Three months ago, we presented an analysis which showed something disturbing: according to Deutsche, the “current business cycle is already the fourth longest in the post- WWII period, and the corporate debt-to-GDP ratio suggests that imbalances are building”, and that worse, as a result of soaring corporate debt and rolling-over profit margins, “a recession could hit as soon as the second half.”
Overnight, and three months since its last such analysis, Deutsche Bank has published an update. It shows that, as illustrated in the chart below, profits per worker have generally trended higher over time. This is a function of productivity gains and inflation. However, this has changed in recent years. “In the current business cycle, margins peaked at $18,752 per worker in Q4 2014. This compares to a ratio of $16,487 per worker as of Q2 2016. Margins have fallen because corporate profits have declined -6.3% annualized over the past six quarters, while private sector job growth over this period has been very steady at around 2.1%.”
And before we get the usual “but… but… you must exclude energy” complaints (we wonder why: it is becoming increasingly obvious that oil is not going back to $100 so the new normoil may well be crude at $50 or lower, which means including all energy-related data), here it the punchline: it’s excluded.
As of the latest sector-level data available through Q1 of this year, domestic profits excluding petroleum and coal products and Federal Reserve Banks were down -5.2% compared to a year ago. In fact, this series has been declining in year-over-year terms since Q2 2015. This means that recent overall margin compression has had less to do with the strengthening dollar and depressed energy prices, and more to do with weak domestic demand coupled with near-zero growth in nonfarm business productivity. From Q4 2014, when profit margins peaked, to Q2 2016, domestic profits have declined by a little less than $200 billion. As we can see in the charts below, this compares to a negligible $10 billion decline in profits from outside the US over the same period. Not surprisingly, the decline in profit growth has occurred alongside a deceleration in domestic demand. The year-over-year growth rate of real final sales to private domestic purchasers peaked at 3.9% in Q1 2015 and has since slowed to 2.3% as of last quarter.
So why are margins important? Because as we noted in our June note, margins always lead en economic contraction and always peak in advance of a recession: there has not been one business cycle in the post-WWII era where this has not been the case.
The reason margins are a leading indicator is simple: When corporate profitability declines, a pullback in spending and hiring eventually ensues. Thus far, firms have reacted to declining profit growth by cutting back on capital spending and inventory accumulation and have kept layoffs to a minimum. For example, real non-residential fixed investment has declined -0.2% annualized over the last six quarters. However, this has done little to stem the tide of margin compression because unfortunately productivity growth has been just 0.1% annualized over the same period, while unit labor costs are up 2.4%. This highlights a major risk that we see to the labor market at present: Nominal income growth continues to outpace nominal GDP, a terrible situation for corporate profitability.
In light of collapsing productivity, declining domestic demand, and sliding growth of real final sales, how has the US corporate sector avoided a full-blown recession so far? Simple: it has been loading up on debt to mask the income statement effects of declining demand. As DB calculates, the corporate sector has taken on a substantial amount of debt in the current business cycle. Nonfinancial corporate debt has increased by $4.5 trillion from its trough in Q4 2009 (the latest corporate debt data correspond to Q1 2016). As illustrated in the chart below, the ratio of nonfinancial corporate debt to nominal GDP is at its highest level since Q1 2009, when the economy was still in recession and nominal output was substantially depressed. Alongside tepid demand, the weakness in corporate balance sheets means that the Fed needs to be alert to any possible tightening in financial conditions, for one reason: based on nominal corporate balance sheets, the US is already effectively in a recession – the only thing preventing the hammer from falling are record low interest rates, keeping interest coverage ratios at all time lows.
So if the corporate balance sheet screams recession, what does the corporate income statement say?
Well, the average and median lead times between the peak in margins and the onset of recession are nine and eight quarters, respectively. This would imply… the second half of 2016. To be sure, as shown in the table below, the time period between the peak in profit margins and the beginning of recession varies substantially across business cycles. Margins can sometimes peak well in advance of the onset of recession, as they did in the 1960s and 1990s business cycles. In the former period, the peak in margins occurred 16 quarters before recession. In the latter episode, the peak occurred 15 quarters ahead of the economy’s entering recession. Conceivably, such a scenario could unfold now. However, the current business cycle is already the fourth longest in the post-WWII period, and as we mentioned before, productivity growth has been abysmal. Hence, there is little cushion for the economy to absorb any negative endogenous shock. And, worse, as the chart above shows, with corporate debt-to-GDP ratio at recession highs, it suggests that imbalances have built up to the point where there is absolutely no capacity for tighter financial conditions.
Summarizing all of the above: based on corporate balance sheets and income statements, the US economy may be in a recession as of this moment… and if it isn’t, even just one rate hike by the Fed, either in the September 21 meeting or in December, will assure that the backbone of corporate America, already straining under record debt and tumbling profits, will finally snap.
By Tyler Durden