Is Employment Growth at Risk to Waning Profits?

The financial position of the U.S. corporate sector has been deteriorating over the past few years, making it more vulnerable to any shock that would reduce earnings. Efforts to contain the new coronavirus represent one such potential shock. Could a decline in corporate profits at this stage of the economic cycle spillover into the labor market and trigger a recession?

In times of stress, one way for businesses to shore up finances is to reduce labor costs, i.e., cut jobs. We estimate that a 10% decline in before-tax profits has historically corresponded to a 1% decline in employment. That said, employment has fallen and the economy has slipped into a recession following more modest drops in profits, particularly when profits declined over a series of quarters. Timing also matters. A decline in profits is more perilous later in the economic cycle, when margins are falling and monetary policy is slow to become more accommodative.

Profit growth has been rather anemic, as economy-wide corporate profits have moved more or less sideways the past five years. Therefore with margins already falling and Fed efforts to ease financial conditions up in the air, the coronavirus and its potential hit to profits could yet lead to trouble for the jobs market.

Corporate Sector’s Financial Health Makes It Vulnerable to a Shock

For more than a year now, we have been highlighting the deteriorating financial position of the U.S. corporate sector. Amid a record amount of debt in the non-financial corporate sector, interest coverage has eroded and net debt relative to earnings has climbed. Our own measure of corporate financial health, which captures eight financial metrics reflecting corporate balance sheets and income statements, is near its lowest levels since the past recession (Figure 1).1 At the same time, corporate profits growth remains rather anemic, as economy-wide corporate profits have moved more or less sideways over the past five years (Figure 2). While corporate finances do not appear so weak at present as to be the catalyst for the next recession, the more fragile financial position in recent years certainly makes the business sector more vulnerable to any economic shock that would reduce earnings.

Such a shock might be upon us. While currently our working assumption is that COVID-19 does not become a full-blown pandemic, it is hard to say with any certainty how events unfold from here. But measures being taken to stem the virus’ spread come with an economic cost. Corporate earnings are already in some degree of jeopardy as travel is curtailed, supply chains are disrupted and stores are closed. Could a deterioration in U.S. corporate profits spill over into key segments of the economy, like the labor market, and trigger a recession?

Source: Federal Reserve Board, U.S. Dept. of Com., S&P Dow Jones Indices and Wells Fargo Securities

How Big of a Drop in Profits Could Derail Hiring?

Businesses in financial peril are apt to cut costs where they can. Major expenditures like capital investments and labor are often on the chopping block. As we have seen in a number of recent periods, such as 2015-16 and the last three quarters of 2019, a decline in real business investment does not always translate to a recession. However, given the commanding share of economic activity driven by the consumer and households’ reliance on jobs for income, a decline in nonfarm payrolls has always corresponded to recession.

To determine the extent to which a decline in profits would affect employment, we employ a statistical technique to “shock” earnings.3 We then calculate an impulse response function between corporate profits and nonfarm payrolls. Specifically, we find that a 10% decline in corporate profits over a single quarter would lead to roughly a 1% decline in employment the following quarter. Such a shock can be long lasting, with the full effect not completely dissipating for about three years.

A 10% decline in profits over a single quarter is exceptionally rare. Indeed, such a drop has occurred once since the 1980s, when the financial crisis was at its height in the third quarter of 2008. However, employment has fallen and the economy has slipped into a recession following more modest quarterly drops in profits, particularly when profits declined over a series of quarters. By the time the past three recessions rolled around, corporate profits were down an average of 6% year-over-year.

Profits & Employment: Timing Matters

It is worth noting that wide-scale job cuts do not always follow periods of declining profits. For example, before-tax profits fell from late 1985 to the end of 1986 (Figure 3). That episode, however, was only shortly after the double-dip recessions of the early 1980s, so there had been little time for the economy to build up major imbalances. Moreover, the FOMC was still cutting interest rates from the marked levels that had been used to tame inflation early in the decade, while corporate profit margins were still expanding. Similarly, declining profits from mid-2014 to 2015 were not enough to stop job growth from strengthening over the period (Figure 3 again). There too, however, the economy was still emerging from the prior downturn, corporate margins were expanding and monetary policy was still highly accommodative.

