Listen to our latest “Talking Markets” podcast. Transcript follows.
Host: Jeff, your team recently published a brief commentary where you stated that October’s equity market rally would eventually fade off and that you felt that we had not yet reached that durable market bottom. Tell us what’s driving your view.
Jeff Schulze: Right, John, there are really two things that are driving the view that a durable bottom has not been felt. And the first is that there were unrealistic expectations of a dovish [US Federal Reserve] Fed pivot.
And the second is that the second phase of this bear market has yet to play out, which is reduced earnings expectations. So, in thinking about those two phases of a bear market. First, you usually see multiple compression, and that’s really been a story of 2022. However, earnings expectations have remained relatively resilient. For example, over the last three recessions, earnings expectations have moved down by 25.8% on average.
And so far this year they’re only down close to 4% from peak. And we don’t think that this reflects the slower growth and possible recessionary environment that we’re anticipating in 2023. So, we think this is obviously going to create some volatility and downward pressure in markets over the next couple of quarters. But in taking a step back, this feels like a counter-trend rally, a dead-cat bounce, a bear-market rally.
But these terms are all synonymous for pockets of market strength that ultimately give way to a lower low during bear market selloffs. And going back to the dotcom bubble, you saw seven notable counter-trend rallies during that recessionary selloff, and eight during the global financial crisis. And the largest of these counter-trend rallies was over 20% in each case, and the longest lasted 101 trading days or four and a half months.1So counter-trend rallies can be quite long and quite robust as far as market price action. And so far here in 2022’s selloff you’ve had five notable counter-trend rallies with the largest and longest occurring over the summer. So the fact that this is the first proper recessionary selloff that we’ve had to endure since the global financial crisis in 2008, we feel that the prevalence of counter-trend rallies are these pockets of strength are going to be something that investors need to contend with over the next couple of quarters.
Host: It does look like the market is finally coming around to share your sentiment, Jeff, regarding the Federal Reserve’s strong resolve to fight inflation. Why do you feel a Fed pivot will continue to remain elusive?
Jeff Schulze: Well, it’s going to be very difficult for the Fed to pivot when they have not come close to achieving their goals on inflation. And the labor market continues to be very robust and labor costs have not rolled down in a meaningful way. So in looking at inflation, you can look at core measures of trimmed mean, you can look at median inflation or just core CPI, but all suggest that inflation remains stickier than the Fed would like. Take core CPI, for example. You’ve seen an average increase of a half a percent on a month-over-month basis over the last three, six and 12 months, which is a 6% annualized rate and nowhere close to the Fed’s 2% target. And yes, inflation is a lagging indicator, but the Fed will not pivot until they achieve a broad-based and sustained slowdown in inflation. And one of the biggest drivers of inflation is labor market and higher wage growth. People tend to spend what they make. So if you have higher wage growth, that means stronger demand and stronger inflation. And with the three major measures of wage growth, although down from the peak, none of them have moved down in a sustainable basis. Now, one thing I’m looking at to gauge labor demand is job openings and the ratio of openings to the number of people that are unemployed. In normal periods, this is a one-to-one ratio, the peak prior to the pandemic was 1.15. And today we sit at 1.86, which means there’s almost two job openings for each individual that’s unemployed. This is a very, very strong backdrop for labor demand. And job openings in the latest release actually increased by over 400,000 against consensus expectations for a decrease. And at 10.7 million job openings, that’s still 3 million more than what you had prior to the pandemic. So, in order for the Fed to feel comfortable that inflation is not going to be here more durably, you need to see weakness in the labor market. You need to see some more weakness in job openings, softer payrolls, and a rise of initial jobless claims. And none of those have come to fruition quite yet.
Host: Okay, a Fed pivot in your estimation is in the distance. Can you tell us why that’s so important to investors today?
Jeff Schulze: This is a really important consideration because if you go back to 1955, there’s been 13 primary Fed tightening cycles and the Fed was able to orchestrate three soft landings or avoid recessions after the start of those cycles. The three soft landings were 1966, 1984 and 1995 and in each of those instances the Fed had cut rates because they recognized economic weakness early and was able to prolong those expansions.
