U.S. earnings have declined for four straight quarters, and market participants are taking notice. Yet making the rounds is a dangerous narrative: that a cyclical fall in profits can occur without the rest of the economy turning down — a so-called earnings recession or profits recession. In reality, however, profits are the heart and soul of the business cycle, not an accessory.
Profits lead other economic activity, and the reason is self-evident. Rising profits cause businesses to increase production, orders, employment and capital investment. Conversely, profits declines lead businesses to retrench by cutting these activities. These reactions cause the changes in private unemployment and gross domestic product that characterize the business cycle.
Modest declines in earnings are accompanied by a weakening of general economic activity. Large declines in profits are accompanied by an outright contraction in economic activity. In the present situation, earnings are down double-digits from a year ago, warning that an economic recession is knocking at the door.
Year-long earnings declines seldom occur outside of broad-based economic declines. In fact, only twice in the past 50 years have earnings per share of the Standard & Poor’s 500 been negative year-over-year for four straight quarters and then recovered without the economy falling into an official recession, as defined by the National Bureau of Economic Research. Yet the factors that enabled the economy to weather the earnings declines in those two periods — 1985–’86 and 1997–’98 — are lacking today.
First, the Federal Reserve cut short-term interest rates — by 200 basis points in 1985–’86 and by 75 basis points in 1997–’98. In contrast, today there is next-to-no room for the Fed to cut rates. Interest rate declines in the earlier instances triggered soaring asset prices and big capital gains, which meant increasing wealth and improved expectations. These conditions encouraged businesses to increase borrowing, hiring and investment despite weakness in operating profits.
Second, increases in private sector debt will be more difficult today. At the beginning of 1985, private nonfinancial sector debt was 105 percent of GDP; in 1997, it was 118 percent. In both instances, this ratio increased sharply in the following years, powering investment and profits. Today, the debt ratio is 148 percent of GDP, higher than any period prior to 2005. A significant rise in leverage from the current level would require notable easing of credit standards and would take the economy back toward the peak levels that triggered financial instability in 2007–’08.
Finally, the other advanced economies were growing robustly in 1986 and 1998. As a result, U.S. exports were able to grow strongly. Fast-forward to today, and the other advanced economies are growing tepidly and some appear to be already in recession.
Indeed, in 2015, U.S. profits have only begun to feel the effects of deteriorating global conditions. The deceleration of global trade is becoming an outright contraction. Financial markets are tightening worldwide, gradually choking off the oxygen of the global economy: credit. Investment in the machinery, rigs and transportation equipment that service global commodity producers is in outright free fall and emerging markets’ capital spending in general keeps deteriorating. The emerging-markets countries have started tumbling into recession.
The present “earnings recession” in the U.S. in all likelihood will intensify in coming quarters. And when profits are falling and appear destined to decline further, smart money prepares for a full-blown economic recession.
David A. Levy is chairman of the Jerome Levy Forecasting Center LLC, a macroeconomic consulting firm that provides research and investment strategy services for clients.
