Beyond Bulls & Bears


PODCAST Anatomy of a Recession update: Gradually, then suddenly

In this episode, we speak with Jeff Schulze, head of economic and market research at ClearBridge Investments about the Federal Reserve, rolling-sector recessions, artificial intelligence, and receive the latest update on the ClearBridge Recession Risk Dashboard.

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Host: Welcome Jeff, and thank you for joining us.

Jeff Schulze: Glad to be here.

Host: Jeff, I wanted to start by asking you about artificial intelligence. AI, as it’s referred to, appears to be a big driver in the strong equity market performance this year. What are your thoughts on the future AI has in the US economy?

Jeff Schulze: Well, obviously AI has supercharged the indexes, for the S&P 500 and the NASDAQ. And there’s some optimism that the productivity wave that we’ll get from AI will keep the economy out of a recession over the next couple of years. And while I’m expecting a large productivity wave that could rival what we’ve seen during the internet revolution in the 1990s and the 2000s, I think the wave is going to come too late this cycle to stave off a recession. And the reason why I say that—a lot of companies are investing in AI technology, so it’s going to take a couple of years to realize the benefits of that investment. But if you look at productivity right now, it’s extremely negative on a year-over-year basis and at levels that are typically seen during recessions. So this is reinforcing the notion that companies are hoarding labor at the expense of profitability. So, while I’m optimistic about AI and the benefits that it’s going to bring not only for the economy, but for the markets and company profitability, I just think it’s going to come a little bit too late for this current expansion to be saved.

Host: Okay. So, shifting topics here. Rolling-sector recessions is a phrase that I’ve been hearing quite a bit about recently to characterize the state of the US economy. Does this resonate with you?

Jeff Schulze: Well, there has been some optimism on a rolling recession: this idea that different parts of the economy will go into recessionary territory, and by the time that they come out of recession territory and they start expanding, other areas of the economy will go into a downturn. Now, a lot of this optimism is coming from the recent strength that you’ve seen in housing, which is one of the most interest rate-sensitive areas of the economy. Housing starts in May saw its largest monthly pickup in over three decades. The Case-Shiller National Home Price Index has rebounded over the last two readings. And, although I’m optimistic about the rebound that we’ve seen in housing, it’s important to remember that historically many past downturns have initially resembled a rolling recession. The only real synchronized downturn that we saw was in 2020 when you shut down the entire economy.

So, the way that it usually works is that housing goes down first, followed by durable goods, and then some of the less cyclical areas of the economy actually go into decline closer to the onset of the downturn, like services and non-durable goods. Now importantly, although we’ve had a bounce in housing, it’s not unheard of to see a bounce within a larger downturn, both in the lead up to and during the past recessions that we’ve seen. Furthermore, the economy can enter into a recession while housing remains relatively healthy. That’s something that we saw in 2001. So, I know that there’s a lot of ink spilled about this being a rolling recession. But, given that this is typically the dynamic that you see heading into an economic downturn, it does give us pause that the probability of one will play out resulting in a soft landing in the coming quarters.

Host: Okay. So in some of our recent conversations, we have focused quite a bit on the leading economic indicators. Are there any changes there to take note of?

Jeff Schulze: Well, yeah, I think it’s important to note that a lot of the data that’s been surprising to the upside, the resilient data has been lagging or coincident. It can tell us where we’ve been or where we are, not necessarily where we’re going. And I think a great analogy for this is like driving a car. When you’re driving a car, you don’t want to be looking in the rear view, you don’t want to be looking out the side window. You really want to be looking through the windshield. And that’s why the Leading Economic Indicator Index by the Conference Board is so important. Now, importantly, usually when you see four consecutive monthly declines of this index, you’re in the recessionary danger zone. Today we’ve seen 14 consecutive monthly declines, and the only two times where you had a greater streak of negative declines was 1973, and then the global financial crisis. From our vantage point, although the data has been resilient, looking into the back half of the year, we’re not so sure that that’s going to continue to be the case.

Host: Okay. Fourteen consecutive monthly declines, that’s a big number. That leads me to the ClearBridge Recession Risk Dashboard. How do things look with your June 30th update?

Jeff Schulze: Yeah, so as a reminder, the Recession Risk Dashboard is a group of 12 variables that have historically foreshadowed a looming recession. Stoplight analogy where green is expansion, yellow is caution and red is recession. And as of June 30th, we have an extremely red overall signal: 10 red, two yellow and zero green signals. If you look back to the last eight recessions, this is traditionally what the dashboard looks like as you head into those recessions. So we continue to believe that a lot of the economic momentum that we’re seeing today is going to start to slow dramatically as we get to the back half of the year.

Host: Okay. So given that view, the obvious follow-up question here is, do you have at this point any additional clarity on when the most anticipated recession will actually begin?

