22 February 2019
In this podcast, Richard Edgar, Editor in Chief, picks apart what's been learned from this year's survey with Fidelity's Global Head of Research for Fixed Income, Marty Dropkin, and Director of Research for Equity, Michael Sayers.
Things may not be as sunny as last year but as you can hear in this show, context is everything. Plus, there are still some reasons for confidence in the year ahead. Listen on to find out more.
Richard Edgar: What can you learn from 16,000 conversations? Well, that's how many meetings Fidelity's 165 analysts have had in the past year with senior management teams at companies across all sectors and all regions. The 2019 Analyst Survey reflects that wealth of information to create a unique view of the global corporate landscape and how we think it will fare this year.
With me today to talk over some of the key findings are Fidelity's Director of Research for Equity Michael Sayers and Global Head of Research for Fixed Income Marty Dropkin. Welcome to you both.
Marty Dropkin: Thank you very much.
Michael Sayers: Thank you, fabulous to be here
Richard Edgar: Jolly good. Well let's start with a bit of background on what makes this survey unique, as I described it. Marty, can you help me out here?
Marty Dropkin: Well it's the ninth year that we've been running the survey, Richard, and it's a great way that we can pull information out of our equity and fixed income analysts who collaborate on a normal basis. We have analysts spread across Asia the UK in particular, and this year in fact we have a growing team in Toronto so we've been able to bring in the North American perspective as well.
Richard Edgar: What does it add that other surveys - you know, macroeconomic data - that they don't?
Marty Dropkin: Well it's a true bottom-up look at the world, if you will. Whereas lots of surveys that come out of banks in the sell side will come from a macro perspective and be very top down. They'll look at data that's already out there. Our survey is based on analyst engagement with management teams and you mentioned the number of meetings that we do. This survey is really built up from the conversations that our analysts have with those management teams and it's very forward looking.
Richard Edgar: Okay. And Michael let me come to you then to ask how they form these opinions, your analysts.
Michael Sayers: Well, it's based on the insight that they gain from talking to the major corporates, the insight they gain from talking to their competitors, to their suppliers, to their distributors, to private companies, to industry contacts, to experts. It's really part of the sort of mosaic of insight that we garner from all of those different sources and which we hope to bring to bear on the investment process.
Richard Edgar: Okay. Well let's get to the meat of this year's survey itself. Tell me about the overall picture, the sentiment indicator where analysts are asked to gauge management optimism for the year ahead. Now that's declined this year right across the board, ending two years of steady improvements. Why is that?
Michael Sayers: Well, I think the first thing to say is yes, sentiment has declined globally, but you've got to recognise this is from a very strong starting point in 2018 which in fact was the strongest sentiment indicator we've recorded during the lifetime of the survey.
Richard Edgar: So, a long way to fall.
Michael Sayers: Yes. And we remain in positive territory globally in every region except China. I think by sector, almost every sector was down in terms of sentiment apart from healthcare no doubt reflecting the traditional defensive qualities of that sector. But again, although they're down, most sectors remain in positive territory. The exceptions being utilities and consumer discretionary, which I think we're going to touch on later in the podcast.
Richard Edgar: We will. And Marty, this is an aggregate number, covering credit as well as equity. What does the sentiment say about the fixed income world? What are your analysts telling you?
Marty Dropkin: So, there's a couple of things to think about there, Richard. First of all, fixed income analysts tend to approach companies a little bit differently. They're much more focused on cash flow. So, the questions are wide ranging and the same questions are asked to every analyst whether they're equity or fixed income. But I think having that balance of views brings out a little bit more depth when it comes to the balance sheet type questions. You know I think the other the other angle of it is - and if I can be a bit cynical about how fixed income analysts are cynical - we tend to be a little bit more sceptical about the world. And so, I think I think you'll get that balance of an equity view and a fixed income view as it relates to the overall environment.
