Beyond Bulls & Bears


PODCAST Anatomy of a Recession: The lagged effects of rate hikes have started

A review of the US economy with Jeff Schulze, investment strategist at ClearBridge Investments, focusing on the most anticipated recession in history. Is it here? What signs are beginning to appear? And how deep will it be?

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Host: Jeff, the first quarter of ’23 has been very interesting. We certainly have quite a bit to talk about today. So let’s get right to it. I’d like to start with that Recession Risk Dashboard.

Can you remind us how the dashboard works and where we currently stand?

Jeff Schulze: So, the Recession Dashboard is a group of 12 variables that have historically foreshadowed a looming recession. It’s a stoplight analogy where green is expansion, yellow is caution, and red is recession. And we’ve had an overall red signal since August of last year. But that red signal has gotten even deeper. And as we currently sit here at the end of the first quarter, we have nine red signals overall. But importantly, our odds of a recession over the next 12 months continue to be 75%.

Host:  Okay, so with 75% probability of recession, is there an indicator on that dashboard that you are currently maybe focused a little bit more on?

Jeff Schulze: Yeah, I would say out of the three signals that aren’t red at the moment, we are laser-focused on initial jobless claims. We call this our canary in the coal mine for the economy. It’s typically the last indicator to turn red, confirming that a recession has formally begun. And importantly, you saw seasonal adjustments to initial jobless claims here recently, with claims revised significantly up higher for 2023.

In fact, year to date, claims are up over 300,000, which equates to about 26,000 per week. Now, for this indicator to turn red, initial jobless claims on a four-week moving average need to rise by 10% on a year-over-year basis. And for this to happen, we need claims to rise by about 25,000 from where we currently stand. So what we thought was a red hot labor market is now a warm labor market that’s rapidly cooling.

Host: Okay. So we’re seeing some change there.

Last month in our conversation, we had a little bit of a dive into the difference between leading and lagging indicators. Is there anything to note today on that topic?

Jeff Schulze: Yes. So a lot of the data that was accelerating in the early part of this year was more lagging or coincident. It can tell us where we’ve been or where we are. More importantly, the leading indicators, the LEIs, are suggesting that there’s going to be slower economic activity ahead. And the gold standard for this is the Conference Board’s LEI index. The initial jobless claims is actually a part of that index. And when you’ve seen four consecutive monthly declines of the LEIs, you’re in that recessionary danger zone. But we’ve seen 11 consecutive monthly declines. Looking at this from a different vantage point, the deepest drop in the LEIs on a year-over-year basis before the start of a recession was ahead of 1980’s downturn at -5.7%. Today, the LEIs are down even more at 6.5%. So we think that the economic die is cast for recession later this year.

Host: So the die is cast. In previous conversations that you and I have had you have stated that the Fed’s monetary policy takes time to drive that impact into the economy. You even used terminology like the long and variable lags that start to move through. Are we seeing any real impact there?

Jeff Schulze: Yeah, monetary policy notoriously has long and variable lags. In fact, if you look at all the tightening cycles that began in the middle towards the end of an expansion, on average, the timeline between first hike and the start of a recession is around 23 months—or two years. But it’s all over the place on when that actually materializes, because every cycle is different. The pace of economic activity going into that hiking cycle is different. The strength of the hiking cycle itself is different, and the drivers of that underlying activity are usually different. So it’s hard to pinpoint when those lags will hit. However, with the recent banking crisis that we saw in March, it does appear that we have seen our first effect of monetary policy hit the US economy.

Host:  Jeff, I’m glad you brought up the banking crisis. I want to follow up on that. Do you think that the worst is over with that crisis or is there another chapter to this saga?

Jeff Schulze: Well, it’s important not to be too confident in the call at this point. If you go back to Bear Stearns in March of 2008, it took about five months for the real credit crunch to begin with Lehman’s bankruptcy. However, I do feel that this is a little bit more idiosyncratic than systematic. One of the reasons I feel that way is that the regional banks that came under pressure, they had unique challenges.

