A "storm brewing" in the US corporate sector, says BNP Paribas
BNP Paribas' Paul Mortimer-Lee says there is a "storm brewing" in the US economy; everyone has been lulled into a sense of complacency by strong jobs growth and solid consumption, and not noticed that the real breakdown in the US economy has been coming from the corporate sector. He argues that the drop in profits in the corporate sector historically pinpoints a recession, with in this case, the stagnant inflation reflecting the inability of US firms to be able to increase prices to the level required to maintain profits, while at the same time labour costs continue to rise. Mortimer, in his report 'US Growth: Storm Brewing', predicts the risk of a US recession over the next 12 months is now between 40-50%.

Lightning flashes behind an air traffic control tower at McCarran International Airport. Ethan Miller/Getty Images

It could get ugly in the US economy before long.

While everyone has been distracted by the strong labor market and the decent consumption, the real breakdown in the US economy has been coming from the corporate sector, which is what Paul Mortimer-Lee of BNP Paribas argues in a note titled "US Growth: Storm Brewing?"

"Why have so many, including the Fed, not seen the risks that now appear all too concrete?" asked Mortimer-Lee, chief US economist at BNP.

"The answer is that they have been looking in the wrong direction, lulled into a sense of complacency by strong jobs growth and solid consumption. What this view has overlooked is that the threat of recession comes from the corporate sector."

According to Mortimer-Lee, the drop in profits in the corporate sector typically presages a recession. In this case, the stagnant inflation has reflected an inability of US companies to increase prices to the level necessary to maintain profits while labor costs have been rising.

Said another way, companies are paying employees more, and they can't hike prices to keep up with the rising cost. Thus, profits fall. This increase, according to Mortimer-Lee, is strikingly like the lead-in to the 2001 recession, which was preceded by a drop in corporate profits.

"We believe that in an economy with a significant profit-oriented private sector, the rate of profit and its dynamic is a key determinant of the business cycle," Mortimer-Lee wrote.

"While some have argued that cycles don’t die of old age, declining rates of profitability are often a sign that the economy is very sick, no matter what the age of the recovery."

The argument on this leading to a recession is one that we've noted before. Corporations respond to falling profits by cutting capital expenditures and investments in their businesses. If you're not building new things, there is no need for new workers, so hiring slows and workers begin to conserve their income. Consumption falls, and the whole thing tumbles down.

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"But capex has been weak recently. Oil investment plays a part, of course, but the bigger picture seems to us to be that previously weaker corporate profitability as a share of GDP is beginning to feed into weaker capex with a lag," Mortimer-Lee wrote. "Frequently, such episodes do not end well."

Add that the stock market stumbles last August and at the beginning of the year have made companies warier of financial conditions and you've got a worrying number of clouds on the horizon.

Thus, Mortimer-Lee projects that the risk of recession over the next 12 months is somewhere between 40% and 50%, depending on how terrible the incoming labor market data looks. This isn't a majority, and thus not the most likely outcomes, but the likelihood is certainly spiking in an uncomfortable direction.

"We will need to hang on to our hats, because it’s going to be a bumpy ride," Mortimer-Lee wrote. "The risk of recession is rising, though this is not currently our central case."