Jeff Schulze:  So, when the overall dashboard went red at the end of August of last year, we had felt in September that it was going to take about a year for the economy to roll over, given the strength that we’ve seen, and the longest length of lead time between an overall red signal and the start of a recession was in 1990’s downturn. That was about 13 months. So we thought there was a pretty strong parallel, at least from a timing perspective. But, given recent economic strength, it actually may not be the third quarter of this year, it may be the fourth quarter. But I think importantly, if you look at why you’ve seen the economy hold up better, and the markets hold up better here recently, you’ve seen some pretty strong economic momentum. If you look at the economic surprise indexes, and you can look at the Bloomberg or the Citi Economic Surprise Index, they measure the frequency with which data releases are beating or missing consensus expectations.

And because you’ve seen such strong data releases here—and we talked a little bit about housing a second ago—this series tends to be mean reverting, and right now they’re in the top decile of all readings, top 10%. Usually when you’re at these levels, they tend to roll over and you start to get a string of disappointing data. And that’s what we’re anticipating again in the back half of this year that is going to remove an important support for the prospects of a soft landing. Now, I think maybe more importantly, if you look at history, it usually shows that the economy often experiences a sharp deterioration in economic momentum as recessionary forces coalesce. And looking back at the last eight recessions—so to the late 1960s—three quarters prior to the onset of a recession, real GDP [gross domestic product] growth in the US has averaged 4.6% on a real basis. In the two quarters prior, that moves down a little bit, but it’s still at a robust 3.5% on a real basis. But the key here is one quarter before the onset of a recession, that 3.5% drops to 0.8%—so barely positive territory. So just because we’ve had some resilience and economic activity again in the first half of the year, doesn’t really tell us about what’s going to transpire in the third and the fourth quarters of this year.

So given that you see this non-linear acceleration to the downside, it actually reminds me of the Ernest Hemingway novel, The Sun Also Rises when the character Mike Campbell was asked, “How’d you go bankrupt?” And he said, “Two ways. Gradually, then suddenly.”

Host: So Jeff, earlier in the year, we had the Silicon Valley Bank failure as well as a couple of additional smaller regional banks go down. Headlines are starting to now poke up on the topic of the banks having potentially some trouble on a go-forward basis. Is there anything unique from your point of view that we should be aware of in the banking sector as we start the second half of 2023?

Jeff Schulze: We’ll only know in hindsight whether we’ve seen the last major regional bank failure. We certainly could see another one as the Fed [US Federal Reserve] continues its rate-hiking cycle. But the one thing that you will see is a continued tightening of lending standards. Now, importantly, even before Silicon Valley’s bankruptcy, lending standards for C&I [commercial and industrial] loans for businesses, lending standards for consumers, were already at recessionary levels, and they’ve gotten even more restrictive as a consequence of some of those banking stresses. But I think maybe more importantly, loan demand has been plummeting for large, medium and small businesses. So there’s less of a willingness for credit creation, but there’s also less of a willingness to borrow. And that’s not really a good dynamic for strong future economic activity. Now, a lot of the tighter lending standards is going to be administered by smaller banks, in our opinion. Those are banks outside of the top 25 in the United States. They aren’t systematically important, so the Fed’s not going to ride to the rescue. Also, they have less regulatory scrutiny, so I’m sure they have a lot of the risk-management issues that we saw with the regional banks that failed. But also, small banks make up a disproportionate amount of lending in commercial real estate—over two-thirds of that marketplace. And obviously that’s an area that’s seeing some strains. So we think small banks are going to pull back the reins on lending, but importantly, they pack a pretty big punch. Small banks make up less than 29% of total banking assets, but they play a disproportionate role in lending—accounting for 36% of the total.1 And in the last year, they’ve accounted for 66% of total loan growth. And a key reason for that is small banks tend to have relationships with small businesses, which we’ve been saying are the key catalysts or the key driver of not only a hot labor market, but the economic momentum that we’ve seen in this particular cycle.

Host: Okay. So clearly keeping an eye on the smaller regional banks is going to be important for us as the year progresses. You mentioned earlier small businesses. How are small businesses faring at this point?

Jeff Schulze: Well, small businesses still tend to feel the impact of monetary tightening with a lag compared to larger companies. Larger companies can access the capital markets. They issue debt in fixed terms. So, when the expectations of a rate hike comes into the marketplace, that’s priced immediately, and it’s felt by those larger companies. Smaller companies, by contrast—they have relationships with small banks, and they borrow from those banks at a floating short-term rate plus a spread. So they feel the impacts of monetary policy decisions when that rate hike actually is instituted and their borrowing costs adjust accordingly. Now, importantly, if you look at the NFIB Small Business Survey, the average rate that a small business is being charged for a loan has jumped from 5% to almost 8% today. So that’s a pretty large jump in borrowing costs in a short period of time.

