USD per GBP Real Yield This edition of EconForum examines corporate profits and their likely impact on future equity returns.

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1 Corporate Profits UK Month in Charts FTSE Breakeven Inflation 1.7 USD per GBP LIBOR Spread 1.8 Corporate Spread 1.1 Real Yield Series plotted relative to the closing position in the previous month. Jan Mar May Jul Sep Nov Dec Week 1 Week 2 Week 3 Week 4 This edition of EconForum examines corporate profits and their likely impact on future equity returns. UK Market Review The FTSE 100 index rose 9% from 5413 to 5900 over 2010, after equities rallied in December, resulting in a 6.7% rise in the index over the month. Over January 2011 the FTSE 100 index gave back some of these gains, falling 0.6% to 5863, as concerns over the UK economy weighed on the UK equity market. Over 2010, MSCI US equities rallied by 13.2%, as optimism over recovery prospects improved and further fiscal stimulus was undertaken. US equities rose a further 2.3% in 1350 MSCI US Equity January. The rise in MSCI Europe ex UK equities, by 1.7% over 2010, was weaker than other markets as concerns over the sovereign debt crisis weighed on bourses. European equities were up 2.5% over January. There has been an increase in volatility in global stock markets with the VIX index rising 10.0% from 17.8 to 19.5 over January However, volatility is still 10% lower than at the beginning of 2010, when the VIX stood at The above charts show the evolution of the daily time series over the past year relative to the horizontal axis, which is set at the last closing value of the last Friday of the previous month. The close of play values at the end of the last four weeks are shown as bars. A bar below the horizontal line indicates that the series has fallen below the value on the last Friday of the previous month. Conversely, if the bar is above the horizontal line the series is above value on the last Friday of the previous month. Page 1 of 16

2 15 year breakeven inflation has remained around 3.5% over the month, only slightly lower than breakeven inflation at the beginning of 2010, when breakeven inflation stood at 3.7%. UK CPI inflation rose to 3.7% in December, up from 3.3% in November. In the year to December, RPI annual inflation was 4.8% up from 4.7% in November. Core CPI inflation rose from 2.7% in November to 2.9% in December. Core inflation is considerably higher than at the beginning of 2010, when core inflation 110 Crude Oil per Barrel ($) was 0.6%. The increase in core inflation is due to the lagged effects of the sterling currency depreciation (which has lost about a fifth of its value since the financial crisis began) and a further rise in VAT. Over 2010 the cost of a barrel of oil rose 19.9% from $77.4 to $92.8 per barrel. This trend accelerated in January, with the cost rising to $99.5 per barrel, a 7.2% rise. With the continuing crisis in Egypt threatening stability in the Middle East, the cost of a barrel has now risen above $100. The corporate bond yield (based on the non-gilts iboxx 15+ AA) increased from 5.5% to 5.6% while the 15 year gilt yield increased from 3.9% to 4.2% over January. Therefore, the corporate spread, as reflected by the difference between corporate bond yields and 15 year gilt yields, narrowed from 1.6% to 1.4% over the last month. (The corporate bond yield was 5.7% and the government bond yield was 4.4%, giving a corporate spread of 1.3%, at the beginning of 2010). The 4.8 Gilt Yield rise in the yields can in part be attributed to growing concern over higher inflation. Over the last month, the real yield increased from 0.5% to 0.7%. Sterling strengthened against a basket of the major currencies over the 86 Sterling Effective Exchange Rate first half of January, rising 1.9% from 79.8 at the beginning of the year to Sterling then weakened over the second half of January due to concerns over inflation and a weaker growth outlook. The sterling effective exchange rate index rose 1.3% over January, ending the month at This brings the sterling basket back to the same level as at the beginning of In particular, sterling appreciated against the US dollar over January, rising 1.9% from $1.57 to $1.60 over the month. This is only just slightly below the exchange rate at the beginning of 2010, which stood at $1.61. Against the euro, sterling remained around 1.17 over January. Compared to the beginning of 2010, sterling has appreciated 3.5% against the euro. The LIBOR spread (the difference between the rate of interest at which banks borrow funds from each other and the base rate) remained around 0.3% over January. This compares with 0.1% at the beginning of In December s MPC meeting, the Monetary Policy Committee (MPC) kept the bank rate at 0.5% and maintained the existing level of quantitative easing at 200bn. While this month s no-change decision is likely to be repeated over the next few months, inflation is running at a high level and should CPI spike above 4%, a rise in the bank rate cannot be ruled out. The Committee remains concerned over the recent rise in inflation and there were two dissenting votes to raise interest rates. However, this was before the latest GDP figures were released, which showed the economy contracted by 0.5% (or was flat if the effects of bad weather are Page 2 of 16

