Beyond Bulls & Bears


PODCAST Anatomy of a Recession Update: A wait-and-see Fed

Continued progress in the ClearBridge Recession Risk Dashboard saw the wage growth indicator move from red to yellow. Jeff Schulze of ClearBridge Investments shares his views on what that move could mean for investors, how many Fed rate cuts we may see this year, and the potential market implications of the upcoming US presidential election.


Jeff Schulze: Great to be here.

Host: Jeff, last month when we spoke, you mentioned that March was the first month since last September where the ClearBridge Investments Recession Risk Dashboard did not experience an individual indicator upgrade. Did that drought continue in April or did we see some additional progress?

Jeff Schulze: I’m happy to say that we did continue to see progress with the dashboard. We saw wage growth move from red to yellow and at the moment it makes six individual upgrades out of the last seven months, all moving from red to yellow. And the overall dashboard is now still a yellow caution color. But right now we are very close to green territory, given the most recent move. So, we’ve continued to see progress, and given the momentum that we’ve had, we think we are going to continue to see that progress into the later part of the second quarter.

Host: Interesting. Wage growth improved. Can you tell me a little bit more about this indicator and how it normally fares through an economic cycle?

Jeff Schulze: So, what we’re trying to measure with wage growth is as it gets hotter throughout an economic cycle, it tends to pressure profit margins and it increases the odds that a company’s going to let go of their employees in order to preserve those margins. So, in this cycle you saw average hourly earnings get up to 5.9% in early 2022, which had caused our wage growth indicator to turn red. However, since then it’s cooled to 4% in last month’s release. So, with this cooling of wage growth, you’ve seen this move from red to yellow, and ultimately this is a positive dynamic that would help company profit margins. Now, this is a unique situation. Usually when the wage growth indicator turns red, it doesn’t move back to yellow until you have a recession and you have a labor market that sees some weakness.

But this has been such a unique cycle that you’re seeing this labor market equilibrium happen without layoffs materializing. And there’s really two sides to this story. The first is that you’ve had so much excess labor demand built up during the pandemic that job openings have dropped by over 3.5 million from peak, but yet you haven’t seen layoffs materialize. And usually when you see lower job openings, you actually see layoffs happen along with it. So this is just a unique dynamic from a pandemic standpoint.

But the other side of the story is, really, you’ve seen strong labor growth with the recent immigration trends in the US. Now, as a reminder to the listeners, nominal GDP growth is basically labor force growth plus productivity growth. Basically, “How many widgets can I make in my factory more this year compared to last year?” And in January, the Congressional Budget Office increased their estimates for net immigration for 2022 through 2026. So five years, they increased their estimates by 7.7 million people. And although immigration is a pretty polarizing issue, this strong increase of labor supply has really increased the speed limit of the economy and job creation than what you would expect at this point in the cycle. So, really for the first time in modern history, you’ve seen the labor market come into equilibrium with lower labor demand and higher labor supply without the Fed having to invoke a recession. So, we’re in a first here with wage growth moving back to yellow without a downturn happening.

Host: So, Jeff, it seems like inflation continues to be pretty sticky in the United States. How concerned are you with this?

Jeff Schulze: Look, I’m modestly concerned, but the path to 2% was always going to be one where there was a couple of speed bumps. And ultimately, I think what we’re seeing right now is a speed bump. Core inflation—it really boils down to three subcomponents. You have goods inflation, you have shelter inflation, and you have what’s called supercore. And that’s services inflation ex that shelter component. And goods inflation really hasn’t been present over the last couple of years. It’s really been a goods deflation story as supply chains have healed. But also, if you look at China and you look at their export prices over the last nine months of 2023, they were down by 7%, and it appears that you’re going to continue to see that dynamic. So, goods deflation is likely going to keep happening as we move through this year. Shelter inflation continues to be pretty sticky. But if you look at all kind of forward measures of shelter inflation, that’s likely going to moderate as we move through the next couple of quarters.

And the real area of concern is supercore. And if you look at supercore CPI over the last three months, it’s running close to 8%, which is near the highs that we saw in 2022. And the reason why the Fed cares about supercore is the Fed believes that service sector prices, unlike goods prices, are predominantly influenced by labor costs, which is a factor that the Fed thinks it can influence. But, importantly, you’ve seen wage growth measures move down really across the board over the last year. Average hourly earnings has moved down. The employment cost index moved up recently this week, but it’s not a move that is something that we’re concerned with. A lot of that move was really employees that are in unions getting a wage gain in Q1, and usually you don’t get those wage gains until inflation has already happened. So it tends to be more lagging in nature. And then the last one is the Atlanta Fed’s wage tracker continues to move lower. So with supercore having a pretty strong relationship with wage growth, given the progress that we’ve seen on wage growth and our indicator moving to yellow, I think that this is just a bump in the road and I think lower inflation is going to persist as we move later into 2024.