So that’s pressuring profitability, but also small businesses have lost the ability to pass through higher price increases. Now, in the aftermath of the pandemic, the differential between the number of companies raising prices and raising compensations was at record highs. So this led to a huge profitability wave. And over the last year, that gap has narrowed considerably with only a few companies looking to raise prices compared to those raising compensation. So profitability is being squeezed for small businesses, and eventually we think that this will lead to cost-cutting measures, which include layoffs. So you’ll finally see that layoff cycle broaden from just kind of large-cap, more tech-oriented companies into Main Street America.

Host: Okay. That certainly makes sense. Do you see any other potential headwinds in the economy? Maybe things that you’re keeping a keen eye on?

Jeff Schulze: Yeah, we think that there’s balance sheet fatigue for consumers. Now obviously there’s tighter lending standards for consumers, as we talked about earlier, that’s going to constrict some, some credit creation. But also, US consumers have been going toward revolving credit in a much greater degree over the last year in order to sustain their spending. And importantly, with the average credit card debt at record highs of 21%, we think that this can continue for maybe three or more, maybe six months, but there is going to be a point where the rubber hits the road.2 Maybe more importantly, if you look at delinquency rates across different avenues of consumer credit, they’ve hooked up pretty meaningfully here recently. You’ve seen an increase of auto delinquencies, other credit delinquencies, credit card debt delinquencies and mortgage delinquencies have moved a little bit higher. But really, I think something that could create more of an increase of delinquencies is the student loan repayments that are likely coming in the fall of this year. Now, we think that this is going to have some knock-on effects to not only student loan delinquencies, but all of those other areas of credit. And if you look historically, when all of these areas start to move up in tandem with one another, that’s not a good sign for the durability of an expansion. So we continue to believe that you’re seeing balance sheet fatigue by consumers, which increases recession odds.

Host: Okay. So the consumer is becoming susceptible. So Jeff, given all that you’ve laid out here for us on the state of the US economy and the data that the Federal Reserve is analyzing, what are they telling us? What are they telegraphing?

Jeff Schulze: Well, the Fed, although they haven’t come out and said it, they’re basically soft messaging that a shallow recession is on the horizon. And the way that you can glean this out is by looking at their dot plots or their expectations for the unemployment rate. Right now, the Fed expects the unemployment rate to be 4.1% at the end of this year. And if that indeed transpires, that would violate what’s called the Sahm Rule, which states that an increase of a half a percent or more in the unemployment rate (and the lows were 3.4%) has always led to a recession over the course of the last 55 years. So, when you think about layoffs, usually you don’t get a little bit of a layoff cycle. It usually metastasizes into a much larger layoff cycle. And I think, importantly, the Fed has little tolerance for job loss historically, and that’s not necessarily the case today.

If you go back to the late 1950s, the median for the first rate cuts usually comes between the instance of the economy creating jobs to kind of a standstill. And a year later, the loss of jobs is at 796,000. Now, what the Fed is implying by their dot plots is they’re anticipating close to 800,000 jobs lost this year in the back half of 2023. And in this environment, they’re expecting themselves to raise rates by another 50 basis points or two hikes. So if the Fed is going to be later to the game in providing stimulus, they’re more comfortable with job loss, we think that this creates a higher recessionary impulse when all is said and done.

Host: Okay. So 800,000 jobs being lost. That’s a huge number. You mentioned the Fed. The FOMC has got their next meeting set for the end of this month, and you mentioned potentially additional rate increases. Do you think that they’re going to take a stance here at the end of July, or will they wait for the next meeting?

Jeff Schulze:  Well, I think they’re going to take the chance to raise rates. Non-farm payrolls came in at 209,000 in June. The three-month average, although it dropped pretty dramatically because of some negative revisions to what we saw in April and May, is still 247,000 jobs per month. To put that number in perspective, the last time you saw sub-4% unemployment was in the back half of 2018. In all of 2019, the US economy was creating about 155,000 jobs per month. So we’re creating roughly two thirds more jobs today than what we saw back then. So, this is still a pretty hot labor market, and barring a huge miss to the downside in the CPI’s release later this month I think the Fed will hike at the end of July. But, at the end of the day, I think that the die is cast for recession, given all the things that we talked about earlier with the leading indicators, with the dashboard, balance sheet fatigue. Again, I think that this is not necessary, but I think that they ultimately will do a hike at the end of this month.

Host: Okay. So Jeff, let’s do a quick pivot here and transition to capital markets. We’ve seen strong positive performance in the S&P 500 index—as a proxy—and the NASDAQ 100. What’s driven this performance in 2023 to this point?

