U.S. Outlook: Profits and Bonds Flash Same Downbeat Signals
The stock market has been mostly celebrating expectations for future Federal Reserve interest rate cuts, and buying the dips has become the norm. But buyer beware: the inverted Treasury yield curve and U.S. corporate profits are sending a far more downbeat view of our near-term economic and financial future.
The warning signs coming from the inverted Treasury yield curve, which has a nearly flawless record of predicting economic recessions 10-to-18 months in the future, is already well-known and getting more insistent and clearer by the day.
Since President Donald Trump’s announcement last week of an additional 10% tariff on another $300 billion of Chinese imports, the entire yield curve has moved about 20 basis points lower.
If the latest tariffs are fully implemented and met with retaliation by China, we estimate that the recent escalation will double the negative impact on U.S. and Chinese GDP over the next two years. While probably not enough to trigger a U.S. recession on its own, the trade war is quickly morphing into a full-scale economic war that U.S. equity markets appear ill-prepared for. If this economic war triggers a financial crisis too, then all bets are off. Global central banks and fiscal authorities would have a difficult time containing the fallout and reversing the slowdown with the tools at their disposal.Profits Peak?
While equity investors are tracking the daily moves of the equity indexes, we are analyzing the earnings reports and corporate profit trends. According to the Bureau of Economic Analysis data, corporate profits after tax, with inventory valuation and capital consumption adjustments, as a share of the economy actually peaked way back in Q1 of 2012, at 10.6% of GDP.
The Tax Cuts and Jobs Act of 2017 temporarily lifted after-tax corporate profits from 8.5% of GDP in Q4 2017 to 9.1% of GDP in Q1 2018. However, by Q1 2019, corporate profits had already returned to their pre-tax cut trend. Corporate profits as a share of the economy peaked six quarters before the start of the last recession. While the timing varies across cycles, a decline in corporate profits as a share of GDP has always preceded recessions by an average of 9 quarters since 1947.Wishful Thinking
Ever the optimists, stock analysts expect earnings per share to return to mid-single-digit growth in Q4. But given the deteriorating global economic outlook, escalating trade war, and ominous signals coming from the bond market and corporate profits, any earnings per share rebound at this juncture seems like wishful thinking, and there isn’t much a quarter-point rate cut in September and October can do about it.
For more, see my full U.S. Outlook, delivered on August 9.