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Recently, the stock market has experienced high levels of volatility. If you are thinking about participating in fast moving markets, please take the time to read the information below. Wells Fargo Investments, LLC will not be restricting trading on fast moving securities, but you should understand that there can be significant additional risks to trading in a fast market. We've tried to outline the issues so you can better understand the potential risks. If you're unsure about the risks of a fast market and how they may affect a particular trade you've considering, you may want to place your trade through a phone agent at 1-800-TRADERS. The agent can explain the difference between market and limit orders and answer any questions you may have about trading in volatile markets. Higher Margin Maintenance Requirements on Volatile Issues The wide swings in intra-day trading have also necessitated higher margin maintenance requirements for certain stocks, specifically Internet, e-commerce and high-tech issues. Due to their high volatility, some of these stocks will have an initial and a maintenance requirement of up to 70%. Stocks are added to this list daily based on market conditions. Please call 1-800-TRADERS to check whether a particular stock has a higher margin maintenance requirement. Please note: this higher margin requirement applies to both new purchases and current holdings. A change in the margin requirement for a current holding may result in a margin maintenance call on your account. Fast Markets A fast market is characterized by heavy trading and highly volatile prices. These markets are often the result of an imbalance of trade orders, for example: all "buys" and no "sells." Many kinds of events can trigger a fast market, for example a highly anticipated Initial Public Offering (IPO), an important company news announcement or an analyst recommendation. Remember, fast market conditions can affect your trades regardless of whether they are placed with an agent, over the internet or on a touch tone telephone system. In Fast Markets service response and account access times may vary due to market conditions, systems performance, and other factors. Potential Risks in a Fast Market "Real-time" Price Quotes May Not be Accurate Prices and trades move so quickly in a fast market that there can be significant price differences between the quotes you receive one moment and the next. Even "real-time quotes" can be far behind what is currently happening in the market. The size of a quote, meaning the number of shares available at a particular price, may change just as quickly. A real-time quote for a fast moving stock may be more indicative of what has already occurred in the market rather than the price you will receive. Your Execution Price and Orders Ahead In a fast market, orders are submitted to market makers and specialists at such a rapid pace, that a backlog builds up which can create significant delays. Market makers may execute orders manually or reduce size guarantees during periods of volatility. When you place a market order, your order is executed on a first-come first-serve basis. This means if there are orders ahead of yours, those orders will be executed first. The execution of orders ahead of yours can significantly affect your execution price. Your submitted market order cannot be changed or cancelled once the stock begins trading. Initial Public Offerings may be Volatile IPOs for some internet, e-commerce and high tech issues may be particularly volatile as they begin to trade in the secondary market. 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Once the order is received, it is executed at the best prices available, depending on how many shares are offered at each price. Volatile markets may cause the market maker to reduce the size of guarantees. This could result in your large order being filled in unexpected smaller blocks and at significantly different prices. For example: an order for 10,000 shares could be filled as 2,500 shares at 5 and 7,500 shares at 10, even though you received a real-time quote indicating that 15,000 shares were available at 5. In this example, the market moved significantly from the time the "real-time" market quote was received and when the order was submitted. Online Trading and Duplicate Orders Because fast markets can cause significant delays in the execution of a trade, you may be tempted to cancel and resubmit your order. Please consider these delays before canceling or changing your market order, and then resubmitting it. There is a chance that your order may have already been executed, but due to delays at the exchange, not yet reported. When you cancel or change and then resubmit a market order in a fast market, you run the risk of having duplicate orders executed. Limit Orders Can Limit Risk A limit order establishes a "buy price" at the maximum you're willing to pay, or a "sell price" at the lowest you are willing to receive. Placing limit orders instead of market orders can reduce your risk of receiving an unexpected execution price. A limit order does not guarantee your order will be executed -" however, it does guarantee you will not pay a higher price than you expected. Telephone and Online Access During Volatile Markets During times of high market volatility, customers may experience delays with the Wells Fargo Online Brokerage web site or longer wait times when calling 1-800-TRADERS. It is possible that losses may be suffered due to difficulty in accessing accounts due to high internet traffic or extended wait times to speak to a telephone agent. Freeriding is Prohibited Freeriding is when