Host: Do you believe that the Federal Reserve will cut rates in 2024?

Jeff Schulze: I do. The markets are pricing in one-and-a-half rate cuts this year. I’ll take the over on it. I think that we’ll get two. I think inflation’s going to start to cooperate, and it’s going to be much more of a clear picture as we move later in the year. And I think this rapid job creation that we’re seeing is going to come down to more normalized levels. But at the moment, given the strong economic backdrop and this increase of inflation, it’s obviously not an environment where the Fed can feel good about cutting. So they’re in a wait-and-see type of environment. But I ultimately think that we will get two rate cuts this year.

Host: So Jeff, I know you’ve done some heavy analysis on past rate-cutting cycles. Should the Federal Reserve have the opportunity to cut, where will the opportunities in the capital markets potentially be?

Jeff Schulze: Yeah, we’ve done some deep analysis here. And if you look at all rate-cutting cycles back to 1974, where the rate-cutting cycle was 75 basis points or more, in a soft-landing scenario, the 10-Year Treasury tends to drop about 1.2% in the three months prior to that rate cut. So, the Treasury markets tend to anticipate the Fed cutting. But, importantly, nine months after that rate cut, the 10-Year Treasury is still down 1% overall from right before that rate cut. So, 10-Year Treasury tends to drop when that occurs. And should we get closer to the fourth quarter and rate cuts, I think the 10-Year Treasury is likely going to be moving lower from here. And I don’t think it’s going to be 1%, I think it’s probably going to be more like a half a percent, but ultimately that should be a nice tailwind to equities.

But, more importantly, when you look at those soft landings and you look at how equity markets perform following that cut, they drastically outperform cash or money markets. For example, in the one year following cuts for soft landings, cash returned 7.2% in the 12 months following—relatively decent return. But if you look out to equities—far superior outperformance. Small caps return 13.8%, which is the Russell 2000. Mid-caps are 14.6%. And the Russell 1000 Growth actually is the best performer at 16% in that year following. So you really want to embrace risk assets if the Fed does cut and indeed we do have a soft landing, which is looking more and more probable as we move through this year.

Host: So Jeff, would the Federal Reserve be viewed as potentially being politically motivated if they do move forward and cut rates ahead of the election?

Jeff Schulze: The Fed’s in a no-win situation politically. Doing a rate cut in September would be unattractive, just because it’s right ahead of the election. And if the Fed doesn’t cut, they’re going to be perceived as politically motivated—because they’re trying not to look politically motivated. If they do cut, it’s going to look like they’re trying to help Biden get a second term.

But if you look at history, the Fed has actually made moves in almost every election year back to 1956. The only year where they didn’t make a move, whether it’s hiking or cutting, was in 2012. And when you look closer at 2012, that year rates were at zero, because we were in the aftermath of the global financial crisis. But there were three tweaks on balance sheet policy that year, which would’ve been effectively a cut or a hike. Even though people don’t think that the Fed moves in election years, historically, that has been the case.

Host: Okay. Jeff, I know it’s early at this point, but what do you think the potential market implications are regarding the upcoming presidential election?

Jeff Schulze: Well, I think there’s a strong possibility that it really doesn’t matter who’s going to win the election when it comes to having some sort of large legislative agenda that’s going to be passed. And the reason being is that even if you do have a majority in the House and a majority in the Senate and you’re retaining the White House, if you look at the House, there’s going to be an extremely slim majority. And obviously, with a lot of individuals that are far right and far left in the House, it’s going to be very difficult to have something that would pass from a legislative agenda perspective. So I’m not expecting a major spending package or anything of that nature, regardless of who wins the Oval Office. But in looking at, you know, the winners and losers, it’s really going to come down to where the president can act unilaterally. And that’s going to be through regulation. So, if Biden wins, it’s going to be a nice tailwind to green energy. It’s probably going to be a mild headwind to areas that would see higher regulation like big pharma, traditional energy and financials and industrials.

If Trump wins, it’s likely going to be the exact opposite. Those four areas are likely going to see less regulation, which is energy, industrials, financials and big pharma. You’ll likely actually see a nice tailwind to defense stocks as well. And then also you might see a little bit of a headwind to green energy.

Host: So we shouldn’t be prepared for a large spending package like we’ve seen in the last two prior presidential election scenarios. Are there any other considerations that might be relevant to the capital markets as we move forward this year?

