Last weekend, we noted that not everybody agrees with Morgan Stanley’s Mike Wilson when it comes to the likelihood of an earnings recession in the US.
Q4 results are in the book, and earnings growth clocked in at around 14%, a sharp drop off from Q3, but still strong as the fiscal tailwind and a relatively robust US economy continued to buoy bottom lines, even as storm clouds gathered.
Analysts long fretted that 2019 would prove challenging as the fiscal impulse waned and margins faced pressure from rising wage costs, higher interest rates and tariff-related price pressures. Now, consensus sees corporate profits shrinking in Q1 for the first time since 2016. After that, bottom line growth is expected to rebound in Q2 and Q3 before inflecting sharply higher, “hockey stick” style, in Q4.
That expected “hockey stick” inflection is what has the likes of Morgan’s Mike Wilson concerned, where that means he thinks it’s unlikely to materialize.
“The projected YoY EPS growth in 4Q19 is ~9.5%… compared to an average projected rate of growth of 1% over 1Q-3Q19, an inflection of ~8.5%”, Wilson wrote earlier this month, before reminding you that “since the early 00s, we have seen this kind of inflection happen a few times but these inflections were all related to 1) comping against negative or slower EPS growth or 2) tax cuts mechanically lifting the growth rate.”
For their part, Goldman has acknowledged that some skepticism is probably warranted. Here’s what the bank’s David Kostin wrote two Fridays ago:
Some investors are skeptical about the current path of quarterly earnings estimates: EPS growth is projected to average 1% during the first three quarters before accelerating to 9% in 4Q. Part of this concern is well founded. Consensus EPS estimates are typically too optimistic and are lowered throughout the year, and analysts usually revise near quarters first.
That said, Goldman still thinks “weak profit growth will be short-lived, and should improve in the back half of 2019.”
But what if Kostin (and anyone else who expects weakness in corporate bottom lines will prove transitory) is wrong? What if we do get an earnings recession? More pointedly, what would a protracted downturn in profit growth mean for the broader economy?
Goldman set out to answer that latter question over the weekend. Specifically, the bank asks if an earnings recession could “lead to an economic recession” and they begin with the standard chart which we’ve used repeatedly. We’ve added a red annotation for the “hockey stick” inflection:
Goldman goes on to say that this isn’t some far-fetched exercise with no basis in reality. There is obviously a clear link between the health of the corporate sector and the economy.
“Profitability is a key driver of business investment and investment spending has often been a large share of output declines during recessions”, the bank reminds you, adding that “declines in corporate profits often lead to a significant tightening in financial conditions in equity and credit markets, a key predictor of recession risk.”
Drilling down, Goldman writes that weak corporate profits exert a drag on GDP growth via three channels. They are, from the note:
- the profits businesses generate affect their willingness to undertake additional investment,
- slowing profit growth typically also leads to slowing investment by tightening business credit conditions,
- profit growth affects consumption through the wealth effect from moves in stock prices
If you want to put numbers to theories (and you know you do), Goldman says that a 10% drop in corporate profits can generally be thought of as exerting a 0.6pp drag on GDP growth. Here is the breakdown on that (and basically, this just shows that each channel contributes equally):
Given that, you might fairly ask what that model would mean in the event earnings growth in the US dropped from the 2017-2018 average (~15%) to zero. Goldman has an answer. “This estimate, taken at face value, would imply a nearly 1pp hit to GDP growth relative to the 2017-2018 period, an apparently meaningful threat to the expansion”, the bank cautions.
That said, it turns out that the historical track record of earnings recessions “predicting” economic downturns is not that good. Specifically, Goldman writes that “13 of the 22 S&P 500 earnings recessions on record were not followed by an economic recession within the next two years.”
As you can see, the bank is more than happy to point out instances of “false alarms.”
If you ask me (and implicitly you have, because you’re here) some of the ancillary points Goldman makes are actually more important than the analytical exercise that forms the basis for the note.
For instance, the banks writes that “much of the Q4 tightening in financial conditions has been unwound by the recent FCI easing”. That’s obviously attributable to the Fed-inspired YTD rally in risk assets and the critical point is that, to quote Goldman again, “the main channel through which weaker profits lower growth” is the FCI channel.
Additionally, the bank reminds you (and you probably didn’t need this reminder) that “lower corporate tax rates contributed nearly half of the roughly 20% growth in S&P 500 earnings in 2018.” The fading of that one-off is an important factor in explaining slowing profit growth and should entail “minimal growth effects” – or so one hopes. Admittedly, that assessment has a “question begging” feel to it, but I’ll let it slide in the interest of brevity.
Finally, Goldman says cheaper oil won’t weigh too much on energy sector capex given the space’s relatively “healthy” financial position (specifically high yield issuers) and as far as rising wages go, the bank notes that faster wage growth actually “raises capex growth as firms substitute capital for labor.”
So there you go. A reasonably benign take on whether an earnings recession presages a “real” recession.
Of course this analysis doesn’t take into account the myriad exogenous shocks that could dent sentiment and prompt management teams to rethink investment decisions and/or trigger another equity market rout with ramifications for consumer spending via the reversal of the “wealth effect.” But that’s an example of a tautology – we can’t know what we don’t know.