3 discounted). With the recovery weakening this will likely ease pressure to raise interest rates, at least for a while. Corporate Profits Introduction The credit crisis resulted in a severe correction in equity markets, where the FTSE All Share return index fell 45.6% from 4124 at its peak to 2243 at its trough. Since then markets have recovered strongly led by strong earnings growth. By early January 2011 the index returned above its 2007 high, no mean feat after a financial and economic crisis of a depth and magnitude that has no post-war precedent. Market movements have broadly matched the pattern of corporate earnings taking the last five years as a whole. In the UK, the price-earnings multiple using historic earnings (i.e. those earnings already achieved in the past year) is only slightly higher compared to five years ago, though with considerable variation within the period. Looking more closely, it is apparent that earnings were still falling as the markets recovered from April However, earnings soon caught up, and have recently been rising a little faster than share prices. In other words, the market recovery since 2009 has not been driven by markets becoming significantly more 'expensive' in terms of valuation multiples. This suggests that corporate profits (or earnings) have strongly influenced the recovery in equities. A natural question is therefore whether corporate profits will continue to drive equities forward? Corporate profits (earnings) During the recession, reported earnings collapsed, falling by over 80% from November 2007 to July Since then, earnings have rebounded sharply, jumping almost 315% over the following 18 months to the end of This leaves reported earnings just 20% below their peak in November Analysts views on earnings Forecasts in 2009 anticipated large rises in earnings in 2010 and Over the course of 2010, consensus IBES estimates for earnings growth were steadily revised upwards, as actual reported earnings came in much stronger than expected. However, the improvement in earnings has led to earnings forecasts for 2011 to be gradually revised down. This can be seen in the chart on the right, which shows current IBES expectations against where earnings expectations stood in December This suggests Source: WorldScope that the consensus view believes that the strong earnings growth in 2010 limits the prospect of strong earnings growth over Page 3 of 16

4 Despite this attenuation in earnings expectations, the consensus view for earnings growth looking forward to 2011 and 2012 still looks much too high. The consensus earnings forecast growth exceeds 70% for the UK for (and 60% for Europe), which is demanding. Real earnings versus trend We can compare consensus expectations for corporate earnings against their long term trend. We do this after deducting inflation to avoid the distortions caused by significant changes in the rate of inflation. We refer to these as "real" earnings. Trend real earnings is the line of best fit that shows the long-term trajectory of growth in real earnings. This is shown in the chart on the right. It is clear from the chart that the real earnings are forecast by the consensus to be well above trend over the next few years. These forecasts look too demanding and may well prove to be too optimistic. It may therefore be unrealistic to expect earnings levels to surpass trend only two years after the huge falls experienced and in the tough corporate environment we envisage. Profit Margins The chart to the right shows that profit margins (the ratio of net profits to sales) have already climbed strongly. Current profit margins in the UK are not significantly above the long term historic average, suggesting that the current UK profit margins may be sustainable. However, further gains imply that that the profit margin would be pushed into unsustainable territory. Furthermore, the US profit margins have rebounded strongly and now look high against their long term averages, suggesting that profits may well soften should profit margins revert to their long-term average. Using consensus IBES sales estimates along with consensus IBES profits estimates, we can calculate an implied profit margin for 2011 and 2012 (see table 1). The implied profit margin for the UK in 2011 is 7.0% and 7.4% in 2012, which is well above the long term average of 5.8%. The implied US and EU profit margins for 2011 and 2012 are much higher than their respective long-term averages, which suggests that should margins mean revert that profits would soften more, all other things being equal. Page 4 of 16

