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U.S. Corporate Profits Plunge Into the Abyss... What Are the Implications?

Conclusion: The ongoing recession in domestic corporate profits just took a decided turn for the worse; this has dramatic forward-looking implications for both the S&P 500 and the labor market.

 

Aggregate domestic corporate profits are released commensurately with the third and final GDP report of any given quarter. With this morning’s release of the 4Q15 statistics, we learned that the ongoing recession in domestic corporate profits just took a decided turn for the worse.

 

The -10.5% YoY rate of contraction was slower by -540bps sequentially and represents a new low for the cycle. You have to go all the way back to the depths of the financial crisis (4Q08) to find a worse YoY growth rate. More importantly, Q4 marked the second-consecutive quarter of declining corporate profit growth; as we were keen to highlight on our 1Q16 Quarterly Macro Themes Conference Call, such occurrences have been proceeded by stock market crashes in the subsequent year for at least the past 30 years (five occurrences).

 

U.S. Corporate Profits Plunge Into the Abyss... What Are the Implications? - Profits Down  Stocks Down Slide 39

 

Recall that we also showed that, over the past 30 years, anytime the TTM EPS reading of the S&P 500 breaks down below its 12MMA, a recession has ensued in short order. With respect to the current business cycle, the breakdown occurred in June 2015 and we’ve been trending below the 12MMA ever since.

 

U.S. Corporate Profits Plunge Into the Abyss... What Are the Implications? - Recession Watch TTM EPS

 

Recall that we also highlighted the headwind to the labor market that is declining corporate profits. Don’t for one second think that the scars of 2008-09 haven’t perpetuated a broad-based “CYA” attitude among executives of large U.S. enterprises. When it comes to protecting their “buyback babies” and their own personal (read: stock based) compensation, we believe they are most likely to eschew labor costs, at the margins. Whether or not they do it fast enough to prevent further declines in corporate profits remains to be seen.

 

U.S. Corporate Profits Plunge Into the Abyss... What Are the Implications? - Profits Down  Employment Headwind Slide 37

 

Unfortunately for this economic cycle, we are in a fairly precarious position with respect to the domestic labor cycle. It literally doesn’t get much better than it has been trending on a trailing 6-12 month basis. That doesn’t mean the U.S. consumer is facing imminent risk of a plunge into the depths of an employment crisis. What it does mean, however, is that if you roll the clock forward by ~6 months, investor consensus could be using a decidedly more sour tone to describe the health of the domestic labor market. As the following chart highlights, once initial jobless claims roll off the lows, there’s no turning back.

 

U.S. Corporate Profits Plunge Into the Abyss... What Are the Implications? - Profits Down  Unemployment Up Slide 38

 

There’s a credible case to be made that we hang out at the aforementioned lows for much longer than previous cycles given the depth and nature of the previous downturn (i.e. a financial crisis). That said, however, we aren’t of the view to bet on such perma-bull hopium. Anything could happen, but we’re not smart enough to side with storytelling over data; our firm has too much at risk for us to miss calling the next big draw-down in U.S. equities. Recall that being a raging bear is how Keith got fired from Carlyle in late-2007, which afforded him the opportunity to start Hedgeye in 2008.

 

Luck matters in this business. So does having repeatable research and risk management processes. And a core tenet of our repeatable risk management process is monitoring the relationship between volatility and price.

 

One way to do this over short-to-intermediate-term durations is by charting the relationship between the VIX futures curve and the SPX. As the following chart highlights, the stock market is in a fairly precarious position with respect to the steepness of the 6 month/1 month VIX curve – specifically in that we’ve yet to sustainably breach 4 points wide since we called for cross-asset volatility to start trending bullishly in mid-to-late-2014. Coincidentally, the aforementioned curve hit 4 points wide just prior to Monday’s highs in the SPX.

 

U.S. Corporate Profits Plunge Into the Abyss... What Are the Implications? - VIX Curve vs. SPX

Source: Bloomberg L.P.

 

While this is one of a myriad of factors we incorporate into our risk management process, this specific factor would seem to suggest another leg down in risk assets is upon us. And given how generally bearish our client base is, I’m not so sure that’s a bad thing.

 

Wishing you and your family a Happy Easter,

 

DD

 

Darius Dale

Director

 

P.S. In case you missed our latest Macro Playbook update from yesterday afternoon, we’re including the link HERE. Feel free to email with questions.