Richard Edgar: Okay. Well let's take a look at one sector on its own now, in fact it's one which has suffered one of the biggest falls in sentiment - the consumer sector. Harriet Wildgoose - she's one of our analysts, equities actually - and she covers some of the big companies in the US and tells us here what she thinks is going on.
Harriet Wildgoose: Over the last twelve months two of the key drivers of cost price inflation have been labour costs and freight costs and they're probably the two biggest cost items for retailers in general. Some companies have been more effected than others because of the way that they ship items around the US.
Richard Edgar: So, inflation pressures there from labour and freight costs, says Harriet. In fact, she goes on later in that interview to say that it's the cost of labour wages within freight that are the biggest burden rather than fuel. Michael, are these sorts of pressures on margins evident elsewhere?
Michael Sayers: They are. I mean I think that we are definitely seeing a pickup in wage inflationary pressures around the world. Normally you would hope that these can be passed on to the consumer and margins would be protected. I think we are seeing some signs that (a) margins are starting from a very, very high starting point, and then secondly, in an environment where consumer is weakening it's harder to pass on those costs to the final consumer.
Richard Edgar: That was one of the strongest responses coming through the survey around margins, wasn't it?
Michael Sayers: Yes, it was. And interestingly I think also the consumer discretionary side was one of those sectors which was suffering the biggest reversal in sentiment and I think there are a number of factors at work there. That's the cost pressures, as Harriet described, a weaker consumer - particularly in China, and really the sort of headwinds that the sector faces in terms of the move from high street to online are really if anything accelerating and obviously as more and more goods are delivered that puts upward pressure on freight and delivery costs.
Richard Edgar: And Martin, how big a concern is that squeeze on margins from a credit perspective?
Marty Dropkin: One of the things that showed up in the survey was that our analysts generically see balance sheets deteriorating, particularly in the US. So that is a factor to think about and we do every day. As far as that goes, you know balance sheets are still relatively strong. If you look at leverage through the cycles over the last 10 years it has increased and its back towards where we were approaching 10 years ago pre-global financial crisis. However, interest rates are still low by historical standards and yes, funding costs are starting to rise, which is another thing that came out of the survey. But they're starting to rise from very, very low levels. And so there's less concern on the credit side as far as what this wage inflation will do to overall company balance sheets.
Richard Edgar: So, you talked about funding cost being low, well that's because we're in a low rate environment at the moment because there's a very benign inflation picture. But are these the first signs that inflation may well start to pick up, when you start to see it in wage increases?
Marty Dropkin: I mean there are some classic late cycle signals coming through the survey and I'm sure we'll talk a lot about that. One of the themes that Harriet picked up on about increasing costs within the consumer sector is a pervasive theme throughout the whole survey.
Richard Edgar: Although with wages rising presumably consumer sentiment would rise which sort of would balance that out too to a degree.
Michael Sayers: You would hope it would balance it out to a degree but that's certainly not the picture emerging from our consumer analysts. As I said that may be in part because they've been somewhat beaten down by some of the other pressures within the sector.
Marty Dropkin: I think Richard one of the one of the points to really be concerned about is if wages are rising you would want to look to see what the ability of companies is to pass that along. And the survey also suggested that there is some pricing power in different sectors but broadly speaking there's a bit of a concern that companies may not be able to pass along the pricing.
Richard Edgar: They'll have to absorb it back into those margins.
Marty Dropkin: Exactly.
Richard Edgar: You've both alluded to where we are in the economic cycle. Of course, the threat of recession - it does seem to be a big theme for 2019, certainly a question on many people's lips. And the survey asked the analysts directly which stage of the economic cycle their companies are in and Michael there's been quite a marked shift, hasn't there?
Michael Sayers: There has. I mean, much more support for the idea that expansion is extremely mature. Many more analysts than last year calling out a slowdown, in fact roughly one third of the analysts in the survey reported a slowdown this year versus just over 10 percent in the prior year, but still interestingly within the survey very little support for the idea that we're in recession.
