Host: Jeff, we’re seeing some deterioration in the Recession Risk dashboard. Remind everyone how the dashboard works, and what’s been transpiring of late?
Jeff Schulze: Well, the ClearBridge Recession Risk dashboard is a group of 12 variables that identify inflection points for the US economy. You’ve seen the dashboard deteriorate quite a bit from the second quarter. And in the month of June alone, you saw three indicator changes with credit spreads moving from yellow to red, retail sales and manufacturing PMI [Purchasing Managers Index] new orders moving from green to yellow. Coming into the second quarter, you had only had two indicators that were indicating caution or recession. Fast forward to today, moving into the third quarter, you have half the dashboard indicating caution or recession. But with the dashboard being a stoplight analogy, we have six green, four yellow and two red signals, but for now we continue to flash an overall green signal. But as the economy deteriorates over the next quarter, we’re fully anticipating an overall signal to turn to yellow, but we’re not there quite yet.
Host: So it sounds like you’re expecting economic conditions to worsen. Some actually say we are already in a recession, is that true?
Jeff Schulze: Well with first quarter US GDP [gross domestic product] growth contracting by 1.6% and second quarter GDP estimates from the Atlanta Fed’s Nowcasting tool now firmly in negative territory, it’s important to address a common misperception about what exactly is a recession.
Now, contrary to popular belief, a recession is not defined simply as two consecutive quarters of negative real GDP growth. Instead, the official arbiter of US business cycles, the National Bureau of Economic Research, better known as the NBER, defines a recession as a significant decline in economic activity, spread across the economy, lasting more than a few months, normally visible in things like real GDP, real income, employment, industrial production and wholesale retail sales. And despite the negative GDP print that we had in the first quarter, many of the indicators that the NBER uses to evaluate the state of the economy remains healthy. For example, personal incomes and payrolls are still at peak levels. So, although people think that we are embarking on a potential recession, this will not be looked at as a recession, at least not at this point.
Host: Ok, so we are not there, at least not yet—but it certainly seems like we have a lot of growing concerns.
Jeff Schulze: The risks of recession are continuing to elevate. In the middle of last month, we updated our recession odds to 55% over the next 18 months. So, recession is now our base case. And the reason for that dramatic shift in expectations comes back to the [US] Federal Reserve. In June, the Federal Reserve [Fed] got two negative data points, which changed their perspective in the trajectory of their monetary tightening. CPI [consumer price index] came in hotter than anticipated, and it continues to accelerate to the upside. But I think more importantly, there’s the potential for an unanchoring of inflation expectations. And this is something that the Fed does not take lightly because, once inflation expectations start to move to the upside, it’s very hard to put the inflation genie back in the bottle. And Fed Chair J. Powell has discussed an unconditional commitment to bringing inflation back down to the 2% target and has implied a willingness to accept higher unemployment in order to restore price stability.
Now, if you look at fed fund futures pricing, or the Fed’s dot plots, the Fed expects to raise the fed funds rate by 3.4% in the first year of this tightening cycle. And if that comes to fruition, going all the way back to 1955, this would be the second fastest tightening to start a tightening cycle that you’ve seen, only trailing 1980, when then Fed Chair Paul Volker broke the back of inflation. And by going from zero to close to 3.5% on the fed funds rate in a year, that is a lot of monetary tightening in a short period of time. And because monetary tightening acts with a lag, there’s a high degree of a Fed policy error by over-tightening and not being able to give the economy liquidity, if we start to see a deceleration from here. So that’s a reason why we think recession odds are our base case at the moment.
Host: So Jeff, I guess the question now is—is a recession even avoidable at this point? Is that “soft landing” commonly referenced still possible?
Jeff Schulze: Although engineering a “soft landing” is no easy feat, it’s not impossible. If you look at these last 13 primary tightening cycles since 1955, you’ve seen three “soft landings”: in 1966, 1984 and 1994. And when evaluating those periods, each one of them had a healthy labor market. And given the fact that you still have strong labor market growth here in the US today, that leads us to a path for a potential “soft landing” for the Fed, but there are some other avenues that we could potentially see. First off, inflation may start to moderate, and energy prices may stabilize, allowing the Fed to pivot from that hawkish path that is currently priced by the markets. Secondly, the consumer could prove very decisive in determining the fate of this economic cycle. And although consumers are dipping into their savings and they’re starting to borrow a little bit more from credit card debt, this is coming from a position of strength. Household net worth is up over $32 trillion compared to the end of 2019. And maybe more importantly, household leverage is at levels last seen back in the early 1970s. So, if you put this differently, maybe consumers are less interest-rate sensitive than what we’ve seen over the past three or four cycles. But I think the final path to a “soft landing” comes from businesses. And the fact that margin pressures have remained somewhat limited to this point and may not induce a full-scale layoff cycle. Now, businesses typically resort to cost-cutting before reducing their head counts. And you usually see head counts reduced when you see margin compression, you see cash burn and you see balance sheets deteriorate. But if you think about businesses today, balance sheets are in really good positions, and they’re flush with cash, but maybe more importantly, the scarcest commodity of this cycle is labor, and businesses may be reluctant to let go of their staff given how difficult it has been to hire in the first place. So, looking at it from a margin perspective, historically, it’s taken about three years from corporations to see peak margins for a recession to begin, and margins just peaked about two quarters ago. So, I think the fate of this “soft landing,” a lot of it depends on whether or not businesses are going to let go of their employees. And by looking at initial jobless claims, yes, you’ve seen them tick up from 53-year lows, but they seem to be stabilizing in this low to mid-200,000 range, which bodes well for a potential “soft landing.”
Host: Ok, a few scenarios there to support the possibility of a “soft landing.” With those possibilities and the in-depth economic data you’ve given us, what does it all mean for investors and markets?
Jeff Schulze: The key question for market participants from here is whether all of the bad news is already priced in, providing the foundation for a potential durable bottom. And history suggests that further digestion may be needed in order for the markets to see some sustained upside from here. Now, this bear market has run for six months. Investors have seen a decline of over 23%, and while this has felt severe, historically, bear markets tend to last 16 months and see a 35% drawdown, on average, with recessionary periods faring worse than non-recessionary periods.
But conceptually, most bear markets have two components. You have multiple adjustments, where P/E [price-to-earnings] ratios come down, and then it’s followed by earnings contraction. And all of the selloff that you’ve seen so far here year-to-date has been from multiple contraction, and we think that earnings estimates for the next 12 to 24 months need to come down to reflect this slower growth and potentially recessionary environment. So, we think that there’s a pretty strong likelihood that we will see a lower low in financial markets over the next six months as this reality is priced. However, we think that this is a good opportunity for investors to start thinking about equities from a long-term perspective, because, historically when you’ve entered into bear market territory, over the last 80 years with all bear markets, although equities have fallen an additional 15.6% from when you entered into that bear market, if you bought the market at that point, looking out 12 months, you would’ve been up 11.8%, on average, over the next 12 months. So, it’s impossible to time the bottom when you’re going through a bear market, and given the fact that bear markets are a rare occurrence, again, we think this may be a good opportunity for longer-term and patient investors.
Host: Jeff, so much data to consider, and as always, we thank you for putting it all in perspective and appreciate you joining us on Talking Markets.
Jeff Schulze: Thank you.
Host: 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 Franklintempleton.com. 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.
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