Check out our latest “Talking Markets” podcast to listen to the conversation.
Transcript
Host: Welcome Jeff, and thank you for joining us.
Jeff Schulze: Thank you for having me.
Host: So Jeff, let’s start this week’s conversation with the recent economic data. What did you see this week?
Jeff Schulze: Well, it was a really busy week with releases. On Monday, we got the senior loan survey by the Fed [US Federal Reserve]—[it] continues to show that credit, lending standards continue to get tighter. On Tuesday, we got manufacturing PMI [Purchasing Managers Index] and, although it increased, it wasn’t as great as what it appeared on the surface, because if you look at the employment sub-component, it dropped pretty aggressively and it’s at its lowest level since July 2020. And this suggests that manufacturers aren’t really excited right now, and we may see some weakness in factory payrolls more consistently as we look into the back half of the year. And this is how recessions usually begin. On a positive note, we got job openings: barely decreased with the most recent release at 9.6 million. Continues to suggest that there’s a lot of labor demand out there. Initial jobless claims: small rebound, but still in a kind of a lower trend, which suggests that the recession’s not here. But I think last but not least, we got the non-farm payrolls release, which came in below consensus expectations by a small margin, but I think importantly, still very strong relative to the last time that we saw sub-4% unemployment last cycle. So, a little bit of a mixed bag here, but I would say on net showing some cracks in the foundation for the economy, but still an economy that’s resilient.
Host: So Jeff, you mentioned payrolls have been strong, but they’ve been coming down. How do you think that the Fed will interpret this recent release?
Jeff Schulze: Well, they have been coming down which is a welcome development for the Fed. But I think when you look at the release, I’m not sure that we’re going to continue to see job creation to this degree, as we, again, turn to the later part of this year. Now, a lot of the move in the payroll creation that we’ve seen since February is people moving out of self-employment and back into corporate employment as they exhaust their pandemic savings buffers, and they reach agreements on hybrid work schedules, and this can only continue for so long. I think you’re going to see a development happen in the labor markets. In order to cool it, you need to have lower labor demand (but by looking at job openings, demand is still pretty robust) or you’re going to run out of labor supply. And I think that’s really going to be the driver, because there aren’t a lot more people to hire.
If you look as of June, the prime age labor-force participation rate, which is individuals between the ages of 16 and 55, it’s at the highest level since May of 2002, which suggests that a vast majority of the slack in the labor market, at least relative to pre-pandemic, is in the market already—with a lot of that weakness really being in that older cohort who’s already retired. And I think this creates a situation for the Fed, because with average hourly earnings it surprised to the upside, and the three-month rate is now significantly stronger than the six-month rate. And with a lot of labor demand (and again, that labor supply likely dwindling), you could see some sticky wage inflation here, and this could keep the Fed more biased to doing more rate hikes as we look out on the horizon. So it was a little bit of a mixed bag. Of course, we’re going to get CPI [Consumer Price Index] next week and we’re going to get a lot more data between now and the next Fed meeting. But I think that the Fed is likely going to be on hold in September. But, given this dynamic, we may see another rate hike.
Host: Okay. May see another rate hike. How about the real GDP growth, which I believe came in above expectations. Is that something that you expect to continue?
Jeff Schulze: Well, it was a strong [US] GDP print at 2.4% annualized, coming on the back of some strength of consumption and business investment. But I don’t necessarily think that that’s going to continue as we get closer to the end of this year. Now, one of the reasons why real GDP has come in above consensus expectations is that the data that we’ve seen released on the economy has been coming in better than consensus expectations. And this is picked up by the Bloomberg Economic Surprise Index. Last month, it hit its highest level since the reopening in the summer of 2020. It was in its top decile, or top 10%, of observations. Because this is a mean reverting series, this is a level from which it often rolls over and you start to see a string of economic disappointments.
Of course, this run of better economic data is a positive development. But if you look at history, it actually shows that the economy often experiences a sharp deterioration in momentum as a recession arrives. So if you look at the last eight recessions, three quarters prior to the start of a recession, real GDP growth has averaged 4.6%. Two quarters prior, it drops to 3.5%. And then one quarter prior, you see a sharp deceleration of economic momentum as recession contagion occurs, and the economy grows at 0.8%.
