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Can recession be far behind?

New York - US corporate profit margins down 7.3% from their peak in Q3 of 2014

Corporate profit margins are falling, an event that has occurred before every recession since World War Two.
What's more, they are falling from record territory, which might imply either a rapid and bumpy descent or a long and slow one. In terms of the outcome, this time probably won't be different, but the lead time - how long from the start of the decline to economic contraction - is far more uncertain.
By its preferred measure, Deutsche Bank says US corporate profit margins are down 7.3 per cent from their peak in the third quarter of 2014. Since the average time from peak to recession, at least since 1946, is eight quarters, that might put the United States in line for a downturn in the second half of 2016.
It may be the US economy that catches a cold from the rest of the world, with a deepening and broadening downturn in emerging markets giving force to the usual downturn in investment that follows a fall in profits.
"The fall in profits in 2015 will tend to undermine domestic investment in 2016," economists at The Jerome Levy Forecasting Centre write in a report to clients. "Moreover, the export decline is likely to accelerate as recession spreads throughout emerging market economies. As global deterioration worsens, not only will the US current account gap expand significantly, but markets will plunge, fixed investment will fall and the US economy will follow the rest of the world into recession."
The slowing in China and its transition from an investment-based economy that sucks up natural resources to something more domestically focused is already dealing substantial pain to emerging markets, from Brazil, which is in recession, to South Africa, which is widely tipped as a candidate for one early next year. On the positive side, it is just possible that the current drop in profits is a bit of a head fake, courtesy of the energy industry, where a fall in prices has eviscerated profit margins, not to mention investment. Something similar happened to the energy industry and profits in 1985 and we didn't see a recession until 1990. After all, cheaper energy is, on balance, positive for growth and consumer spending.
Credit spreads and wages
Noises from the credit market are an eerie echo of the groans from corporate profit ledgers. Spreads are widening, again led by the energy sector, indicating that investors are pricing in a higher probability of less-certain cash flows and less-sure repayment. While much of the noise has come from the high-yield bond market, spreads have widened considerably among safer investment grade credits as well in the past year, albeit from historically low levels.
Some suggest that this reflects in part a growth in liquidity premiums - the extra a bond yields to compensate for the risk it could be hard to sell. Banks are, indeed, less willing to step in as short-term holders and prices can be expected to be choppier. But given the other signal from profits, it would be unwise to put too much faith in this idea. Credit spreads are wider because they ought to be.
One thing is clear: 2016 will not be a re-run of the last two recessions. In both 2001 and 2007, bubbles were popped and margins crashed, with the peak preceding the onset of recession by just months, rather than quarters. The angle of descent is nowhere near that now.
One key factor to watch is wage pressures. Thus far, wage rises have been muted, though steady. But with wages comprising more than 60 per cent of corporate costs, pay rises are what usually brings corporate margins back to earth. There simply isn't very good evidence of that happening this time, and though job creation has been reasonably brisk, it has generally been at the lower-skilled service end of the spectrum, perhaps capping the potential for a wage spiral.
All of this makes 2016 likely a difficult year for riskier assets like equities. The best-case scenario is gently rising wages and declining margins buffered by revenue growth as those higher wages are spent. But consumers still seem unwilling to use much leverage to expand their buying power, a factor that could blunt the positive impact of stronger wage gains if they come.
The negative scenario is quite a bit worse. If we were to get the beginning signs of a recession late next year, perhaps touched off by some debacle in China or emerging markets, the Federal Reserve would find itself with perhaps only 75 basis points of interest rates to cut.
That would be a unique set of circumstances and not likely one investors will enjoy. - Reuters