Beyond Bulls & Bears


Anatomy of a Recession: The Fed’s job problem

A review of the US economy with focus on the Federal Reserve (Fed), labor and housing with Jeff Schulze, investment strategist at ClearBridge Investments.  


Host: Welcome, Jeff, and thank you for joining us today.

Jeff Schulze:  Great to be here.

Host: Jeff, I can’t believe it’s February already. The new year has really started to move with such pace and capital markets have been quite interesting already. Equity markets have been roaring with the S&P 500 and the NASDAQ indexes up approximately eight and 15%, respectively, year to date. This has been also a very big week on the economic front.

On Wednesday, the Fed took the step of further tightening, increasing the fed funds rate 25 basis points. And this morning, the employment report seemed to be, well, outstanding. So let’s start there with your view on this morning’s job report.

Jeff Schulze:  Well, I think the jobs report was a blockbuster report from an economic perspective, but not so much from the Fed’s vantage point. It’s clear that the labor market is continuing to accelerate, even with the Fed hiking 4.5% over the last year. So clearly, the job is not done. And I think this puts a bias to higher interest rates and more hikes than what the markets are currently pricing.

Now, looking within that report, one of the more interesting things is the huge revisions that you saw on the second half of 2022’s numbers. Instead of a job market that was decelerating, you’re seeing a pretty firm backdrop. And maybe to put some numbers around it: Over the last six months, you’ve seen average job creation of around 377,000 jobs per month.

When you compare that to the last time you saw sub 4% unemployment, at the tail end of last cycle, there was a job creation of around 156,000 per month. So today we’re seeing 2.5 times that job creation. So while it was a very strong print overall, I’ve got to think that it makes the Fed a little bit uncomfortable with where the fed funds rate is now. And I think the bias is clearly to the upside for more hikes.

Host:  So, was there anything else in that report maybe underneath that you thought could have some type of impact here?

Jeff Schulze: Well, those in the soft-landing camp or you know, kind of the bullish camp, will point to average hourly earnings and the fact that they were stable. You know, even with this robust jobs print, they didn’t re-accelerate. But, if you look at other measures of wage growth, whether it’s the Atlanta Fed’s wage tracker or the Employment Cost Index, yes, they’re down from peak, but they’re still very elevated and not consistent with the 2% inflation target that the Fed is looking to hit.

Maybe more importantly, when you talk about average hourly earnings, there’s a mix shift issue. And what I mean by that is that a large portion of the job creation that happened in January was from hospitality and leisure, about 25% of it. But that area is only about 11% of total employment, and this is typically a lower-paying sector. So when you add a lot of low wage jobs into the mix, it pulls down the average, just the way that this is calculated. So this may be a number that’s a little bit lower than what it should be. But I think maybe more importantly, that’s only one half of the equation from the Fed’s vantage point. You also need to look at how many more hours somebody’s worked this week than last week. And the average work week jumped substantially.

Now, there’s a way to measure this. It’s called aggregate weekly payrolls. It combines not only wages, but hours worked. So it’s take-home pay. And there’s a very strong relationship with this measure and consumption. And the jump that we saw this month compared to last was the biggest increase that you’ve seen since August of 2020. So this means that the consumer is probably going to be very strong in the first half of this year, really keeps their foot on the fire from an inflation standpoint. It means that the Fed still needs to press on the economic break.

Host: Jeff, as I think about it, you began to identify this increased probability of a recession in the middle of the summer last year. And as the year has started, you have remarked that your belief is that a recession is in the cards here with a 75% probability. Does any of this detail change that view?

Jeff Schulze: Well yeah, we were calling for the dreaded R word well before it was fashionable to do so. And yes, we still believe 75% probability of a recession. Look, tremendous jobs number. But if you look at other facets of the economy, you’re seeing some pretty broad-based weakness. Take manufacturing PMI [Purchasing Managers’ Index], for example. It continues to decline. The new orders component, which is part of our proprietary dashboard, fell to 42.5. You saw weakness in industrial production. You saw it in retail sales. You’re really seeing areas of the economy decline. It just continues to be a story about labor market as the last domino to fall. And given the fact that leading economic indicators from the Conference Board, you’ve seen 10 straight months of declines in that index. Usually when you get four months of declines, you’ve hit a recession. Ten months, you’ve always had a recession. And the fact that on a year-over-year basis, it’s at -6% in that survey. And the deepest that you’ve seen the decline there before recession hit was -5.7% ahead of the 1980 recession. I think that the recessionary cake is baked here. Whether the Fed does one hike, two hikes, three hikes, I think we’re going to come to that reality as we move through this year.

