‘We are experiencing a profit recession without an economic recession. [But] the broader economic is decidedly not at risk of heading into recession. In other words, we’re not looking at a real recession’.
Torsten Sløk, Deutsche Bank
The US economy may not be in recession. But its corporate sector may as well be. Profits have fallen sharply over the last three quarters. Since October 2014, profit margins are down US$109 billion since hitting a peak US$1.6 trillion.
So company profits are sliding, but apart from that everything is hunky dory…at least that’s how this DB economist sums up the US economy.
But is that true? Can we divorce profit recessions from economic recessions? Or is there an underlying link between the two?
Even if you’re no economist, Sløk’s conclusion might seem odd. Just consider what plunging profits actually means.
If profits margins are declining, it means there’s less money in the economy. Money that businesses use to invest in projects or people. And those people then earn the income and then spend said money on goods…that feed into the very same company’s profits.
This kind of logic you can teach to children. But it’s one that this particular seasoned economist struggles to grasp.
There is clear and damning evidence supporting a link between profit recessions and economic recessions. In fact, if you’re looking for signs of looming recessions, start with profit margins. It’s a good an indicator as you’re likely to find anywhere. Let’s take a look why.
A profit recession leads to a real recession
Barclays bank recently looked into this relationship between profit and economic recessions. It analysed US trends over seven business cycles. Covering a 40 year period dating back to 1973.
What did Barclays find? In short: the results aren’t encouraging. Not for the market, and not for the economy.
Contrary to Mr Sløk’s argument, there’s a direct link between falling profits and recessions. When profits declined by 0.60% in the space of 12 months, it usually coincided with a recession…
Here’s a quick rundown of its findings.
From April 1975, US profit margins fell over an eight month stretch. At the time the economy was just coming out of recession.
In 1980, margins declined over the space of two a half years. The US economy, as you might remember, entered a double-dip recession August 1981.
From December 1985, profit margins fell over a period of four months. The US economy managed to avoid a recession on this occasion.
In 1990, profit margins declined gradually over 24 months. The economy, once again, entered recession in August of that year.
In May 2001, profit margins declined over 12 months, as the US again entered recession.
Finally, 2008 kicked off the Global Financial Crisis. Profit margins dropped over the course of 15 months. And, yet again, the economy went into recession.
Out of six business cycles dating back more than 40 years, the US economy went into recession five times!
I didn’t mention the impact these cycles had on markets. But here too there was a consistent trend. The S&P500 fell by an average of 4.5% during the five recessionary cycles.
So, as Barclay’s notes, none of this is encouraging. It’s worse than discouraging. It’s a trend. There’s a clear link between declining profit margins and recessions.
What about Australia then? Are we experiencing a profits recession too? Unfortunately yes. And it’s worse than you might think.
Australian corporate profits on the decline
Remember that an annual 0.60% decline in US corporate profits always led to recession.
Over the past year, Aussie corporate profit margins are down by 0.96%!
In the past 20 years, we’ve seen profit margins dip on three separate occasions. The first was in immediate aftermath of the GFC in 2009. The second was between 2011–2012. The third, and current, one began in early 2014.
Why didn’t we enter recession in 2009 or 2012 then? There’s a good reason for that.
Unlike the US economy, Australia is more dependent on its exporting sector. Exports account for 20% of Australian GDP. That’s roughly double the US.
More importantly, what we sell is a big point of difference. Australia was able to ride the coattails of China. The Chinese economy was growing at double digit rates during the GFC. As construction boomed, Aussie iron ore helped fuel China’s demand for steel.
The difference today is that China isn’t growing like it did back then. It’s economy is slowing faster than many expected. Leading banks expect GDP to fall as low as 6.5%, down from 7%.
Factory output has declined for much of this year. Exports are falling amid slowing global growth, down 1.1% during last month. Imports plunged by as much as 18% in September, suggesting slowing domestic demand. And all this against the background of interest rates and lending terms which have never been more generous.
As you might imagine, it’s hitting Australia’s corporate sector where it hurts.
In the quarter to March 2014, Aussie corporate profits peaked at $70 billion. By June of that year, profits were already down to $64.7 billion. This was right around the time that iron ore prices started falling.
Ever since, profits have been declining slowly but surely. $64.6 billion…$64.5 billion…$64.5 billion again…and most recently $62.8 billion in July this year.
For the better part of 18 months, corporate profit margins have been on a downward spiral.
If we use the US as a case study, it doesn’t bode well for Australia. Without the Chinese cushion we’ve become so reliant on, we’re already in a ‘profits’ recession. That’s been the case since last year. If you recall, 30 months was the longest stretch of time the US went before entering recession.
That could suggest Australia is on course for a likely recession in 2016.
This time isn’t different
Following from his ‘profits recessions aren’t real recessions’ guff, Mr Sløk went on:
‘Lower energy prices and a higher dollar are hurting certain parts of corporate America at the moment. But with the China shock fading and the dollar and energy prices stabilising it is becoming clearer that we are not about to enter an economic recession because the service sector — which makes up 85% of the US economy — is doing just fine’.
For one, services might be ‘fine’, but low oil prices play a major role here. They may be hurting American energy producers. But they’re freeing up households to spend elsewhere like, say, services…
And anyway, Barclay’s research more or less puts paid to any idea that’s sustainable in the long run. If profits dip into recession, then the US economy follows suit. The timeframe is inconsistent, but the outcome is anything but.
Yet Sløk assessment is interesting for another reason altogether. Deutsche Bank analysts can’t seem to agree on much of anything these days. Here’s what another strategist noted just a few days ago:
‘The system failed in 2008/09 and rather than allow a proper creative destruction cleansing, policy makers have been aggressively propping it up ever since. This has surely led to a large level of inefficiency in the system which helps explain weak post crisis growth and thus forces them to do even more thus supporting asset prices if not the global economy.
‘So do we think we’re now entering a period where central banks are increasingly impotent? The answer is that they have been for a while on growth so not much has changed. However they can still buy more assets and continue to keep policy loose. Although we don’t think QE and zero interest rates does much apart from prop up an inefficient financial system it’s all we’ve got until we have a huge policy sea change which probably only happens in the next recession’.
‘We’ don’t agree on much it seems. But at least this DB economist has a better grip for where things truly stand. Central banks are impotent. Interest rate policies are inefficient. To the point where they have little bearing on the real economy. That’s as true in Australia as it is the US.
But that’s beside the point. If we go back to the main argument, the outlook is clear.
Corporate profits have a very real, very troubling, relationship with recessions.
The problem for Australia is that we’re in the middle of a profits recession. One that, if evidence is anything to go by, could result in a ‘real’ recession by next year.
The Daily Reckoning’s Greg Canavan thinks it could strike as early as this year. He’s one of Australia’s leading investment analysts. And he reckons we’re on the cusp of our first recession in 23 years.
In a free report, ‘Australian Recession 2015: Unavoidable’, Greg reveals how we’ve found ourselves in this position.
The profits recession is just a symptom of the wider economy. From falling GDP growth, to declining terms of trade, all signs point to a crash. Trade imbalances have been growing for the better part of a year. Government revenues are down, and household debt is up. It adds up to a recession that’s coming sooner than you think.
But there is a silver lining in all this. There are actions you can take now to lessen the blows of the coming recession.
Download your free copy today to learn how to protect your wealth from the coming crash. To find out how to download his free report right now, click here.
Contributor, The Daily Reckoning