Last week the International Monetary Fund revised its projection for UK economic growth in 2014 to 3.2%, the fourth consecutive time it has raised the number. This comfortably outdoes all other developed nations, including the perennial powerhouses of the USA and Germany, projected to grow at just 1.7% and 1.9% respectively. This is not a one-year only phenomenon either with the IMF predicting a robust 2.7% in 2015 for the UK.
Yet a study produced by EY builds on other evidence seen this year to suggest all is not well among the nation’s biggest companies. EY has found that profit warnings issued by UK companies have been more numerous during the first half of 2014 than at any time in the last three years.
You may say the cause of this seemingly counterintuitive situation is the rising strength of the UK pound and you would be right, but only up to a point. As the British economy strengthens relative to global peers so does the currency and the pound has made big gains on the US dollar in particular. The expectation of a near term interest rate rise is also pushing up sterling.
This means earnings drawn overseas in dollars and other currency become lower than before when converted back into sterling. However given this is an entirely predictable issue it does not fully explain why there have been 137 profit warnings issued by UK listed companies during the first six months of the year. EY said that just a fifth of these warnings were attributed to adverse currency movements, which is high historically speaking but still means 80% were not down to the pound.
Arguably a much bigger issue for UK plc than the rising pound is the increased competition and squeezing of margins in many industries. This is something which will not resolve itself as simply as the currency problem, which will be alleviated when the pound’s rise returns to a much more limited pace or is even reversed to a fall.
The economic strength of a country as a whole and the profitability of its big companies appear to be entering an age of increased dislocation not seen previously.
“For UK plc, the improvement in domestic demand has been a welcome fillip and this growth rests on a broader base than 2013 encompassing a rise in investment as well as consumption, however translating this into profitable growth remains more problematic,” said Keith McGregor, EY’s capital transformation leader for EMEA and India.
The household goods sector is perhaps the prime example of this. Strong economic growth and confidence among consumers has done nothing so far to help the likes of beleaguered supermarket giant Tesco. It appears it does not matter how well the host country is doing economically as a whole if a company has aggressive competitors squeezing its margins in the way Tesco does with Aldi and Lidl.
“The FTSE general retailers sector has already undergone a deep level of restructuring in response to relentless competition and structural change, this pace isn’t letting up and the grocery sector looks set to face the next round,” said Alan Hudson, EY’s head of restructuring for the UK and Ireland.
Other sectors bearing more than a fair share of the profit warnings include support services, software and computer services and electrical equipment, according to EY data.
This developing situation likely has a lot further to run and means investors and fund pickers need to tackle UK equities with a more cautious and sophisticated approach. Funds and managers which base stock selection more on companies' competitive position within a given industry than on wider economic factors or trends appear to be the order of the day.
It seems even in the fastest growing economy in the developed world stock picking will be far from fool-proof over the coming months and into 2015.