Host: Okay, so a slight kind of pivot here. Equity investors appear to me to be pretty bullish, with indices continuing to rise. Do you have any additional perspective on this dynamic?
Jeff Schulze: Oh, I do. For those that think that the recent market price action is a reason that the economy won’t go into a recession, history suggests that the market’s ability to sniff out a recession well ahead of time is checkered at best. So, while the markets are forward-looking, and I think it’s important to note that the S&P 500 [Index] is a part of the leading economic indicator index, they’re not always right. So in modern history, so since World War II, the market has experienced a positive return 42% of the time in the six months prior to the start of a recession and 25% of the time in the three months prior. If you look at the returns on average of those 12 recessionary periods, they’ve been muted: -2.9% on average six months prior and -2.1% three months prior. So, if you put this differently, a lot of times investors cling onto the bull case right up to the very end. And although we’ve had some positive price action, it doesn’t necessarily preclude the economy from slipping into an economic recession.
Host: Okay, so why do you continue to believe that that recession is coming?
Jeff Schulze: Well, it comes back to the output of our proprietary model, the ClearBridge Recession Risk Dashboard, a group of 12 variables that have historically foreshadowed an upcoming recession. A stoplight analogy where green is expansion, yellow is caution, and red is recession. And at the moment, we have 10 red, two yellow and zero green signals. But this is a very deep red signal if you look back in the model’s history. And I think, importantly, this is an output that you usually see when a recession materializes. And in this model’s history, it’s had nine overall red signals. Eight of them turned into recessions. One of them was a false positive that happened in 1967, where economic activity slowed to 0.2% on an annualized basis. That was very early on in the model’s history. And the model has eight recessions that it’s learned from, and it’s a lot smarter. So having a deep red signal is what’s giving us conviction that a downturn is ahead of us.
Host: Okay. So, Jeff, the Recession Risk Dashboard went to an overall red signal 11 months ago. Back then, I recall you drawing a comparison to the 1990-91 recessionary period. Does that still hold value from a comparison point of view?
Jeff Schulze: It does, yeah. When the overall signal went red at the end of August and September, we had talked about the fact that, we felt that from a timing perspective, this would be similar to what occurred ahead of 1990s downturn. That was the longest lead time from a red signal to the start of a recession, which was 13 months. So we’ve always kind of felt that the end of the third quarter would be when this recession started. But, again, given the recent economic data that we’ve seen, we’re likely going to have to push that out. We think it may be towards the end of the year or maybe in the first quarter of 2024. We think that this ultimately will be the longest time that we’ve ever seen from a red signal to the start of a recession, just given how robust the economy was coming into this period in this hiking cycle.
Host: In the past you’ve stated that the Federal Reserve has done enough. Do you still have that view?
Jeff Schulze: I do. Right now, the real fed funds rate is in meaningfully positive territory, same territory that you generally started to see recessions occur. And a lot of people look at the level of the fed funds rate to say whether or not monetary policy is restrictive or accommodative—meaning it’s slowing the economy or it’s helping the economy grow quicker. You have to look at the level of the fed funds rate versus inflation. And when it’s above inflation, that means that monetary policy is actually slowing the economy overall. But we don’t like to look at inflation, because inflation tells us where we’ve been. I think a better way of looking at this is to look at inflation expectations—or what people are expecting inflation to be. Because whether you’re a consumer, you’re an investor, you’re a corporate decision maker, you’re going to focus on what you think will happen in the future rather than what’s happened in the past when making that purchase or making that investment or that capital allocation decision.
A great example of this is consumers. They are much more likely to buy a house or a car today if they think that prices are going to be higher in a year from now—not necessarily what happened over the last 12 months. So when we use a one-year inflation swap, which is a good proxy for what inflation expectations are, and we compare that to where fed funds has been, the Fed has only started to get restrictive and slow the economy above that level in November of last year. And we all know that monetary policy acts with long and variable lags. A lot of people consider that lag to be six to 18 months. So if policy just started to slow the economy in late 2022, that means we should start to be expecting a recession today all the way through the middle part of 2024. So we’re really just entering into that window.
