Beyond Bulls & Bears


PODCAST Anatomy of a Recession: Economic reacceleration in perspective

It shouldn’t be a surprise that the US economy is seeing some latent economic strength at this point, says Jeff Schulze of ClearBridge Investments. Learn why in this Anatomy of a Recession update.


Host: Jeff, I can’t believe we’re already in the month of March. The days are getting longer and soon spring will be upon us. As I reflect on the first couple months of the year, it’s certainly been quite interesting. In the capital markets, equities had a great start in January and then struggled in February. Inflation, as we started the year, seemed to be heading in the right direction, and now it appears to be reversing course a bit. I’m thinking about the path forward and whether we have additional clarity or if the environment is getting a bit murky at best. Over this short period of time, the consensus narrative appears to be changing, or maybe there is no consensus view of where the economy is heading in ‘23. Jeff, what do you think?

Jeff Schulze: Well, it’s been a very interesting start to 2023. You’ve had really three distinct macro narrative changes in a very short period of time, right? Coming into the year, consensus was convinced that a recession was a near certainty. By mid- to late January, a soft landing became the primary storyline following cooler inflation and wage prints, which is something that several FOMC [Federal Open Market Committee] members reinforce as a potential possibility. And you fast forward to today, and the main narrative really centers around whether or not the Fed is behind the curve again with inflation firming and an economy that appears to be reaccelerating. So certainly, dynamics have changed quite a bit in a short period of time, and I think it’s going to be a very difficult year for investors to get a handle on in 2023.

Host: So, let’s talk a little bit about the data. There’s been quite a bit of data, and from my point of view, the data seems to be maybe in conflict or there’s some contradiction. Are we seeing a genuine reacceleration of the economy at this point?

Jeff Schulze: Well, the data that we’ve received, it has been a broad-based move higher, and it’s been pretty robust. So this is a genuine reacceleration. Now, I’m not sure about the durability of it. But yes, there’s no smoke and mirrors at this point. Take the labor market, for example. January’s jobs report was a blockbuster. You saw over a half a million jobs created. I think maybe more importantly, you saw huge revisions higher to job creation in 2022, and in particular, the back half of the year. And the six months through January, average job creation is 349,000 per month. Now, that may not sound like a lot, but the last time that we saw sub-4% unemployment, at the end of last cycle, the US economy was creating about 145,000 jobs per month, which is kind of the level that I think is sustainable at these points. So, job creation is running about two and a half times those levels. So, you’re not seeing the labor market weaken materially. Initial jobless claims continue to grind lower. Job openings popped back up to 11 million. And at the moment you have 1.9 job openings for every person that’s unemployed—which is about double what you normally see. So labor is certainly showing, really, signs of some resilience and strength.

Looking at retail sales, for example, it shouldn’t be a surprise that retail sales are doing well. This has been an unusually warm winter in January. It’s easier for consumers to go out and about. A lot of industries that were shut down are open. So those individuals are making and spending money. You saw a pretty big boost to auto sales as rental companies brought more cars into their fleet. But also you saw a huge cost-of-living adjustment from Social Security, with recipients receiving 8.7% more in their checks. So, consumption is certainly being resilient. Not a lot to poke holes in there. And then lastly, manufacturing PMI [Purchasing Managers Index] just came out, and the new orders component, which is in our proprietary dashboard, moved up substantially. So, manufacturing’s been weak over the last six to nine months. You’re starting to see some signs of stabilization. So, I do think that this is a genuine reacceleration, at least for the time being.

Host: Interesting. So, a genuine reacceleration of the economy. You hit the employment data, strong retail sales, as well as the manufacturing sector. Now, let’s connect this directly to inflation. How does this play into the inflation picture?

Jeff Schulze: Obviously, “transitory” was a word that we talked about with inflation for a long time. I think we’re not allowed to say that word anymore officially in financial circles. But with inflation, maybe we’re seeing transitory disinflation. Disinflation has been something people have been talking about as inflation has moved down. But you’re clearly seeing a stalling in that momentum, right? I think one thing that’s underrated is you saw seasonal adjustments to core inflation last year, and that fourth-quarter inflation slowdown really wasn’t much. On a three-month basis, you’re seeing core inflation run at a 4.1% annualized level. So, inflation is not moving down as much as people are anticipating.

But I think also one of the core reasons why inflation has been moving down is you’ve seen goods deflation with this healing of supply chains, with people buying experiences instead of things, you know that transition that we’ve been seeing. And the last CPI [Consumer Price Index] print that we got, goods inflation actually increased for the first positive print that we’ve seen since September. So, if this is no longer bringing down inflation actively, I think inflation tends to stabilize here. And that’s really going to complicate the Fed’s job, because if inflation is lagging and it’s starting to stabilize here, and you have an economy that’s reaccelerating, the stronger economy may even put upward pressure on inflation from here. So again, I think inflation is going to grind down, but it’s going to be pretty sticky in the near term, which is going to keep the bias to the Fed for more hikes and more pressure.