Richard Edgar: Why not? I mean, because if you read headlines, there's so much negativity around then people seem to have talked themselves into it to a degree but the analysts are not saying that?
Michael Sayers: They're not seeing it. That's not reflected in their forecasts. That's not the narrative they're picking up from talking to companies. Now, you might argue that companies are almost the last to know in some cases but just not the message we're getting. When I look at our numbers, the aggregate numbers from all of the financial models in the system is really consistent with the message that yes, growth is slowing, but we're not in recession. Now clearly there are some factors that we need to think more closely about in terms of fiscal stimulus, in terms of is the path of interest rates going to be quite as aggressive as some of the sort of people calling for a recession have talked about? We're certainly getting a more dovish tone from the Fed so far in 2019.
Richard Edgar: It's definitely changed, hasn't it Marty?
Marty Dropkin: Michael raises the right point which is yes, growth is slowing, but we're coming off of a very, very strong period of growth in 2018. So it's still growth. And I think that's what's driving a lot of the analysts' responses is yes, things are slowing down, but it's not disastrous. And at this point, when they look 12 months out, they're still seeing high single digit earnings growth in aggregate. And so that to me is still growth.
Richard Edgar: Okay. Well let's take another moment with one of our analysts: Lee Sotos, who covers financials for equities again. He's been noticing other late cycle signals.
Lee Sotos: One of the phenomenon that we've seen in the back half of 2018 is a significant influx of alternative sources of capital, which has been an inhibitor to US bank loan growth. Alternative sources of capital might be hedge funds, private equity funds, insurance companies, or even loan funds by mutual fund companies. It tends to enter the market sort of later in a cycle. You tend to find that that is typically yield seeking or risk seeking types of funds.
Richard Edgar: So bad news for banks that can't or won't compete on price perhaps. Marty, tell me about these alternative sources of capital.
Marty Dropkin: As Lee mentions, this is classic late cycle signals where banks who are under some significant regulatory scrutiny from the global financial crisis are still under this pressure. And so, companies need to raise funds and there's demand and so they're looking at other sources of capital. I think one of the places that we really see in the credit markets is leveraged loans and there's been phenomenal growth in leveraged loans. Some of this is on the demand side. Investors are positioning for a rise in rates and leveraged loans tend to be floating rate instruments and so there's some natural hedging that's involved in that. The risk is that leveraged loans are supposed to be the safer part of the balance sheet and unfortunately, because it's late cycle, companies have a lot of pricing power and there's very few investor protections that we'd typically like to see in a more senior part of the capital structure.
Richard Edgar: The covenants aren't particularly vigorous
Marty Dropkin: They're not vigorous and in some cases non-existent. And so I think when Lee picks up on that it is something to really watch out for.
Michael Sayers: I mean it's interesting from an equity point of view. Probably equity investors are reassured that the banks are not chasing growth at the expense of margin because clearly what we've seen since the global financial crisis are the banks significantly repairing their balance sheets, substantially improving their capital ratios and really putting themselves in a position where for the first time since the crisis they can start really thinking about returning excess capital to shareholders, about boosting dividend growth. And my sense is that bank investors would much rather see that capital come back to them than chasing growth that may or may not be there at attractive rates of return on that capital.
Richard Edgar: But they're finally in a position to tackle the last crisis, maybe we can talk in another discussion about whether they're positioned for the next crisis, whatever it might be.
Michael Sayers: They're certainly better positioned if another crisis comes because their balance sheets are in much better state than they were last time round.
Richard Edgar: With funding costs going up, Marty are there expectations that default rates would go up this year?
Marty Dropkin: It's picking up on quite a few themes here. So, one of the dynamics in the market is we have a fairly flat yield curve. And so what companies have been able to do is, if they would have taken advantage of lower interest rates at the shorter-term part of the capital structure they would have had more short term financing. A flat yield curve has meant that they can push out these maturities. So, I think another one of the reasons that the analysts don't see an imminent recession is that the funding wall is quite a few years out. And so if you look at the statistics, it's not until 2021, 2022, where we really look at refinancing needs for companies.
