Beyond Bulls & Bears


PODCAST Anatomy of a Recession update: Soft landing chances rise

In the latest release of the ClearBridge Recession Risk Dashboard, we’ve seen that a particular indicator upgrade was enough to change the overall dashboard—going from red recession to yellow caution—the first time that it’s been yellow since August of 2022. We speak with Jeff Schulze of ClearBridge Investments about this change and his current base case for the US economy.

Host: Welcome to Talking Markets with Franklin Templeton. We’re here in the studio this evening with ClearBridge Investments’ Head of Economic and Market Strategy, Jeff Schulze. ClearBridge is a specialist investment manager of Franklin Templeton, and Jeff is the architect of the Anatomy of a Recession Program, a program designed to provide you with thoughtful perspective on the state of the US economy.

It’s great to have you here in the studio this evening, Jeff. Let’s get right to it. You mentioned the odds of a soft landing were improving on the last podcast. Did you see anything specific last month in the data that made you more constructive on that potential outcome?


Jeff Schulze: There was, and it came in the early part of February with January’s payroll release. Now, prior to that payroll release, the three-month average job creation in the US was 165,000. And when you go back to 1948, the average monthly job creation in the quarter prior to a recessionary start is 180,000. So you’re right in that danger zone. But with the January payrolls report coming in more than double consensus expectations with strong positive revisions to December and November’s readings, that three-month average job creation jumped from 165,000 to 289,000. So, we’re much further away from the danger zone of a potential recessionary start, and it really puts the view of a recession in the back half of the year at the earliest.

Host: Jeff, in the last four months, we’ve seen quite a bit of change to the ClearBridge Recession Risk Dashboard, with four indicators moving from recessionary red to yellow caution. Have there been any changes with your February update?

Jeff Schulze: Well, I’m happy to say that the positive momentum that we have been seeing since the end of the third quarter continued in February with housing permits, the latest indicator moving from red to yellow. And, as it currently stands, right now we have zero green, seven yellow and five red signals. But this particular indicator upgrade was enough to trigger an overall signal upgrade going from red recession to yellow caution, which is the first time that we’ve been yellow since August of 2022. So, the positive momentum that we’ve been seeing in the economy is being updated in the dashboard, and, accordingly, we’ve increased our probabilities of a soft landing to 60%. So, it’s our base case as we look out over the next 12 months. But I will say we still think that the odds of a recession are 40% as the historical precedents that you normally see with a recession are still front and center. But this is a positive dynamic for the economy, and it does appear that a soft landing is coming into view.

Host: So, a soft landing is now your base case. Would this be the first time the dashboard has moved from red to yellow without a recession materializing (should a soft landing occur)?

Jeff Schulze: No, it would not be. We did have one false red, if you will, going back to 1967. Now, I would say that’s a good false red (if there is such a thing) for a couple of reasons. In 1967, economic activity slowed to 0.2%, so it was a near-miss from a growth perspective. But, also, we really only started collecting data in the dashboard in 1963. So, it was really early on in the model’s history, and quite frankly today we have 55 years’ more data and eight recessions, which has made the model more smart. So, again, I think it’s too early to say that this is a false positive; 40% probability of a recession is still out there.

And the reason why we’re hesitant to fully embrace this soft landing and make it 80% or 90% is historical precedent. And when you go back to the late 1950s and look at every persistent rate hiking cycle, if you highlight the ones where those hiking cycles began in the middle or the end of an expansion (which is where we think we are today, given the fact that the US economy has sub-4% unemployment), the average length of time between that first hike and the start of a recession was 23 months. And, believe it or not, it was 23 months ago that the Fed [US Federal Reserve] began this tightening cycle. So we’re kind of still in the danger zone when it comes to the lagged effects of monetary tightening. But, nonetheless, the data that we’ve seen has been positive and has gotten us much more constructive on the prospects of a soft landing.

Host: Okay. So, in a danger zone. Is it fair to say that this time period is different?

Jeff Schulze: The four most dangerous words in finance are: “This time is different.” And while you look at the economic and market landscape since 2020, it actually does show more differences than similarities to previous decades. So, why this time could be different (I think I’m more comfortable saying “could be” different), there are a lot of things that are unique about what we’ve witnessed over the last four years.

