Beyond Bulls & Bears


PODCAST: Anatomy of a Recession: Looking Ahead to 2022

In our latest “Talking Markets” podcast, we hear from Jeff Schulze, Investment Strategist at ClearBridge Investments, about the Federal Reserve’s timetable for tightening, slow growth, the COVID-19 Delta variant, and the resilience of the US consumer. He explains how all of these variants are factored into determining the risk of recession along with the investment implications.


Interviewer: Jeff, let’s start with the dashboard, which gives us a foundation of your economic outlook. Remind us, as always, how it works. And then most importantly, what it looks like right now?

Jeff Schulze: Well, the ClearBridge Recession Risk Dashboard is a group of 12 variables that have done an excellent job of being able to foreshadow an upcoming recession. It’s a stoplight analogy, meaning green is expansion, yellow is caution and red is recession. And since the end of June, we have an entirely green dashboard, which is a pretty rare occurrence, but maybe more importantly, even with the slowdown that we’ve seen here recently because of Delta, these are still some of the strongest outputs that we’ve seen in the model’s history, going back to the early 1960s.1 So, recession risk right now is pretty low.

Interviewer: Recession risk may be low, but we’ve seen some pretty significant changes since your update last quarter. At the beginning of Q3, we were talking about some projecting upwards of 6% US GDP [gross domestic product] growth. Now, we’ve got projections as low as just over 1%. How concerned are you about deceleration?

Jeff Schulze: Yeah, you’ve seen a huge drop in the Atlanta Fed’s GDP nowcasting tool, but it’s important to note that in economists’ forecasts, even though they’ve dropped, they’re still optimistic at 5%. So, I think GDP will probably come somewhere in the middle, probably closer to the 5% level than 1.3%, but you’re starting to see clear signs of reacceleration. What I like to look at is the Citigroup Economic Surprise Index.2 It looks to see how much the economic data is beating or missing consensus expectations. And that’s been moving up fairly aggressively over the last three weeks from a lot of the soft data beating to the upside, but also some strength in housing and some of the consumer stats as well. The one that gets me most optimistic is the Manufacturing PMI [Purchasing Managers’ Index]. It came in at a very healthy 61.1 level [in September]. This usually leads GDP by two quarters, and it does tell me that you’re going to continue to have strong economic activity in the tail half of this year—61 is usually consistent with real GDP growth around 6% overall.

Looking out to 2022 though, I’m more optimistic than consensus for a couple of reasons. First off is the consumer. The consumer remains very well-supported. [US] Household net worth right now is at US$141.9 trillion. That’s a combination of around US$2.5 trillion dollars of excess savings, record home prices and very robust financial markets. So, this certainly has the ability to keep consumption above trend over the next couple of years. Also, I liked the fact that we have record [US] job openings right now with 10.9 million of them; in September, about 8.5 million people lost their federal unemployment benefits. That combination, I think, is a very strong combination for job creation as we go into the fourth quarter, and also, you have very strong wage growth. You have almost record hours worked per week. If you think about the strongest report for consumption, it’s compensation, and compensation continues to be very well-supported.

The other part of the equation is business investment. Businesses are going to be restocking their inventories very aggressively over the next six quarters. That’s going to be a tailwind to GDP growth. And also, I think businesses are going to embark on a very strong CapEx [capital expenditure] cycle because, for the first time in a long time, you have not only strong US demand, but as the global consumer comes and reaches herd immunity, there’s US$5 trillion of excess savings around the world that can be spent and create a very strong demand backdrop. And the other thing that’s going to really drive CapEx, at least over the next 15 months, is that 100% expensing of capital equipment is going to expire at the end of next year, so a lot of corporate managers are going to throw the kitchen sink in and do all of their CapEx over the next 15 months.

But looking out to 2022, we’re in the final stage of reopening, people are going back to work. Kids are going back to in-person learning. You’re going to have much more interaction with the services side of the economy and entertainment. And the US, quite frankly, has learned to deal and live with the virus. And one of the things that I’m really optimistic about is the positive clinical trials from the Merck antiviral pill, which shows to dramatically reduce hospitalizations without negative side effects. So, I think even though we’ve had a couple of disruptions because of COVID this year, I think next year is going to be much smoother sailing.

