Beyond Bulls & Bears


PODCAST Anatomy of a Recession update: The dominoes are falling

Jeff Schulze, Head of Economic and Market Research at ClearBridge Investments, provides us with an update on the Recession Risk Dashboard, a current view of those lagged effects, and perspective on first quarter earnings. In addition: the debt ceiling and perspective on the latest Fed meeting.

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Host: Welcome to Talking Markets with Franklin Templeton. Today we’re talking about the state of the US economy with Jeff Schulze, Head of Economic and Market Research at ClearBridge Investments, a specialist investment manager of Franklin Templeton. Last month, Jeff highlighted for us how the lagged effects of the Fed’s rate hikes were beginning to show up in the economy.

We’ll ask him for an update on the Recession Risk Dashboard, a current view of those lagged effects, and perspective on Q1 earnings. In addition: the debt ceiling and, of course, perspective on the outcome of today’s FOMC [Federal Open Market Committee] meeting.

Welcome, Jeff, and thank you for joining us.

Jeff Schulze: Great to be here.

Host: So, Jeff, let’s start with the most recent topic in that list: your take on the FOMC raising the Fed’s [US Federal Reserve] funds rate 25 basis points and [Federal Reserve] Chair Powell’s comments in the press conference this afternoon.

Jeff Schulze: Well, look, I think that the Fed had to take the olive branch that the market was extending to it with fully pricing in this rate hike. Also, this brings the Fed funds rate to where the Fed views terminal rates to be or peak Fed funds. And I think they needed to do it this meeting, because if you look out to June or July, potentially going to be dealing with debt ceiling issues as well.

So given the sticky inflation picture that you have, the strong labor markets, and more importantly, the fact that wages appear to have peaked (but now they’re plateauing at elevated levels much higher than what would be consistent with 2% inflation), I’m not surprised that the Fed took this opportunity to raise by a quarter percent at this meeting. But more importantly, this meeting was in line with expectations. Powell really didn’t pre-commit to anything, and he really left the door open to further hikes if needed and the data continues to come in hot. So I think we will see a pause. But if the data continues to move higher, we could get more hikes on the horizon.

Host: Earlier this week, we heard from Treasury Secretary Yellen that she had notified Congress that the US could default on its debt as early as June 1st. How serious is this situation?

Jeff Schulze: Well, I don’t want to downplay it because it certainly is serious if they go through the X-date of June 1st—or maybe a little bit later—and have a technical default. And the fact that that X-date is earlier than anticipated maybe increases the probability a little bit. But I would say, you know, although a lot of people are saying a one-in-three chance of this happening, I would say there’s probably a 15% chance of this materializing.

And if it does and we do go through the X-date, I don’t think it’s going to be as much of a default event as an economic event, because the US generates enough cash flow to pay those interest payments to pay Social Security, Medicare, defense and veterans. But unfortunately, the rest of the government would be shut off. And if it’s shut off for a sustained period of time, that would have a huge impact to GDP.

And obviously markets would have to price in that lower growth and inflation outlook. But again, if you do get to that point, I think it will be short-lived and it will create the impetus for compromise to be forged. But more importantly, taking a step back, looking at the potential agreement that’s going to be at hand, if you do get an agreement prior to that X-date, I think the markets are really going to be looking at how much austerity is going to be imposed on the economy and obviously how much that’s going to shave off of the growth outlook. But I do think that an agreement will be forged prior to hitting that X-date of potentially June 1st.

Host: Clearly a serious issue as we would expect, but you see resolution coming down the road. Moving to another topic here, we’re in the middle of Q1 earnings. Broadly speaking, how have the earnings been coming in from your point of view?

Jeff Schulze: Fantastic. Q1 earnings have been beating estimates fairly aggressively. But, you know, it’s important to remember that this was a low bar. Estimates were down quite a bit heading into this earnings season. And although 2023’s estimates moved up by a dollar, it’s primarily because of the beat that we’ve seen this quarter. Putting it a different way, 2023 estimates have not moved if we strip out this quarter’s earnings. And that could be viewed as something maybe a little bit less optimistic from an investor standpoint, because investors don’t really see much more upside in earnings than what’s already being baked in. Another way of teasing this out is if you look at companies that have beat on both the top and bottom line on revenues and earnings, they’re barely outperforming the market when they traditionally outperform by close to 2%.

