Plunge in U.S. corporate profits is economic warning sign

This analysis is by Bloomberg Intelligence economists Carl Riccadonna, Yelena Shulyatyeva and Richard Yamarone. It appeared first on the Bloomberg Terminal. 

A sharp contraction in U.S. corporate profits is the most important signal for the economy in the third print of 4QGDP, a mixed release at best that also revised overall growth in the quarter higher. The battered bottom lines evident in this report are a troubling development for private-sector activity, as business managers may find it hard to justify hiring and investment when profits are falling.

Corporate Profits Tumble

• Headline GDP defied expectations and was revised higher to 1.4%, from 1.0% as last reported and 0.7% as initially reported. This will be welcome news, particularly since it occurred as the result of a positive evolution among the underlying components, as it nudges the economy a bit further away from a stall.

• Consumer spending was revised up to 2.4% from 2.0% as previously reported, due to stronger spending on durable goods (3.8% vs. 3.4%) and services (2.8% vs. 2.1%), while spending on non-durable goods was weaker (0.6% vs. 1.2%). Business investment deteriorated (-2.1% vs. -1.9%), but residential investment firmed (10.1% vs. 8.0%). Government expenditures were revised slightly higher (0.1% vs. -0.1%). Additions to inventory in the quarter were slightly smaller than previously reported as well ($78.3 billion vs. $81.7 billion).

Real GDP, Spending and Investment

• Corporate profits fell -7.8% in the quarter, the biggest decline since 1Q11 (-9.2%). Profits have declined in four of the last five quarters, and are now down -11.5% in year-on-year terms. This is the worst drop since the Great Recession. Plunging profits are a troubling development, because they can foreshadow a loss of “animal spirits” in the private sector, which can ultimately result in recession. When profits contract, it is often an early warning of recession, although as the accompanying graphic illustrates, there are a few exceptions — notably late in the 1980s and 1990s expansions. This should serve as a stark reminder to policy makers that the economy remains vulnerable to shocks, even though inflation pressures are building and the labor market is close to full employment. A slow-growing economy with weak corporate profit growth may be able to avoid recession, but it likely cannot handle — nor does it need — significant tightening of monetary policy.

• BI Economics continues to assess that the risk of recession is low (close to 15%), but this is largely contingent upon the resilience of the labor market. If weak corporate profits beget a material hiring slowdown — or worse, layoffs — this would be a troubling development for economic prospects. This is not the baseline view, but it places even greater focus on the next several jobs reports.

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