Why an economic recession is imminent
Michael Roberts is an Economist in the City of London and a prolific blogger
Cross-posted from Michael Roberts’s Blog
The inflation rate for consumer prices in the US has clearly peaked and is falling steadily. The latest figure for year-on-year inflation in December was 6.4%, down from a peak of 9.0% last summer. Core inflation (which excludes prices for food and energy) has also peaked but not by nearly as much. That’s because it is food and energy price inflation that has slowed the most. Energy price inflation has halved as oil and gas prices drop back and there has been a peak in food prices. But housing costs continue to accelerate and other services prices fell only a little; so core inflation remains ‘sticky’.
What the latest figures show is that the ‘supply shock’ to prices from supply chain blockages and shortages of food and energy supplies since the Russian invasion of Ukraine have eased somewhat.
Inflation may be subsiding as the US economy slows, but remember, the hit to average worker’s living standards has been significant since the pandemic. Inflation means a change in prices, so even if inflation slows, price levels remain higher than before. Since the start of the pandemic, US consumer prices have risen 15%, but average weekly earnings have risen only 7.8%. Wage increases have actually been higher for non-management workers; the hit to the living standards of professional and lower management staff has been greater. Even so, from the beginning of 2021 to the end of 2022, hourly earnings for lower grade workers have risen 11.5% while prices have risen 14%. Living standards have been hit across the board, as wage increases fail to match price rises – there is no wage-price spiral.
And the inflation spike is not over, partly because the supply chain blockages remain, if at a lower level, and partly because productivity growth is so low that any increase in raw material or labour costs puts pressure on profitability, forcing companies to try and compensate by raising prices. But the ability to do that is disappearing fast.
I wrote a post last September that noted profit margins were beginning to fall. Profits are made up of the profit margin between costs of production and sale prices multiplied by total revenue from sales. During the post-pandemic recovery, US non-financial corporate profit margins (that’s the ratio of profits to per unit of costs) reached multi-decade highs as the surge in inflation boosted corporate pricing power while wages languished. A true profit-price spiral.
However, margins are now beginning to be squeezed. The average profit margin for the top 500 US companies in 2022 is estimated at 12.0%, down from 12.6% in 2021, if still well above the ten-year average margin of 10.3%.
And as overall economic growth in the US slows (real GDP yoy % in graph below), corporate sales revenue growth is slowing too.
And we can see that in the profits growth recorded by the US non-financial corporate sector. Indeed, in Q3 2022, profits fell.
And the slowdown in US corporate profits is replicated in all the major economies. Below is my latest estimate of global corporate profits based on five key economies. The pandemic slump recorded a 15% fall in global corporate profits in 2020, followed by a 40% recovery in 2021, but now profits growth has slowed to just 3.4% in Q3 2022. And note, as I have done before, that profits had stopped rising through 2019, that’s even before the pandemic, suggesting that the major economies were heading for a slump before COVID emerged.
I have argued before that there are two factors driving the US and other economies into a slump this year: the first is profits, which are heading south; and the second is the cost of borrowing and servicing debt. As for profits, I have argued on numerous occasions that they are the driving force of capitalist investment and therefore employment and income growth. If the profitability of capitalist investment falls and eventually leads to a fall in total profits, then investment and employment follow. So it is the strongest indicator of an impending slump in capitalist production. The close (if lagged) relationship between profits and investment is well established by several studies, including my own.
As for the cost of borrowing and servicing existing debt, the US Federal Reserve and other central banks are engaged in a severe monetary tightening by raising their basic interest rates that set the floor for other rates for borrowing; and by reducing the available money supply to raise debt. This is squeezing credit and ‘liquidity’ for companies. These two factors are what I have called the ‘blades of a scissor’ that are now closing, to end economic expansion and turn economies into recession.
A tremendous credit boom took place in 2022, which led a surge in US bank lending of $1.5trn.
Alongside bank loans, there has been an explosion in ‘low-quality’ lending that has brought debt loads in corporate America to record highs. The total US stock of “subprime” corporate debt (junk bonds, leveraged loans etc) has reached $5tn. According to the national accounts, total non-financial corporate debt (bonds and loans) stands at $12.7tn, making low-quality debt as much 40% of the total. This debt is financing very speculative or highly indebted companies either in the form of a loan (“leveraged loans”) or non-investment grade bonds (“junk bonds”) and includes corporate loans sold into securitizations called Collateralized Loan Obligations (CLOs); as well as loans extended privately by non-banks that are completely unregulated. Years of growth, evolution and financial engineering have spawned, yet again, a complex, highly fragmented and non-regulated financial market.
And this is replicated globally. Here’s last month’s annual report from the Global Financial Stability Board on the so-called Non-Bank Financial Intermediation (NBFI). It found that “the NBFI sector grew by 8.9% in 2021, higher than its five-year average growth of 6.6%, reaching $239.3 trillion. […] The total NBFI sector increased its relative share of total global financial assets from 48.6% to 49.2% in 2021.” The rise in high-risk, opaque subprime corporate debt has far-reaching consequences. Non-bank financial institutions such as hedge funds and private equity firms now account for a significant share of financial sector activity, despite enjoying far lighter regulatory and reporting requirements compared to banks and mutual funds – posing what is called “a systemic risk to financial stability”.
Up to now, because corporate profits have risen so much, even though corporate debt to GDP has risen to all-time highs, debt to profits has not (except of course for the 20% of companies deemed as ‘zombies’ ie not making enough profit to cover debt costs).
Most US firms have been able to cover their debt servicing costs comfortably up to 2021. But with debt costs set to rise even more over the next six months, if central banks stick to their monetary tightening, we can expect to see an increased inability for firms to cover their interest costs.
The blades of the scissor of slump are closing.
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