Jeff Schulze: There is, and it’s going to come back to tariff policy, another area where the president connect unilaterally. And we’re going to see higher tariffs regardless of who gets elected. If it’s Biden, it’s going to be much more of a targeted, much more of a surgical approach when it comes to tariffs. Biden recently visited Pennsylvania, and he had talked to the United Steel Workers Union there and mentioned that he’s going to be tripling steel and aluminum tariffs on China, which would bring those tariffs up to 50 and 35% respectively. So, obviously that’s a key swing state, and that would be something that’s beneficial to Biden’s reelection chances. So again, much more of a targeted approach. I think Biden’s also going to look to raise tariffs on other critical products such as electric vehicles. The administration has already stated its strong concerns about Chinese EVs entering into the US. So I think again, you’re going to see more tariffs, and most of them are probably going to be directed towards China as a theme on the campaign trail is going to be who is tougher on China. It really does play well in the US political backdrop.

When it comes to ex-President Trump, it’s going to be much more of a potentially disruptive tariff situation. And on the campaign trail, he’s really talked about two potential possibilities. The first is raising tariffs on Chinese imports from 19% to 60% as well as a 10% across-the-board tariff on all US imports. And when thinking about those two, the first really kind of strikes me as more likely campaign rhetoric than anything else. Moving from 19% to 60% is a very huge move. But I do think that there’s a serious policy proposal on the table with a 10% across-the-board tariff and that’s going to affect all of our trading partners. And it really does invite tit-for-tat retaliation because of beggar-thy-neighbor policies, where you’re going to see higher tariffs on US exports. And really this has the potential to be a modest headwind to multinational companies in the US. And if you’re a domestic company, probably going to be able to outperform a little bit on a relative basis. Now, again, I don’t think this is going to be a huge headwind. It may cause a repricing in the markets of a couple percentage points, but it’s obviously going to be something to take into consideration. And those companies that have a larger chunk of their revenues coming from China may be disproportionately affected.

Host: Jeff, it seems like we’re seeing an increase in geopolitical events. Is this true? And what advice do you have for investors as we move through those types of events?

Jeff Schulze: Well, we’re right kind of where we have been historically when it comes to the frequency and the magnitude. It’s important to remember that, you know, other generations saw large geopolitical events, whether it was World War I, World War II, Korean War, Vietnam War, the Gulf War, the War on Terror.

I think the biggest takeaway here is that, yes, you do see dislocations with the larger geopolitical events, like when Russia invaded the Ukraine. You saw a massive move in natural gas and oil. You saw a big move in wheat, for example. But for most of the smaller ones, it has paid to really fade the initial market move. Usually, you see a geopolitical premium that’s built into the commodity market, or you see equity sell off, or you see a bid to the 10-Year Treasury in the days leading up to that geopolitical event. And when it actually happens, you usually see a reversal of that.

And you clearly saw that when Iran retaliated against Israel a couple of weeks ago. You would’ve thought that the 10-Year Treasury would’ve dropped, that equities would’ve been down, gold would’ve been up and oil would’ve been up. But that didn’t occur. In fact, if you go back to 2010, there’s been 32 major macro shocks and geopolitical events, and the average drawdown for the S&P 500 has been 8%. So they have had an impact on the market. But importantly, if you look out three months from that event, the S&P 500 was up 0.4% on average. So it really wasn’t lasting in the markets.

But if you strip out the tail events, the bigger ones (for example, when the pandemic happened, you had a pretty large selloff in the markets) and you look at the median (which is basically what you would expect normally to happen), the median return three months after the event happened was positive 2.8%. So usually the trend that was embedded in the markets tends to continue after you have that geopolitical event occur. Should you have more of these on the horizon and the markets react, we would advocate that it’s probably a good opportunity for longer-term investors to put some money to work into equities.

Host: Thank you, Jeff. As we begin to wrap up today’s conversation, any final thoughts for our listeners?

Jeff Schulze: Yeah, we’re going through a correction in US markets. This is healthy. You’ve seen a major move higher from the October lows of last year. When you have a move of this magnitude, you’re going to have some sort of digestion period. And when you think about a corrective phase, it really comes in three stages. First, you have a break from the markets moving higher and higher. Then you have a bounce. And then finally you have a lower low that really kind of serves as an emotional test for the longs. It shakes out some of the weaker hands.

And it kind of feels like we’re going through that third phase of a correction, shaking out some of these weaker hands. And you know, as we’re going into a weaker seasonality part of the year, we may see some choppiness and some jitter as we move through this quarter and into Q3. But again, with the prospects of this expansion likely continuing and earnings expectations holding up really well, we would suggest that any downside that we see in equities should be an opportunity for longer-term investors.

Host: Jeff, thank you once again for your terrific insight as we 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 May 2, 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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