Listen to our latest “Talking Markets” podcast. A transcript follows.
Host: Jeff, we have the next FOMC [Federal Open Market} meeting coming up on September 19th and 20th, and then two more after that for the remainder of 2023. Do you think we’re at or near the end of the hiking cycle given the progress we’ve seen with inflation?
Jeff Schulze: Well, we’ve seen a lot of progress with inflation. Obviously, still some more work to do, which is why the Fed is going to have “higher for longer” policy. They’re going to keep rates elevated for the next couple of quarters at a minimum. But I do think, given the weakness that we saw with the labor market data and the signs that you’re starting to see a rebalancing—with lower job openings and the payrolls reports seeing some strong revisions downward and the rise of the unemployment rate up to 3.8%—I think that will likely give the Fed some comfort that they’re starting to make some progress on cooling the economy and returning inflation to 2% on a sustainable basis. So, if you look at September, the markets are pricing virtually a 9% chance of a rate hike. So, I don’t think it’s going to be coming here in the next week. We may get one in November. Again, it just depends on how the data comes in for inflation in the labor markets. But from my vantage point, I think you’re going to see continued weakness in the US economy, and I think we have seen the last rate hike of this cycle.
Host: So, Jeff, shouldn’t that weaker labor data mean that a soft landing is actually going to happen?
Jeff Schulze: Well, the soft-landing camp is certainly cheering that with the price action last week, but I want to say that the landing always looks soft before it ultimately is a hard landing or a recession, right? Look at the [US] unemployment rate. It was flat on a year-over-year basis during the summer of ‘07, during the spring of ‘01 and early 1990. Obviously, those all materialized into recessions. A hard landing has to go through a soft landing first.
So, looking at the job openings data: dropped from 9.6 million to 8.8 million. That is a massive move lower. And let’s not forget that the job openings data has a lag of around six weeks, so it’s probably weakened even further. Maybe more importantly, you saw the quits rates move lower, which is good for inflation. But looking at the epicenter of labor market tightness, which is leisure and hospitality, the quit rate actually dropped from 5% to 3.9%. That is a massive move. And that leisure and hospitality is punching well above its weight with 23% of jobs created over the last year. So, if the epicenter of labor market tightness and job growth over the last year is loosening to a very strong degree, that’s maybe a situation where the labor market is going to overshoot to the downside. Also, there’s other signs of concern that we saw in late August with those releases. The Conference Board’s Consumer Confidence Survey dropped way more than consensus expected. More importantly, our job sentiment indicator in our Recession Risk Dashboard—which is the number of consumers that are saying “jobs are plentiful” minus those that are saying “hard to get”—dropped by a full 6% down to 26. That is a massive move, and it’s the lowest that we’ve seen since April of 2021. But more importantly, from a labor market and an economic perspective, this is consistent with the unemployment rate rising over the next couple of months.
And the last thing I’ll mention—although the [August] payrolls report appeared to be a healthy one, you saw the payrolls revised over the last two months by 110,000 downward. This is a trend that we’ve seen in each and every initial payroll release this year; the initial release has been revised lower. More importantly, a couple weeks ago, the preliminary benchmark revision to March 2023’s data was -306. And the reason why I say this is that when you get the jobs report, in order to get that jobs number, the BLS [Bureau of Labor Statistics] makes an assessment of how many companies were created over the course of that month and how many companies went under. It’s the birth-death adjustment. And usually when you get close to a late cycle or early recession period, payrolls are overstated and you see some chunky downward revisions. And that’s exactly what we’re seeing here. So yes, things look good on the surface, but I think when we look back at this period, the job growth that we’re seeing may not be as strong as we initially had thought.
Host: So, Jeff, it does certainly sound to me like you still have a firm view that the US economy is going to experience a downturn. Are there other things that are driving you to that conclusion?
Jeff Schulze: There are a couple other things. The Leading Economic Indicator Index by the Conference Board was down for another month in a row, so that’s 16 consecutive months. The only two times where you saw a stronger streak was going into 1973’s recession and the global financial crisis. So, as Wayne Gretzky would say, he wants to go where the puck is going. The LEIs—or Leading [Economic] Indicator Index—they usually show you where the economic puck is going, which is for weaker activity as we get closer to 2024.