Host:  Okay. So recession is definitely any cards, in your view. A lot of folks have been talking about a shallow recession when it finally comes. Do you have any thoughts there relative to the depth?

Jeff Schulze:  I would say that we’re not in consensus in that regard, in the fact that on a scale of 1 to 10, I think most people think a one or two type of recession is going to come. Very, very mild. I’m more in the camp that a four or five recession is going to transpire, and it really comes back to a Fed’s reaction function that’s going to be severely delayed compared to history.

Now, the Fed knows that they need to create labor market slack or else they’re going to repeat the sins of the late 1960s when that FOMC [Federal Open Market Committee] cut rates into a very tight labor market. And after that transpired, you saw almost a doubling of core CPI [Consumer Price Index] over the next three years. And that really laid the foundation to the higher structural inflationary 1970s. So the Fed recognizes this. They need a labor market that’s not as tight. They need to create some slack. And in looking at their dot plots, their expectations for unemployment at the end of this year, they’re projecting the equivalent of almost 2 million job losses throughout 2023. Now, what’s unique about this is that usually the Fed anticipates job losses and they usually cut as the job market is transitioning from job creation to job loss.

And then 12 months later, on average, after that first rate cut, you see close to 800,000 job losses. What’s different today is that the Fed is projecting that they’re going to see 2 million job losses. And not only are they not cutting, they’re going to be actively raising into this environment. So you’re going to have a delayed reaction function from the Fed, liquidity coming later. And I think that amplifies the recession risk to make it more of a medium recession rather than something that’s shallow.

Host: Wow, 2 million job losses. That’s a stunning number, but it certainly gives a pause here for a different type of perspective. I mean, Jeff, in your previous comment, you mentioned the ClearBridge Recession Risk Dashboard and can you just remind our listeners what you’re tracking and how you are tracking the economy with that dashboard?

Jeff Schulze:  Yeah, it’s our proprietary recession dashboard. It’s a group of 12 variables that have historically foreshadowed an economic downturn. And it’s a stoplight analogy where green is expansion, yellow is caution, and red is recession. And we went from green at the end of June to red at the end of August. A very fast transition, historically speaking. And since that shallow red August, we find ourselves in deep red recessionary territory. And that’s with, of course, not the full effects of the Fed tightening cycle hitting the economy quite yet and more hikes likely to come.

Host:  Okay, so recession territory. With your most recent update, that’s a monthly update that you make. So with a January 31st update, have there been any changes? 

Jeff Schulze:  Well, there has. You saw housing permits move from yellow to red. So it’s one of, was one of four signals that weren’t red yet. And it shouldn’t be a surprise. Permits are down nearly 30% from their peak one year ago. So we’ve been flirting with red territory for the last month or two, but we finally have moved it to a formal red signal. And of course, housing is the most interest rate sensitive part of the economy, so this really shouldn’t be a surprise.

Host:  Okay. Housing permits moving in the wrong direction. It kind of puts a thought in my head here relative to the great financial crisis and the impact that the housing market had in that scenario. Do you have similar concerns here in 2023?

Jeff Schulze:  Yes, I have concerns that the housing market is going to affect the economy in a negative fashion. But I think there’s a lot more differences than similarities. Thinking about borrowers, back during the run up to the global financial crisis [GFC], about 50% of homebuyers were using adjustable-rate mortgages or ARMs. Today given how low interest rates were, 13.5% of individuals have ARMs.

So even though higher mortgage rates may dissuade new buyers from coming into the market, the impact on actual mortgage payments for a vast majority of Americans is blunted compared to the hiking cycle that you saw back in 2004 into 2006. The other thing that’s different is quality of the mortgages that were originated. Over the past five years, over 80% of mortgages went to super prime borrowers. Those are individuals with credit scores north of 720.1 And only a couple of percentage points of mortgages went to subprime borrowers. That’s a stark contrast to the GFC, where you had 10% of borrowers that were subprime, less than 60% super prime. So you’re not going to see this forced liquidation, this forced selling that depressed prices a lot more fifteen years ago than what I’m anticipating over the next year or two. The last thing I’ll mention is that housing completions were at their highest level since 2007 last fall, and it’s likely that this year we’re probably going to see the highest number of new multifamily units come into the market in several decades. So you’ve actually seen strong gains, believe it or not, in construction jobs, which is kind of at odds with the weakness that you’ve seen with housing, generally speaking.