So I think there’s a little bit of trepidation on what’s being priced as we look out on the horizon. And I think there’s some concerns about potentially a recession materializing.

HostNow, let’s transition to the economy. The ClearBridge Recession Risk Dashboard has been flashing, what I would say, a pretty deep red recessionary signal here with only a few indicators not currently red. Has there been any change as we’ve moved through the month of April?

Jeff Schulze: Yeah. As a reminder, the dashboard has 12 variables that have historically foreshadowed a recession. Stoplight analogy where green is expansion, yellow is caution, and red is recession. And moving into April we only had three non-recessionary indicators, and all three of them took a turn for the worse. Initial jobless claims and truck shipments went from green to yellow and job sentiment went from yellow to red.

So, as it currently stands, ten red, two yellow, zero green signals, but still a very strong recessionary signal coming from that dashboard and it’s a clear reason why we think the recession is going to transpire in the back half of this year.

Host: I guess you would say it even deeper red. Thinking about what you just talked about, the [US] labor market seems to still be extraordinarily strong. I believe job sentiment and jobless claims are leading indicators. I know we’ve talked a lot about lagging and leading. Are these two changes that you just mentioned a real cause for concern?

Jeff Schulze: They are. It’s not uncommon for payrolls to come in pretty strong and then they turn when the recession materializes. But there’s indications that labor was moving in this direction well ahead of time through indicators like job sentiment and jobless claims.

Now, jobless claims is our economic canary in the coal mine—top three ranked variable in the dashboard. Usually when it turns red, it’s confirmation that the recession has started. And if you look at initial jobless claims, you had a huge seasonal factor adjustment for them in the beginning part of April. And after that adjustment, claims were higher by about 300,000 for the year, which importantly reflected a much weaker start to 2023 than what we thought prior to that adjustment.

So this was a key catalyst in us adjusting initial jobless claims from green to yellow. And more importantly, if this moves up to the mid—call it 255,000 per week range—that will trigger a red signal and, in our opinion, the formal start of the economic downturn. But we’re not there quite yet.

Host: The truck shipments downgrade. I mean, I think that that’s pretty clear that obviously there are less goods moving through the system. Is there anything more that you could speak to around that indicator?

Jeff Schulze: Yeah, just another domino that’s falling and showing some broadening out of economic weakness. Now, the reason why truck shipments are so important is that 72% of total freight moved each year goes on a truck. So when you’re seeing lower volumes, that’s usually a sign that the economy is slowing. And when you look at the American Trucking Association’s tonnage index, the latest release that we got saw one of its worst monthly declines on record going back to the early 1970s.

So, from our vantage point, this is a clear indication that supply chain pressures have renormalized. Freight volumes are easing, inventories have been rebuilt, and there’s less stuff moving through the economy. And it, again, brings us one step closer to a potential recession.

Host: Switching gears a little bit here. Last weekend we had the First Republic takeover by the federal regulators and ownership then being transferred to JPMorgan. Any perspective on this development?

Jeff Schulze: The First Republic going into receivership and having the merger there—I think it was, you know, from that vantage point, it was a win-win-win. It limits the FDIC’s [Federal Deposit Insurance Corporation] loss. It helps the First Republic employees in its acquisition, because JPMorgan is able to treat them pretty well. And it obviously benefits JPMorgan shareholders with JPMorgan expecting about US$500 million a year in earnings increases. So I think it was the best case scenario for this particular situation.

But I think more importantly, if you look at trading this week, you’ve seen halts on trading of a number of regional banks like PacWest and Western Alliance Bancorp. You could potentially see some issues with other regionals as we look out on the horizon. So I do think that this is probably the last large failure that we’re going to see. But, there is maybe some indications that maybe we’re not through that transition.

