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Conjuring recessions

22 March 2016

Poor company earnings should always concern investors but, taken in isolation, they are far from reliable indicators of imminent recession.

Whichever way you look at it – and companies have tried several angles – corporate earnings season in the US was disappointing. Fourth-quarter earnings for S&P 500 companies in 2015 were 3.5% below 2014 levels1, and forecasts for the first quarter of 2016 were revised down from 2.3% (annualised) to -5.7%. The results not only spooked markets, but also raised fears that the US may be on the brink of a recession.

Markets are often accused of overreacting to bad news, a tendency memorably highlighted by the late American economist Paul Samuelson, who wrote in 1966 that the stock market had “predicted nine out of the last five recessions!”

When it comes to interpreting disappointing corporate earnings in the US, Samuelson’s warning looks to be as relevant as ever. Research recently conducted by Payden & Rygel suggests that a contraction in corporate earnings has not usually presaged imminent recession. The US fund manager studied monthly earnings data going right back to 1871, in order to assess how often a contraction in US corporate earnings had been followed – within 12 months – by an economic recession.

The results, published earlier this month, found that negative earnings growth (an “earnings recession”) had occurred 32 times since 1871. Yet in only 11 of those cases did a real recession follow within 12 months. In other words, in 66% of cases negative earnings growth served as a false predictor of economic recession.

Payden & Rygel found a closer correlation between corporate earnings recessions and economic recessions in the postwar data. On the 16 occasions that US corporate earnings have turned negative since 1945, a recession followed (within 12 months) on seven occasions. Yet even for that more limited timespan, 56% of earnings recessions not being followed by economic recessions.

The report also points out that, before the most recent earnings season, the last US corporate earnings contraction came in February 2015 – and there has not been a US recession in the 12 months since.

While it is not unusual to see corporate earnings dip ahead of a recession, the limited level of correlation indicates that an earnings contraction is almost never enough to indicate a recession on its own.

“When earnings growth does signal a recession, a host of other leading indicators tend to corroborate the forecast – something we do not see in the economic data today,” Payden & Rygel concluded. “In short, we acknowledge the risks presented by the contraction in corporate earnings, but we still aren’t betting on a recession.”

Broader view

If corporate earnings point downwards, several other leading indicators point in a different direction. For example, US unemployment is at an eight-year low of 4.9%, and the latest Federal Reserve report forecasts it to dip to 4.5% by 2018.

Moreover, perhaps the most elusive element of the recovery since the financial crisis has been inflation. Now US inflation finally appears to be rising; in February it reached 1.0%, a figure that is still carrying the weight of cheap commodities. Strip out those commodities (as well as food) and the core inflation figure was 2.3%. A report published earlier this month by Capital Economics argued that inflation is likely to overshoot expectations in 2017, pushing the Fed to take quicker tightening action than the market currently forecasts.

There are plenty of headwinds in the global economy at present, but a poor round of US corporate earnings should not be misread as proof that the US is on the brink of recession. Indeed, a number of leading indicators even suggest the opposite: that the US is the one major economy just entering its stride.


Payden & Rygel is a fund manager for St. James’s Place Wealth Management.

This material is not a recommendation, or intended to be relied upon as a forecast, research or advice. The views of Payden & Rygel are not necessarily shared by other investment managers or by St. James’s Place Wealth Management.

1 Thomson Reuters, 2016


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