For example, take private fixed residential investment, aka housing. It saw a string of nine consecutive quarterly contributions that were negative to GDP growth. Nine consecutive. So, this happened for two years straight. And that was a direct consequence of the Fed’s aggressive tightening campaign. And in a normal period, it would be reasonable to expect that this would’ve coincided with a recession, because housing is so economically important, and it has a large multiplier effect. For example, if someone buys a new home, there’s a lot of additional economic touch points. It has an effect on construction workers or materials if you buy a new home or you’re going to do some sort of renovation. Real estate brokers. Movers. Furniture. Appliances. A lot of different economic impacts. So, housing had its recession in 2022 and 2023, and the economy continued to move forward. So that’s one instance where this time was different when it came to the economy.

Another important difference, I think, is that you had a lot of recessionary indicators going off in the manufacturing sector here recently. And that came back to the consumption patterns that were prevalent because of the pandemic, right? When you had the pandemic, the economy shut down. Everybody bought goods and things instead of services because of mobility restrictions. And then when the economy opened up in a more durable fashion, you had revenge spending in areas like dining out, like travel, and in-person services generally speaking at the expense of the goods sector. And because of that, you’ve really had a manufacturing recession in the US over the last 12 months, which has triggered a lot of these recessionary indicators that are normally more reliable, because, although manufacturing is smaller and volatile, it does pick up on economic downturns generally speaking. So, again, this is just another situation and dynamic that’s unique about this cycle where the normally reliable recessionary indicators that a lot of economists rely on really aren’t playing out the same way that you traditionally see it.

Host: Okay. You mentioned a couple of unique elements about this cycle. Is there anything else in this particular cycle that’s different or unique?

Jeff Schulze: A couple others come to mind. The first is that you’re seeing the labor market cool without actually layoffs occurring. In the beginning of the pandemic, you had a worker shortage. You had a very hot economy. You had this huge insatiable demand for workers. And that caused job openings in the US to go from seven million prior to the pandemic to 12 million at its peak. And right now, job openings are at nine million. And, because of this drop of labor demand, you’re actually seeing wage growth move down, and it’s giving the Fed more confidence that the labor market can continue to normalize without layoffs actually occurring. And generally speaking, when job openings move down, layoffs happen along with it. So that’s one dynamic, again, that’s unique this time around than what we’ve seen in cycles past.

The other dynamic that’s unique is that the US consumer is locked into fixed mortgages, and this has caused a lot less interest rate sensitivity to the US consumer as a whole. And when you look at the effective interest rate on mortgage debt outstanding, even with the Fed raising rates on the short end by over 500 basis points, it’s caused that effective rate to only move from 3.2% to 3.7%, which insulates a lot of people from an increase of cost on their largest monthly outlay. Now, what I will say is that, as a whole, the US consumer is less interest-rate sensitive, but we’re not completely immune because 36% of American households, according to the 2019 Census Bureau, are renters. And the CPI rent component has moved up by 25% since 2019, which equates to $500 in your median monthly rental. So, yes, we are less interest-rate sensitive as a group, but we’re not completely immune.

Those are two things that just come to mind which make this time a little bit more unique and different than what we’ve seen in cycles past.

Host: Jeff, have any other traditional recessionary indicators taken a turn for the better recently?

Jeff Schulze: Yeah, two come to mind. The first is the Leading Economic Indicator Index—or LEIs for short. As a reminder to the listeners, when you have four monthly declines in the LEIs, you’re in the recessionary danger zone. The LEIs have continued to decline for 22 consecutive months. So this has not developed into a slower growth environment when it comes to the economy. And, although the latest release was still a decline, that decline is actually getting less robust. So, since March of 2023, the rate of the six-month annualized decline has slowed from -9% to -6%. Also, the breadth of the declines is beginning to narrow with only four of the 10 subcomponents of that index contributing negatively over the last six months. So, although the LEIs are still weakening, they’re weakening at a rate that’s less aggressive than what we’ve seen and really could mean that even though we’re anticipating a growth slowdown in the back half of the year, it may not actually be recessionary after all.

So that’s one dynamic that is getting better and a normally reliable recessionary indicator that so far has been proven wrong. And the other one comes from the Fed’s Senior Loan Survey, the number of banks that are net tightening with their lending standards to businesses and consumers. Although those levels are clearly at recessionary levels where you do see a decline of credit and a decline of economic activity, in the latest release the willingness to lend to businesses from a C&I loan perspective, whether you’re a small or a large business, it got better. Still restrictive, but much better from what we saw from the previous quarter. And willingness to lend to consumers, again, is still tight, but not as tight as what we saw with the last quarter release. So, although you have very tight bank lending standards right now, things are starting to get better, which means that things could continue to thaw when we turn the page to 2025. So, positive dynamics. Again, normally recessionary indicators have not shown a drop in economic activity, but things are starting to get better in the margin.

