Beyond Bulls & Bears


PODCAST Anatomy of a Recession: The long view for a new year

In our latest “Talking Markets” podcast, we meet with regular guest, Jeff Schulze of ClearBridge Investments, to discuss the US economy—focusing on inflation, the US labor market, and the Federal Reserve.


Welcome, Jeff. Happy New Year and thank you for joining us today.

Jeff Schulze: Glad to be here.

Host: All right. So let’s jump right in. Do you still feel like a recession is forthcoming in ‘23?

Jeff Schulze: I do. Recession has been our base case really since June, when the Fed [US Federal Reserve] was focusing all of their attention on restoring price stability and was willing to create higher unemployment in order to achieve those goals. But since then, our stance has hardened as the Fed has embarked on one of the fastest tightening cycles that we’ve seen in modern history.

And I know that this may be the most anticipated recession ever, but there is kind of a dynamic of reflexivity. If everybody believes that a recession is going to happen, maybe consumers start to pull back the reins a little bit on their spending. Maybe businesses, instead of doing CapEx [capital expenditures] or hiring someone, they pull back the reins and it becomes a self-fulfilling prophecy.

But, although consensus is a recession in 2023, we have hardened our view and we continue to believe that that’s going to transpire.

Host: I noticed that the December 31st update of the Recession Risk Dashboard from ClearBridge had no change. Can you remind us how that Recession Risk Dashboard works? And if you’ve got any perspective on the current view—strength of the overall signal maybe?

Jeff Schulze: So, the ClearBridge Recession Risk Dashboard is a group of 12 variables that have historically foreshadowed an upcoming recession. And it’s a stoplight analogy where green is expansion, yellow is caution, and red is recession. And from June 30th, we had an overall green signal on the dashboard. But since that time frame, we’ve moved into a very deep recessionary red signal.

And as it stands at the end of December, we have eight red, two yellow, and two green signals. But given the fact that the Fed is still likely going to be doing more rate hikes in the year coming, and due to the lagged effects of monetary tightening that has already occurred, we continue to think that the dashboard is going to become even more red, recessionary, and recession will eventually materialize. So, things are continuing to deteriorate.

Host: Okay. So in the analysis that you do, is there a particular time period where you think the Fed is really looking at to leverage and set their policy on a go-forward basis?

Jeff Schulze: I do think there is a time frame that the Fed is specifically honing in on, and I think it’s the soft-landing scenario that you saw in 1966. If you go back to 1955, there’s been 13 primary Fed tightening cycles. Three of those tightening cycles did not end in a recession. They were soft landings: 1966, 1984, and 1995.1 And I think 1966 is the strongest parallel to where we find ourselves today. The Fed doesn’t want to go down that same path.

So in each of those instances, the Fed cut rates in order to prolong those expansions. But there’s a very different inflationary feel after 1966’s pivot. After 1984 and 1995’s pivot, inflation actually dropped in the three years that followed. In 1966, core inflation almost doubled, going from 3.3% to 6.2% three years later. And the key difference between those periods is that in 1966, you had an extremely tight labor market with the unemployment rate at 3.8% at the time of pivot.

And that really kicked off the high inflationary 1970s and structurally higher inflation. So with the unemployment rate today even lower at 3.5%, I think the Fed really wants to create some labor market slack. And if they don’t do that and they take their foot off of the brake, economically speaking, they run the risk of having structurally higher inflation in the back half of this decade, which may require an even more aggressive monetary policy response than what we’ve already seen.

Host: Okay. So, with inflation clearly being in the focus of the Fed, have you seen anything change in the data recently?

Jeff Schulze: Well, inflation is moving down. We’ve clearly seen peak inflation in the US. And when you look at core CPI [Consumer Price Index], you can really boil it down to three essentials. Goods inflation, which actually was transitory—it just took a little bit longer for us to get to that transitory period. But one of the things that are driving inflation lower over the last couple of prints is broad-based goods deflation with supply chains healing and demand shifting from consumers shifting their spending back into services at the expense of goods.

