Beyond Bulls & Bears


PODCAST Anatomy of a Recession Update: What’s different about this cycle?

Jeff Schulze, Head of Economic and Market Strategy at ClearBridge Investments, joins us to discuss the updated ClearBridge Recession Risk Dashboard, which has seen some progress underneath the surface despite not having any indicator changes. And, he shares his views on US equities and the impact of the Magnificent Seven.


Jeff Schulze: Good afternoon.

Host: Jeff, it’s great to have you here in the studio today. Why don’t we get right to it? Last month you mentioned that things were getting brighter on the United States’ economic front with the dashboard as the housing permits indicator experienced substantial improvement. Has there been any additional progress in the month of March?

Jeff Schulze: Well, just as a reminder to the listeners, the ClearBridge Recession Risk Dashboard is 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 the dashboard had previously seen five consecutive monthly upgrades of individual indicators since the October release. But in March, this was the first time in a half a year where we didn’t have an individual indicator upgrade. But importantly, over the course of the first quarter, the overall signal went from a recessionary red to a yellow caution. And we did see some progress underneath the surface, even though we didn’t have any indicator changes last month.

Host: So with no Recession Risk Dashboard economic indicator changes in March, does that mean that things are possibly stalling and that you’re currently more concerned about recession risk in the US economy?

Jeff Schulze: You would think so. But importantly, if you look at several other historically reliable macro leading indicators of a recession, you saw a notable improvement during the first quarter. So, the Conference Board has their Leading Economic indicator index. You saw the first positive monthly print in that series since February of 2022, so it’s 23 consecutive monthly declines. And that index tends to lead economic activity and had never previous fallen this long or to this magnitude without a recession materializing. So that positive reading was a really encouraging development on the sustainability of the economic momentum that we’ve seen over the last couple of quarters.

Furthermore, if you look at housing, it typically moves in tandem with the economy. And because of that dynamic, it’s really the genesis of the old adage: “As housing goes, so does the US economy.” And housing had an activity downturn for nine consecutive quarters between 2021 and 2023. And when you look throughout history, there’s only been two other times where housing and GDP decoupled from one another: the 1960s and the mid-1990s. And if you think about this decoupling, it was due to a strong labor market and the proliferation of low fixed-rate mortgages, which really helped insulate the US consumer from the pain of higher mortgage rates. And housing prices were kept afloat because you had a constrained inventory situation, because nobody wanted to sell their house. And that kind of had a positive wealth effect and kept the economy moving forward.

But I think, importantly, housing has emerged from its activity slump that we saw for the better part of two years with the recent rebound in existing home sales, housing starts and the NAHB home builder survey, which tends to lead housing activity. So you’ve seen some positive developments in areas that are really economically sensitive and it appears that they’re actually going to add to GDP as we look further into 2024.

Host: Are there any other notable developments on the macroeconomic front that are worth highlighting, Jeff?

Jeff Schulze: Yeah, one other leading macro indicator that we watch is the Federal Reserve’s Senior Loan Survey. You saw a sharp reversal of the tightening of credit conditions for both commercial and industrial loans (i.e. C&I loans for businesses) and commercial real estate loans. And this is a huge development, because this moderation tends to lead economic activity and lending activity. So, although the gap hasn’t fully closed and we’re still in net negative territory, it’s narrowed substantially, which means the downside risks of restrictive bank credit [are] easing and there’s going to be a more positive impulse at the end of this year. So, if you maybe put that in more layman’s terms, it appears that the worst is past on that front, which again is a good sign for the potential of a soft landing.

Host: Interesting. So many normally reliable recession indicators could have actually been falsely triggered during this economic cycle, if we have a soft landing. Why do you think that is?

Jeff Schulze: Well, billionaire investor Carlos Slim once famously said, “With a good perspective on history, we can have a better understanding of the past and the present—and thus a clear vision of the future.” So, while each economic cycle is unique, they generally share some common elements which can help strategists construct a better mosaic on what to expect going forward.

And, as we move further from (hopefully) a once-in-a-lifetime global pandemic, it’s becoming increasingly apparent that there’s a lot more differences between this cycle versus history than what we had previously perceived. So it’s becoming clear that this time may be different when it comes to the prospects of a soft landing because of these differences. And although we don’t want to get overly complacent on the risk of a recession, these differences are key in keeping activity resilient.

So one thing that we’ve been looking at is that the economy is less interest-rate sensitive. We talked about the fact that consumers have been insulated from higher mortgage rates because of fixed- rate mortgages, but the same can be said for corporate America. So, if you look at corporate interest payments, they typically rise at the end of an economic cycle because the Fed is in tightening mode, [it] creates profit margin pressure. But similar to consumers, a lot of companies locked in low rates following the pandemic with their debt, which has helped drop net interest expense. And it’s been further aided because these companies are getting higher returns on their corporate cash just like a lot of people are in money market funds. And this is all despite a really aggressive tightening cycle from the Fed. So, counterintuitively, with the Fed hiking cycle, it’s actually led to stronger corporate balance sheets, which reduces the urgency for these companies to cut costs and ultimately jobs compared to prior cycles.