5 Table 1. Implied Net Profit Margins LT Average US 6.00% 7.90% 8.50% EU 3.50% 6.00% 6.40% UK 5.80% 7.00% 7.40% Factors influencing Corporate Profit Margins It can also be argued that there are a range of factors that are likely to squeeze profit margins and lower profits. Firstly, thinking more about the current cycle, the problem behind sustaining the 2009/10 rate of improvement into 2011 and 2012 is that part of it represents one-off gain in productivity from reducing costs; this includes workforce and other cost rationalisation measures, such as real estate occupancy. In other words, gains are now going to depend much more on growing sales or revenues. This is where the macroeconomic picture for companies is less reassuring. Secondly, globalisation boosted profit margins over the past decade. For example, the impact of the integration of China into the global economy, which has cheapened manufactured goods and restrained wage growth worldwide. Other factors that have supported high profit margins are falling costs of capital and lower effective corporate tax rates. However, the gains from rapid globalisation are diminishing, as the trend towards globalisation itself slows, emerging country currencies and the cost of capital become more expensive, the cost of capital rises and protectionist measures potentially come back into favour. Thirdly, higher rates of corporate taxation and greater regulation appear inevitable as governments attempt to repair their balance sheets and manage their economies better in the future. Nowhere will this final feature be more evident than in the financial sector and the rapid rise in profit margins, as illustrated in the chart right, which has run its course in our view. Economic Environment The strength of the economic growth environment will also be an important driver of future corporate earnings growth. After all, it was the severity of the recession that caused earnings to fall by over 50% in the 2008/9 recession, even for the non-financial sector. Slowing growth is therefore of concern. That said, a large proportion of earnings (or sales) come from overseas and we must also account for world growth as a whole. Page 5 of 16

6 Our expectations are that conditions favour moderate world growth, with slower growth rates than those seen in the pre-crisis growth environment. The IMF's forecasts look to be a fair basis for us to work our earnings assumptions. Table 2. IMF Macro Forecasts (advanced countries) Pre-crisis Post crisis Real GDP growth 2.9% 2.4% Inflation (consumer prices) 2.2% 1.6% Nominal GDP growth 5.1% 4.0% Unemployment Rates 6.0% 7.2% Budget Deficits (% of GDP) -2.0% -4.8% Examining the above table, there is a clear expectation that the macroeconomic picture ahead is going to be less favourable than seen in the cycle that played out just before the credit crisis, (excluding the years as recession and transition periods). In advanced economies, real GDP growth is expected to be about 0.5% weaker than in the previous period, but because inflation is also expected to be lower, nominal GDP growth (a measure of growth relevant for gauging impact on corporate earnings growth) shows a larger shortfall of over 1% on average. The IMF is factoring in quite a lot of fiscal and monetary tightening as budget deficits are reined in from very high levels and interest rates rise. Even so, unemployment stays higher than the pre-crisis period and budget deficits are unlikely to fall to levels seen pre-crisis. For example, in the UK, the government has already committed itself to substantial fiscal tightening in order to balance the public sector budget and ensure that public sector net debt as a percentage of GDP is falling by 2015/16. This involves a 128bn fiscal contraction per year by 2015/16, just under 80% of which will be achieved by cuts to public spending (while the remainder is achieved through higher taxes). UK monetary policy is currently still quite loose, with the bank rate standing at 0.5%. However, with CPI inflation currently running at 3.7% (which is well above the target 1% to 3% range) and further spikes in inflation likely, the Bank of England may well be forced to raise rates sooner rather than later, in order to maintain credibility. Further quantitative easing is also unlikely to be undertaken given the current economic environment. The growth rate in the UK has been slowing over the last few quarters of 2010, even before the fiscal consolidation begins. Consequently, as policy tightens this will hamper the recovery and make slow economic growth the most likely outcome over the next few years. With an economic environment of lower world growth going forward, it is likely that this will hurt corporate profits and therefore moderate returns on equity. If governments are saving more (as they must do to reduce their budget deficits) and consumers are also saving more (or at least not increasing their debts, as will surely be the case in the Anglo Saxon world) then the corporate sector must reduce its savings, in the absence of a significant improvement in the balance of trade, which seems less likely over the next few years given the current economic climate. This is an economic "fact" and in practical terms means that corporate profits are Page 6 of 16

