“It is the rear-guard action of companies that ’causes’ recessions as they slash both jobs and, above all, business investment,” SocGen’s Albert Edwards said Wednesday, of corporate behavior when profits begin to fall.
Not surprisingly, Edwards thinks a US recession is a very real possibility, even if labor hoarding tied to the most acute worker shortages in living memory forestalls layoffs outside of the tech sector, where management has been cutting jobs for months.
Corporate earnings fell on a YoY basis for the first time since the onset of the pandemic in Q4, and even notoriously rosy bottom-up consensus expects another quarter or two of contraction. Of course, company analysts generally expect margins to hold up better than many top-down strategists, to say nothing of those who harbor an overtly bearish view.
Commenting on all of this, Edwards on Wednesday plotted forward earnings with core durable goods orders, using the latter as a proxy for business investment.
“Corporate demand for investment goods has begun to decline [in] contrast with the robustness of payrolls, where labor hoarding has delayed the jobs downturn relative to ‘normal,’ but it is just a question of time,” Albert remarked, adding that core durable goods orders “closely mirror the business fixed investment cycle.”
He also addressed the multi-faceted inventory issue. In the simplest terms: Corporate America has an inventory glut, which has led to a very high ratio of inventories to trailing sales. Assuming that relationship “has” to normalize, either the numerator has to come down or the denominator has to move up — so, either the excess inventory has to be discounted or written down, crimping margins, or consumers will be asked to pay more, boosting sales.
With margins already squeezed from elevated labor costs, and pricing power set to wane assuming consumers ever run out of ways to finance spending, that represents an especially onerous scenario that likely presages additional margin compression, and thereby lower earnings.
Edwards suggested it’s just a matter of time before inventories are a drag on the economy. “In addition to leading the business fixed investment cycle, profits also lead another key component of investment, namely business inventories,” he wrote Wednesday. “Amid the continued well-publicized problems at the retail level, inventory growth is set to slow, which will act to reduce GDP.”
Note from the visual that the juxtaposition between profits and inventories is especially stark in the pandemic era. The sharp run up in earnings reflects the boon from inflation as pricing power juiced sales, which outran (or maybe front-ran, is more apt) the eventual, lagging surge in COGS, while the inventories glut only became apparent starting early last year, when companies were forced to come to terms with the disconcerting reality of their own over-ordering and double-booking in 2021.
In any case, Edwards went on to show that margins have receded below a long-term trend line. He then plotted the YoY net change in margins with GDP, as well as margins relative to the same trend with growth, noting that it’s debatable which is more important. I’m not sure it makes much difference in the context of the visuals he used, given that both suggest overall growth is on the brink of slowing further.
As usual, the takeaway from Albert’s latest was straightforward. “A downturn in the corporate profits cycle” can be “a prelude” to a broader economic slump, he said. “Declines in profits (and profit margins) usually occur just before a recession.”
I wonder whether continuing supply chain issues and geopolitical uncertainty has resulted in businesses deciding to carry higher inventories than was normal over the past 20 years. That would mute the recessionary impulse of an inventory drawdown, although still a challenge to overall margins.
Good comment. Higher interest rates work to combat the impulse to carry higher inventories though. This appears to be building into a bullwhip type of market. Very worrisome.
The primary cost of holding excess inventory is financial. One dimension involves the actual cost of funds required to acquire the actual goods, materials, etc. and the other is the opportunity loss arising from the loss of profits foregone by not using the invested cash for other profitable activities. In either case, higher rates would seemingly have to stimulate cuts and the higher the rates, the deeper the cuts should be. However, as inventory is cut, there is also the risk of another type of loss stemming from sales lost if the firm cuts too much and loses sales because they can’t fulfill customer demand. Fun huh? Does anyone really think Powell and his all seeing economists know exactly how this mechanism works?
I’m living this scenario, as I swing between cutting year-end inventory, rebuilt it and now cutting back down again as cash is a little scarcer, though I then lose out on some margin by not buying at the steepest discount. Surprisingly, and as anecdotal as this is, I found a Staples in North Jersey yesterday to be noticeably low on inventory throughout the store, and my wife said the same about a chain pet store (I don’t know which one it was). I think retail cycles are like everything else these days…..a little out of whack and bouncing off both guardrails.