As we enter the second half of 2017, the outlook for the U.S. economy and financial markets remains sanguine. Economic data has been solid over the past month, particularly on the labor market front, with the unemployment rate near a decade low at 4.4%. Will this optimism persist? Recall that a set of metrics called leading economic and financial market indicators can be helpful in accurately gauging the stage of the business cycle and predicting recessions and recoveries. These early warning signals can be an extremely useful tool to help guide investors’ asset allocation decisions. Indeed, this is why we selected each of our 11 indicators for the Clearbridge Recession Risk Dashboard on the basis of how useful we believe they are in anticipating the turns in the markets and the broader economy. Most of these guideposts are in green (positive) territory at the moment. Taken as a whole, this tells us the current strong market performance has legs, at least through the end of this year.
Exhibit 1: Recession Risk Dashboard
One especially interesting indicator to us at this relatively late stage of the economic cycle is corporate profits. This month, we look at so-called National Income and Products Accounts (NIPA) profits, a metric compiled by the Bureau of Economic Analysis that is a more comprehensive sample of U.S. corporations than the S&P 500 Index. Specifically, the NIPA statistics include small to medium-size businesses (SMB), whose condition is not only more reflective of the state of the U.S. economy, but also tends to peak before the S&P 500 ahead of a downturn in the broader economy.
Corporate profit margins are a good leading indicator of the business cycle because they touch upon many other areas of the economy. Most obviously, narrowing corporate profit margins often lead to declines in capital investment and hiring. These, in turn, ultimately result in higher unemployment, lower consumer spending and decelerating economic growth.
Corporate margins can narrow for various reasons, including overinvestment, high leverage in the face of rising interest rates, or rising costs of labor. NIPA profits are an especially good indicator as they include profits of SMBs that account for roughly 77% of total U.S. employment. Indeed, according to ADP employment data, small- and medium-sized corporations have accounted for a disproportionately large share of employment growth since 2005, adding over 11 million jobs compared to just over 1 million for large corporations. NIPA profits tend to peak earlier than S&P 500 profits: roughly two thirds of the way into a business cycle compared to three quarters of the way for the S&P 500, thus providing a better leading indicator. With this in mind, where are the NIPA corporate profits today, and what signals are they sending us about the broader business cycle?
As Exhibit 2 illustrates, NIPA profit margins last peaked in 2014. Looking back, NIPA profit margins have historically peaked ahead of recessions.
Exhibit 2: NIPA Profit Margins Are Off Their Peak
Some investors are understandably concerned that this late in a nine-year cycle, corporate profits are bound to begin getting squeezed. Higher labor costs would be the most obvious culprit. With labor markets tight, corporations compete for talent by raising compensation, which invariably eats into corporate profits. Nonetheless, so far this year we have witnessed solid growth in corporate revenues and believe this momentum will be sustained for the rest of the year. This would help corporate margins remain flat, at a minimum, despite possibly higher labor costs. Indeed, labor costs, as proxied by average hourly earnings, are another one of our economic indicators that has picked up recently. However, they are still far from the peaks reached in previous cycles - average hourly earnings growth is hovering above 2%, and have peaked around 4% in previous cycles. Although we believe average hourly earnings may peak earlier in this cycle - due to subdued inflation - we do not see corporate margins eroding materially until average hourly earnings accelerate to a year-over-year increase of at least 3%.
Taken as a whole, our 11 indicators paint an optimistic picture of the economy. We emphasize, as before, that the indicators must be viewed holistically, since, in isolation, any one indicator can give a false positive. Today, corporate profits might be flashing yellow, but we don’t believe investors need to worry.