They had a high degree of customer concentration. They had an outsized share of uninsured deposits. Those are accounts that are above the FDIC’s $250,000 threshold. Also, they had overexposure to industries that were under strain, like tech and crypto. And maybe most importantly, they had really poor risk management when it came to hedging out the duration of the securities on their balance sheets, like Treasuries and mortgage-backed securities.

Now, a lot of banks have one or two of these issues, and if that’s the case, it can be properly managed. But a combination of them all is rare. And we obviously saw that it was challenging to both Silicon Valley Bank and Signature Bank, which are the second- and third-largest bank failures by assets in US history. So it does feel a little bit more idiosyncratic than systematic.

But the other thing I’ll mention on this front is that policymakers acted very quickly and aggressively to ring-fence the contagion and restore confidence to the banking sector. And when you look at the discount window and the Bank Term Funding Program that the Fed had set up to support the banking system, use of these two institutions actually dropped over the last two weeks. So that’s a really good sign that maybe the worst is over for this crisis and things will be better going forward.

Host: Yeah, that’s definitely a good sign and hopefully some great news. Sticking on the topic, though, are there any additional impacts related to the monetary policy kind of settling into the economy that you see?

Jeff Schulze: Although the worst of the crisis may very well be over, you’re going to see this affect the economy through tighter lending standards. Now, the gold standard on lending standards comes from the Federal Reserve’s Senior Loan Survey. And even before recent events, the net percent of banks tightening standards on commercial and industrial loans, better known as C&I loans, was at levels consistent with the last four recessions.

On the consumer side, willingness to lend fell to -12.5%, a level that you typically see ahead of economic downturns. And given the fact that this has hit smaller banks and you’re seeing deposit flight from smaller banks, lending standards are going to tighten even more aggressively, especially for banks outside of the top 25. So this is going to pressure the consumer and pressure the US economy, broadly speaking.

Host: You mentioned the consumer there. Small businesses. Do you have any additional perspective on that?

Jeff Schulze: Well, it’s going to hit the consumer, absolutely. But it is going to disproportionately hit small businesses. Banks outside of the top 25, they represent over 55% of the lending that you’ve seen over the last year. So they pack a punch well above their weight. But when it comes to small businesses, they’re less likely to have relationships with larger banks. And small businesses don’t really have access to capital markets like larger companies. So they’re going to feel the pinch as credit conditions tighten. It’s going to curb their ability to grow and weigh on job creation. And this really highlights, in my opinion, the difference in access to capital between large and small businesses. It really highlights the difference on how monetary policy acts with variable lags.

You know, larger businesses tend to issue debt in the capital markets at fixed rates. And because the markets are forward looking, the impact of potential rate hikes is felt immediately, even before they happen. If you look at small businesses, by contrast, they usually borrow from banks at floating short-term rates. So the impacts of monetary policy actually hit small businesses only after that rate hike occurs and their borrowing costs adjust upwards. And if you look at the NFIB small business survey, borrowing costs for small companies have risen from 5% to 8% over the last 15 months. And as the Fed continues to raise rates and small banks tighten lending standards, I wouldn’t be surprised if this rises to somewhere closer to 10%. And that’s a huge rise that’s really going to squeeze profitability at a time where small businesses are having less ability to pass through price increases to their customers and they have stickier costs embedded into their structures through higher compensation costs.

So even though you’ve heard about layoffs with larger companies, we think that this will broaden out into smaller companies in the third quarter and really mark the official start of this recession.

Host: Clearly there is a going to be a connection in the labor market as that starts to really permeate out. Jeff, you haven’t brought up inflation yet in your comments. Have we seen a favorable change there?

Jeff Schulze: Well, if you break down core CPI into its main components, you have goods inflation, you have shelter inflation, and then you have services inflation without that shelter component. And one of the biggest drivers of lower inflation in the back half of 2022 into this year has been goods deflation. Right? It always was transitory and we saw it normalize, it just came later than a lot of people were anticipating. The problem is that over the last three months, that deflation has changed. Now goods inflation is relatively flat. And if that’s no longer going to be an anchor, bringing overall inflation lower, given the stickiness that you see in shelter and then services ex-shelter, I think this is going to make the Fed uncomfortable in cutting rates or providing any type of stimulus to the economy. And it could actually favor more rate hikes than what the market’s currently pricing.

