Beyond Bulls & Bears


PODCAST: Anatomy of a Recession: Plateauing but Strong Economic Activity

While US gross domestic product and earnings growth remain strong, we hear from Jeff Schulze, Investment Strategist at ClearBridge Investments, about three potential economic and market risks for the second half of the year. Plus, if a near-term equity market pullback occurs, learn why it may be a buying opportunity.

Listen to our latest “Talking Markets” podcast. A transcript follows.


Interviewer: Jeff, let’s start with the Recession Risk dashboard. It’s always at the center of your economic outlook. Remind everyone quickly how it works, and what it looks like right now.

Jeff Schulze: Yes. So, the dashboard is 12 economic indicators that run across the three fault lines of the economy. The biggest part of the dashboard is consumer health because it’s the biggest part of the US economy. We look at business activity because businesses are responsible for hiring and doing CapEx [capital expenditures]. And last but not least, we look at financial stresses because usually they’ll emanate first before the economy rolls over. And as of the end of May and continuing on until today, we have a fully green dashboard with all 12 indicators flashing expansion.

Interviewer: Ok. So, if the dashboard all green right now, that sounds like all is well and we are in good shape! But of course, there are always risks—what threats are you focused on that could change things?

Jeff Schulze: Although it is all green, there’s always going to be risk to the economy and markets. And the three that I’ve been focusing on most are the Delta variant, the Fed [Federal Reserve] miscommunication, and then also a hotter-than-expected transitory period of inflation. So, first and foremost, the Delta variant has obviously roiled international markets. You’ve seen shutdowns in the UK and Australia, but also the UK is reopening because the link between cases and hospitalizations has been broken.

But here in the US, over the last two weeks, cases have gone from 15,000 up to 35,000. And this is a number that could see a much stronger rise because close to 45% of the US population is currently unvaccinated. And a lot of these unvaccinated individuals are in social networks that include other unvaccinated individuals, like kids going to school, for example, or people that have similar views on the vaccine. Also, the Delta variant is twice as transmissible as the variant that caused the last spring’s outbreak, which means herd immunity is probably higher than 70%. So, I don’t expect government shutdowns, like we saw obviously a year ago, but there could be some voluntary pullback in economic activity If you do start to see cases rise dramatically.

Interviewer: Certainly, the Delta variant is the big headline related to the pandemic right now, and we’ll have to continue to monitor it and see how it plays out. You also mentioned Fed miscommunication as a threat. Why did you say that and what you mean by that?

Jeff Schulze: At the last FOMC [Federal Open Market Committee] meeting, the Fed acknowledged their tapering discussion, but they also shifted up the median dot plot of their first rate hike in 2023 from zero hikes to two hikes. And while the dot plots shouldn’t matter because the average inflation targeting framework is outcome based rather than forecast-based, the communication really felt more like the Fed of old—the preemptively fighting Fed rather than the start of a new regime. And if you look at bond markets, that’s certainly what they’ve been pricing over the last couple of weeks. Since the FOMC meeting, you’ve seen a big drop in both 10-year and 30-year Treasuries, which signals that the markets think that the Fed is back to its standard approach, of preemptively fighting inflation. So ultimately, I think it was a miscommunication. If you look at the hawkish view of the Fed, it’s a minority. More importantly, the majority is ultimately what is going to be impacting policy decisions, and FOMC leaders Powell and Williams are certainly in the majority. They’re dovish, and I think they’re going to stay committed to the Fed’s framework.

Interviewer: Alright. And then we have inflation as the third potential threat. What’s your take on the most recent US CPI [Consumer Price Index] data?

Jeff Schulze: It came in higher than the highest estimate for CPI, and I think this is going to be a situation that’s with us into the fourth quarter. First off, the inventory situation continues to go from bad to worse. Inventory to sales is close to record lows right now that we saw back in 2011, even though there’s been a desperate effort to restock. Also, if you look at the net share of small business owners raising prices per the NFIB [National Federal of Independent Business] survey, it’s up to 47%. We haven’t seen this level since 1981. Also, services inflation is now bottoming. Shelter inflation is bottoming. These are no longer going to be offsets to goods inflation. So, I think it’s going to be difficult to see the pandemic disruptions resolve themselves by Labor Day [September 6]. I think it’s probably going to be a situation that we find ourselves with towards the end of the year, but ultimately, the longer that we have these higher inflationary prints, you could see some volatility in financial markets.

Interviewer: Expanding on inflation spiking, some argue it’s a bit misleading, with large increases in focused areas, like used cars and gasoline. Does that impact how you look at it?

Jeff Schulze: Well, I think that’s why we’ve seen such a muted market response with CPI. A large portion of it was driven by services and the reopening of the economy—very strong hotel rates, you also saw strong prints from used cars and new cars as well. But I do think that shelter inflation, which is about one third of CPI, is going to continue to rise over the course of the next 15 months because there’s a lagged effect between housing prices and shelter inflation of 15 months. And housing prices started to move up pretty aggressively about 15 months ago in 2020. So, that’s going to act as a persistent tailwind to higher inflation prints even as we move into next year.

Interviewer: So, with those risks in place you have detailed, is economic growth and market performance at a point of “as good as it gets” right now? Or, can things get even better?