Host: Outside of the continued dashboard improvement, are there any developments that you’re watching that could move the odds of a soft landing even higher?

Jeff Schulze: There’s two things. Restrictive monetary policy with the fed funds rate still above 500 basis points, but if you can get some fiscal stimulus that could go a long way to support the economy. And that’s a key reason why the economy has been so resilient over the last couple of years.

A couple areas that I’m looking at specifically are in relation to some stimulus potentially going to businesses. So, right now there’s a discussion with Congress with the Wyden-Smith tax proposal. If that does move forward, that would be potential stimulus of around US$136 billion over the next two years. And, in looking at those aspects that would help businesses—give them a hundred percent bonus depreciation, R&D expensing, interest deductibility expansion—it would actually be backdated to 2022. So, this would be money that would hit large company coffers (if it moves forward) very quickly. So, this could go a long way in supporting the margins of some larger businesses and reduce the need or the desire to let go of employees—kind of short-circuiting potential layoffs that are on the horizon. I would put that as a coin flip, 50/50. But, again, a positive dynamic if it moves forward.

The other thing that I think will happen regardless is the distribution of the employee retention tax credits by the IRS. Now, this is going to really support small businesses, and the IRS made US$150 billion of payments to small businesses in 2023, which really helped support small business and small business employment. Now, because of advertisements on the TV, this has been made known to a lot of small businesses over the last couple of quarters. And the IRS got a flood of applications, and they stopped making those payments earlier this year. But right now, there’s about a million applications for this employee retention tax credit, which actually goes to businesses that employed people in 2020 and 2021 during the pandemic. Now, the good news is, if these payments start to move forward sometime in the second quarter, in the second half of the year, that could go a long way to supporting small businesses and could be anywhere from US$100 to US$150 billion that’s going to be paid out. And, in my opinion, small businesses right now are the most vulnerable in the US. They’ve seen their borrowing costs rise with the fed funds rate, because most small businesses borrow floating rather than fixed. Also, small businesses don’t have the ability to pass on higher costs as easily as you see with larger businesses. And also, they’re dealing with higher employee costs as well.

So, if that starts to get paid out by the IRS and we can potentially get that Wyden-Smith tax proposal moving forward, those are two things that I think could short circuit the desire for businesses to actually let go of employees.

Host: Jeff, the probability for a soft landing for the US economy would be great news. Do you think that that outcome is currently being priced in the capital markets?

Jeff Schulze: It would be a tremendous outcome for the economy. We’re pulling for a soft landing, but the markets have largely sniffed this out and have priced it already. The S&P 500 [Index] is currently trading at 20.5 times forward earnings, which is fairly high from a historical perspective. And earnings expectations for 2024 are actually pretty solid at 11.2%. So, with these lofty expectations priced into equities, it wouldn’t be a surprise to see a period of digestion in a soft-landing scenario—given how much equities have moved higher from the lows that we saw on October 27. But, ultimately, even if we do get that period of digestion, we think it would be good for long-term investors to take advantage of any weakness that emerges from that dynamic.

Host: Okay, let me hit you with two follow-ups here. Where do you see the best opportunities in this market? And will the stocks commonly referred to as the Magnificent Seven continue their positive performance run?

Jeff Schulze: I’ll take the first question first here. I think the best opportunities in this market right now are the areas that, quite frankly, haven’t done well on a relative basis since the beginning of 2023. It’s pretty much everyone outside the Magnificent Seven, right? So, small caps, mid-caps are priced pretty cheaply compared to their history. They would be direct beneficiaries in a soft-landing scenario (and you see a broad earnings recovery). We think that large-cap value could do well in this environment and the S&P 493, which is pretty much the stocks outside of the Magnificent Seven. And you did see all of these areas move up in tandem with the Magnificent Seven after the October 27 lows. But more recently you’ve seen the Magnificent Seven continue to kind of take back some of that relative performance.

