Profit warnings: An ominous sign for investors?

In recent weeks there has been a flurry of high-profile profit warnings – is this a sign that all is not well in the UK economy?

At face value, given that UK company profits hit a five-year high in the second quarter of 2017, the overall picture looks more rosy than gloomy.

In addition, despite there being some headline-grabbing profit warnings of late, most notably from Provident Financial (PFG) and WPP (WPP), overall profit warnings in the April to June period posted their lowest quarterly total since the second quarter of 2010.

All-in-all there were 45 profit warnings, notes Ernst & Young (EY); that is comfortably below the post-financial crisis second-quarter average of 58.

But rather than this being a vote of confidence for British businesses and by extension the UK economy, EY urges caution, noting that profit warnings are a measure of performance against expectations.

In other words, “the bar is being set low,” points out Darius McDermott of FundCalibre, the fund ratings firm. “If expectations are low, performance doesn’t need to be spectacular to meet or beat them,” he adds.

Tougher times are ahead, predicts EY: the high level of warnings from retailers and business-to-business sectors is “an ominous sign that reflects weaker consumer confidence and a return to squeezed disposable incomes”.

Further, EY cautions that “political unknowns are also starting to hit business confidence and decision-making”.

In addition, the UK economy has also started to feel the pinch. In July, the UK economy was given the thumbs-down by the International Monetary Fund (IMF), which downgraded the growth forecast for the UK economy in 2017 due to “weaker-than-expected activity” in the first quarter of this year.

For investors, further uncertainty is created by the growing gap between stated and adjusted profits reported for FTSE 100 firms, which has reached its highest level in 10 years.

According to McDermott one sector that is showing particularly worrying signs is general retailers, where the number of profit warnings is up, bucking the overall trend. He points out that various active funds are underweight this sector, for example Marlborough Special Situations and Schroder Recovery.

“The sector is systemically challenged – shopping habits have been disrupted by the internet, and the high street, in particular, is at the mercy of consumer confidence. Stock-picking in this sector will be key, but money can still be made, as we saw with food retailers a year or so ago.”

This article was originally published in our sister magazine Money Observer. Click here to subscribe.

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