But as that backlog of projects clears out, I think we’re going to see that typical layoff in construction this spring. And you know, some of this economic pain that you usually feel in housing is going to start to feed into lower economic activity. But in short, yes, there’s some similarities, but I don’t think you’re going to see as negative of an impulse to the economy from housing as we did back in the aftermath of 2008.

Host: Okay. So housing permits moving from yellow to red. Are there any other indicators on that dashboard that you are concerned about or focused on as we move forward here in the new month?

Jeff Schulze:  Yes. So there’s only three that aren’t red at this point. Truck shipments, job sentiment, and also initial jobless claims. The ones that I think could turn over the next couple of months are truck shipments from green to yellow or job sentiment from yellow to red. They are on the line there of a potential move. But again, I think that we’ll probably see a fully red dashboard sometime in the first half of 2023. Now, interestingly, you may actually see credit spreads move back to yellow, given the strength that you’ve seen in the markets. But again, as recession is fully priced, I would imagine that will probably move back to red if you do see a positive color change there.

Host:  Okay. So we know in our last conversation you had stated that you really expect, you know, fairly choppy capital markets here for, whether it’s the first half of ’23 or the entire year. And I think you also stated that you didn’t think that we had seen that equity market bottom yet. Do you still feel that way? Is that your view currently?

Jeff Schulze:  It is. if you think about the rally that we’ve seen here in 2023, it’s really been more of a sentiment rally than a fundamental rally. If you look at this earnings season, you’ve seen clear margin deterioration. You’ve actually seen stocks rallying on misses and bad guidance. If you look at the number of companies that are beating expectations, it’s the lowest that we’ve seen since 2020 and prior to that 2013. I do think that the bottom that we saw in mid-October will be retested and potentially broken before all is said and done.

Host:  When you’re thinking about investing new money or potentially reallocating, are there types of companies that you would want to focus on and maybe target to play some defense?

Jeff Schulze:  Yeah. Again, this rally that we’ve seen, it’s really been a risk rally. Early cyclicals have done fantastic. Some of the more questionable balance sheets, the junkier companies, if you will, have really screened higher in this environment. And that’s really come at the expense of quality companies and more defensive-oriented companies. So I think you want to really think about quality, but I think dividend growers represent a really good opportunity given the weakness that you’ve seen in that cohort over the last month.

They have a high degree of earnings visibility, and when you’re going into a potential recession, that is an attribute that investors put a premium on. They tend to outperform during rate hiking cycles after the last rate hike on a three-, six- and 12-month basis. They have rock solid balance sheets, generate a lot of free cash flow.

But I think importantly with the jobs print that we saw, if the Fed needs to hike more than what’s being anticipated, which is maybe a pretty decent possibility, that higher dividend will help negate some of the duration effects of higher interest rates. So I think given the weakness that you’ve seen in just quality and dividend growers in general here recently, I think it represents a really good opportunity for those to ride out some of this volatility.

Host:  Is there anything that you would want our listeners to focus on as they move forward?

Jeff Schulze:  Yeah, I think you need to take this opportunity to start dollar cost averaging into the market. You know, bear markets are very rare occurrences. It’s usually paid for long-term investors to allocate money in times of stress. So when we do see this choppiness, definitely want to try to take advantage of it. And in fact, if you go back to 1940, for every bear market that you’ve seen, once you’ve hit that -20% territory, yes, the markets go down another 15.6% on average. But if you had bought the day you hit bear market, yes, you have some initial weakness. But 12 months later on average, the markets are up over 11%. Eighteen months later, the markets are up over 18%. And I think a lot of people forget that we’re over seven and a half months away from when we entered into bear market territory. 

So while I’m expecting some choppiness and some downward pressure in the markets, having a methodical plan and taking advantage of these selloffs I think makes a lot of sense for longer-term investors.

Host:  And Jeff, when you mention the markets, we’re using the S&P 500 essentially as our proxy?

Jeff Schulze:  Correct. Correct.

Host:  Okay, perfect. Well, Jeff, I want to thank you again for providing terrific insight to our clients as we navigate the markets here in 2023.

For all of our listeners, you can prepare yourself by reviewing Jeff’s monthly commentaries and checking out the ClearBridge Recession Risk Dashboard at

Once again, today’s guest was Jeff Schulze, the architect of the Anatomy of a Recession program from ClearBridge Investments.

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 anywhere else you get your podcasts.

Thank you all for joining Talking Markets.

This material reflects the analysis and opinions of the speakers as of February 3, 2023, 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.

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1. Sources: Federal Reserve Bank of New York Consumer Credit Panel/Equifax; Bloomberg. Data as of September 30, 2022.

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