But the reason why I think the Magnificent Seven could start to lag as a group compared to the average stock in the S&P 500 or potentially to all these other areas, is A, if we have a soft landing and you have a broad earnings participation and broadening out that we see, if the Fed cuts rates that could be supportive to smaller capitalization companies that have higher floating debt than fixed debt. But I think another reason is that after the Magnificent Seven really had a sharp decline in 2022, it’s important to remember that at the beginning of 2023 consensus forecast for the Mag Seven was for just over 10% earnings growth. And they easily surpassed that. They saw a huge rebound in profit margins. And this year the forecast is for that group to see 22% higher earnings growth and margins moving to record levels. And although developments in artificial intelligence may boost the profitability of these companies, a lot of upside is already baked into those expectations. So, in our opinion, it leaves a lot of room for disappointment. And if you look at the average stock versus the Mag Seven, you’re going to start to see the earnings expectations for the S&P 493 get competitive with what’s expected for the Magnificent Seven in the third quarter, in the fourth quarter of this year. So, we think that’s probably going to be a good reason for a broadening of the market to continue in the later parts of 2024.

Host: Okay. So, clearly room for disappointment in your opinion. Are there any other additional risks that investors should be aware of?

Jeff Schulze: Well, look, I think we talked a little bit about this, that the expectation or our probability of a recession is still 40%, right at the average length of time between a first rate hike and the start of a recession. So, we’re not out of the danger zone quite yet. You do have some concerns on the consumer front. Retail sales has only been positive one time in the last four months. You continue to see higher delinquency rates with credit card debt and auto loans. So, there are some signs that the consumer’s feeling some balance sheet fatigue. So these are obviously things that we’re going to be watching going forward.

But I think from a market perspective, I think the concentration risk that you have right now in the S&P 500 is something that’s underappreciated by investors. Because of the move in the Mag Seven, the top five comp. weights in the S&P 500 has moved to 24%, which is the highest that we’ve seen in at least four decades.

And while this dynamic can persist, history suggests that a reversion to the mean will eventually occur with the average stock outperforming in the coming years. And a different way of looking at this is to look at the S&P 500’s cap-weighted index, which does well when you have this concentration risk and the Mag Seven doing well versus the S&P equally weighted index. And that’s an index that would put Amazon on the same footing as Walmart or Target. And last year you saw the biggest outperformance of the cap-weighted index versus that equally weighted index since 1998. And when you go back to the late nineties, again, similar to today, elevated market concentration, pronounced mega-cap outperformance, but in the 2000s, you had a reversion to the mean and the equally weighted index outperformed for the next seven years—from 2000 to 2006.

And we think we could be seeing a period like that as embedded expectations in the group may be a little bit too much for reality. And it’s not to say that the Mag Seven is a bad group of stocks. We think it’s an excellent group of stocks, and we think that some of these stocks will be able to get to expectations and maybe beat them. But we do think that there may be some disappointments. And we ultimately think it’s going to be great for active managers that can sidestep that concentration risk and really understand what’s being embedded into each one of these Magnificent Seven stocks that have been on a tear since the beginning of 2023.

Host: Jeff, any final thoughts for our listeners today?

Jeff Schulze: Yeah, I think, again, we’re going to probably get a digestion period in the markets—soft landing or hard landing. But I think the one thing that’s underappreciated by a lot of individuals is how much money has moved into money markets, gone to the sidelines, as the Fed has embarked on this aggressive hiking cycle. And if you go back to 1990 and look at every major market low, the year following 2022, you saw the greatest amount of money moved to money markets really since 1990 following those major market lows. USS1.1 trillion went into money markets in that year following October 2022’s lows. Increase on a percentage basis was 24%. And more money has even flowed into money markets over the last six months. So, with the Fed likely cutting in a soft-landing scenario anywhere from 75 to 100 basis points (in a hard-landing scenario, that would probably be 2% or 3%), we think a lot of this money will move off the sidelines (because they’re getting lower yield) and into risk assets. So, in a soft-landing scenario, this could be really the next leg higher as we move to the back half of the year when the Fed is expected to start that cutting cycle. In a hard-landing scenario (again, which is a lower probability continuing to get lower as we get better data), that could really negate the selloff that you would see in a potential recessionary outcome. But, nonetheless, a lot of cash on the sidelines, and we think that’s a good thing for markets overall as we look out on the horizon.

Host: Jeff, thank you again for your terrific insight as we continue to navigate the capital markets here in 2024. To our listeners, thank you for spending your valuable time with us for today’s update. If you’d like to hear more Talking Markets with Franklin Templeton, you can visit our archive of previous episodes and subscribe on Apple Podcasts, Google Podcasts, Spotify, or just about any other major podcast provider.


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