US recession risks rising as profits fall by most since 2008

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US pre-tax earnings probably fell 9.5 per cent in the fourth quarter from a year earlier, the biggest decline since the 31 per cent free fall during the height of the financial crisis. Photo / AP
US pre-tax earnings probably fell 9.5 per cent in the fourth quarter from a year earlier, the biggest decline since the 31 per cent free fall during the height of the financial crisis. Photo / AP

On the face of it, the economic update that the US government is releasing on Friday should be a big yawn. Economists expect the revised numbers to confirm what we know already - that gross domestic product grew at an annual rate of just 1 per cent in the final three months of 2015.

But it would be a mistake to dismiss the release - even if you're off from work for the Easter holiday. That's because the US government also will be publishing its first estimate of what happened to company profits in the period. And the news isn't expected to be pretty.

Pre-tax earnings probably fell 9.5 per cent in the fourth quarter from a year earlier, after dropping 5.1 per cent in the third, according to economists at JPMorgan Chase in New York. That would be the biggest decline since the 31 per cent free fall in the closing months of 2008 during the height of the financial crisis.

Profits last quarter probably were unusually depressed by a $20.8 billion penalty payment by BP to settle claims over the 2010 oil spill in the Gulf of Mexico. But even after stripping out that one-time charge, earnings likely still fell about 5 per cent, by JPMorgan's reckoning.

The risk is that they'll respond to the margin squeeze by cutting back on hiring and spending, leading to a recession.

Why is that important? Well, history shows that when profits fall, the economy often follows them downwards. An earnings hit of the size that JPMorgan says is taking place has led to a recession within three years about 90 per cent of the time.

Now the bank doesn't think the odds of a downturn are anywhere near that high. After all, a big reason why profits are dropping is because energy companies have been hurt by plunging oil prices, which on net should be good for the economy.

Yet that's not the only reason earnings are under pressure. Companies are being pinched by poor productivity and rising labor costs on one side and an inability to raise prices in a lackluster economy on the other. The risk is that they'll respond to the margin squeeze by cutting back on hiring and spending, leading to a recession.

"With wages picking up but productivity growing in slow motion, margins are likely to continue their declines, which have historically signaled an expansion near its end," JPMorgan economist Jesse Edgerton wrote in a March 21 research note.

The bank puts the probability of a recession beginning within two years at around one-in-two and within three years at about two-in-three. Now that's something worth paying attention to.

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