Also, although consumption has been strong, I’m not necessarily sure that that’s going to continue to be the case as we move into the holiday season. First off, the San Francisco Fed released a paper saying that, by their estimates, the excess savings accrued in the aftermath of the pandemic has exhausted this quarter. Gas prices are up 20% year-to-date. You have student loan repayments happening now. You saw a drop in credit card debt, a revolving credit, last month. That’s the first decline that you’ve seen since 2021. And I think that’s a direct result of record high credit card rates and tighter lending standards. And then also, delinquency rates are moving up right now, whether you’re looking at autos, other credit, credit cards. Even mortgage delinquencies are moving higher. And although we’re back at pre-pandemic levels, usually when all of these move up in tandem with one another, it’s a sign that a recession is on the horizon. And let’s not forget: if delinquency rates are rising with the labor market as tight as it is now, if you do start to see some loosening, which is one of the conclusions that we saw with that jobs differential that we just talked about, we think that we’re going to see some weaker consumption on the horizon.
Host: So if that recession is on the horizon and it’s to come here sooner rather than later, I think this actually might be a great point in time to remind our listeners of the formal definition of a recession and who actually will declare it.
Jeff Schulze: Well, I know everybody thinks that a recession is two consecutive quarters of negative real GDP [gross domestic product] growth, but it’s not that simple. You’ve actually had two recessions in the US that did not have two consecutive negative quarters, and you never saw that in 2001’s recession. You never saw it in 1960’s recession. The proper definition of a recession comes from the National Bureau of Economic Research, the NBER, which is a private nonpartisan organization of nearly 1,700 economists in North America. And their definition is that a recession is a significant decline in economic activity that is spread across the economy and lasts more than a few months. So you’re going to see this in consumption, manufacturing, sales, payrolls, personal income. You need to see all of those moving lower at the same time. And although a couple of these boxes are checked, we’re clearly not there yet. But again, I know a lot of people think of it as two consecutive negative quarters of real GDP growth, but that’s not the definition of a recession—at least not by the NBER’s standards.
Host: So, Jeff, the ClearBridge Investments Recession Risk Dashboard is really the foundation for your thought and perspective here. What did we see, if anything, change with the August 31st update?
Jeff Schulze: Nothing. As a reminder, ClearBridge 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 the current output is exactly as it was at the end of July. You have zero green, two yellow and 10 red signals. But more importantly, still have a very strong red color (or recession color) coming from the dashboard.
And I just want to remind everybody, this dashboard went red literally a year ago. And when we had gone to an overall red, we felt from a timing perspective that the start of this recession would be similar to what was seen ahead of 1990’s downturn because of the strong economic activity that we saw last year. The 1990 downturn was the longest length of time between an overall red signal and the start of a recession, which was 13 months. So we’ve always kind of had our eye on late third quarter for the start of this recession. But given recent economic strength, we’re pushing that back to the end of the year or maybe even the first quarter of 2024. But we continue to believe that this is a valid red signal.
Host: Recently, there’s been quite a bit of conversation about the yield on the 10-year US Treasury. Why is that so important for investors?
Jeff Schulze: Well, it’s important for investors because it has ramifications for not only equity market valuations, but leadership as well. So, if you look at the last 10 hiking cycles, going back to the early 1970s, when you look at the market pattern for equities, credit and the [US] dollar, it’s all the same leading up to the last rate hike. But after that last rate hike, you have very different outcomes based on whether or not the economy goes into a recession or has a soft landing. Now, if you look at the 10-year Treasury going into that last rate hike, the 10-year Treasury falls regardless of the fate of the economy. So, again, going back to the early 1970s, last 10 hiking cycles, 10-year Treasuries at peak has coincided exactly with the peak of the Fed funds rate, or that last rate hike, on average. Sometimes it comes a little bit earlier, sometimes a little bit later. But it usually is right in line with that. So, with the Fed likely nearing the end of its hiking cycle (if not already, sometime later in the fourth quarter), you’re probably going to see long yields decline. And that’s going to have, again, important ramifications for equity market valuations and leadership.