But I think maybe more importantly, whether or not we do see another bank failure, you’re going to see materially tighter lending standards in the economy and lending standards per the senior loan survey by the Fed, which is the gold standard on the matter, were already in recessionary territory prior to the banking crisis. C&I [commercial and industrial] loans were at recessionary levels. Willingness to lend to consumers were at recessionary levels. And although we won’t know the next senior loan survey until next week, I would venture to say that they’re going to be a lot tighter, which is ultimately going to slow economic activity. So although it appears that maybe the worst is over with the banking crisis, we’re going to feel the lingering effects in the next number of quarters.

Host: Sticking with, I guess, kind of a bank theme, you’ve been talking quite a bit about lending standards becoming tighter. I just heard Chairman Powell mention that there is going to be a lot of focus on lending standards by the FOMC as they move forward. Where is the concern here?

Jeff Schulze: I think the concern is really the two pillars of strength of this expansion. And the pillars of strength of every expansion are different. This expansion, it’s been the consumer and small businesses. As I mentioned before, willingness to lend to consumers were at levels that were already recessionary. I think that’s going to come at a time where you’re going to see a lot of consumers have issues because of the student loan repayment restart that’s going to happen in the third quarter. This is going to affect roughly 45 million Americans. And per a study by the New York Fed, the average student loan payment was about US$393 per month, and these individuals have not been paying their loans for years. So this is going to be a genuine shock to their ability to spend and their consumption patterns.

It’s also going to hurt small banks the most, because small banks are not necessarily going to be the ones that are systematically important and are going to be saved by policymakers. And small banks obviously play a big role in lending not only to consumers, but small businesses—as small businesses don’t have relationships with larger banks. They have no access to capital markets. And small businesses have seen a huge increase in the amount that they’re paying for their loans over the course of this year, because the loans that they have are floating instead of fixed, like you see with a lot of larger companies.

So if you look at the NFIB Small Business Survey, the interest rate paid by small business at the beginning part of 2022 is 5%. Today, it’s 8%. And with the Fed hiking today and tighter lending standards, it wouldn’t be a surprise to me if this gets up to close to 10%. So they’re going to see a doubling of their interest expense in a short period of time. And this also comes at a point where they’re unable to pass through price increases as aggressively as they were previously. And also, they have kind of stickier cost structures with a hot labor market.

So small businesses are really an important dynamic of this recovery, because they had a lot of profitability in the beginning part of this cycle and that profitability is coming under pressure. The last thing I’ll mention here (I’m really kind of teasing out this idea of how important small businesses are for the cycle) is that if you look at labor demand—job openings in particular—job openings were seven million prior to the pandemic. They popped up to 10 million here recently. And out of that increase of three million job openings, small businesses—businesses with less than 250 employees—are responsible for 94% of those new job openings. And that’s a pretty interesting statistic, considering that small businesses employ only about 45% of Americans. So as this profitability siege continues for small businesses, although they’re labor hoarding at the moment, it’ll eventually get to a point where they’re going to start to do cost cutting measures and a formal layoff cycle. And I think that point when the rubber hits the road is the third quarter of this year.

Host: There’s been tremendous focus on commercial real estate. Is that just a headline in the media or is there something there to be factored in as another kind of piece of this concerning puzzle?

Jeff Schulze: Well, it comes back to small banks really quickly. Small banks play a disproportionate role in the lending for commercial real estate. They make up about 70% of the lending. So this is, again, another reason why small banks are going to retrench and going to have that effect on small businesses. But, kind of breaking down the numbers a little bit, about US$2 trillion of commercial real estate are on the balance sheets of small commercial banks. Of that US$2 trillion, about US$300 to US$400 billion is maturing this year because when commercial real estate is issued, it’s usually in five- to 10-year increments. So not all of it comes due on an annual basis. And it’s important to note that commercial real estate is heterogeneous. It has a lot of different property types. If you think about a grocery store, very uncorrelated to the business cycle. A hotel is pro-cyclical. And hotels have been doing great here recently. But the real area of concern is office real estate. Because not only are we dealing with potentially a cyclical slowdown, but we have the structural issues from the work-from-home phenomenon. And out of all the debt that’s due this year, about 25% of it is offices, which is about US$75 [billion] to US$100 billion. So not a huge number when you kind of think about the pie, the puzzle.

