Why the decline in earnings isn't that bad

Even as the U.S. economy continues to expand, largely on the back of solid household spending, the corporate profits environment is turning south after several years of exceptional performance (chart 1). This profits recession has led many to believe that an economic recession may be around the corner. However, while a return to substantial corporate profits growth is unlikely in the foreseeable future, we don't believe this decline signals an imminent recession for the economy as a whole.

Chart 1

Source:Bureau of Economic Analysis. Shaded areas are periods of recessions.

But let's take a step back first. How did corporate profitability perform so strongly in the first five years after the financial crisis, despite the mediocre growth recovery? Part of the answer lies in a period of remarkable cost-cutting that began in the late 1990s and continued through the Great Recession, which saw U.S. workers replaced with technology (productivity growth) or less expensive labor located in emerging countries (offshoring). Likewise, there is growing evidence that increased industry concentration in many U.S. sectors drove rising profitability over the past decade.

Two additional factors contributed to the high profitability rates of U.S. corporations during the post-crisis years. First, as a result of high unemployment, wage growth was historically low between 2009 and 2015. Second, interest rates have also remained historically low ever since the Great Recession, thus reducing the cost of financing. Corporate profits soared from the confluence of all these forces.

But periods of very high profitability tend not to last very long, and it seems that U.S. corporate profits peaked in the second half of 2014, and are now on a downward trend. Some of the trends that contributed to high profits earlier have reversed themselves in recent years. Offshoring activity has declined substantially from the previous decade, productivity growth has been anemic in the last six years, and tighter labor markets are beginning to accelerate wages. On top of that, the appreciation of the U.S. dollar lowers profits generated in other countries.

The recent decline in profits has raised the alarm about the possibility of a recession. In almost every expansion since 1959, a recession followed less than two years after a peak in corporate profits (chart 2). We are now about two years removed from the 2014 peak. Is a recession therefore imminent?

Chart 2

Source:Bureau of Economic Analysis. Shaded areas are periods of recessions.

As the current economic growth trend is only about 1.5 percent and corporate profits are declining, the probability of a recession is indeed higher than in most periods of expansion. Investors and executives do not like to see profits declining, and we could be approaching a watershed moment that decisively shifts companies into a cost-cutting mindset, followed by drop-offs in spending and investment. And indeed, business investment fell by one percent over the last four quarters—the first decline over four quarters in a non-recessionary period in 30 years. And remember, it takes much less to move the current growth rate of 1.5 percent into negative territory than dropping from three percent—the average postwar growth rate during an economic expansion—to zero.

But all that said, The Conference Board Leading Economic Index® (LEI) for the U.S. has yet to show any signs of looming recession. The household and government sectors seem able and willing to continue to spend, and thus offset the lower spending of the business sector. In addition, partly as a result of the very mild expansion, the U.S. economy has yet to develop the sort of obvious bubbles or over-spending and -leveraging that triggered previous recessions.

If a recession does occur, corporate profits will plummet, as they always do when demand contracts. However, even if the U.S. economy manages to avoid a recession in the coming years, the outlook for corporate profits remains negative. Economic growth is likely to remain slow and the labor market is only getting tighter. Having fallen back down to earth from the antigravity era of 2011–14, the sustained headwinds now squeezing corporate profits should incentivize business leaders to find new ways to increase the productivity of their existing workers. The urgent question is how—and the answers may determine the shape of U.S. economic performance for years to come.

Commentary by Gad Levanon, vice president and chief economist for North America, The Conference Board.

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