I think maybe more importantly, history does suggest that it’s too early in the hiking cycle to expect a recession. The initial rate hike occurred 16 and a half months ago in mid-March. Historically, a recession has started 23 months after the first increase of a persisting hiking cycle. And going back to the late 1950s, only three of the last 12 persistent hiking cycles saw a recession at this point. And, given how far behind the curve the Fed was coming into this cycle—with inflation almost reaching double digits, fed funds starting at zero—it’s pretty understandable why the recessionary headwinds haven’t coalesced and created that downturn, at least not at this point.
Host: Okay. So outside of policy getting restrictive late last year, are there any other reasons why we haven’t had a recession yet?
Jeff Schulze: Well, monetary policy, again, acts with a lag, but it’s not the only thing that acts with a lag. Lending standards—as I mentioned a little bit earlier—they act with a lag on actually lending by four to six quarters. Again, the Senior Loan Survey by the Fed is the gold standard on this matter. And with the latest release, lending standards continue to tighten for both commercial and industrial loans, or C&I loans, for firms of all sizes (small, medium, large), for commercial real estate loans. Lending standards tightened for all categories of residential real estate loans, consumer loans. So lending standards were already in recessionary territory. They’ve continued to get tighter. And, again, if lending standards really just started to get restrictive at the beginning of the year, that means it’s likely going to start to affect economic activity as we get closer to year end in 2024. So, obviously if you have a restriction of credits, that’s going to naturally slow economic activity. And that’s what we’re anticipating over the next couple of quarters.
Host: Okay. How about the other side of that coin? For example, loan demand? I’d imagine that it’s elevated with a still resilient economic backdrop, right?
Jeff Schulze: I think the other side of the coin to tighter lending standards—or the lack of availability of credit—is whether or not people are looking for loans. Loan demand in that same release weakened for both C&I [commercial and industrial] loans and commercial real estate loans for corporations. On the household side, you saw weaker demand for real estate loans, weaker demand for autos and other consumer loans. And credit cards were basically unchanged. So, that’s not a great combination. A lack of availability of credit and, again, people not necessarily wanting that credit because of concerns of maybe an economic recession as we look on the horizon.
Host: Jeff, are there any other reasons why we haven’t yet entered into a recession?
Jeff Schulze: Well, we talked about the fact that policy only became restrictive maybe eight months ago. I think an underrated reason for the resilience of the economy that we’ve seen is that fiscal stimulus has been negating a lot of the effects of the Fed tightening. And, depending on whose estimates you use, the deficit has grown by about $1 trillion over the last 12 months. That’s a massive amount. And what’s important to note is usually at this point in the cycle, you don’t have a lot of deficit growing. Usually, deficits are moving down. And it tends to move with the unemployment rate. So if you think about the unemployment rate when it’s high, usually tax receipts are falling, and general welfare spending has to rise. So bigger deficits. When the unemployment rate falls, tax receipts rise and public transfers fall as well.
But today, the deficit is almost at the same levels that you saw during the global financial crisis, and the [US] unemployment rate is at 3.5%, which is just a touch higher than 50-year lows. So I think that this has been a big reason why the tightening cycle that the Fed has done has not hit the economy in full force. But I think importantly going forward, although you’re going to see some more spending from some of the packages that have been released—like the Infrastructure Investment and Jobs Act, the CHIPS act, the Inflation Reduction Act—because of the debt ceiling and the deal that was made, the deficit needs to be stable over the next couple of years. So, although this has been a tailwind over the last 12 months, it’s no longer going to be a tailwind as we go forward.
I think another interesting dynamic is that corporations aren’t feeling the pinch from interest rates like they usually do. Now, usually when the Fed raises rates, it increases the amount of interest expense that they have. But today, corporations are generating more income from their cash. The S&P 500 ex- financials are generating about $6.5 billion each month. And because a lot of corporations have termed out their debt, they’ve issued debt in fixed terms, you’re actually seeing this increased generation of cash bring down their interest expense. So from 2009 to 2019, if you look at interest expense minus how much you’re earning on your cash, it was around $142 billion. Today it’s $128 billion, but I think importantly over the last eight months, this number has been around that $128 billion. So it’s remained static, and it suggests that a lot of this benefit is likely nearing its end as more companies need to refinance their debt over the course of the last 12 months. So there’s been a couple of reasons why the economy has been resilient, but I just don’t see those same supports as we look forward.