Interviewer: Ok, you touched on a lot there, including the consumer. Let’s talk more about that. Consumer sentiment has dramatically shifted downward in recent months. Could this drop be a bad omen for the economy and markets?

Jeff SchulzeIt can be. Before every recession, you always see a sustained drop of consumer sentiment or confidence. But when you’re in the middle of a new expansion and you see a large drop of confidence, it’s actually usually a buying opportunity. What we found as we looked at the Conference Board’s Consumer Confidence index, and when you’ve had a drop of this magnitude or greater in a non-recessionary environment, there’s been six of them since the late 1970s, your next 12-month returns in the S&P 500 [Index] have been 15.3%.3 And it’s understandable why consumers are not confident right now. Obviously, you’ve had the Delta-related disruptions. You’ve seen this large deceleration of economic activity, but also consumers are the least optimistic on buying a house and a car since 1982, given the price increases that we’ve seen. But if you look at some of the confidence surveys here recently, it does appear that they’ve stabilized. And again, as we re-accelerate out of this Delta-related disruption, I think consumer confidence is going to become more buoyant and you’re going to see some stronger spending numbers.

Interviewer: Alright, let’s talk about the ongoing supply chain bottlenecks and labor shortages. Several companies have pre-announced Q3 earnings misses due to these issues. So, what’s your latest view on inflation? Is it transitory or more sustained, and is stagflation a possibility?

Jeff Schulze: Well, anything is always a possibility, but I think stagflation is a very low probability. If you look at the pre-announcements so far for third-quarter earnings, there’s a lot of companies that are talking about broader supply chain bottlenecks, some labor shortages. I think a lot of companies are going to kitchen sink this quarter because of those issues, but looking out over the next six months, a lot of the disruptions that we have are really from labor, shipping and COVID. Those three are all going to ease in the coming quarters. As I mentioned, if you look in Asia, 11 out of the 12 largest countries are expected to reach herd immunity by the end of the fourth quarter. That should go a long way to alleviating some of the bottlenecks that you have over in Asia. You also have kids going back to school, so parents that are home because of that unique school schedule that we had last year should transition back into the labor market. And then also, people that are scared of getting COVID will likely start to transition once we get past this peak of COVID, and we get down to more manageable levels. So, I think all of these bottlenecks are starting to alleviate themselves, and I think, as we get into the early part of 2022, it’s going to become clear that this is indeed transitory, even though you could have some acute bottlenecks still in areas like microchips.

Interviewer: Now recently, Jeff, we’ve seen a lot of market volatility. I know when we spoke last quarter, you highlighted how new bull markets generally experience a consolidation around this point in the cycle. So, we finally experienced the first 5% [stock market] correction in almost a year. Do you feel like we’re in for more volatility?

Jeff Schulze: Well, unfortunately the streak of 226 trading days without a 5% correction is over. It was the seventh longest in history and the next milestone would be a 10% correction. And while it’s been a year and a half since we’ve experienced one, the US has gone stretches of upwards of seven years without having a 10% correction in the past. So, it’s not necessarily a forgone conclusion. There are several headwinds that we need to deal with in the near term, before we get through this period of volatility. The first one is third-quarter earnings. Obviously, with this huge deceleration of economic activity and companies talking about supply chain bottlenecks and labor shortages, this could be a disappointing quarter after seeing record earnings surprises, really since the COVID recession had ended last year, I think earnings will still continue to beat, but it may not be at the same level, and it’s not clear whether or not investors are going to look through this quarter because of the COVID-related disruptions, or they’re going to punish companies that miss to the downside.

The other headwind is higher corporate taxes. If corporate taxes go to 25%, foreign income taxes go to 16.5%, that’s probably going to shave about US$9 off of 2022 earnings, which will be a headwind of around 4%-5% overall for the S&P 500 Index. You also have higher 10-year Treasuries, Fed liftoff, and also again, potential margin compression from inflation that we talked about earlier. So, no shortage of headwinds to deal with as we move through the fourth quarter, but a lot of the damage may have already been done with the correction that we’ve seen. The average stock has corrected a lot more than the overall indices. If you’re looking at the overall indices, they’ve gone down anywhere from 5%-6%, but the average stock, for example, in the S&P 500 is down 20.7%. So, it’s officially in bear market territory. If you look at the Russell 2000 [Index], it’s down 44%. Looking at it from a different vantage point, 71% of the S&P 500 [Index] has already experienced a 10% drawdown while 75% of the Russell 2000 has gone into a bear market. So, the fact that you’ve had these rolling corrections happening over the last couple of quarters could prove a bit of a cushion for the headline indices, and it really does lessen the chances of a substantially worse decline from current levels.

