While increasingly more economic indicators suggesting the US economy is dramatically slowing down (confirmed just last week not only by a truly terrible payrolls report but also by the Atlanta Fed cutting its Q3 GDP forecast from 1.8% to 0.9%), and the word “recession” being ever more casually tossed around, there has been little actual empirical work done to correlate what matters most for the business cycle – the current state of corporate profits – to the broader economic cycle, i.e., can corporate profits time the next recession?
Overnight Barclays did just that. The bank analyzed the link between profit margins and recessions for the last seven business cycles, dating back to 1973. In its own words: “the results are not encouraging for the economy or the market.”
As Barclays notes, profit margins have declined 60bp in the last 12 months to 8.5%.
It then ominously warns that declines of this magnitude are rare when the economy is not entering or in a recession.In fact, in the last 40 years it has only happened once.
More from Barclays:
Figure 2 illustrates the link between profit margins and recessions for the last seven business cycles, dating back to 1973. Figure 3 adds detail by providing a summary of what happened the other six times profit margins declined 60bp in a 12-month period. The results are not encouraging for the economy or the market.
The profit margin decline in 1980 was a signal that the economy had not recovered and a double-dip recession occurred. In 1990, the decline in profit margins predicted a recession and a large decline in the S&P 500. In 2001 and 2008 profit margins fell as the economy entered recessions. This preceded substantial declines in the S&P 500. 1975 was different because profit margins fell after the economy exited a recession and the S&P 500 went up during the subsequent six months. Note that in every period, margins continued to decline.
So on 5 out of 6 occasions, or a 83% hit rate, a 60% plunge in margins as has happened now, resulted in a recession: hardly a ringing endorsement for the future of economy. The one outlier, however, is Barclays’ (which does not currently “expect” a recession) saving grace: it is the case of 1985 when margins drop due to a plunge in the energy sector. To wit:
1985 stands out among these examples. In this period the economy did not enter a recession. In fact, the S&P 500 staged a material rally, increasing 21% in six months. This is noteworthy because there are similarities between 1985 and 2015. Most importantly, the decline in profit margins was caused by the energy sector. In 1985, profit margins for the energy sector collapsed as oil prices began a 60% plunge. But, outside of the energy sector profit margins were stable. Similarly, the drop in profit margins that has occurred in 2015 is primarily the result of lower margins from the energy sector, once again due to falling oil prices. Perhaps a decline in profit margins is a less reliable signal for recessions when it is caused by the energy sector because lower oil prices are good for the economy.
Ah yes, but as Barclays accurately points out, the drop in 2015 has been “primarily” as a result of the energy sector. The problem is that with every passing day, more and more sectors are also impacted as can be seen on the following chart showing the Y/Y consensus change in Q3 EPS: while energy sticks out, now more than half of all industries are poised to drop…
… which is no longer just a function of the crashing commodity complext, but more a function of the soaring dollar which is impacting increasingly more, especially multi-national, companies. As such with every passing day the parallels to 1985 become weaker. And finally, let’s not forget that the current “business cycle” is anything but: courtesy of ZIRP and QE, corporate profits are artificially boosted due to record low interest expense. If and when the rate hike cycle finally kicks in, that’s when companies will finally have to start factoring in interest outflows as part of their declining EPS, something Barclays has completely ignored forgetting there has never been as artificial a “business cycle” as there is now.
To summarize Barclays’ thinking, the bank says “profit margins have declined by 60bp in the last 12 months. This has happened before. Since 1973 there are six other examples. In five out of six, the decline in profit margins coincided with a recession. The one time it did not was in 1985. But, 1985 resembles 2015 because the decline in profit margins is primarily the result of lower oil prices.” … but is increasingly the result of a soaring dollar, something which won’t change if other central banks expand their quantitative easing programs while the Fed remains on hold.
Finally, here is Barclays’ – which, again, does not expect a recession as of right now: once again Goldman will have to take the Penguin lead on that one – flow chart of how to tread from here on out, at least until the NBER does admit that the US is in a recession.