Happy Easter

Happy Easter - HETV macroshow title


Investing Ideas Newsletter

Takeaway: Current Investing Ideas: LAZ, MDRX, FL, NUS, JNK, TIF, WAB, ZBH, CME, ZROZ, XLU, MCD, RH, GIS, TLT

Dear Investing Ideas Subscriber,

 

Please see below a special holiday weekend edition of Macro Overlay where Hedgeye CEO Keith McCullough reviews each of our fifteen current high conviction long and short ideas. Our regular analyst updates will return next week. We added CME Group (CME) to the long side and removed Darden Restaurants (DRI) from the short side on Thursday.

 

Keith's updated levels for each ticker follows beneath the video.

 

Have a great weekend.

 

 

Updated levels for each of our long and short ideas.

LEVELS

Investing Ideas Newsletter - levels 3 24

 

Trade :: Trend :: Tail Process - These are three durations over which we analyze investment ideas and themes. Hedgeye has created a process as a way of characterizing our investment ideas and their risk profiles, to fit the investing strategies and preferences of our subscribers.

  • "Trade" is a duration of 3 weeks or less
  • "Trend" is a duration of 3 months or more
  • "Tail" is a duration of 3 years or less

Daily Trading Ranges

20 Proprietary Risk Ranges

Daily Trading Ranges is designed to help you understand where you’re buying and selling within the risk range and help you make better sales at the top end of the range and purchases at the low end.

Howe: A ‘Foreboding’ Election And Its Implications

 

Hedgeye's Demography Sector Head Neil Howe discusses the GOP and Democratic presidential candidates, how Donald Trump could “destroy the traditional Republican party,” and what it means for markets.  


REPLAY | Keith McCullough, Darius Dale and Neil Howe on The Macro Show

Did you miss Keith, Darius and Neil on The Macro Show today? Catch the replay HERE.

REPLAY | Keith McCullough, Darius Dale and Neil Howe on The Macro Show - TMS 3.24

 

This dynamic trio hit on a wide-ranging number of topics in a very thoughtful discussion including:

  • Being The Bear in commodities
  • Another Fed policy mistake
  • What the next Bull Market will look like
  • How much pain (both economically and institutionally) we'll have to undergo to get there
  • Why it's time to be positioned short "rich people"/long "poor people"
  • and much more...

 Don't forget you can watch The Macro Show week-day mornings at 9:00AM ET HERE.


Macro Playbook: Helping Bears Maintain Our Collective Conviction

Yesterday, were asked by a very sharp, longtime client of Hedgeye if we still had conviction in our #USRecession theme after the recent sharp rally in risk assets, which came amid a number of positive surprises across various economic data throughout the YTD. For those economic cycle junkies among you, we expand upon our answer to his question in great detail below:

 

Yes, we still do believe the U.S. economy may experience a shallow recession over the intermediate term and that it has the highest likelihood of commencing in/around 3Q16. Specifically, our top-three U.S. recession indicators (i.e. the Jobless Claims, Consumer Confidence and Corporate Profit cycles) are all continuing to progress according to our previously defined expectations:

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction - Recession Watch Jobless Claims

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction - Recession Watch Consumer Confidence

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction - Recession Watch TTM EPS

 

Additionally, the domestic #CreditCycle continues to deteriorate in kind with the trends we identified at the onset of the year:

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction - Hedgeye Macro U.S. Bank Credit Cycle Indicator

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction -  CreditCycle Delinquencies Slide 35

 

That being said, however, the meaningful retreat in HY OAS is new and noteworthy, so we must be cognizant of the extent to which the market is pricing in all of the above fundamental signals as head fakes. On that note, HY spreads would have to get back below their long-term historical mean of ~500bps on an index basis for us to consider that to be true. Right now, they’ve currently retreated back to just above 600bps, which implies a considerable amount of tightening from here for the credit markets to shake us off our recession view.

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction - HY OAS by Sector

 

Commensurate with this decline in spreads, Standard & Poor’s notes that the U.S. distressed ratio – a gauge of the proportion of speculative-grade bonds with a spread over Treasuries of more than 10 percentage points – had fallen to 24.8% as of March 15 from 33.9% at the end of February. That’s the first bi-weekly decline since last May. Per S&P via the Financial Times, there were 279 borrowers with bonds trading in the distressed range, affecting total debt of $214B in March, compared with 353 issuers affecting $327B in debt the month prior.

 

Time will tell whether or not the aforementioned sequential improvement is a short-term, reflation-based market head fake. Credit spreads can widen just as quickly as they’ve tightened since mid-February…

 

But above all else, as we’ve stressed repeatedly throughout the year, a U.S. recession is actually the least pressing of what we consider to be the biggest risks to asset markets. Those risks are as follows (in order):

 

  1. Corporate profit recession (ongoing)
  2. Deteriorating credit cycle (ongoing)
  3. #BigBangTheory – i.e. market participants broadly losing faith in central bank Policies To Reflate (TBD domestically)
  4. A technical recession in the U.S. (progressing according to plan, but likely to be shallow like the 2000-02 C&I lending led downturn)

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction - Profits Down  Stocks Down Slide 39

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction - Spread Risk HY Slide 43

 

Obviously risks #1 and #2 are intricately linked, as is #3 – specifically because that would be proof of the Fed losing its perceived ability to counteract microeconomic gravity with shell games of ZIRP and debt-financed buybacks.