So obviously, you have some issues in the oil market with OPEC, surprising the market with the meaningful supply cuts recently. If you see oil start to move back up towards $90 or $100 a barrel, again, that really complicates the inflation story for the Fed and keeps them biased for higher. So, again, I do think inflation is going to move lower over the course of this year, but the pace of that is going to be really important for monetary policy and the economy.

Host: Let’s transition to a couple of capital market related questions. Given the economic outlook and the insight that you’ve just delivered, do you think that we have seen that equity market bottom or will we retest the lows of last October?

Jeff Schulze: Yeah, I do believe that we will retest the lows that we saw last October. The reason being is that if the market bottom is in and we have a recession, it would be the first time in modern history where the bottom occurred prior to the start of a recession. Usually, the market bottom will come about two thirds of the way into a recession.

Now, what I will say is the market has had a head start on pricing this recession. So the market bottom may come earlier on, when the onset of the downturn occurs. But I don’t think we’re there quite yet. Looking at forward multiples for the S&P 500 [Index], it’s at an elevated 18 right now. I think we could get back to, you know, around 15, is what we saw back in October. But also more importantly, earnings expectations I think are too lofty for the downturn that I’m anticipating.

Over the last three recessions, peak-to-trough decline in earnings expectations were 25.8%. Today, we’re only in mid-single digits negative. So I think there’s a little bit more to go on that front. But more importantly I don’t see a lot of excesses in the economy. We may retest the lows. We may get a little bit past that. But I don’t expect a downturn to the magnitude of what we saw going through the global financial crisis or the bubble.

Host: Given maybe that choppy and volatile market environment here that we’re going to see in the months ahead, is there an asset class that you think may fare well during that environment?

Jeff Schulze: I think there’s a couple of areas that you want to overweight in your portfolios. Typically, growth outperforms value in the six months after the start of a recession. It also outperforms in the six months before and after the end of a recession. So although value really took the baton last year, you’ve seen some growth leadership this year. And I think that will likely persist over the next 12 to 18 months. And a key reason for that outperformance is a lower 10-year Treasury as investors price in lower growth in inflation. So I think that could be an opportunity from a style perspective.

One area that we think looks really attractive is dividend growers. Dividend growers usually outperform during the entirety of a rate hiking cycle and after that last rate hike is delivered. But I think maybe more importantly, they have all the attributes that you want as you head into a recession. They’re high-quality companies. They have strong balance sheets. They don’t need to access the capital markets. They can fund their own growth. But also, they have a high degree of earnings visibility. And when earnings expectations are moving lower, investors put a premium on that particular attribute. And if the Fed needs to hike further (and they may if inflation is stickier or the labor market continues to hang in there), higher dividend payments will help negate some of the duration effects of higher interest rates. But overall, we’re really advocating quality. I think that is really what you want out of your companies.

The last thing I’ll mention here is that, you know, you probably want to take advantage of some of the volatility as we price this recession. The fact that we’ve hit bear market territory is usually a good entry point for longer-term investors. Since 1940, once you’ve hit -20%, in every bear market, the markets continue to go down by another 15.6%. But if you had bought the day you hit bear market territory looking out 12 months, you recovered all of that initial decline, and the S&P 500 was up 11.8%. Looking out 18 months, the S&P 500’s up 18.5%. So we hit bear market territory in the US nine months ago. For longer term investors, I would embrace some of the volatility that we’ll see here and methodically put money to work if you’re looking out on a longer-term time horizon.

Host: Jeff, thank you for your terrific insight here as we continue to navigate the markets. To our listeners, you can prepare yourself by reviewing Jeff’s monthly commentaries and checking out the Recession Risk 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 Apple Podcasts, Google Podcasts, Spotify, or just about anywhere you listen in. Thank you for joining Talking Markets.


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