Jeff Schulze:  Well, believe it or not, almost all of the rally that you’ve seen in the S&P 500 has come since Silicon Valley Bank’s collapse and seizure in mid-March. From that point until the beginning part of June, most of that rally was the top 10 names in the S&P 500—mega-cap tech stocks that are really going to benefit from the AI wave that the economy’s going to experience. But really since the beginning part of June, you’ve seen a broadening out of participation into more cyclical areas of the market and smaller-cap names. Now, again, that’s a really good dynamic. If that continues as we move through the summer, maybe they have some sustainability of this rally. But given our views on the economic surprise index that we talked about earlier and the slower pace of economic activity, we don’t necessarily think that that’s sustainable. But I think another reason potentially for concern is that almost all of the advance that you’ve seen in the S&P 500 from the October 2022 lows has been driven by multiple expansion (forward PEs [price/earnings] moving higher), and none of it’s been driven by improved earnings expectations. So, with forward earnings of the market back up over 19 times earnings, we think that adds a very optimistic outlook that’s being embedded in equities right now.

Host: Okay. Jeff, I can clearly hear the concern in your commentary. In some previous conversations, you’ve mentioned retesting the equity market lows that were experienced back in October of 2022. Do you still think that that’s probable?

Jeff Schulze: Yeah, I think we will retest. Will we ultimately break through the lows? It’s hard to say at this point. I mentioned before that PEs are now above 19 times forward earnings, which is historically pretty rich. I think also more importantly, if you look at consensus year-over-year expectations for earnings growth, there’s an expectation that it’s going to rise to over 20% positive by the third quarter of this year.3 It’s going to turn positive as we get through this earnings release is the expectation. And that’s in stark contrast to what consensus economist forecasts are for nominal GDP growth. So one of these two cohorts are ultimately wrong. Given our view on economic activity, we think that the market is pretty optimistically priced at this point, but I think maybe more importantly, if you look in the post-World War II era, you’ve had 12 recessions. You’ve never seen the market trough or bottom before the start of a recession.

And if October 22 was the lows for this cycle, that trough would’ve occurred a year potentially ahead of this upcoming downturn. So, I do think that the markets are not pricing in this upcoming recession that we’re anticipating. Now, will we break through the lows? That’s hard to say, because we’re probably in the honeymoon phase right now of artificial intelligence. The AI narrative is quite appealing. This is the emergence of a technological innovation that can transform businesses by boosting productivity and enhancing margins in the process. Companies there are large, they’re cash rich, they’re tech leaders well-positioned to benefit from what’s appears to be a very large addressable market opportunity. And although a lot of people compare this to the bubble, it’s not as high from a valuation perspective as what we saw in those heady times. Valuations are about half the levels for the S&P 500 as what you saw back in March of 2000.

Also, the S&P 500 is 50% more profitable as measured by return on equity as what we saw in March of 2000. So the real wild card in my vantage point is, will investors buy the dip in these perceived AI beneficiaries that keep the indexes elevated compared to what you would normally think a recession would materialize with? And it’s hard to know, how much euphoria or positive sentiment and capital is going to flow into that space. But ultimately, we think, we’ll retest the lows. I’m not sure that we’ll break through those lows. That real wildcard comes back to the excitement around AI.

Host: Terrific insight there, Jeff, and I love that analogy of a wild card. Any final insight today for our listeners?

Jeff Schulze:  So with the recession on the horizon, obviously this has been a little bit of a glass half full view for what we’re anticipating for financial markets. We’re certainly expecting some volatility as this recession is priced. With the recession on the horizon, we’d advocate that any selloff that we see in this downturn be used as an opportunity for long-term investors, because we do believe that the AI movement will likely produce a productivity wave that’s going to help insulate corporate returns from the megatrends of an aging population, de-globalization, and re-shoring.

Although the obvious beneficiaries have seen their valuations swell as we just talked about, I think the larger benefit may actually accrue to the old economy—labor-intensive companies with thin profit margins that can upscale their more junior staff relatively quickly, leading to a pretty big boost in earnings power from efficiency and productivity gains. And this can help boost a lot of the underperformers, quite frankly, that we saw from the last cycle, and provide the catalyst for what I believe would be the last leg of the secular bull market that I believe that we’ve been in since the March 2009 lows following the global financial crisis.

And if you’re not familiar with the term secular bull markets, they’re usually a 20-year period where you see outsized equity returns. But they’re usually followed by secular bear markets, which is a 10- to 20-year period where the markets don’t move up materially. And this is a dynamic that’s been going on since the early 1930s, and if history continues to run in these cycles, that would suggest that this secular bull market still has another seven years to run through the end of this decade. So, although we’re expecting some downside volatility, it’s important to keep that long-term perspective intact.

Host: Jeff, thank you for your terrific insight as we continue to navigate here in 2023. 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 else you listen. Thank you for joining Talking Markets.


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1. Sources: Federal Reserve, FactSet. Past performance is not a guarantee of future results. (note: sourcing is for pages with full transcript listed)

2. Ibid.

3. Sources: S&P, FactSet, Credit Suisse. 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.

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