 

We discuss risk #4 in great detail at the conclusion of our 2/3 note titled, “Ex-Energy?”:

 

“And even if the U.S. economy avoids recording a technical recession, we could just have an 2000-02-style corporate deleveraging cycle that drags down equity market cap alongside it. After all, it's EPS that matters most to stocks, not GDP. Recall that the 2001 downturn was the shallowest recession in U.S. history; that didn't preclude the stock market (SPX) from getting cut in half [DESPITE the Fed cutting rates by a cumulative -525bps during the decline].”

 

Like Rome, economic contractions aren’t built in a day. Domestic high-frequency economic data needs to continue decelerating from here in order to become equally as reflexive on the downside as it is during an expansion.

 

And much like with bear markets that are historically rife with massive short squeezes to lower-highs, there will be “green shoots” (i.e. sequential upticks) across several key data sets that lead perma-bulls to believe the bottom is in with respect to growth. The TREND remains your friend on that front, however.

 

As the following chart highlights, every major category of high-frequency economic growth data continue to decelerate on a TRENDing basis in spite of whatever recently released, sequentially positive data points the bulls want to anchor on; meanwhile, every major category of high-frequency inflation data is accelerating on a trending basis. This confluence is a double-negative for TREND real GDP growth expectations for both investors (think: flows) and corporations (think: capex) alike.

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction - U.S. Economic Summary

 

Sure, select indicators such as last week’s Retail Sales report or today’s Service and Composite PMI readings have ticked up in the February/March timeframe, but does cheerleading that on A) account for the fact that they are all still making a series of lower-highs on a trending basis; or B) account for the sharp deterioration across the housing sector (CLICK HERE and HERE for more details) or nascent cracks across the commercial real estate sector?

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction - RETAIL SALES CONTROL GROUP

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction - MARKIT SERVICES PMI

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction - MARKIT COMPOSITE PMI

 

Of course they don’t. Anyone who thinks they do likely lacks a repeatable process for contextualizing macro data, which we dissected at length in our recent Early Look titled, “Bull Market Marketing”.

 

It does, however, call attention to the analytically weak nature of the nascent bull thesis for U.S. stocks and credit. As the following table highlights, there’s a lot of green (i.e. accelerating) in the “Sequential Data” column to the right, while the “Trending” and “Quarterly Average” data columns are as red (i.e. decelerating) as ever:

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction - U.S. Economic Summary Table

 

Let’s ignore the ongoing, trending slowdown in Industrial Production growth in order to play devil’s advocate for a second. Can the nascent recovery in domestic manufacturing activity get back to healthy enough levels in time to offset ongoing degradation in the growth rate(s) of consumer spending?

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction - INDUSTRIAL PRODUCTION

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction - DURABLE GOODS

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction - CAPITAL GOODS

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction - ISM MANUFACTURING PMI

 

To answer the question, base effects support some version of the soft bigotry of low expectations that is “muddle-along nirvana” for a quarter (i.e. Q1) while compares for both “C” and “I” are easier on a sequential basis – but not for much longer than that:

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction - PCE COMPS

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction - Industrial Production Comps

 

As an aside, base effects for Real PCE in the four quarters ended in 3Q16 remain as tough as anything the U.S. consumer has experienced since the four quarters ended in 3Q08. Recall that Real PCE growth decelerated sharply from +2.7% YoY in AUG ’07 to -1.2% in SEP ’08. As such, we continue to anticipate real consumption growth as having downside risk to +1% YoY in a moderate scenario. As one very astute client accurately pointed out in a recent meeting:

 

“While that may not produce an actual technical recession, it may certainly feel like one – especially relative to consensus expectations of a “resilient” U.S. consumer.”

 

Indeed.

 

As Keith remarked during a client meeting on Tuesday, it’s actually easier to make the bearish economic cycle call today than it was [at the top] in early July, as most economic data series weren’t broadly slowing then. Now we can simply sit back and watch market prices [hopefully] continue to come our way on a trending basis. Sounds simple enough.

 

And by the way, #Quad4 starts next Friday…

 

Macro Playbook: Helping Bears Maintain Our Collective Conviction - Brent Crude Oil

 

Happy Easter,

 

DD

 

Darius Dale

Director


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