Equity markets certainly decided to look at the negatives from the US employment report released at the end of last week. That does not happen in bull markets.
On the surface, and ignoring a few inconsistencies, the employment report was not bad at all. The problem is that employment is a lagging indicator (coincident at best) and so does not tell us anything much about future prospects for the economy.
To be fair, it is obvious to every economist that employment has been the bright spot within US data for some time. Yes, we can all question the quality of the jobs created (and we do) and point out that the unemployment rate itself has been flattered by a collapse in the participation rate. But at the end of the day, employment growth has been strong. In our opinion, this leads many to claim two false premises; first, that with the unemployment rate so low and wage growth picking up, the US economy cannot possibly suffer a recession. And second, as consumer spending makes up around 70% of the economy, and with decent employment and wage growth, a US recession cannot be imminent because the consumer is doing well.
The chart below shows the year on year percentage growth rate in the number of employed persons. As can be seen, employment growth peaks and starts declining well ahead of recessions (as indicated by the red arrows). Now, the deterioration has been quite mild so far, and so many will claim that it is far too early to ring the alarm bells. That may be true, and so we really need to understand what drives job creation, and what may happen in the next few quarters.
Chart 1 – Annualised growth rate in the number of persons employed
To try and dispel the two myths noted above, we would point out that the most volatile domestic component of the US economy is business investment, as shown in chart 2 below. The data for the chart is nominal rather than real, and what is interesting is that Personal Consumption Expenditures and Government Spending have only once dropped into negative territory on this basis since WWII. What this data is really saying is that with business investment being the most volatile component, although it may only be a small part of the GDP calculation, it is in fact the driver of changes in GDP.
It is the swings in business investment that determine weak or strong growth. We therefore believe that those who are looking at consumer spending to have a view on the US economy are in fact looking in the wrong place. They need to look at what drives changes in business investment to determine whether the economy will be strong or weak.
Chart 2 – Year on year changes in the major domestic components of US GDP
So, what drives changes in business investment? Well, as chart 3 below shows, it is the change in corporate profits. When profits growth is strong, companies will invest more which is great for the economy and creates more jobs (and therefore gives consumers more money to spend). When profits fall, companies will reduce capex and reduce the number of people they employ.
Chart 3 – Business investment growth and corporate profits growth
Now, on the way we have calculated corporate profits for the chart above, profits growth is only just dipping into negative territory year on year; hardly a disaster. However, the simple year over year number is now down by over 5%, as seen in chart 4 below. Of course, the profits performance can give false signals as seen in 1986 or be very early as seen in Q4 1998. However, we believe that if profits continue to decline, then we will soon slip into recession. If only we can predict corporate profits in the future!
Chart 4 – US Corporate Profits (y/y %) versus GDP
In chart 5 below, the blue line shows corporate profits after tax as a percentage of GDP – a simplistic measure of profit margins. The orange line shows the subsequent 4 year annualised profits growth. The message here is that profit margins post the financial crisis jumped to record levels, and we do not believe that this represents a new paradigm. Because profit margins are mean reverting, high profit margins are followed by both lower margins and lower (or in the current case negative) profits growth.
Chart 5 – Corporate profits as a % of GDP and subsequent 4 year annualised profits growth
We have previously made the case that executives focus far too heavily on managing earnings and trying to boost their share prices. We aim to speak about this at more length in a separate note, as we believe that this has become a structural headwind for the economy. Why do executives focus on boosting share prices? Because the vast majority of their compensation is in the form of share options.
What this means is that companies are substituting capital with labour to boost production. Capex actually hurts short term profits (although benefits profits in the long term) and management would prefer to use cash flow to buy back shares. We believe that this short term focus by management helps explain why low paying job creation has been strong in recent years (substituting labour for capital). Management are incentivised to boost share prices even though this may in fact be hurting their company’s potential long term performance.
It appears to us that a period of weak profits in the quarters ahead (as indicated in chart 5) is baked in. If this happens, then because of the warped management incentives that companies now have, executives will do everything they can to boost profits, which ultimately means reductions in capex (business investment) which is the swing factor between growth and recession. Furthermore, executives will have to cut jobs (how many companies announce job cuts and share buybacks in the same set of results?) which will ultimately impact consumers.
So, at the margin, we believe it is a combination of contracting profit margins that are baked in, together with warped executive incentives and already negative profits growth that are the best indicators to watch at the moment. In fact, given this set of circumstances, the single best indicator to watch is the equity market itself. If we were executives of a large US company, knowing that we would personally gain the most from our share options if the share price was high and rising, the most troubling item in our daily/weekly management meetings would be a falling share price. If the share price was falling, we would feel compelled to cut back on all costs including capex and wages in order to try and boost the bottom line and convince investors that our shares were worth more.
Collectively, if the equity market as measured by the S&P 500 is falling, will executives collectively sit there and do nothing? Or will they cut costs and risk collectively causing a recession? We think they will cut costs and risk causing a recession.
The chart below of the S&P clearly shows that share prices are falling. Investors are worried about falling profits and the risk of a recession. This becomes a vicious circle and the next month or two could easily tip the balance. Momentum is clearly turning lower (the 40 and 80 week moving average crossover is a decent trend indicator of bull and bear markets), and further earnings and macro disappointments could easily encourage further selling by investors. Indeed, data shows that all investor groups (institutional, hedge funds and retail) have been net sellers in recent years, and it is only the buying of companies themselves (and up until recently reserve managers and central banks) that has supported share prices. Declining profits and lack of access to bond markets will severely impact corporate cash flow and end the buyback mania, at which time equities may be extremely vulnerable.
Chart 6 – S&P 500 weekly with 40 and 80 week moving averages
So, apologies for the length of this report, but we wanted to explain a little of why we think that a recession is more likely than many believe (although this view is clearly gaining popularity). It is the link between share prices and executive compensation to decisions on business investment and jobs creation that will drive changes in growth of the economy. Share prices have only levitated in the last couple of years because of aggressive share buybacks funded increasingly by bond issues.
Companies are finding it harder to fund buybacks with cheap bond issuance and with share prices now falling, it appears the game is up. Executives either slash costs to generate cash to buy shares which will be self-defeating, or they focus on long term investment and stop buying shares. Neither outcome is desirable for share prices.
Our analysis indicates that equity markets in the US and likely globally are very vulnerable and the Fed is unlikely to raise rates this year. We expect high quality bonds to perform well and the US Dollar is likely to remain quite mixed. The next few months hold the potential to be extremely volatile and central banks may move to even more extreme policies despite the reality that current policies do not appear to be working as they would like. We fear that it is time to really batten down the hatches.
Stewart Richardson
Chief Investment Officer