Another development that was underappreciated by many, including us, is [that] recent immigration has really increased the growth potential of the US economy more than usual. So as a reminder to the listeners, GDP growth is really just population growth plus productivity growth. And productivity growth is how much more a business or an economy can produce without increasing their cost or their inputs. So, in January, the Congressional Budget Office published an updated population projection, and they had huge upward revisions for net immigration for 2022 through 2026. And to put these numbers in perspective, these new numbers suggest that there were 3.3 million more net immigrants in 2022 and 2023, and they expect 4.3 more million foreign born people in 2024, 2025 and 2026. And while this is certainly a polarizing issue, strong immigration is likely a key driver of labor supply, and it increases the speed limit of potential economic growth and job creation than what you would normally expect in a given cycle given where we are. So if this is indeed the case, the economy in the labor market could remain stronger for longer without exacerbating the inflation outlook, and it brings the labor market more into equilibrium without a recession to cool things down. So I think that, coupled with the fact that the economy’s less interest-rate sensitive, is lots of reasons why this expansion has lasted a lot longer than people had thought just 15 months ago.

Host: Very interesting perspective, Jeff. Is there anything else that makes this period of time unique?

Jeff Schulze: Well, we’ve talked about this on prior podcasts. It’s just the use of fiscal stimulus has become much more prominent, and it’s negated a lot of the headwinds from higher interest rates from the Fed. Typically budget deficits decrease as the economic cycle evolves, because the economy is in less need of support. But if you look at the last two economic cycles, it really hasn’t followed that paradigm with larger deficit spending occurring alongside a low and declining unemployment rate. And, while the fiscal impulse is getting smaller, it’s not completely gone.

A great example of this is the employee retention tax credit payments that are set to be dispersed again starting in late spring after it was paused by the IRS in September of 2023 due to concerns about fraudulent claims. And, given the massive backlog of applications and future submissions, up to $180 billion could be provided to small businesses over the next year whose revenues were severely impacted by the pandemic but they held onto their workers during 2020 and 2021. And this stimulus comes on top of the $200 billion that was already dispersed from the program between late 2022 and September of 2023. So, you know, these types of supports at the margin, just like lower interest expense like we talked about earlier, really reduces the urge of businesses to reduce their headcount even if they are having some profitability issues.

And the last thing I’ll mention here is that another underappreciated dynamic is that the Federal Reserve unveiled a huge series of measures to ensure that the regional bank crisis didn’t intensify into an actual recession—as it would have in previous cycles. So there’s a lot of differences today compared to cycles past and it’s just made the economy much more resilient.

Host: So given this unique period, what are the odds of a soft landing now versus an economic recession in the US economy?

Jeff Schulze: We’ve upgraded our odds of a soft landing to 65% and a 35% probability of a recession. So two-thirds and one-third.

Host: Okay, so an economic soft landing is becoming more likely. Let’s shift to the capital markets and focus on a bull market in US equities. Has the recent strength been a function of performance of the seven companies that include Nvidia, Apple, Tesla, Microsoft, Google, Meta and Amazon, commonly referred to as the Magnificent Seven?

Jeff Schulze: Well, the Magnificent Seven have certainly helped the stock market rally. But I would actually argue it was really a Magnificent Seven story until the October 27 lows last year. At that point, small caps, mid-caps, the S&P 493 and the Russell 1000 Value, they were all in negative territory year to date. But from that point forward, you really have seen a broadening out of participation with not only the Magnificent Seven stocks moving higher over the last five months, but all of those stocks moving higher as well. And, to illustrate the magnitude to which the Magnificent Seven has grown, the Mag Seven makes up almost the same weight in the MSCI ACWI, which is a global index, as all the equities in Japan, Canada, the UK, France and China combined. So each one of these Magnificent Seven companies are essentially countries at this point, from an earnings and a market cap standpoint. And if you look at those five countries, they’re not small countries. China is the second largest economy in the world measured as GDP. Japan is the third largest. The UK is sixth. France is the seventh largest and Canada is the ninth largest. But it was a function of the Magnificent Seven early on in the rally, but a significant broadening over the last five months.

Host: So Jeff, what are your thoughts on the aforementioned Magnificent Seven companies continuing to lead US equity markets?

Jeff Schulze: Well, after behaving fairly monolithically in 2023, all moving up and down with one another, the performance of the Mag Seven has diverged substantially so far here in 2024. And if you look at the first-quarter’s price performance, three out of the seven Magnificent Seven stocks are underperforming the S&P 500, and two of them have outright negative returns. And for those unfamiliar with the term Magnificent Seven and its origin, it actually came from a movie “The Magnificent Seven” back in 1960. Those seven people were Led by Yul Brenner, and ultimately only three out of the seven gun-slingers survived the shootout at the end of that movie. And, although it’s very unlikely that any of these companies are going to suffer that same dire fate (because these are genuinely good companies with huge moats and generate a lot of free cash flow), we think that the ability to understand what expectations are embedded into each of these stocks and whether or not that’s attainable, is going to be paramount as we move forward. So, if you maybe put that in different terms, after a tremendous run by the Magnificent Seven, they become the “divergent seven” and it creates a little bit of concentration risk in the S&P 500. And we think active managers that can evaluate these risks effectively have a competitive advantage.