Host: Okay. So, you just painted a fairly complex picture. You also use the term “lagging” as it related to one of the pieces of data there. Can you speak more about “lagging” or “leading” economic data and why this is important?

Jeff Schulze: Yeah, so obviously inflation’s lagging, as you alluded to, but I think something that may be lost on some investors right now is that a lot of the data that we’ve seen that’s been surprising to the upside has been “lagging” or “coincident,” meaning it can tell us where we’ve been or where we are, but it doesn’t necessarily tell us where we’re going. Take non-farm payrolls, for example. Great coincident indicator. Great in telling us what’s happening in real time. But when you go into a recession, payrolls demonstrate what we call non-linearity. They collapse very rapidly when that recession takes hold. So even though we’re having healthy payroll readings today, it doesn’t really tell us much of what’s going to happen next quarter or maybe six months out into the future. So, I think investors should temper their enthusiasm on some of these data points and the strength that we’re seeing today and what it means for the back half of this year.

Now you know, one of the reasons why I say that is if you look at leading indicators, indicators that can tell us are what’s going to happen in the future, that’s a much more precarious story. The Conference Board Leading Economic Indicator Index, better known as the LEIs, in January saw its 10th consecutive monthly decline. Usually when you have four consecutive monthly declines, you’re in that recessionary danger zone. We’re clearly well past that threshold. And in looking at this from a different vantage point, the most that the LEIs have moved down on a year-over-year basis ahead of a recession was 5.7% ahead of 1980’s downturn. Today, the LEIs are down 5.8%. So I think, again, the leading indicators are telling us that although things are looking good now, that may not hold up as we get to the back half of the year.

Host: Okay. So clearly you still have a view here, a strong view, if I may, that a recession in ‘23 is going to happen. You’re still thinking second half of the year, and with that strong probability that you’ve referenced of 75%?

Jeff Schulze: We do. Our proprietary Recession Risk Dashboard at ClearBridge turned red in August of last year. We had felt that a recession was going to take about a year to transpire, similar to the red signal that happened prior to 1990’s recession, which took 13 months to develop. So, we’ve been thinking the third quarter of 2023 for quite some time now, and nothing has altered that view. So yeah, we still think it’s going to be a second-half story and in particular the third quarter when those recessionary headwinds finally coalesce to create that downturn.

Host: Okay. Just to dive a little bit deeper there, I’ve heard you say in at least one conversation that cake is already baked when referring to the recession. Can you explain that for our audience?

Jeff Schulze: Yeah. In looking at our dashboard, the Leading Economic Indicator Index with its 10th consecutive monthly decline, I think the Fed, quite frankly, has done enough to cause a US recession. And I think the fact that we don’t have a recession right now shouldn’t be a surprise to people. If you look at all the tightening cycles since the 1950s, in particular those tightening cycles that started in the middle or the tail end of an expansion, from first rate hike to the start of a recession, the timeline has been about two years. And we are not even a year from the time where the Fed did their first rate hike. So, it shouldn’t be a surprise that we’re seeing some latent economic strength at this point, especially from the position that we were coming from. But I think that the Fed has already done enough to cause a recession. But with the inflation picture firming today, with this pulse of economic growth that we’re seeing today, the Fed’s going to have to continue to hike into this environment. And the markets are pricing another three hikes for 75 basis points. I think that ultimately compounds and creates maybe a little bit deeper of a recession than what consensus is thinking right now. But either way, I think the cake is baked for a recession this year.

Host: Okay. So, the cake is baked and your view is that it’s coming and based on Fed action that hasn’t yet occurred, the depth of this recession could be a little bit deeper than people are expecting. How about the capital markets? We talked in the past about ’23 being a year where volatility is present, markets are choppy. We’ve already seen it here in the first couple months on both sides. Thoughts relative to that continuing?

Jeff Schulze: Yeah, you know, we’ve always felt that we were going to retest the lows in October. We haven’t deviated from that view, even with this pulse of activity that we’ve seen here recently. But what I think is interesting is that valuations continue to get more expensive for the market. And when I say the market, I mean the S&P 500. Forward earnings are close to 18 times. That’s pretty rich considering we have a 4% 10-year Treasury. And in my opinion, I think recession risks are pretty high as we look out on the horizon.