Host: Okay, makes sense. So Jeff, you clearly, clearly have a recession in your view. Do you have clarity on when it may begin?
Jeff Schulze: Well, if I had to take an educated guess, I would say close to the end of the year. So it could easily be the fourth quarter. It could easily go into the first quarter of 2024. And I think the key really to this equation is the consumer. I’m expecting some weaker consumption because of incomes being brought down over the course of the next two to three quarters, tighter lending standards, elevated interest rates. And then also, I think a lot of those excess savings that’s been being spent down has already entered into the bloodstream of the economy. But gas prices are up about 20% year to date. And I think that’s one thing that can continue to weigh on the consumer, coupled with the fact that student loan repayments are going to be restarting in October.
Now there’s a couple of offsets to those student loan repayments. There’s going to be a 12-month on-ramp for financially vulnerable borrowers, which means that they don’t have to pay those payments back, but they will accrue interest. So that’s going to take some of the burden off of some consumers. And then also there’s some generous protection from payments with the poverty line going from 150% of income to 225%, which will shelter a lot of individuals on actually how much they’re going to have to pay. So, this will offset maybe 30 or 40% of the drag.
But if you look at delinquencies, whether it’s credit cards, whether it’s autos, whether it’s other credit, even housing delinquencies are starting to move higher, at the margin, this is going to continue to put stress on the consumer. And when all delinquencies are rising in tandem with one another, it generally speaking, ends up in a recessionary type of environment. So I think the key comes down to the consumer, but there is some clear evidence that you’re starting to see consumer balance sheet fatigue already.
Host: Last time we spoke the topic of rolling sector recessions had surfaced. Would you like to comment on that idea?
Jeff Schulze: Yeah, it’s a popular idea, and it could happen. I’m not going to say anything can’t happen, because this has been a little bit of a quirky cycle. But I will say that almost every recession looks like a soft landing and a rolling recession until it’s not. Aside from 1980’s and 2020’s downturns, you don’t really see sudden stop conditions. Think about 1980. [Former Fed Chair Paul] Volcker imposed credit controls, because he wanted to get inflation down, so he effectively cut off credit from the economy. So you kind of had that sharp downturn. And in the pandemic, you literally shut down the economy. Usually, you know, this is kind of a slow dance into a recession, and it always kind of feels like a soft landing.
Now one of the keys to this view has been housing. But if you look at the housing data that’s been released over the last month, a lot of shine is off of that story. Housing starts fell by 8% in the latest release, and that release in May that got everybody so excited was revised down pretty aggressively. Building permits are falling. New home sales are decreasing. Existing home sales are decreasing. Mortgage apps [applications] are still kind of bouncing around the lows, which are down by about 50% from the highs. So although housing may tread water, I don’t see an acceleration from here. And I think it’s important to note that, again, it’s not uncommon to see areas of the economy bounce even before recession or going into a recession. And housing in particular was fine in the 2001 recession. But I come back to the idea that it always kind of resembles a rolling recession as you’re heading into these economic downturns. So this has not changed our view.
Host: Okay, that makes sense. So Jeff, as we look to close out today’s conversation, do you have any final thoughts for our listeners?
Jeff Schulze: Yeah, we think it’s going to be a little bit of a bumpy ride as we look through the next couple of quarters—clearly think that the economy is not on as solid a footing as what people have been suggesting. Although there’s always a chance for a soft landing, we continue to believe in the output of our model. And we do think that the economy will experience a recession sometime over the next couple of quarters, especially given where inflation is and how determined the Fed is in order to bring inflation back down to trend.
Host: Thank you, Jeff, for your terrific insight as we navigate the markets. Once again, today’s guest was Jeff Schulze, the architect of the Anatomy of a Recession program. If you’d like to hear more Talking Markets with Franklin Templeton, visit our archive of previous episodes and subscribe on Apple Podcasts, Google Podcasts, Spotify, or just about anywhere else you listen. Thank you for joining Talking Markets.
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