7 likely to fall. Now, this need not apply to all individual regions (and, for example, Asian consumers could increase their borrowings) but it must apply globally. This logic seems powerful in arguing that profits growth will at best be subdued. Conclusion Earnings are very sensitive to a slowdown in economic growth as illustrated by the fall in earnings which the consensus is assuming for Consequently, our view is that the current economic environment and global challenges faced will make it difficult for companies to meet expectations of continued strong earnings growth. We believe that economic growth is likely to be modest over the next few years, probably combined with a squeeze on profit margins as companies struggle to pass on higher input (commodity) costs to consumers. This suggests that equity returns are likely to be less robust over the next few years than the general consensus believe. The macroeconomic risks we face will have an important bearing on the degree of exuberance investors have for equities. If investors become worried about unstable macroeconomic conditions, such as risks of rising inflation, or large and destabilising exchange rate movements, or financial system stress (such as that arising from a sovereign default), we would expect risky behaviour to be discouraged and for equities to find gains hard to sustain. For pension schemes concerned about market shocks Aon-Hewitt offer a service to stress test pension funding levels using a broad range of scenarios, forecasting their impact over a five year period. For more information please speak to your consultant. Accounting The Aon200 deficit at the end of January 2011 stood at 68bn, which is largely unchanged from the 65bn deficit at the end of December Whilst this represents a slight deterioration over the month, it is still a considerably improved position from the deficit of 97bn twelve months ago. Despite the improving position, analysts are still expecting - 40bn - 50bn - 60bn - 70bn - 80bn - 90bn - 100bn - 110bn - 120bn Jan Mar May Jul Sep Nov Aon 200 Index Source: Aon-Hewitt Dec Week 1 Week 2 Week 3 Week to be a year for companies to review pension scheme design to ensure that the benefits awarded are fit for purpose. Source: Aon Hewitt Page 7 of 16

8 Funding UK equity markets ended the month slightly down, whereas overseas equity markets ended the month slightly up. Government bond yields (both fixed and real) rose, leading to a reduction in the liabilities. Taken together, funding levels are likely to have improved slightly over the month. Whilst care has been taken in the production of this EconForum and the information contained within, Aon does not make any representation as to its accuracy and accepts no liability for any loss incurred by any person who may rely on it. In any case, the recipient shall be entirely responsible for their use of this EconForum. Page 8 of 16

9 Appendix All charts are as at close of business on 31 January 2011 except where stated otherwise. LIBOR The graph below shows the extra amount banks have to pay above the Bank of England base rate to borrow and lend to each other. The LIBOR rate is the London Inter-Bank Offered Rate that is one of the global benchmarks for the cost of borrowing. It reflects the ability and willingness of banks to lend and as such it can be considered as a barometer of banks faith in each other. During the last months, the 3-month LIBOR rate spread ranged between 0.25% and 0.3%. This compares with 0.1% at the end of December % 2.8% Spread between Bank of England Base Rates and 3 month UK LIBOR Collapse of Lehmans and bail out of AIG 2.6% 2.4% 2.2% 2.0% 1.8% 1.6% 1.4% 1.2% Interest Credit rates crunch raised to 5.75% reduced to 4.50% Banks stop Central lending to each banks other hence global central Banks intervention become the only lender in the markets reduced to 3% Interest Rates reduced to 2% Interest rate reduced to 1% Launch of Quantitative Easing 1.0% 0.8% 0.6% 0.4% 0.2% 0.0% -0.2% reduced to 4.5% raised to 4.75% raised to 5.5% raised to 5.25% raised to 5% reduced to 5.5% reduced to 5.25% Interest rate reduced to 5% Interest rate reduced to 0.5% reduced to 1.5% 50bn QE extension 25bn QE extension -0.4% Mar-05 Jun-05 Sep-05 Dec-05 Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 General Election 2010 Page 9 of 16

10 Currencies The graph below shows the value of the US dollar relative to a basket of seven of the world s major currencies including the Euro, Canadian dollar, Japanese yen and British pound. Against a basket of other major currencies, the US dollar index rate decreased 1.1% from 73.2 to 72.4 over the last month. Over 2010 the US dollar index decreased 2.0% from 74.8 to USD vs a Basket of Major Currencies Index Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Source: Federal Reserve Page 10 of 16

11 The other two graphs shown below are the effective exchange rate of Sterling and the Euro. These rates are calculated using the weighted average against other major currencies and then converting them into an index using a base period. During the last month, the UK Sterling index rose 1.3% from 79.8 to 80.8 and the Euro index rose 1.3% from 93.7 to Over 2010, the sterling index ended the year at a similar level to where it started, remaining around However, the euro index fell 9.2% from to 93.7 over Effective Exchange Rate Index, in Sterling (Jan 2005 = 100) Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Effective Exchange Rate Index, in Euros (1990 average = 100) Jan-05 Apr-05 Jul-05 Oct-05 Jan-06 Apr-06 Jul-06 Oct-06 Jan-07 Apr-07 Jul-07 Oct-07 Jan-08 Apr-08 Jul-08 Oct-08 Jan-09 Apr-09 Jul-09 Oct-09 Jan-10 Apr-10 Jul-10 Oct-10 Jan-11 Page 11 of 16 Source: The Bank of England