So, goods deflation is happening, and that’s helping to normalize the inflation picture. The other component is shelter inflation. Now, this continues to be high, but shelter inflation is notoriously lagging. But in looking at some of the more leading mechanisms of being able to determine shelter inflation, they’ve all rolled over pretty hard, whether it’s Zillow, whether it’s Apartment List, or it’s just home prices nationally speaking.

So, we think that is going to help bring inflation lower as we move through the next couple of quarters. The one area, though, however, that’s going to be sticky—and [Fed Chair Jerome] Powell and the Fed has mentioned this several times over the last couple of speeches—is services inflation, ex-rent. So, you strip out that shelter component, and this is going to be something that’s going to remain sticky because it has a very strong relationship with the labor market. So, inflation has peaked. It’s going to move down. But because of that stickiness of services inflation ex shelter, I think it’s going to be difficult to get all the way back to the Fed’s 2% target on a sustainable basis.

Host: Okay. So how about anything additional relative to the labor market in that equation? Is there any more detail that we should be focused on?

Jeff Schulze: Well, again, services inflation, ex-rents, ex-shelter, it has a very strong correlation with the labor market. It’s 0.5 correlation, a very good relationship. And that’s a key reason why the Fed is laser- focused on creating some more of that labor-market slack. And when you look at core CPI, because the Fed likes to look at core measures of inflation, that services ex-rents component is around a third of that overall bucket.

But the Fed actually has a more preferred measure of core inflation, which is core PCE [Personal Consumption Expenditures]. And when you look at that component of core PCE, it’s close to half the bucket of inflation. So, with a red hot labor market, I think it makes the Fed very uneasy with inflation potentially normalizing back to levels that were seen prior to the pandemic, and they recognize that the labor market needs to cool from current levels in order to accomplish those goals.

Host: So it definitely sounds like the American worker is still in a position of strength. Would you agree with that?

Jeff Schulze: Absolutely. If last decade, workers really didn’t have any negotiating power when it came to employment, the tables have completely switched in the other direction. Workers clearly have the upper hand. So what we’re going to be anticipating over the next three to four months is an increase of average hourly earnings as a lot of workers renegotiate their wages for cost-of-living adjustments due to the high inflation that we saw last year.

And, unfortunately, businesses don’t have a lot of leverage given how tight the labor market is and the fact that you still have pretty strong demand in the economy overall. So, we think that they are going to make those wage concessions. And although average hourly earnings and wage growth recently ticked down, we think it is probably going to move up over the next three or four prints.

Now, one way to gauge how much leverage workers have is to look at the quits rate. Quits rates have come down from peak levels seen at the end of 2021 to 2.7%. That’s still higher than anything seen prior to the pandemic in that data set. Workers know that if they don’t extract the wage concessions that they’re looking for, they’ll be able to find another job around the corner.

So I think workers this cycle have a very different position of strength than they had in the previous cycle coming out of the global financial crisis.

Host: Okay. So the worker is still in a position of strength, but as we move forward and you think about this topic, how are you thinking about big business versus small businesses?

Jeff Schulze: Well, a lot of the anecdotal evidence that you’re hearing is from larger businesses. Amazon recently laid off quite a large number of workers. Meta. Big businesses are starting to shed their workers, but small businesses have yet to do that. And small businesses are really the engine of growth in the US economy. In order for the Fed to really break the labor market, they need to break small business labor demand.

In looking at all of the increase of job openings that you’ve seen today, prior to the pandemic, you’ve seen an increase of over three million job openings. Of those three million additional job openings, small businesses, businesses with less than 250 employees, make up over 90% of those increases in job openings. So, it’s really a small business story when you’re talking about this insatiable labor demand.

And it makes sense because, in looking at the NFIB Small Business Survey, small businesses have enjoyed very strong profitability and margin expansion. They ask small businesses two important questions in that survey. “Are you planning to increase your prices over the next three months?” And “are you planning to increase your compensation for your employees over the next three months?”

