United States: Profits and Recession
News: Historically , a decline in US corporate profits has been an indicator of the risk of an economic downturn. Of 11 episodes of significant declines in corporate profits, nine led directly to a recession within the following three years. This was the case in 2000 before the bursting of the internet bubble, as well as in 2008 before the financial crisis.
The decline in profits is not limited to companies in the energy sector
Profits have been declining since 2014, but a significant number of analysts believe that this decline is concentrated solely in the energy sector. According to S&P 500 data, the decline in profits of the largest US companies since mid-2014 disappears if we exclude companies in the energy sector. However, this index only accounts for 60% of total US private sector profits.
Market expectations for earnings remain positive (+2%) for this year. However, this is based on a valuation of capitalized assets. The revision of earnings for high-yield oil companies has thus led to a widespread revision, which can be explained by the low diversity of available ETF (Exchange Traded Funds) products, resulting in a certain sectoral contagion on these financial products. Credit spreads on high-yield bonds have thus reached 800 points, a level that usually heralds a recession.
The decline in profits outside the energy sector remains greater than the S&P 500 data would suggest. The National Income and Products Accounts (NIPA) data takes into account American SMEs and micro-enterprises using the quarterly « Quarterly Financial Reports » (QFR) survey, unlike the S&P 500 data. The NIPA measure thus shows that non-energy companies account for nearly 40% of the decline in profits since the last quarter of 2014.
While falling energy prices affect the results of producers in this sector, they can have a positive effect on the intermediate costs of US companies (lower supply costs) and therefore have a net positive effect on the US economy. However, no increase in profits has been observed, suggesting that other factors are weakening their performance.
A slowdown in profits can be a sign of a recession: four explanatory factors
1) Falling demand leads to a contraction in profit growth, which is a leading indicator of capital expenditure (capex). Year-on-year, profits are down 10%, but capex growth remains positive for the moment. Furthermore, a reduction in demand (private consumption) coupled with a negative contribution from investment has historically always preceded a recession.
2) The recovery in wages would further squeeze expected profits. However, the one-year growth forecast has risen from 0.5% to 1.5%, a level previously reached in 2008. The share of wages in GDP rose from 52.5% in 2012 to 54% in 2016, while the share of profits in GDP fell from 12.5% to 10% over the same period. To offset the negative effect of wage increases on margins, productivity growth of at least the same magnitude would be necessary.
3) The corporate financing gap is negative at -$200 billion. This gap is the difference between cash flow and productive investments (capital expenditure) or cash outflows (dividends). This level had only been reached in 2000 and 2007.
4) Accounting adjustments. Default rates remain close to 1% and have rebounded slightly. However, they have been postponed, particularly in the oil sector, through accounting adjustments designed to take into account future assets that do not generate any income during the accounting period.
Co-written with Thomas Lorans