12 The graph below shows the value of both the US dollar and the Euro relative to Sterling (i.e. relative to 1). Sterling appreciated against the US dollar over January, now buying $1.60 (against $1.57 at the end of December). Against the Euro, the value of Sterling, rose from 1.17 to 1.20 in the first part of January before falling back to 1.17 at the end of January. Over 2010 Sterling depreciated 2.5% against the US dollar and appreciated 3.5% against the Euro. USD, Euro vs GBP since January US Dollars Euros Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 US Dollar vs UK Sterling EU Euro vs UK Sterling Page 12 of 16

13 Equities UK equities fell slightly in January with the FTSE 100 index falling 0.6% from 5900 to This comes off the back of a 9% rise in the FTSE 100 over Over January, the FTSE 100 implied volatility index increased 1.1% from 18.8 to This is lower than the volatility at the beginning of 2010, when the index stood at As the wider equity market backdrop still looks uncertain, the UK equity market may experience greater volatility going forward. Price level of FTSE 100 UK Equity Index 7,000 6,500 6,000 5,500 5,000 4,500 4,000 3,500 3,000 Jan-05 May-05 Sep-05 Jan-06 May-06 Sep-06 Jan-07 May-07 Sep-07 Jan-08 May-08 Sep-08 Jan-09 May-09 Sep-09 Jan-10 May-10 Sep-10 Jan-11 Page 13 of 16

14 Fixed Interest The credit spread decreased from 1.5% at the end of December to 1.4% at the end of January. This compares with 1.3% at the beginning of Corporate bond yields (based on the non-gilts iboxx 15+ AA) rose from 5.4% to 5.6% while the long term gilt yields rose from 4.0% to 4.2%; this compares with a 5.7% corporate yield and a 4.4% gilt yield at the beginning of Over 15 Year Gilt Yield vs Corporate Bond Yield 7.5% 7.0% 6.5% 6.0% 5.5% 5.0% 4.5% 4.0% 3.5% 3.0% Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Corporate Yield Gilt Yield Credit Spreads between Iboxx AA 15+ Corporate Yield and Gilts 15+ Yield 3.5% 3.0% 2.5% 2.0% 1.5% 1.0% 0.5% 0.0% Mar-06 Jun-06 Sep-06 Dec-06 Mar-07 Jun-07 Sep-07 Dec-07 Mar-08 Jun-08 Sep-08 Dec-08 Mar-09 Jun-09 Sep-09 Dec-09 Mar-10 Jun-10 Sep-10 Dec-10 Source for both graphs: DataStream iboxx AA+15 yr yield vs Gilts +15 yr yield Page 14 of 16

15 The Shape of the Gilt Yield Curve The yield curve is a measure of the market s expectations of future interest rates given the current market condition. The shape of the yield curve should normally be upward sloping, i.e. the interest rate you should receive for lending your money to someone should increase as the term of the loan increases. The graph below shows the UK gilt yield curve on 7 January, 14 January, 21 January and 29 January It can be seen from the graph that yields rose over the month to 21 January and then fell back slightly by 29 January. 4.90% UK Government Bonds Yield Curve 4.40% 3.90% 3.40% 2.90% 2.40% 1.90% 1.40% 0.90% 0.40% 1 Years 2 Years 3 Years 5 Years 7 Years 10 Years 15 Years 20 Years 30 Years 7-Jan Jan Jan Jan-11 Source: Bloomberg Page 15 of 16

16 Property The IPD UK Monthly Total Return Index below is the benchmark for most UK property funds. The index rose 0.9% from 766 in November to 773 in December. Over 2010 the IPD index has risen 14.5%; however, the property return index is still substantially below it s peak in July 2007, when the index was 943.The fears that credit conditions may be tightening again and the possibility of renewed weakness in the labour market will continue to weigh on property market for some time. UK IPD Total Return Index 1, For further information and questions, please contact: Mark.Jeavons@aonhewitt.com Editor: Mark Jeavons Theme Author(s): Mark Jeavons Tapan Datta Sub-Editors: Trevor Connor Sarah Abraham Regular Contributors: Andrew Firth Andrew Claringbold END Page 16 of 16