you buy a security low and sell it high, during the same trading day, but use the proceeds of its sale to pay for the original purchase of the security. There is no prohibition against day trading, however you must avoid freeriding. To avoid freeriding, the funds for the original purchase of the security must come from a source other than the sale of the security. Freeriding violates Regulation T of the Federal Reserve Board concerning the extension of credit by the broker-dealer (Wells Fargo Investments, LLC) to its customers. The penalty requires that the customer's account be frozen for 90 days. Stop and Stop Limit Orders A stop is an order that becomes a market order once the security has traded through the stop price chosen. You are guaranteed to get an execution. For example, you place an order to buy at a stop of $50 which is above the current price of $45. If the price of the stock moves to or above the $50 stop price, the order becomes a market order and will execute at the current market price. Your trade will be executed above, below or at the $50 stop price. In a fast market, the execution price could be drastically different than the stop price. A "sell stop" is very similar. You own a stock with a current market price of $70 a share. You place a sell stop at $67. If the stock drops to $67 or less, the trade becomes a market order and your trade will be executed above, below or at the $67 stop price. In a fast market, the execution price could be drastically different than the stop price. A stop limit has two major differences from a stop order. With a stop limit, you are not guaranteed to get an execution. If you do get an execution on your trade, you are guaranteed to get your limit price or better. For example, you place an order to sell stock you own at a stop limit of $67. If the stock drops to $67 or less, the trade becomes a limit order and your trade will only be executed at $67 or better. Glossary All or None (AON) A stipulation of a buy or sell order which instructs the broker to either fill the whole order or don't fill it at all; but in the latter case, don't cancel it, as the broker would if the order were filled or killed. Day Order A buy or sell order that automatically expires if it is not executed during that trading session. Fill or Kill An order placed that must immediately be filled in its entirety or, if this is not possible, totally canceled. Good Til Canceled (GTC) An order to buy or sell which remains in effect until it is either executed or canceled (WellsTrade® accounts have set a limit of 60 days, after which we will automatically cancel the order). Immediate or Cancel An order condition that requires all or part of an order to be executed immediately. The part of the order that cannot be executed immediately is canceled. Limit Order An order to buy or sell a stated quantity of a security at a specified price or at a better price (higher for sales or lower for purchases). Maintenance Call A call from a broker demanding the deposit of cash or marginable securities to satisfy Regulation T requirements and/or the House Maintenance Requirement. This may happen when the customer's margin account balance falls below the minimum requirements due to market fluctuations or other activity. Margin Requirement Minimum amount that a client must deposit in the form of cash or eligible securities in a margin account as spelled out in Regulation T of the Federal Reserve Board. Reg. T requires a minimum of $2,000 or 50% of the purchase price of eligible securities bought on margin or 50% of the proceeds of short sales. Market Makers NASD member firms that buy and sell NASDAQ securities, at prices they display in NASDAQ, for their own account. There are currently over 500 firms that act as NASDAQ Market Makers. One of the major differences between the NASDAQ Stock Market and other major markets in the U.S. is NASDAQ's structure of competing Market Makers. Each Market Maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares. Once an order is received, the Market Maker will immediately purchase for or sell from its own inventory, or seek the other side of the trade until it is executed, often in a matter of seconds. Market Order An order to buy or sell a stated amount of a security at the best price available at the time the order is received in the trading marketplace. Specialists Specialist firms are those securities firms which hold seats on national securities exchanges and are charged with maintaining orderly markets in the securities in which they have exclusive franchises. They buy securities from investors who want to sell and sell when investors want to buy. Stop An order that becomes a market order once the security has traded through the designated stop price. Buy stops are entered above the current ask price. If the price moves to or above the stop price, the order becomes a market order and will be executed at the current market price. This price may be higher or lower than the stop price. Sell stops are entered below the current market price. If the price moves to or below the stop price, the order becomes a market order and will be executed at the current market price. Stop Limit An order that becomes a limit order once the security trades at the designated stop price. A stop limit order instructs a broker to buy or sell at a specific price or better, but only after a given stop price has been reached or passed. It is a combination of a stop order and a limit order. These articles are for information and education purposes only. You will need to evaluate the merits and risks associated with relying on any information provided. 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