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How Rising Profits Could Prevent the Economy From Faltering

Profits have been making a comeback. That makes a comedown for the U.S. economy seem less likely.

The Commerce Department on Wednesday reported that before-tax corporate profits rose 1.1% from a year earlier in the third quarter. This compares with a decline of 6% in the second quarter. Moreover, that profit figure includes the income of Federal Reserve banks, which have lately been losing money owing to the combination of their big holdings of Treasury and mortgage securities and the sharp increase in rates. Exclude the Fed, and corporate profits rose by 6.7% in the third quarter compared with a gain of 1.6% in the second.

The profit rebound has been more than evident at big public companies, too. With most results in, earnings per share at companies in the S&P 500 look to have risen 7.1% in the third quarter from a year earlier, according to London Stock Exchange Group, after slipping 2.8% in the second. The profit gains look likely to continue: Analysts, whose estimates tend to be too dour this far along into a quarter, expect S&P 500 earnings to grow by 5.2% in the fourth quarter.

The rebound in profits might matter a lot not just for the stock market but also for the economy. That is because available Commerce Department data back to the late 1940s show that by the time corporate profits are growing again after a decline, a recession is either well under way or has just come to a close—or there was no recession at all. An exception was in 1990, when the shock of the first Gulf War coupled with the continuing savings & loan crisis helped push the U.S. into a downturn even as profits recovered.

The reason an economy that isn’t already in recession tends not to drop into one during a profits recovery probably owes something to employment: Companies that are watching earnings rise again aren’t all that eager to fire people, so the job market stays healthy and consumers don’t retrench. This is particularly true of more cyclical industries—such as manufacturing—that often drive profit, and economic, cycles.

Moreover, because once profits start growing again they tend to keep growing for a while, the economy maintains its footing and recession risks fade.

Of course, just because profits are growing doesn’t preclude a recession next year: Putting complete faith in a one-factor prediction for something as complex as the U.S. economy is perilous, especially in light of all the continuing distortions the pandemic introduced. Consider those forecasters who have been calling for a recession ever since the yield on the 10-year Treasury note slipped below the 2-year yield in July 2022—the dreaded yield curve inversion—for example.

What the profits recovery does do, however, is boost the chances that a recession doesn’t happen. Almost any hand can lose, but it helps that the economy has been dealt an ace.

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