But also I think an underappreciated aspect of this is that, again, because these loans are issued in five- or 10-year tenures, there’s been a lot of appreciation for these loans over the last five or 10 years. So you have a cushion there. And most of these commercial real estate loans, they lend with loan-to-value ratios of less than 80%. So there’s a lot of equity in there in the beginning. So you’re going to hear a lot of questions and a lot of concerns about commercial real estate. You’re going to have some bankruptcies, but ultimately, I don’t see it being a systematic crisis like the global financial crisis was.

Host: As I think about what we’ve talked about here today, there certainly is quite a bit to be concerned about, to be focused on. I feel like I know the answer to this question, but I’m going to ask you anyway. There are those out there who are still clinging to the potential of that soft landing scenario. Is that really off the table for you?

Jeff Schulze: Look, I said a 75% probability of a recession. That’s about as confident as I’ll say anything will be. The only thing that’s certain in this life are death and taxes. But there are maybe a couple of scenarios where the soft landing could play out. One is the immaculate slackening, the idea that job openings can move back to pre-pandemic levels. That creates lower wage growth, lower inflation. And the Fed may ease in that type of scenario. One thing else to mention is that you’ve never seen a large drop of job openings without a material layoff cycle. But this cycle has been so unique, maybe this is another first that we put on the mantel. The other way that you have a soft landing, at least economically speaking, is that labor hoarding continues. Now, that’s not going to be good for profitability. It’s not going to be good for the stock market, because margins are going to go down. But that would be a scenario where maybe we avoid a recession.

The reason why I feel strongly that a recession is on the horizon is that the leading economic indicators are showing a pretty pronounced drop. It’s not uncommon for the data to be mixed as you head into an economic downturn. The leading indicators turn down first. Coincident indicators are mixed. That’s what’s happening today. And lagging indicators are strong. So that’s why there’s a lot of confusion and disagreement as you’re going into an actual recession. And when you look at the leading indicators, as I alluded to before, they’ve been down for 12 consecutive months in a row. The only two times where you saw a greater number of months of declines was 1973 and 2007.

So again, I don’t think it matters if the Fed hiked today. I don’t think it mattered that the Fed hiked in March. From my vantage point, I think the die is cast for recession as we look to the back half of the year.

Host: So Jeff, with the die being cast, as we look toward the second half year of 2023, do you have any final thoughts for our listeners regarding positioning a portfolio for the long term with that stated high probability of a recession that could be of value?

Jeff Schulze: Yeah, we continue to advocate for more higher quality, more defensive areas of the marketplace. From a sector level, we like healthcare and consumer staples. Those tend to do better on a relative basis in the second half of recessionary selloffs.

One asset class within the equity markets that we like are dividend growers. They have all the attributes that you want. They are high-quality companies. They have rock solid balance sheets. They generate a lot of free cash flow, so they can fund their own growth and they don’t need to access the capital markets. Also, they tend to have a high degree of earnings visibility, which is an attribute that’s coveted when earnings expectations are lower. And then if the Fed has to do more hikes (and don’t say it’s impossible because the Fed has surprised to the upside for the last year), that higher dividend growth will negate some of the duration effects of higher interest rates. So we think those are areas of potential opportunity if we’re going to see some choppier markets.

And the last thing I’ll mention is that, you know, you may want to embrace some of this volatility to start putting money to work in a more methodical manner. Because just because we’ve hit bear market territory is usually a good chance for longer-term investors. So when you go back to 1940, look at all bear markets, once you hit -20%, the markets go down another 15% after that point. But if you had bought the day you hit bear market territory, 12 months later you recovered all of that downside and an additional 11.8%. If you look out 18 months later, you’re up 18.5%. And a lot of investors forget that we hit bear market territory over 10 months ago. So if we do see some volatility and a repricing of the markets, for longer-term investors we think this is an excellent opportunity to start methodically putting some money to work.

Host: Thank you, Jeff. Thank you for your terrific insight today as we navigate the markets. 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 Apple Podcasts, Google Podcasts, Spotify or anywhere else you listen.

Thank you for joining Talking Markets.


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