Business cycles are intrinsic to the way capitalism operates; they are the outcome of contradictions generated by the private pursuit of profit. In fact, it is the movement in profits that drives the cycle, with a sustained downward movement in the profit margin signaling growing dangers of a recession.

And, it is a sustained downward movement in the profit margin that is leading business forecasters to raise warnings of a coming recession. A case in point: a June 2016 J.P. Morgan special report titled Profit Stall Threatens Global Expansion states:

One metric for gauging the stage of the business cycle is the level of the profit margin. In this regard, the timing does not look encouraging. The US experience is instructive in this regard. The rolling over of the profit margin has led every US post-World War II recession by one to three years. Indeed, it is partly for this reason that our medium-term recession-probability models show the odds of a recession within the next three years running near 90%.

Recessions mean hardship, especially for working people. Unfortunately, because most Americans have benefited little from the current expansion, few will have the financial resources necessary to moderate the social costs that come with any downturn.

Business Cycle Theory

Some definitions are needed to show why profit margins are key to gauging the state of the business cycle. Profits are the difference between a firm’s total revenue from selling products and its total cost from producing them. The profit margin is the firm’s profit per dollar of sales or revenue; it is calculated by dividing total profits by total revenue.

If we think about the corporate sector as a whole, we can define total corporate profits as the product of corporate total revenue (or sales) multiplied by the average corporate profit margin (or earnings per dollar of sales). Total revenue is a function of the level of demand in the economy. The profit margin is heavily dependent on changes in the cost of production (most importantly changes in productivity, which include the intensity of work, and wages). Not surprisingly, both demand and business production costs, and thus total revenue and the profit margin change over time, sometimes moving in the same direction and sometimes not.

Coming out of a recession, corporations tend to enjoy rapidly increasing demand for their products and, for them, still pleasingly low costs of production thanks to their recession-era leverage over workers. This translates into rapidly increasing profits and expectations of continued profitability. This, in turn, encourages more hiring and investment in new plant and equipment, which helps to strengthen demand and further the expansion.

However, at some point in the expansion, costs of production begin to rise from their recession period lows, causing a fall in the profit rate. For example, productivity begins to slow as firms press older equipment into use and workers take advantage of the improving labor market to slow the pace of work. And, as unemployment falls over the course of the expansion, workers are also able to press for and win real wage gains. With costs of production growing faster than product prices, the profit rate begins to decline.

For a time, the growth in sales more than compensates for lower profit margins and total profits continue to rise, but only for a time. Eventually steadily declining profit margins will overwhelm slowing growth in sales and produce lower profits. And when that happens, corporations lose enthusiasm for the expansion. They cut back on production and investment, the effects of which ripple through the economy, leading to recession.

The Data

The following figure from the J.P. Morgan study shows movements in productivity and the profit margin with each point representing a two year average to smooth out trends. The grey stripes denote periods of recession. As noted above, the profit margin turns down one to three years before the start of a recession. The recession, in turn, helps to create the conditions for a new upward movement in the profit rate.

As J.P. Morgan analysts explain:

Indeed, for the US, the turn down in the profit cycle weighs heavily in our estimate of rising recession risks. The deeper historical experience of the US better highlights the linkage between productivity and corporate profitability. The latest downshift in US productivity suggests the disappointing profit outturns of late likely will not stabilize absent a pickup in productivity growth to an above-1% annualized pace, all else equal. While some acceleration is embedded in our forecast, recent experience suggests the risks are skewed to the downside.

As we can see, in the case of the current expansion, the profit margin is not just falling, it has now moved into negative territory. Thus, although profits remain high [see figure below], the current decline into negative territory means that profits are now actually falling. If past trends hold, it is only a matter of time before corporate responses push the US economy into recession.

When discussing the business cycle it is also important to add that we are not describing a regular pattern of ups and downs around an unchanging rate of growth. Corporate responses to the conditions they face influence the pattern of future cycles. For example, if corporations decide to respond to growing worker gains during an expansionary period by shifting production overseas, future recessions will likely be more painful and expansions weaker in terms of job creation and wages. If fear of corporate flight leads governments to slash corporate taxes, public finances will suffer and so will support for needed investments in physical infrastructure and social services, again boosting profits but at the expense of the longer term health of the economy and its majority population. This dynamic helps to explain the growing tendency towards long term stagnation coupled with minimal wage gains even during expansions.

J.P. Morgan analysts are not just pessimistic about the US. They also estimate that profit margins are falling throughout the world, as illustrated in the figure below.

Thus:

If the US experience is any guide, recession risks are elevated broadly. Globally, profit margins peaked near the end of 2013, and declines have occurred across nearly all countries with the exception of Taiwan, Korea, and South Africa [figure above]. Margins have been stable in the Euro area, Japan, and China. By comparison to the huge declines in some countries, the margin compression in the US appears relatively modest. Not surprisingly, Brazil—already in its worst recession since the Great Depression—has seen the most significant margin compression. A similar message is seen for Russia. But for those economies still in expansion, the fall in margin is the most concerning for Poland, the UK, the Czech Republic, Thailand, Australia, Turkey, and India, in order of largest margin declines.

The takeaway: we have plenty to worry about.