Returning to earth

Corporate profits – Returning to earth

07 June 2016

Heading into the May employment report there was an air of complacency about the health of the labour market. The consensus was that non-farm payrolls would increase by 160k in the month despite the Verizon strike, while Federal Reserve (Fed) officials continued to cite the improving labour market as the main reason why it would soon be appropriate to lift interest rates again. How wrong we all were. According to preliminary estimates, non-farm payrolls increased by just 38k in the month; this was the worst outturn since September 2010, while the previous two months’ gains were collectively revised down by 59k. Sure, the unemployment rate fell to a new cycle low of 4.7%, while the U6 measure of broader underutilisation also declined, but both were driven by a drop in the participation rate that mostly reversed the gains recorded from November through March.

Should we have seen a poor result coming? In hindsight the answer is probably yes. Total hours worked by non-supervisory and production workers in private industries had already been flat since December, the longest sustained run of weakness since the labour market began to recover in early 2010; and as we observed a few weeks ago, the Fed’s Labor Market Conditions Index had been losing momentum for the past 18 months as the economy has been edging closer to full employment. On a deeper level, the non-financial corporate sector has been showing signs of stress for quite some time. Corporate profits, which reliably lead the employment cycle (see Chart 2), peaked in the third quarter of 2014 and have subsequently fallen by 15%. Bank lending standards to large and medium-sized firms have been tightening for the past three quarters. The ratio of non-financial corporate debt to EBITDA (earnings before interest, tax, depreciation and amortisation) has reached worrying levels, with the vulnerabilities created by high and rising leverage masked by low interest rates, long debt maturities and the elevated level of corporate equity. Corporates have already been cutting back on their investment spending – the value of manufacturers’ new capital goods orders (excluding defence goods and aircraft) is currently at its lowest level since April 2011 (see Chart 3) – so with unit labour costs rising it was only a matter of time before firms adjusted their use of labour too in a bid to claw back margins.

The current constellation of business and employment indicators looks suspiciously like the trends we typically see towards the end of the business cycle. So has the current expansion run its course? We still see reasons to think that a recession is not imminent. Collapsing investment in the energy sector and allied industries, weak global growth conditions, particularly in emerging markets, and a substantial rise in financial stress and the US dollar have all been weighing on corporates and the broader economy in recent quarters. It was natural that the labor market would eventually feel some of the pain too. Fortunately, all four of these headwinds are beginning to fade, which should allow the underlying strength of the consumer and housing sectors to shine more brightly over the coming quarters and along with an improvement in productivity growth, help corporates rebuild some of their lost margins. Nevertheless, while we wait for confirmation in the data that better times lay ahead, the Fed will probably mothball plans it had to recommence normalising interest rates until at least September.