I discussed last week, the start of the New Year has seen a flow of gloomy economic news with the Chancellor of the Exchequer and Governor of the Bank of England both raising concerns, especially about the state of the global economy. The EY ITEM Club struck a note of optimism, arguing that the latest falls in oil and commodity prices together with the delay to changes to tax credits announced in the Autumn Statement would boost consumer spending and hence growth.

EY’s latest Profit Warnings Report seems to be a blow to those of us clinging to the optimistic messages from EY ITEM Club. After a positive early summer with relatively low numbers of profit warnings, businesses found the going tougher as 2015 drew to a close. The EY report shows there were 100 announcements in the fourth quarter alone, the highest quarterly total since 2009, with the highest percentage of companies warning in one quarter since Q4 2001. In total UK profit warnings totaled 313 in 2015, up from 299 in the previous year and the highest annual amount since 2008.

Should we be more worried? What do profit warnings tell us about the state of the economy?

Is it the global slowdown that is causing the problems?
The decline in commodity prices including oil has been widely chronicled and this does go some way to explaining the high number of companies warning in 2015. Around one fifth of all warnings cited falling commodity prices, although these were mostly from companies outside the sector. In addition, around 50% of FTSE Oil Equipment, Services & Distribution companies issued a profit warning in 2015 as pressures passed down the supply chain.

It is becoming increasingly clear that the slowing of the global economy did not just affect companies exposed to commodities. Manufacturing companies featured highly in the profit warnings list, with falling capital budgets, volatile currencies and uncertain export demand all contributing to the sector’s difficulties. In 2015, 42% of FTSE Electronic & Electrical Equipment companies, and 40% of the FTSE Aerospace & Defence sector issued profit warnings.

Taken together the impact of falling commodity prices and a slowdown in manufacturing also hit Support Services (16 warnings). Almost 40% of the Industrial Supplier sub-sector warned in 2015. Clearly the global slowdown does have implications for the UK economy and we must not lose sight of this.

Profit warnings by sector (Q4 2015)

There are other factors at work.
We also saw relatively high numbers of warnings from General Retailers (7), Media (6) and Travel & Leisure (6) in the final quarter of 2015. While the global slowdown might impact these companies to an extent, the range of sectors hit by significant numbers of warnings illustrates once again how complex the economy is to call currently. There are domestic influences impacting individual sectors in different ways. We have left the days of predictable growth in which most businesses were able to do reasonably well behind us and now find ourselves in a more complex world.

With further fiscal austerity ahead, along with the introduction of the National Living Wage (NLW) and no let up on pricing pressures, we can expect to see more stress in a number of sectors in 2016, especially those with government, wage or contract-reliant profiles, such as:

 FTSE Software & Computer Services;
 Construction seems to be a very difficult sector to call with peaks and troughs more prevalent that we would expect even in this traditionally volatile sector; and
 Although healthcare spending is increasing, the care sector will be disproportionately affected by the NLW and the drive for greater fiscal balance.

Balance risk and ambition
The last time profit warnings rose to over 100 in a quarter in 2008-9, earnings forecasts reset and profit warnings fell away dramatically. Maybe there is nothing to worry about. But, of the 240 companies warning in 2015, 59 — just under a quarter — warned more than once. With each warning leading to a median share price fall of just under 14% in Q4 15, failure to forecast accurately can be very expensive.

The UK economy is challenging but as the EY ITEM Club forecast pointed out last week, there are also opportunities with for example, consumers and some export markets offering good growth prospects. The Profit warnings report serves to emphasise the key messages for businesses from EY ITEM Club. Companies should undertake a realistic assessment of their business and their markets, looking at their operational resilience and where and how they can create value, balancing risk management with focused expansionary strategies. Robust forecasting and scenario analysis should be at the core of planning in this challenging environment.

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