Richard Edgar: So, no pressure really until then.
Marty Dropkin: No big pressure. That's right.
Richard Edgar: Well that sounds all rather encouraging. What other positive things have you found in this survey, Michael?
Michael Sayers: I think that from an equity investors point of view I think it's important to note that we are perhaps less positive on dividend growth outlook but still positive. So, dividend growth is in fact the strongest indicator of sentiment within the survey. And when I dig down into our analysts’ models and forecasts yes, we've got dividend growth slowing in 2019, but we're still looking for 5 per cent globally. That's a real rate of growth versus inflation and it is positive albeit less than the 8 per cent we were seeing in 2018. And I think a similar picture emerges on things like capital spending. Yes, capex is weaker, but certainly that has to be seen in the context of really a very strong survey for capital spending in 2018. And in fact, first predicted in the 2017 survey.
Richard Edgar: Well, let's talk about capex because it is interesting. We'll get an analyst's view. Sumant Wahi is an analyst who covers tech stocks and he points out about how the effects of fiscal stimulus in the States are fading meaning slower business in his sector.
Sumant Wahi: Sentiment in IT spending has changed a fair bit from last year but I think that is something that you should observe on relative terms rather than on absolute. The reality around this is that last year the United States, which is one of the largest spenders in IT spending, had a significant tax change which allowed a lot of companies to move some of their tax savings into IT projects and that led to a significant acceleration in IT spending - it went up to 8, 9 per cent, if you will. And since that time, for that as a comparison point, 2019 was always expected to slow down.
Richard Edgar: So Sumant's giving us an example there of some of the front loading that's been happening as a result of President Trump's policies last year. And does that explain the fall in capex expectations we see in this year's survey, Marty?
Marty Dropkin: It certainly plays into it. And clearly if you look at the US there were two major themes going on last year. You had some fiscal stimulus hitting the market and you had the change in tax code and so both of those were significant drivers of earnings growth in 2018. I think one of the things that came out of the survey is an expectation that the Trump policies won't be as positive across the companies that analysts cover this year. Well that shouldn't be that much of a surprise given that 2018 was such a big year and the political situation is a little bit less certain this year, given that the Democrats have taken over the house. So, I'm not at all surprised to see that analysts are a little bit more cautious on the ability for the US to manage some of the fiscal policies this year.
Richard Edgar: And in fact, internationally, Michael, a lot of the analysts have turned quite negative. They're still just positive on Trump within the US but externally it's really gone sour.
Michael Sayers: Yes. So, I think there's been a real change in the narrative around Trump. I think when we look at the prior years' surveys there's a lot of discussion about deregulation, particularly in the financial sector, and there was talk about sort of pump priming through fiscal stimulus, so clearly some of the shine has come off that. And at the same time, the whole narrative around trade has I think being a very significant negative particularly as I think it was particularly prevalent in the news at the time of the survey. So that's clearly one of the factors we need to see how that plays out going through 2019.
Richard Edgar: Well let's hear directly from Asia now. Casey McClean is an analyst based in Hong Kong, he covers the Asia regional tech hardware and semiconductors companies, and he's telling us a little bit more about that fall in sentiment in China.
Casey McLean: The biggest change I've observed in China over the last year is a big increase in uncertainty both from consumers and corporates. I think the major driver of this has been the trade wars. Within the corporate sector I think there has been a big push to delay automation of factories and capacity expansions. In the back of their mind they have the risk that they may need to relocate their capacity to South East Asia to avoid tariffs.
Richard Edgar: So, Casey there telling us that companies have halted some investment in case they need to move. In fact, he also describes Taiwanese companies considering moving home from the mainland and American companies which have already moved their operations to South East Asia: Vietnam, Malaysia, and Thailand. Well that's definitely hurt the outlook for China which is where we've seen the biggest fall in sentiment, isn't it?