And in the aftermath of the pandemic, the number of firms looking to increase their prices shot up dramatically. And although firms looking to increase compensation rose, it didn’t rise nearly to the degree that you saw overall prices rising. So that created an environment of very strong profitability for small businesses generally speaking. So, it shouldn’t be a surprise that they have a lot of labor demand.

What’s changed over the last four months is the number of firms planning to raise prices has plummeted. What hasn’t plummeted was the number of firms looking to raise compensation for their employees. So, we’re rapidly approaching a situation where profitability and earnings are going down in small businesses. And it’s only a matter of time before they’re going to be looking to cut those costs, which could be some layoffs coming down the pike and maybe the start to this recession. So, it’s probably going to take a couple of quarters for this to develop. But I do think some of the layoffs that we’ve seen with larger companies is going to transition to smaller companies in the US.

Host: Jeff, great perspective first on inflation and the current state and then a connectivity to the labor market and wages. Let’s bring this now full circle right back to the Fed. Are they creating any clarity for us as we move forward here in ’23?

Jeff Schulze: The Fed could not be more clear. They are going to have a different reaction function to what they have historically. And the reason is they want slack in the labor market. If you look at the Fed’s projections, or their “dot plots,” for the unemployment rate over the next year, the unemployment rate is expected to rise per the Fed from 3.5% today to 4.6%.

That’s a full percentage increase in the unemployment rate. And if that comes to fruition, that would violate the Sahm rule, which says you’ve never seen an increase of the unemployment rate by a half a percent or more without creating a recession. When it comes to the labor markets, an object in motion tends to stay in motion, and you very rarely get a small rise in the unemployment rate.

So, the Fed is saying that a shallow recession basically is on the horizon. But this is very different compared to the Fed’s usual reaction function. If you go back to prior rate-cutting cycles, usually the Fed cuts rates before job losses really occur, and job losses tend to snowball about a year after that first rate cut. They’re usually anticipatory of that.

And what the Fed is signaling is that they’re going to do more rate hikes this year, and they are projecting over 1.6 million job losses in hiking into that environment. So, the Fed has made it abundantly clear that their reaction function is going to be later to the game than what you’ve traditionally seen. In our opinion; this creates a higher probability of a recession than consensus is appreciating.

Host: Okay, so the Fed is creating clarity. We’ve got transparency. They’re driving us in a direction where a recession is highly probable. So, the two questions that folks are asking now are “when will it start” and “how long will it last?” Any thought there?

Jeff Schulze: Well, my economic canary in the coal mine is initial jobless claims, a top-three variable in the Recession Risk Dashboard. It’s usually the last domino to fall or turn red as a recession is starting. And usually when you’ve seen an increase of 10% or more on a year-over-year basis, the recession has officially begun. Now, this has been a relatively stable indicator in the dashboard. It’s still green at the moment. So we’re not there yet. But if you do start to see initial jobless claims pick up, we’re going to know that a recession is at hand.

Now, when could it potentially transpire? Well, if you look at all of the persistent rate-hiking cycles since the late ‘50s, especially the ones that have started later in an economic expansion from first rate hike to the start of a recession on average, that distance has been 23 months.2

Now, it may feel like an eternity ago when we have started this rate cycle, but it’s only been nine months. Because of the long and variable lags in monetary policy, it usually takes some time for those recessionary headwinds to coalesce into creating an economic downturn. But again, if I had to make a best guess on when the recession starts, I’d probably put it in the third quarter of 2023.

Host: Okay. Third quarter of 2023. Jeff, another topic that is constantly being discussed is the Fed pivot. Based on your commentary, it seems like the probability of a pivot in the near future is pretty low. Can you share with us the potential impact—a pivot happening sooner as opposed to later will have on the capital markets?

Jeff Schulze: Well, it’s about timing, right? If the Fed pivots, call it this quarter or next quarter, I think that’s going to be great for the markets. I think it would maybe stave off a recession potentially. If it’s going to be, you know, towards the end of 2023 into 2024, it may not be such a rosy market experience. You know, be careful what you wish for when a Fed pivot comes, because historically it’s actually meant more downside for markets.

