A Shaky US Economy

For many months now the popular thing to say has been that the US economy is great and that we will prove resistant to an overall global economic slowdown. However, I do not share this opinion and as the year has progressed the ratio of negative to positive economic data has slowly increased. This increase has picked up pace in recent weeks. For example, just last week Factory Orders, the United States Trade Balance, and Wholesale Inventories missed estimates to the downside. This resulted in the Atlanta Federal Reserve downgrading their first quarter GDP estimate to a paltry 0.1%. In early February this estimate had been as high as 2.7%! A chart of the evolution of this estimate is below:

gdpnow_q1_2016

The tale that the media and Federal Reserve have been telling about how our economy is operating at a healthy level simply isn’t true, and it is becoming harder for these deniers to stay disconnected from reality. Those that argue we are no where near a recession enjoy spending their time spouting off labor statistics, but at some point the jobs data is going to turn south as well. Plus, let’s not forget that the jobs data isn’t as shiny as some would lead you to believe.

In order for businesses to continue hiring instead of cutting workers or hours those businesses need to be running a profit. This is common sense. It only makes sense to keep a worker on payroll if his or her contribution leads to a profit (By the way, this is why a government mandated $15 minimum wage is destined to fail. If businesses don’t get $15 per hour of productivity out of hiring a new worker then they just won’t hire any new workers. Higher structural unemployment!). With this idea in mind I invite you to consider that first quarter corporate earnings are slated to be the worst that they’ve been since 2009:

corporate earnings dropoff

But wait, you might say that this is because US energy companies have been hemorrhaging due to low oil prices. But that does not paint the full picture. Yes, energy companies are far worse off but the pain is going to be felt in a broader selection of industries. In fact, analysis by one Bank of America analyst suggests the approaching wave of defaults is slated to one of the most painful on record. There are a few different reasons for this but in my opinion the most important is that debt-to-asset ratios are alarmingly high. From Business Insider, below is a chart depicting the debt-to-asset ratio for non-financial companies since the turn of the century.

debt to asset ratio

We see from the chart that corporate debt-to-asset ratios have been nearing record highs for this period. A lot of this has been due to the cheap money that has been available ever since the Federal Reserve cut interest rates to zero following the financial crisis. For a lot of these companies, instead of investing in more physical or human capital, the trend has been to borrow money at these low interest rates and then to turn around and buy back shares of their company. So what we have is a situation where many corporations are holding very high levels of debt relative to their assets at a time when corporate earnings are beginning to plunge. This spells trouble. The next chart also from Business Insider helps put these two ideas together:

cash flow versus debtThis chart depicts insanity. Net debt levels have been rising at an incredibly fast pace, yet operating cash flow growth has been in negative territory since the onset of this latest earnings recession. This situation cannot last forever. At some point in time there is going to be a corrective phase due to these fundamentals. And that time is nearing. Consider one more chart in favor of this hypothesis:

Negative sales growth since the beginning of 2015 of course has contributed to the falling corporate earnings referenced above, but take a moment to also notice the trend in the Inventories-to-Sales ratio. This increasing level of the Inventories-to-Sales ratio of course reflects the notion that fewer goods are being sold, but this ratio increase also suggests why our latest quarters of GDP haven’t been even lower and why the jobs number may not be telling a sad story yet. When a company produces a good but fails to sell it this production is still counted towards GDP as inventory investment. If it weren’t for this inventory buildup, fourth quarter GDP growth would have been much lower than the already meager estimate of 1.4%. In fact, this inventory buildup might also be why we haven’t seen negative jobs data yet since companies haven’t turned their spigots off. But once profit margins slide enough, this inventory buildup will slow or cease and the time will have arrived for those corporations to lay people off to cut back on expenses.

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