Profit Recession On Deck Due To Surging Dollar And Plunging Crude, Deutsche Warns

Plunging oil prices may be unambiguously good for those US consumers who have to gas up ever two weeks for their work commute (assuming they are not part of the 101.5 million working age Americans who don't have a job), but they are unambiguously bad for those US corporations which have a direct top-line exposure to energy, or are located downstream in the energy vertical and are impacted by the profitability (and viability) of energy companies. A simple example: the bulk of new jobs created under the Obama administration has been almost entirely courtesy of the shale boom, as reported previously: a boom which may quickly transform into a bust if the tumbling price of crude isn't arrested. And with the Energy sector responsible for a third of S&P 500 capex (or the I in the Y=C+I+G+(X-M) equation), slashing energy spending budgets (as ConocoPhillips already warned), the result would be a material drop in GDP as well.

But while there will be much debate over the economic pros and cons to tumbling oil prices (there is no debate if the plunge is confirmed to be the result of a global collapse in demand: that would scream global recession) with a definitive answer unlikely to be forthcoming for at least several quarters, when it comes to corporate profitability the outcome is already known, because between plunging oil prices and the soaring dollar, what is most likely next in store for the US economy may or may not be a full-blown economic recession, but a profit recession seems virtually inevitable.

What is a profit recession? This is how Deutsche Bank's David Bianco explains it:

There have been three S&P profit recessions since 1960: 1967, 1985/86, 1998

We define a profit recession as 2 quarters of down S&P EPS y/y when real GDP is up. It’s not a common thing, but it occurred in 3 of the 4 US expansions that lasted 5+ years. The cause of divergence between economic growth and profits is one of capacity growth outpacing demand growth and a significant deterioration in pricing power, which is usually most pronounced at Materials, Energy and Industrials. Dollar strength and commodity price weakness are profit recession hallmarks. We still expect up S&P EPS, however our 2015E EPS of $123 is at risk from current oil prices and the pace of dollar strength.

Dollar surges and oil price swoons are the typical causes of profit recessions

The 1998 profit recession was short, only 2 quarters and its principle cause was a ~30% oil price decline, mostly affecting Energy and Materials. Financials earnings also declined slightly on market turbulence associated with the Russian default. The 1985/86 profit recession was 4 quarters. Caused by a very strong dollar that contributed to a ~40% oil price plunge, which both weighed heavily on US capex and exports. Earnings declined most at Materials and Energy, followed by Tech, Industrials, Consumer Discretionary and Health Care. It was a broad based profit recession despite 4%+ real GDP. The 1967 profit recession lasted 3 quarters on GDP deceleration from Fed Chairman William Martin’s famous “punch bowl removal” policy tightening, exacerbated by GBP devaluation. The 2001 recession is often described as mostly a profit recession on the sharp downturn in US capex on tech and telecom equipment.

Small bear markets at onset of profit recessions in 1966, 1998, but not 1985/86

From 2/66-10/66 the S&P fell 23%, its worst decline outside a recession except 1987. This was due to a stern Fed on rising unit labor costs. The Fed eased after the S&P fell and GDP slowed, but then resumed hikes in mid 1967. From 7/98-10/98 the S&P fell 19% on Russia’s default in August and oil’s extended slide to $9/bbl. The S&P kept a 20+ PE. 1985/86 did not suffer a correction, despite prolonged poor EPS. Dollar strength and oil weakness helped convince investors that double-digit inflation and interest rates were quashed and the S&P PE climbed from 10 at 1985’s start to 15 at 1986’s end. In all cases, Materials, Energy and Industrials underperformed, but most Financials did fine.

We expect up S&P EPS in 2015: $120-125 remains our best range estimate

Oil at $65-70/bbl vs. the $80-85/bbl assumed in our 2015E S&P EPS of $123 would likely shave $2-3 from our estimate net of benefits to other sectors. This would be the third cut to our EPS from oil. But, before we cut again, we note the potential for 10%+ EPS growth at Financials, from less litigation net of higher loan loss provisions, at Health Care from strong underlying trends, and Consumer Discretionary and Transports from stronger households and lower fuel costs. If S&P EPS is $117.50 in 2014, inc. ~$2.50 of bank litigation costs, then S&P EPS should be $120+ in 2015 even if oil doesn’t rebound to $80. S&P EPS oil price sensitivity: Oil down $5/bbl from ~$85, hits Energy profits by 10%+, which directly hits S&P EPS by $1.50, or $1 net of benefits elsewhere. S&P EPS FX sensitivity: Every 10% dollar gain vs. the trade basket hits S&P EPS by $2 or 2% or every dime the euro falls from $1.25 hits S&P EPS by $1. Our $123 EPS assumes $1.20 euro, 120 yen, $1.55 GBP on average for 2015.

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All of this, of course, ignores the very real possibility of another harsh winter - because after all, everyone "knows" that the reason the US economy lost over $100 billion in trendline annualized GDP growth in Q1 of 2014 is because of last year's "harsh winter."

So yes, the US may or may not have decoupled from the rest of the world, but just pray it doesn't snow.

As for plunging energy costs, just keep an eye on those earnings warnings by the energy companies due shortly. Once those hit, all of the above will seem, in retrospect, to be painfully obvious.


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