Jeff Schulze: Well, it is as good as it gets as far as economic momentum and earnings momentum. So yes, it is as good as it gets, but I think we need to look at this current situation with a different lens. Now, one of my favorite metrics to assessing economic momentum is manufacturing PMI [Purchasing Managers’ Index] because manufacturing PMI leads GDP or economic activity by two quarters. And it’s done an excellent job of foreshadowing peaks and troughs of GDP since 1950. Now, manufacturing PMI hit its cycle high of 64.7 back in February, and there’s a lot of participants that were concerned that we’re going to have a market correction because of this. And the reason why they think that way is that, since the end of World War II, there’s been 36 peaks in manufacturing PMI. And if you exclude the episodes where the manufacturing PMI peak ended in a recession, which is the dynamic I think that we’re in today, the S&P 500 has sold off around these growth peaks of around 8.4% median. So, while it is true that we’ve probably hit the peak GDP this quarter, we hit peak manufacturing PMI back in February, I think it’s important to remember that knowing the macro playbook is very different than fully understanding why these relationships have worked in the past. And the relationship is different this time, because the decelerations that we’re seeing are merely the result of abnormally high growth rates that we saw as we lapped last year’s shutdowns. There’s a very different market implication when manufacturing PMI and consequently GDP are high and stable, rather than high and falling. Put differently, I think that we’re plateauing. We’re going to continue to have strong economic activity. We’re not having the large deceleration that you would normally see at this juncture. So, I think we’ve had this plateauing type of activity, financial markets have been able to push through that and ultimately move higher, and that’s my expectation for the back half of the year.

The other peak obviously is peak earnings. And similarly, it’s one thing to know the macro book. It’s a different thing to understand how the relationships have worked in the past. And peak earnings shouldn’t be interpreted as a negative for stocks because we’re going to have strong economic activity in the back half of the year. And it’s going to help forward earnings projections keep advancing and maybe more importantly, earnings revisions aren’t going to move back persistently into negative territory. Now, two of the biggest considerations that one needs to make when assessing the market’s vulnerability to an earnings peak is the likelihood of a recession and the strength of the earnings growth you’re going to see in the 12 months following that peak. Neither of these are an issue today. A: I think the odds of a double-dip recession are fairly low, and B: earnings growth over the next 12 months is projected to be a very healthy 22%.1 And what we found is, if we looked at all earnings peaks since 1962, when you’ve had earnings growth in that next 12 months above 10%, there’s been a very different market experience when you were below that threshold. So, with all these periods above 10%, your next six-month returns were 4.2%. Your next 12-month returns were 11.2%, which is well above the long-term average. If you’re below that 10% bogey, your next six-month returns were 40 basis points or 0.4%, and your next 12-month returns were 5.4%. So yes, this is as good as it gets as far as earnings and economic momentum, but I don’t think this is going to be a reason for the markets to have a large sell off. It’s going to be much different than what you typically experience at these peaks.

Interviewer: So bottom line your outlook for us, as we move through the second half of the year—what should investors keep a close eye on or be expecting?

Jeff Schulze: Well, even though I don’t think the twin peaks are going to cause a real consolidation in the markets, it’s important to recognize that, if you look at every bear market low since 1967, that this point in the cycle, the market has generally needed to digest those gains for a couple of quarters before resuming its upward trajectory. And although the S&P 500 is trading well above the average where these consolidations have occurred because the market’s up 96% from March lows, I think it’s important to remember the unique nature of this recession. We’ve never seen policymaker support like this, and it’s resulted in minimal structural damage to the economy. If you put that differently, I don’t think that financial markets are poised for a larger-than-usual consolidation if we get one just because we’ve had these robust returns. And in fact, the period of digestion may have already begun because the S&P 500’s upward trajectory has slowed meaningfully since mid-April. So, there may be a little bit more to go with this period.

But ultimately, if we do get some sort of pullback, and we haven’t had a 5% correction since October of last year—so nine months ago—I think it’s a buy-the-dip type of moment. The reason why I say that is because, if you look at the Conference Board’s Leading Economic Index, LEI for short, it’s a group of 10 sub-components, that have traditionally foreshadowed economic activity. One of those sub-components is the stock market. There’s a number of those sub-components that are in the Recession Risk Dashboard, like jobless claims, like credit spreads, like housing permits. But when you look at this LEI index, and LEI’s have been up 7% on a year-over-year basis, you’re in the top decile or top 10% of observations. When you’re in this top decile, your next six-month returns have been positive 82% of the time, but maybe more importantly, your next six-month returns, on average, have been a very robust 7.5%. On an annualized basis, that’s 15%. So, although LEI’s have slowed a little bit in the most recent print that we have, it’s still at a very, very robust 14.7%, which is basically double the threshold on what you need to get to be in this top decile.

The other reason why I think people should remain positive if we have some sort of consolidation, is that since 1949, if you look at the second year following every bear market, your average return during that second year is 12.6%. The markets are positive 100% of the time. When you isolate just the bear markets, where the market sold off 30% or greater, which is the period that we find ourselves in today, your average return in that second year has been a very robust 17.1%. And although the markets are up since March of 2021, this would suggest that there’s a lot more upside as we move through the next nine months. So, if we do get some sort of consolidation, which wouldn’t be uncommon at this point in the cycle, I think it’s a buy-the-dip moment for long-term investors.

Interviewer: Great insights, as always, Jeff. That’s Jeff Schulze, Investment Strategist with ClearBridge Investments and also the author of Anatomy of a Recession. You can get more of Jeff’s thoughts and check out the full Anatomy of a Recession program at Jeff, thank you for joining us.

Jeff Schulze: Thank you. 

Host: And thank you for listening. If you’d like to hear more Talking Markets with Franklin Templeton, visit our archive of previous episodes and subscribe on iTunes, Google Play, Spotify, or just about any other major podcast provider. And we hope you’ll join us next time, when we uncover more insights from our on the ground investment professionals.

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