There’s a couple of other reasons to be positive. Even though the headline [US] indices were only down around 5%, you’ve seen a pretty big reset in retail sentiment. One of my favorite gauges to understand sentiment is the American Association of Individual Investors, better known as the AAII. It’s been tracked since 1987. And you like to look at the spread between bullish and bearish participants, and the most recent reading was -11. You haven’t seen these readings since we were back in the COVID-related recession and its aftermath. So, this tends to be a contra-indicator. Usually when you see a lot of bearishness, that means you’re probably closer to a bottom than at the beginning of a new selloff. When it’s very positive, you’re probably closer to an actual correction. And the fact that there is a lot of negativity already embedded into markets, I think is a good indication that we may be further along through this correction than people think.

And maybe the last thing I’ll mention here, what’s really going to dictate how deep this correction gets is whether or not the retail put comes back into play. Global equities have seen US$756 billion in inflows this year, and to put that number in perspective, through the years of 1996 through the year 2020, so the last 25 years, you’ve only seen US$179 billion worth of inflows. So, we’ve seen four times the inflows this year than the last 25 years combined. So, if the retail investors buy the dip, we may have already seen the bottom in equity markets so far.

Interviewer: Another key factor, obviously, is the potential moves by the Fed, which has signaled the possibility the tightening cycle could start with a November taper announcement. On top of that, fiscal stimulus as a percent of GDP will be over 8% lower next year. So how big of a deal is it that peak stimulus, monetary and fiscal, is likely in the rearview mirror?

Jeff Schulze: Yeah. So, in the latest long view that we just released, that we talked about the peak and peaks, obviously the two peaks that people are talking about today is peak fiscal stimulus and peak monetary stimulus. 8% less as a percent of GDP and stimulus is around $1.8 trillion. So, it’s a massive number, but again, given all those positive dynamics that I talked about earlier, the support for the consumer, very strong job creation, wage growth, hours worked, that’s really going to support the economy coupled with stronger business investment in 2022 and provide that offset to the stimulus measures that we’ve seen over the last couple of years.

In regard to peak monetary stimulus, I think it’s important to recognize that, although the Fed is likely starting its tightening cycle, it’s starting its tightening cycle way later than it has in previous cycles. And one of the ways to gauge this is by looking at the U-6, or the underemployment rate. This includes part-time and marginally attached workers, and today it currently stands at 8.5%. When we started the taper back in 2013, it was at 13.1%. When we started the rate hike cycle 1994, it was 11.4%. And when we started it in 2004, it was 9.6%. So, the Fed is behind the curve, if you will, compared to those other timeframes, and given the Fed’s new inflation framework, the Fed is purposely going to be behind the curve. It’s going to let the economy run hot, and let’s not forget, if you look at the US projections, by the end of the fourth quarter, the US is the only country that’s going to be above its pre-pandemic growth pace. And if you have a very accommodative Fed still, even though we are embarking on a tightening cycle on the beginning of tapering, I think that’s a really good concoction for continued equity gains.

Interviewer: A lot to consider, Jeff—we appreciate you taking us through it all. 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

Host: And 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.

This material reflects the analysis and opinions of the speakers as of October 8, 2021 and may differ from the opinions of portfolio managers, investment teams or platforms at Franklin Templeton. It is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.

The views expressed are those of the speakers and the comments, opinions and analyses are rendered as of the date of this podcast and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, security or strategy. Statements of fact are from sources considered reliable, but no representation or warranty is made as to their completeness or accuracy.

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1. There is no assurance any estimate, forecast or projection will be realized.

2. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.

3. Indexes are unmanaged and one cannot directly invest in them. They do not include fees, expenses or sales charges. Past performance is not an indicator or a guarantee of future results.

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