But, taking a step back for a second, the reason why these companies have been prioritized by investors over the last year and a half is because the Magnificent Seven have had superior earnings growth at a time when the broader equity universe and particularly smaller caps—their earnings growth has been lackluster. So the outperformance has been actually justified from a fundamental basis. For example, if you look back to 2023, the Mag Seven stocks grew their earnings by 34%. The S&P 493 actually had negative 4% earnings growth. And the Russell 2000, which is a small cap index, had negative earnings growth of 10.5%.

But if you look at expectations for earnings for this year, that advantage is going to narrow substantially. And when you look out to 2025, the Mag Seven is only expected to grow by about 4% more than the S&P 493. And the small cap index is expected to grow over 11% more than the Mag Seven. So we think as this gap closes, that’s going to be a catalyst for a durable rotation into kind of your average stock in the S&P 500, but also smaller caps that have really lagged during this bull market. So I think that markets are starting to sniff this out, and it’s a reason why you’ve started to see that rotation over the last couple of weeks.

Host: So Jeff, are you concerned with the high valuations represented by the stock price over company earnings of the companies in the S&P 500?

Jeff Schulze: I’m not as concerned as many. If you look at the S&P 500’s forward multiple on earnings, it’s 21 times earnings. That’s really being exacerbated by the top 10 names in the index—the Mag Seven names, if you will, and the other three largest companies.

But I think if you look at market valuation today compared to history, it’s a bit like comparing apples to oranges because of changes in market composition as well as fundamentals. For example, the S&P 500 today has much less volatile earning streams. There’s less financial leverage in the S&P 500, greater profitability. Those are all attributes that support a higher multiple, all things being equal. And obviously some of this is due to changes in corporate behavior after the global financial crisis, but also some of it is attributed to a shift of the makeup of the index itself.

So when you look at the S&P 500 today, it has a larger weighting into areas that are more defensive and growth-oriented. So that’s going to be tech, telecom, health care, staples, consumer discretionary, utility and REITs. It’s at 71% in these areas. Again, these areas tend to trade at a higher multiple. And you have a reduced exposure to cyclical areas like financials, industrials, materials and energy. And the reason why cyclical areas trade at a lower multiple is huge fluctuations in their earnings based on what’s happening with the underlying economy. And, generally speaking, investors will ascribe a lower multiple to those types of companies. So, if you think about that fact, the S&P 500 should be trading at a higher multiple than what you normally associate it with. So again, if maybe 16.5 is your average long-term multiple, maybe we should be saying 17.5 or 18.5 should be that average.

I think an additional potential driver of higher multiples is the fact that the Fed is much more flexible than where they have been in history, because they utilized their balance sheet as a policy tool after the global financial crisis. And I alluded to this just a second ago. By employing the use of their balance sheet, you can really short-circuit crises. It was done in the regional bank crisis. You saw it in the beginning parts of the pandemic, where the Fed set up the alphabet soup of programs to support the economy. And that really reduces the odds of recessions happening. So a faster, more nimble Fed that reduces recessionary tail risks theoretically should increase the multiple of the S&P 500 all things considered. So just like you know, this is a unique cycle, we may be in the midst of a unique valuation regime. And it’s not to say that the market isn’t cheap. Now, the market’s clearly trading expensive on a historic basis. But, again, we should think that the average multiple in the S&P 500 is higher than what we’ve normally ascribed over the last couple of decades.

Host: Jeff, I’ve got one more for you on this topic. The S&P 500 Index hit a new all-time high in the month of January of this year and has done so another 21 times in the first quarter of 2024. Any additional thought on this positive activity?

Jeff Schulze: Believe it or not, I know investors shy away from putting money to work when you have all-time highs because people ask themselves, “How much better could things really get?” But if you look at the S&P 500, although all-time highs may incite fear history shows that deploying capital at peaks tends to outpace deploying capital when the markets are lower on a forward one-, three- and five-year basis since 1989 on average. So with the all-time high being attained in January and seeing a lot of them over the course of the first quarter, that’s actually a positive dynamic and it should actually get investors more excited to being invested in US equities.

Host: Jeff, any closing comments for our listeners today?

Jeff Schulze: Yeah, I think obviously it wouldn’t be a surprise to us if we see some sort of pullback here. You’ve had a monster rally over the last five months, so I think there’s a period of consolidation that’s likely going to occur. Also, you generally see heightened volatility from July to November as you move into the presidential election cycle.

But, with economic indicators continuing to improve and recession risks further ebbing, we think that investors would be best served to focus on areas that you’ve seen some relative underperformance. We talked about the S&P 493, kind of your average stock. We think small caps look attractive. And as that earnings gap closes between the Magnificent Seven and the rest of the broader equity universe, we think that could fuel a rotation and ultimately a positive relative performance.

Host: Thank you, Jeff, for your terrific insight and unique perspective as we continue to navigate the capital markets here in 2024. To our listeners, thank you for spending your valuable time with us. 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 any other major podcast provider.

This material reflects the analysis and opinions of the speakers as of April 3, 2024, 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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