Published on June 5th, 2014 | by Michael Drury at McVean Trading and Investments LLC0
Weekly Economic Update
In a capitalist economy, the key leading indicator is profits. With real GDP growth in the first quarter revised down to -1.0% and nominal GDP (or business revenues) up a scant 0.3%, sustained hiring meant corporate profits plunged at a stunning -34% annual rate. Profits now stand -4.0% below a year ago – a traditional signal of the late cycle, as recessions typically begin roughly a year after that occurrence. A big bounce in profits is likely in the second quarter, as nominal GDP should exceed compensation by 2% (likely 5.5% vs. 3.5%), which would translate into roughly a 20% annualized increase. However, profits grew at a 16% annual rate in 2013 Q2, and then north of 5% in the second half as margins widened. Bottom line, even after a bounce, if rising wages narrow margins profits in the second half, profits will remain negative compared to a year ago.
Over the past three cycles, profits spiked early as government stimulus fed through to sales with little initial increase in hiring. After the initial spike, profits growth moderated. In the 1980s, a pause that refreshed came two years after the initial spike, but profits succumbed again 22 quarters -37.5% after the spike – and recession was declared a year later. In the 1990s, there was a 16 quarter gap between the peak in annual profit growth and the first negative. A slump came that was associated with the Asian crisis, but Y2K and the tech boom gave a brief respite and recession was declared six quarters after the second drop into negative profits. In the new millennium, profits fell seventeen quarters after the initial spike, and recession was called one year later. Once again, we are seventeen quarters after the initial spike in profits, and apparently headed for a year of negatives. With few excesses in the economy, we expect a shallow period of negative profits, like in 1990, and a mild recession to follow – perhaps only a growth recession (less than 1% growth). Bottom line, we feel increasingly certain the die is cast. Corporate CEOs are likely to begin to respond to weaker than expected profits with new rounds of cost control, and there is no stimulus left from monetary or fiscal authorities that is likely to change their minds. A further shake out in financial markets as weakened debtors falter is likely to be the focus of the correction, rather than sharply lower output.
Dead Cat Bounce
There were two strong signals on the size of the bounce this week, and both were disappointing. Consumer spending fell -0.1% in April, after a strong 1.0% bounce in March. The smaller than expected follow through has estimates for consumption in the second quarter now softer than in the Obamacare & utility fueled first quarter. On the capital goods side, new orders for non-defense capital goods excluding aircraft unexpectedly fell -1.2%, after a strong 4.7% bounce in March. Even after two solid months for new orders, nondefense capital goods for the past three months are up just 4.7% from a year ago and up at a 4.9% annual rate from the past three quarters. This is fractionally stronger than nominal GDP, but as capital equipment accounts for only 10% of GDP a double digit growth rate is needed before it can be considered a locomotive for growth. Given that the demand for capital goods is closely associated with profits, a double digit breakout is unlikely.
We are frustrated by the Street’s continual push for a more optimistic outlook. The main question investors are asking is why are interest rates so low? The answer is the same as it has been this entire cycle – there is far more capital than there are acceptable investment projects – note the $2 billion price tag on the LA Clippers, which was estimated at $500 million. Recently, international turmoil has been sending capital back to traditional safe havens. The China slowdown and the imposition of a consumption tax in Japan have funds scurrying out of slowing emerging markets in Asia. The instability in Ukraine has money flooding out of Russia and away from East Europe. Now the US and China are firing nationalistic rhetoric at each other over defense and cyber security, with corporate revenues the primary casualties. A recent survey in Europe showed that rising Chinese labor costs, increasing regulation and government interference had dropped the Middle Kingdom from third to fifth on a list of preferred investment sites. This is not the environment of the late 1980s, when the Wall fell and Germany flooded the world with stimulus. Nor is it the late 1990s, when Y2K forced investment and a tech boom was unleashed. It is decidedly not 2005-7, when booming home values and easy access to credit spurred spending and business creation. We are late in the cycle, and we see no sector ready to carry the load going forward.
True, we do not see much excess – other than debt – so a deep recession in output is unlikely. However, a shakeout which reduces capital to a level where interest rates can return to positive territory in the next expansion is a strong possibility.
In essence, this would be completing the correction that was short circuited by government intervention post-Lehman. We are not arguing that TARP, QE, etc. were unnecessary – just that they resulted in the malaise that still confounds investment markets. Surpluses on corporate balance sheets remain the greatest outlier compared with previous cycles. Ongoing payouts from these reserves to sustain stock values are likely as profits falter. Whether firms will continue to hire as their revenues and these reserve decline will determine how soon the next recession begins – 4 quarters away? Or more?