And in looking at those three in particular 1966 stands out because it was the only instance where the Fed pivoted and core inflation accelerated three years later. And the key difference was you had a very tight labor market in 1966 versus 1984 and 1995, which had a lot of labor market slack. In fact, in 1966 when the Fed pivoted, the unemployment rate was 3.8%, which is just a shade higher than today’s 3.7%. So, I think the Fed recognizes that if they pivot too early without creating enough slack in the labor market, they risk seeing an acceleration in inflation over the next three to five years, which is going to be harder to stamp out and require a deeper recession down the road. So a Fed pivot is really instrumental to a soft landing and given the tight labor market, I just don’t see it forthcoming any time soon.
Host: Jeff, this is a big week in American politics with elections taking place. Historically, do equity markets enjoy a favorable tailwind post the mid-term elections?
Jeff Schulze: It does. You know, one of the reasons why we’re optimistic on a counter-trend rally coming into October was that markets were washed out. There was very negative investor sentiment, as evidenced by the American Association of Individual Investors Survey, better known as the AAII, which is the gold standard for retail sentiment. And in late September, you saw the fourth-worst and the 10th-worst reading in that survey’s 35-year history. Historically, this has been a sign of retail capitulation and signals a near-term buying opportunity.
But the other reason why we had expected a counter-trend rally was because of the tailwind from the presidential cycle seasonality. So, the best three quarters during the presidential cycle is Q4 of year two, followed by Q1 and Q2 of year three.2 And we entered into Q4 of year two here in October.
And the reason why you have such superior market returns during this time frame is as you get through the midterm elections, uncertainty over control of Congress and the policy agenda start to abate. Now, today could be a little bit different compared to history and the fact that with our expectation of a recession in year three, this would be the first time that this has occurred in the post-World War II era.
So, it may snap that long running, third-year growth streak that we’ve typically seen. And one of the reasons why we feel like a recession is our base-case scenario is the output of our proprietary Recession Risk Dashboard, which is currently flashing a recessionary red signal.
Host: Ok, Jeff, let’s close today’s conversation with perspective on the current state of the ClearBridge Recession Risk Dashboard. Can you provide some insight?
Jeff Schulze: Well, it’s a stoplight analogy where green is expansion, yellow is caution and red is recession. And the dashboard has seen quite a bit of degradation since the middle part of 2022. In fact, we had an overall green signal at the end of June. That went to an overall yellow signal at the end of July to an overall red signal at the end of August.
And that red signal, which was very weak at the end of August, has gotten to a very deep red signal with two indicator changes in October, with job sentiment going from green to yellow and the yield curve moving from yellow to red. The yield curve is a really important indicator, and it’s had no false positives over the last eight recessions.
And our preferred measure of the yield curve is the three-month, 10-year portion because of its history and its perfect track record. And the average time from inversion of this portion of the yield curve to recession has been 11 months. So, we think that the shot clock for this recession has started. But importantly, in talking about the dashboard, it’s very rare to see such a quick economic progression to recession, and this has perfectly coincided with the Fed amping up its hiking cycle to 75 basis points per meeting. And with the Fed hiking 75 basis points just a couple of weeks ago, we think the lagged effects of Fed tightening have yet to be felt in the economy, and that’s going to weigh on growth prospects as we move into 2023.
Host: Great. Thank you, Jeff, for your terrific insight as we navigate the impacts of inflation, Federal Reserve policy, and capital market volatility. As you mentioned, opportunity certainly exists for long-term investors with a sound financial plan.
Jeff Schulze: Thanks, John. Thanks for having me.
Host: Once again everyone, that was Jeff Schulze, investment strategist with ClearBridge Investments and the architect of the Anatomy of a Recession program.
Thank you all for joining Talking Markets. Be prepared for what’s next by accessing Jeff’s insight at franklintempleton.com/aor. And 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.
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1. Sources: S&P, FactSet, NBER, and Bloomberg. Past performance is not a guarantee of future results. Investors cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges. See www.franklintempletondatasources.com for additional data provider information.
2. *Based on the four-year presidential cycle. Data as of Sept. 30, 2022. Sources: FactSet, S&P. Past performance is not a guarantee of future results. Investors cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges. See www.franklintempletondatasources.com for additional data provider information.