“One key precursor for a recession has now fallen into place. Slowing productivity growth means that unit labor costs are now running well ahead of output price inflation… This means a margin and profits downturn is now about to unfold. That typically is a key precursor of recession.”
In the latest issue of ‘Global Strategy Weekly,’ SocGen’s Albert Edwards reaffirms his view that the US is in the midst of a “structural valuation bear market” that typically features a series of economic cycles in its life. These economic cycles reach successively lower lows – each triggered by a recession.
The cyclical picture
Let us understand, from Edwards’ perspective, where we stand in the grand scheme of these cycles. In the chart below, the three cycles shown inside of the ellipse have been longer than normal (averaging 95 months) considering the historical norm. Edwards calls these three “Fed-inspired freaks of economic cycles.” The normal duration for an economic cycle, not counting these aberrations, is about 36 months. By that standard, Edwards claims that the latest cycle, which commenced in June 2009, is already 55 months old.
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The die is cast
Given that we are inside of a maturing economic cycle, why are we on the threshold of a recession as posited by Edwards?
“We have long believed that corporate profits should be watched closely, not for their direct impact on equity valuations, but their impact on the economic cycle. Most economic models have profits dropping out as a residual, but they are a key driver of the economic cycle. Growth in profits determines the growth of investment, inventories and employment,” says Edwards.
And, according to Edwards, corporate margins are now under threat, as shown by this graph.
What we see is that the growth in unit labor costs is overtaking that of corporate output prices – a margin squeeze in the making.
Margin pressures would ultimately lead to diminishing business investment, which is a consequence of corporate profits. A downward swing in business investment is the natural harbinger of a recession.
Edwards offers further evidence that we are far out in an “elderly cycle” – according to the country’s Productivity and Costs press release for Q3, non-farm business productivity growth was 0% year-on-year, compared to 1.5% in 2012, an indication that the economic recovery is getting harder to sustain, which is why US corporate profits “are now beginning to struggle” as shown below:
This is only the beginning…
Having made the case that falling business profits inside the US would leave its economy highly vulnerable to an economic reversal as well as demote its pricing power, Edwards says the coup de grâce would probably be delivered by “Asian and EM devaluations releasing surplus capacity onto the West and crushing pricing power even further.”