Michael Sayers: It's certainly hit the outlook for China. Sentiment was particularly weak in China. Trade was part of the narrative but I also think just the economic performance, particularly in the fourth quarter, was really some of the weak we've seen in China for a long time. Auto sales were down over the course of the year in China but actually the fourth quarter was down double digits and a very similar picture emerging on smartphone sales. So, we're really seeing the first sort of negative numbers being printed in China certainly in the duration of this survey. And I think one of the intriguing things was that yes, sentiment in China was negative, but actually the closer you get to China in terms of analysts on the ground the more negative it was and that's actually a reversal of the prior year survey where actually our analysts outside China were much more concerned.
Richard Edgar: And what about the picture in China because there's been some stimulus from monetary policy attempts to boost the economy, there is fiscal stimulus as well, but what's the picture there?
Marty Dropkin: Growth is slowing. The government has recognised that there' s too much debt in the system. It's something we've been paying attention to for quite some time. And we're starting to see some defaults in China and you may be surprised to hear this from a fixed income person but it's a positive thing that we're starting to see a little bit of what I would call 'managed' defaults. It's not pervasive.
Richard Edgar: Is it a return to reality?
Marty Dropkin: I think you could call it that. It's probably a good way to describe it, Richard. It's for companies that perhaps received funding that didn't have the most robust business plan, some of those companies are now being allowed to fail, if you will.
Richard Edgar: So, the idea is that we're left with a healthier economy at the end of it.
Marty Dropkin: And if it's managed well by the government who clearly is quite involved in things then then I think it would leave us in a much healthier state and that is our general view.
Richard Edgar: Let's just try and come up with a few summaries from this year's Analyst Survey. What's the main message that you're left with, Michael, at the end of all this?
Michael Sayers: I'm very much left with the message of slowdown rather than recession and a slowdown that we have to see in the context of a very high starting point in 2018.
Richard Edgar: Marty?
Marty Dropkin: Yeah, I think that's clear, it doesn't matter if you're equity or fixed income - that's the view. We asked the analysts a number of questions on ESG and sustainability and last year the theme was a dramatic increase in the focus on companies that we cover on ESG. We didn't see that dramatic increase this year but we see a continual increase in things. Picking up on the China theme - that's showing some continued increase in the number of companies in China that are actually thinking about ESG. If there's something that's a little bit surprising that came out of the survey it's that in China even, the number of companies that are focused on ESG continues to increase.
Richard Edgar: Which isn't something you'd expect in people's preconceptions, perhaps, of attitudes towards ESG and sustainable business.
Marty Dropkin: That's right. And I'd like to think that we have a little bit of something to do with that because our analysts are asking lots of questions to management teams and we hope that that's planting a seed globally for them to start thinking about sustainable issues.
Richard Edgar: And Michael, give you an opportunity to think of anything surprising that popped out of the survey as you first went through the data when we got it back from the analysts.
Michael Sayers: I think two surprising things that I would highlight: one is perhaps, although we are saying it's a slowdown and there is a certain amount of gloom and doom, that perhaps could it be worse would be my question. And then the second thing is perhaps people are just becoming, for want of a better phrase, bored with the whole political environment because I definitely feel that some of the sort of geopolitical risks that clearly we can all list were certainly not as aggressively recorded as I might have expected.
Richard Edgar: So not as bad as it could have been. That's a particularly stoic ...
Michael Sayers: That's a wonderful epitaph for everybody.
Richard Edgar: Excellent. Well, Michael Sayers, Marty Dropkin, thank-you both very much indeed for joining me. And if you're listening and would like to read the full Analyst Survey we have the data, charts and detailed analysis on our websites. So, thanks very much for listening to For Investment Professionals Only, the Analyst Survey edition. I'm Richard Edgar. Goodbye.
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