And when you’re thinking about the two phases of a bear market, the first one is multiple compression. P/Es usually go down. The second one is earnings expectations tend to be lowered as well. And at the October lows, the forward earnings of the market was around 15. So at 18, markets got a little bit more expensive. I think P/E levels need to come down. We may retest back to 15 times forward earnings, which is maybe a little bit higher than what you see at bear market troughs, but I think we probably revisit that. But secondly, earnings expectations have started to come down, and year to date S&P 500 earnings are down by about seven bucks. I think we need to probably get to about $200 for earnings to accurately reflect the environment that we’re anticipating. So, again, given the fact that the markets are a little rich right now, and I think earnings are unrealistically high, I think volatility’s going to be here. And I think we’re going to see more downward pressure on equity markets over the course of 2023.

Host: Hmm. So, although the current earnings season was by accounts decent, you don’t really see this as a reason for optimism?

Jeff Schulze: You hear that in the media that the earnings season was decent, but from my vantage point, it really wasn’t a good earnings season. Yes, sales held up. But earnings were negative, right? The percent of companies beating estimates in the S&P 500 was 68%. It’s the lowest that we’ve seen since COVID. The surprise factor was the lowest that we’ve seen since the financial crisis. So, we’re going back 15 years to see that surprise factor get this low. But I think more importantly, operating margins are down by about 160 basis points since the peak. And when you think of a decline of this magnitude, they’re typically associated with recession. So, you’re seeing broad-based margin compression. Yes, companies are able to pass along some of their price increases, but they’re not able to do it like they were last year. But I think more importantly, a lot of their cost structures, in particular compensation, remain sticky. And if inflation starts to come down, economic growth starts to come down, I think margin pressure is going to continue. And I think that’s a key reason why earnings are going to disappoint. But a lot of people say that this was a good earning season. From my evaluation and my standpoint, I didn’t think it was a good earnings season at all.

Host: Okay. So clearly some mixed messages out there in the marketplace. Now how about maybe just  a minute here on the January equity market rally that really seemed to be fueled more by growth stocks and cyclical stocks. Do you expect that to continue as we move through the year?

Jeff Schulze: Well, it’s interesting, right? Because you’ve seen over the course of this year, the 10-year Treasury rise higher as participants know that the Fed needs to incorporate more rate hikes. And you’ve kind of seen this pulse of economic activity, and with the 10-year Treasury rising, you’ve seen growth and more importantly a lot of the more speculative areas of growth outperform, which is not the dynamic that you would normally see with that. So that tells me that, again, a lot of this rally that we’ve seen with the mixed earnings season that we just talked about has really been fueled by sentiment rather than fundamentals. But I think, more importantly, when you’re looking out on the horizon, the areas that have underperformed over the last two months, which are more quality areas of the marketplace, more defensive areas (dividend growers is an area that did really well last year and is having some difficulty this year)—if our view that a recession remains the most likely outcome is correct, I think a reversal of the recent leadership should ensue, which will lead to a return of outperformance for higher-quality companies, defensive companies, and dividend growers in particular. So I think that, again, we’re starting to see signs that this is reversing, but I think that’s going to become more apparent as we move further into 2023.

Host: Okay. So the signs are there. Jeff, as we close out today’s conversation, and I think about what you stated here, which is that high probability that the recession is coming, potential that the recession will be deeper than folks are thinking, and that the equity markets in particular will remain choppy at best, is there anything that you would like to share with our listeners that they should focus on as they progress?

Jeff Schulze: Well, look, there’s a lot of negativity that’s priced in the markets already, right? But if you have cash on the sidelines, I would be methodically putting money to work as we make our way through 2023, I mean this recession is ultimately priced. But I think more importantly, this doesn’t feel like the same backdrop as we had heading into the bubble, or the global financial crisis, where you had wild overvaluation with the bubble, or you had deep structural issues with consumer balance sheets and bank balance sheets in the global financial crisis. So I think this is going to be maybe a deeper recession than consensus expects, but the core fundamentals of the economy are on pretty stable foundations right now. So I’d be advocating to stay the course, maybe think about higher-quality dividend-growing equities as a way to ride the storm and negate some of that volatility. But again, I would be actively and methodically putting money to work during this downturn for what I believe is the last leg of this secular bull market that started after the global financial crisis in 2009. And if you’re not familiar with the term secular bull market, it’s usually 20-year period where US equities have meaningful outperformance and upside pressure. And I believe that started in 2009 and it’s still continuing.

Host: Okay. Jeff, thank you for your terrific insight today as we seek to navigate markets.

You can prepare yourself by reviewing Jeff’s monthly commentaries and checking out the dashboard that Jeff referenced at

Once again, today’s guest was Jeff Schulze, the architect of the Anatomy of a Recession program. If you want to hear more Talking Markets with Franklin Templeton, visit our archive of previous episodes and subscribe on Apple Podcasts, Google Podcasts, Spotify, or just about anywhere else you listen. Thank you all for joining Talking Markets.

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