Corporate profit margins and gross domestic product (GDP) are economic indicators that run in cycles and reveal a great deal about the state of the economy. Since World War II, these two metrics have tracked one another closely. When profit margins peak and then begin to recede, GDP has a tendency, usually around eight quarters later, to do the same. Contraction of the GDP for two or more consecutive quarters officially signals a recession. For this reason, economists have long viewed declining corporate margins as a harbinger of recession.
The most recent recession, the infamous Great Recession, which began in December 2007, coincided with the steepest corporate margin drop in recent memory, from 9 down to 2%. Profit margins -- and the economy -- began to recover in 2009, and margins peaked again at nearly 10% during the third quarter of 2014. They began to ebb, however, shortly thereafter, and as of the third quarter of 2015 have fallen by over 7%.
With many analysts calling for a recession in 2016, one of the most frequent metrics cited is the steep drop in corporate margins from late 2014. Every time a similar drop occurred in the last several decades, save for once in 1985, a recession followed. What made 1985 a unique circumstance was that it resulted from an oil collapse severe enough to drive the entire average downward; that collapse, however, was mostly localized within the energy industry and managed not to affect the broader economy.
Corporate margin drops signal recessions for a couple of reasons. When the economy is in an expansionary cycle, companies across a broad spectrum of industries tend to achieve healthy margins. The ability to make profits in a healthy economy attracts competition, which, of course, drives prices downward and begins to narrow margins.
Once margins are squeezed to a level that endangers a company's financial position, its management has some tough choices to make. Either the company takes action to increase revenue while keeping costs the same, or, if this is not feasible, it must cut expenses to increase its margin. The first expense companies often target is wages and salaries, which means that when margin concerns present themselves, jobs disappear.
As unemployment ticks up, consumers begin pulling back on discretionary spending, either because their household incomes have been cut due to job loss or because they are hoarding every last dollar in fear of looming job loss. A spending pullback means less sales revenue flows into businesses, which causes the snowball set in motion by contracting margins to accelerate as companies cut expenses further to bring them in line with their dwindling revenues. This is the second reason deteriorating margins often foretell recessions. Frequently, they are the result of diminished revenues, another telltale sign of economic contraction.
This entire process, beginning with competition driving down margins and ending with two consecutive quarters of GDP contraction -- the official definition of recession -- takes some time to materialize, which is why, on average, eight quarters (or two full years) elapse between margins falling and a recession being declared.
What This Means for 2016
Margin losses that have occurred since 2014 have been much more widely distributed than in 1985, meaning the chance of at least some economic slowdown is strong. The jury is still out, however, on whether the United States will officially enter a recession in 2016. As of February 2016, many economic indicators are still reasonably strong, including jobs data and corporate earnings. Moreover, analysts point to a host of blue-chip stocks that still have profit margins above 20%, including Discover Financial Services, Johnson & Johnson and Oracle.
For many reasons, one being declining margins, a rosy economic outlook for 2016 is probably unrealistic. That said, signals are too mixed at this point to get too worked up over the specter of recession.