Host: So Jeff, it’s extremely important for equity market valuations. Tell me why that is.
Jeff Schulze: The declining long-term interest rates bode well for equity market valuations, because future cash flows are discounted by a smaller amount. In effect, the value assigned to future profits rises as the discount rate declines, which increases the value of that asset, even though you’ve actually seen no change in the underlying cash flows themselves. You could think of it as a teeter-totter, if you will. The discount rate (or the 10-year Treasury in this instance) as it moves down, the value of that asset tends to move higher. And when you look at the S&P 500 [Index], it’s not cheap at the moment. At 18.8 times next 12-month earnings, it looks expensive on a historic perspective, but if the 10-year Treasury (and, by extension, discount rates) drop from here with the end of this tightening cycle, the market multiple is going to look a lot less stretched than it does right now with the 10-year yielding over 4%.
Host: So does this dynamic tend to favor companies that are considered growth or those referred to as value?
Jeff Schulze: Well, beyond just the level of valuations, bond yields can also influence market leadership. And you’ve seen this clearly in the recent market choppiness this summer. So, generally speaking, equities with defensive and growth characteristics, they tend to benefit when long yields decline. On the opposite end of the spectrum, cyclical and value stocks tend to outperform when rates move higher. So, in the middle part of this summer through late August, you saw a sharp rise of the 10-year Treasury. Sectors that were more defensive and growth-oriented (like utilities and information technology), they underperformed—while areas that were more cyclical and value-oriented (like energy, for example), they outperformed. And this dynamic occurs for a couple reasons. First reason is that lower bond yields tend to signal a decelerating economic environment. So, when you have slower economic growth, equity investors are going to seek out companies that have more resilient earnings profiles, so you have more certainty of what that earnings expectation is going to be. And they also seek out companies with more attractive dividend yields, because that dividend is going to provide some buffer to your total return. This is an attribute that you see in defensive companies. By contrast, higher yields tend to accompany an economy that’s improving. So that boosts the cash flows of more cyclical companies, companies that are very highly tied to what the economy is doing to a much greater degree. Also, as yields move higher, investors can find more attractive yield opportunities in the fixed income space, which diminishes, again, that higher dividend that you get with defensives relative to cyclicals. So that’s the first way.
The second way that high interest rates impact leadership is related to the discount rate that I mentioned a little bit earlier. Growth stocks tend to have a much greater emphasis on cash flows further in the future. So we’re talking five or maybe eight years out. And, as a result, those types of equities tend to be punished more when the discount rate rises (or the 10-year Treasury in this instance) and the value of those future cash flows is reduced. By contrast, if we look at value stocks, they really are priced on cash flows that are occurring over the next couple of years. So they’re much less susceptible to changes in the 10-year Treasury than their growth peers.
Host: Jeff, that’s very, very interesting. How could this impact an index like the S&P 500?
Jeff Schulze: Well, the S&P 500 has become more dominated by companies with these growth and defensive characteristics in recent years. And you’ve seen the share of cyclical and value companies decline pretty dramatically. The important thing to note is that this is not a new phenomenon. This is a trend that’s actually been going on for a century. So, today, the share of S&P 500 companies that can be classified as growth or stable or defensive is over 70%. That’s up from 60% 10 years ago and 40% 100 years ago. So it means that the S&P 500 has become much more sensitive to changes in bond yields in the recent past. And, if bond yields are nearing their peak (or have reached their peak, if we’ve had that last rate hike), lower rates could help support valuations certainly in a soft-landing scenario. Or, if the recessionary scenario comes to fruition like we’re expecting, it could blunt some of the pain for equities if we do go into an economic contraction. Now, how far will Treasury yields fall is an open question. I think they may fall a little bit less than what we’ve historically seen, because investors are going to want to get greater compensation because of the uncertainty around inflation. But nonetheless, long yields always fall when a recession materializes. And that’s something that we’re anticipating, which would clearly be a tailwind for more defensive companies, as we’ve talked about, and, we think, growth over value.
Host: Jeff, thank you for your terrific insight today as we continue to navigate the markets. 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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