For years now, many economists have been predicting that a business investment recovery would come, spurring corporate profits, GDP growth, jobs, and all sorts of wonderful things for the economy.
However, Albert Edwards and his colleagues at Societe Generale warn that it’s not coming.
“The bulls will point out, quite correctly, that on many key measures the profits situation in the US looks quite healthy,” wrote Edwards in a new research note to clients. “But experience shows us that it is not the level of profits, nor the rate of profitability (ROE), nor the level of margins that drives the investment cycle. Instead it is the rate of growth of profits that should be monitored.”
Edwards’ seven-page note leads with the chart above showing profit growth and business investment growth.
“Over the years we have found that profits are probably the single most important leading indicator of recession,” he said. “A decline in profits is inevitably followed by recession shortly thereafter as investment, the most volatile of all GDP components, is cut.”
Edwards acknowledges that at 13% of GDP, business investment is a pretty small component of the economy. But…
“…swings in this component of business spend can often determine the overall trajectory for the economy (the argument is even stronger if one includes business inventories as we do in these charts). Corporate behaviour can often dominate the economic cycle even ignoring swings in employment and the subsequent impact on consumption expenditures.
Indeed in an accounting sense, recessions can be said to have been ‘fully explained’ by downturns in business investment. We update a chart (below) we showed recently with more back-data that clearly demonstrates that when there is a recession and GDP declines, the contribution of business investment FULLY accounts for that recession. Put another way, without the corporate sector responding to declining profits by cutting investment, soft- landings would be much more frequent occurrences!”
Here’s the chart Edwards is referring to.
“This cycle is already long in the tooth at 56 months and the resultant slowing productivity growth is beginning to impact profits adversely,” said Edwards.
“While profits growth is so anaemic, any adverse shock such as an Asian currency devaluation that we have discussed previously (including both Japan and China), will be enough to deepen that profits recession and send US investment expenditure into decline. While most equity investors appear to believe that the US economy has reached escape velocity, a recession carries a far higher risk than the market supposes.”