If you go back to the last number of recessions the time frame between the first cuts or pivot and the bottom of the market has traditionally been 14 months. So, you’ve seen more sell off, more market pain when the pivot has come. The average drawdown from pivot to market bottom has been 31%.3 So, pivots aren’t usually a good thing for the markets. But what I will say, what is different this time around is that between the market peak and when the Fed eventually pivots, because the Fed is usually anticipatory there’s a lot more negativity that’s baked into the markets and really should help soften the blow to markets when that pivot eventually comes and that bottom is formed.

Host: Okay. So you’ve just made a nice transition to the markets. Let’s dig into that a little bit. Do you have any thought on whether we’ve seen that bottom in the equity markets to date?

Jeff Schulze: I don’t think we have. If we have seen the bottom of the markets, this would be the first time since 1948—so in modern history—that the market has bottomed prior to the start of a recession. Usually, the markets will bottom about two thirds of the way into a recession. And given the strength of the labor market, I just don’t see a recession on the horizon at this very moment.

Now, what I will say, over those last 12 recessions, the market has bottomed in either month one or two after the start of a recession five times. And since the market has gotten a head start in pricing this, I think that’s probably the dynamic that will take place. But I think we probably haven’t seen the lows of the bottom quite yet. It’s probably going to take some time. But what I will say is that a lot of negativity has been baked into the markets and if we can just get back to the average recessionary selloff in the post-World War history, which is 30%, it doesn’t mean that there’s that much more downside to the markets from current levels.

But again, I’m expecting a kind of a choppy, a bumpy trading range in the markets in 2023 until visibility is restored on: a) if we have a recession; but b) how deep of a recession is that and what does that mean for the earnings picture?

Host: Okay. So, it definitely sounds like in your view, as we get off to a start here in 2023, volatility will continue. Is there any reason for folks to be optimistic as we move forward?

Jeff Schulze: There is. As I alluded to before, there’s a lot of negativity that’s already priced into the markets. And the fact that we hit bear market territory [in 2022] is a pretty rare occurrence. Usually that means it’s a pretty good entry point for those investors that are willing to embrace the volatility and they have a long-term focus. In fact, if you look at every bear market since 1940, once you hit that bear market territory, which is -20% in the S&P 500 [Index], initially the markets go down further, another 15.6% on average.4

However, if you had bought the day you hit bear market territory, yes, you have some near-term pressure to the downside. But 12 months later, the markets are up 11.8% on average. Eighteen months later, the markets are up 18.5% on average. And a lot of people forget that we hit bear market territory almost seven months ago. So, if this historic pattern plays out anywhere close to what we’ve seen with the averages, especially considering that the market is still basically at bear market territory, -20% [in 2022], investors may be pleasantly surprised if they start to put money to work methodically in 2023, taking advantage when we can get to the other side of this recessionary selloff. But again, I think there’s a lot of negativity priced and things could surprise to the upside for those that are longer term in nature.

Host: Okay, Jeff, our time is up for today’s session, but I really wanted to thank you for your terrific insight as we look to navigate the markets here in a new year 2023. To our listeners, you can prepare yourself by reviewing Jeff’s monthly commentaries and checking out the dashboard at 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 iTunes, Google Play, Spotify or just about anywhere else you get your podcasts. Thank you all for joining Talking Markets.

This material reflects the analysis and opinions of the speakers as of January 6, 2023, 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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1. Sources: US Bureau of Labor Statistics, Federal Reserve Bank of St. Louis, FactSet. Data as of Dec. 31, 2022.  Past performance is not a guarantee of future results.

2. Sources: Bloomberg, FactSet, US Bureau of Labor Statistics. Latest data available as of December 31, 2022. Persistent Hike Cycle is when the vast majority of Fed rate hikes in a tightening cycle occur, and may not align with initial hike when there have been long delays between initial and subsequent hikes.

3. Source: FactSet, as of November 30, 2022. Based on S&P 500 Index returns. Past performance is not an indicator or a guarantee of future results.

4. Sources: S&P, FactSet, and NBER. Past performance is not an indicator or guarantee of future results.

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