Transcript
Host: Welcome to Talking Markets with Franklin Templeton. Happy New Year to everyone. As 2024 kicks off, we’re sitting down with ClearBridge Investments’ Head of Economic and Market Strategy, Jeff Schulze. ClearBridge is a specialist investment manager of Franklin Templeton. And Jeff is the architect of the Anatomy of a Recession program, designed to provide thoughtful perspective on the state of the US economy with practical insight that you can use.
Happy New Year, Jeff. We’re excited to have you here in the studio as we kick off the new year.
Jeff Schulze: Happy New Year.
Host: So, Jeff, in 2023, your view was that a recession was forthcoming. The economy really seems to have held up to this point. Has your view changed as we enter the new year?
Jeff Schulze: Well, our view hasn’t changed, but we’ve increased the odds of a soft landing to 45% over the last quarter. You’ve had some strong economic data. You’ve seen a labor market that’s become more in balance, and you haven’t actually started to see layoffs materialize. And I think, maybe more importantly, you’ve seen a faster pace of disinflation, which allows the Fed [US Federal Reserve] to potentially cut rates to increase the odds of the economy continuing to move forward. So, while recession continues to be our base case of 55%, we think that the odds of a soft landing are getting better. But we really need to get through the next six months before we’re a little bit more confident embracing that more fully.
Host: General consensus out there seems to be that the economy will have a soft landing and there won’t be a recession here in 2024. You don’t believe we’re out of the woods. What are your biggest concerns at this point?
Jeff Schulze: Well, although fourth quarter saw some encouraging data, it really doesn’t preclude a recession from occurring. So historically, the data tends to turn down in a non-linear fashion as the slowdown builds some steam. And you can see this in a number of different areas.
Take the labor market for example. As you near a cycle peak, the economy transitions quickly from strong job formation to outright losses. So, when you go back to 1948, the average job creation per month in that final quarter before the recession starts is 180,000. And then as soon as that recession hits, in the quarter afterwards, job creation goes to -213,000 per month. And if you look at the last three months, job creation has been around 165,000. So we’re pretty consistent with what you see ahead of prior recessionary periods. Maybe if I put this a little bit differently, strength in the labor market, which is a notoriously lagging indicator, means that we’re not out of the woods quite yet.
And the same thing happens with consumer spending. If people are losing their jobs, consumer spending turns pretty quickly at the onset of a recession. And, in fact, going back to the last eight downturns, in that quarter of the recession start, five out of eight of those quarters saw positive real consumption. And really after that job loss starts to accelerate, you see, broadly speaking, some negative consumption trends.
So, yes, you’re seeing a healthy labor market right now. Yes, this consumer has been a beacon of strength in 2023. But, again, that doesn’t really tell us what to expect over the next six months as we’re expecting a deeper growth downturn as the lagged effects of Fed tightening hit the economy and you don’t have that fiscal support that you saw in 2023.
Host: Given what you’ve just laid out there, I’m really excited to hear if there has been any change to the ClearBridge Investments Recession Risk Dashboard with your December 31st update.
Jeff Schulze: There has been some change, which is one of the other reasons why we’ve increased the probabilities of a soft landing. So, over the course of the fourth quarter, we actually had three individual indicator upgrades. Back in October, we had Retail Sales go from red to yellow. And in December we had two upgrades with Credit Spreads and Commodities both going from red to yellow as well. So that’s a really good dynamic. And while it’s too soon to wave the all-clear flag, it wouldn’t be a surprise to see the overall signal move from red to yellow if we can continue with the momentum that we’ve been seeing over the last three to six months. And, looking at some of these other indicators, Manufacturing PMI [Purchasing Managers’ Index], New Orders and Building Permits could see a change to yellow in the coming months.
But the one thing I want to mention: we’re expecting a growth downturn, slower economic activity in the first half of 2024, which could halt or maybe even reverse some of the progress that we’ve seen. So, obviously, this is something that we’re going to monitor and continue to provide updates, but it is a positive sign when you take it by itself.
Host: So, three red signals moving to yellow in the quarter, two with this most recent update. But your overall signal’s still red. Has there ever been a point where the Recession Risk Dashboard has flashed red for a period of time and a recession hasn’t happened?
Jeff Schulze: Yeah, it has. Not including today’s overall red signal, but prior, going back to the early 1960s, we’ve had nine overall red signals, eight of which were recessions. So the hit rate’s very strong.
But you did have one false positive red signal back in 1967. During that timeframe, economic activity slowed to 0.2%. So it was a near miss from a negative growth perspective. But the other thing that’s really important to realize is that it was extremely early in the dashboard’s history, which really started to monitor data in 1963. So, today we have an additional 55 years’ worth of data, so the model’s smarter—and eight recessions to be able to make smarter decisions. So, while the hit rate for a red signal is very strong, there is an incidence back in the 1960s where a red signal did not manifest into a recession.
Host: Are there any other, you know, red flags or things that are keeping you up at night as it relates to the recession front?
Jeff Schulze: Well, the Leading Economic Indicator (LEI) Index continues to decline. We had 20 consecutive monthly declines. Usually, when you can decline for four months, it signals that you’re in the recessionary danger zone. So, we’re well through that threshold. But if you look at the LEIs, a lot of the weak spots in there are more sentiment-based. And there’s been a disconnect between the hard and soft data, really, for the last couple of years. So, there’s reasons to suggest that, although the LEIs have been tremendous in being able to highlight weakness in the past, they may not be as good this time around. But that’s one red flag that gives us some concern.
Another comes back to the consumer. And there’s increasing signs of balance sheet fatigue. And I know that we’ve talked about this on prior podcasts, but there’s still more and more people that are transitioning into early delinquencies, which means they’re late by 30 days. You’re seeing a continued uptick in delinquencies for auto loans, credit card debt, other credit. And autos and credit card delinquencies are actually at the highest levels that we’ve seen, really, in over a decade. And this is a clear sign to me that higher rates are really starting to hurt the consumer. And if you’re seeing delinquency rates rise in a pretty strong labor market (all things considered), if you do start to see some weakness, which is our base case right now, it’s going to put even further pressure on an already stressed consumer. So, obviously, this is a trend that bears monitoring, and we think we likely will see a step down in consumption over the next couple of quarters.
Host: Jeff, how about inflation? It appears to be coming down, getting closer to the Fed’s target of 2%. Is that accurate? How do you feel about where we stand with inflation?
Jeff Schulze: Well, I didn’t think I’d be saying this in early 2024, but I actually feel pretty good about inflation. If you look at core PCE [personal consumption expenditures] (which is the Fed’s preferred measure of inflation), over the last six months, on an annualized basis, it’s come in at 1.9%, which is actually below the Fed’s 2% target. And, in fact, if it wasn’t for a pretty strong monthly inflation print in September, inflation would be well below target. So this is a really good sign.
The one measure within inflation that the Fed cares about most, which is Core Services Ex-Housing, on a six-month annualized basis is 2.7. Again, that would be consistent with below-target inflation. All good things from the Fed’s standpoint, from the economy’s standpoint as well. So, inflation continues to come down, which means Fed policy is having its desired effect.
Host: So, Jeff, if the economy does slow substantially and turn for the worse here, can the Fed act to ignite growth?
Jeff Schulze: Well, I think the Fed can act to spur growth in a soft landing or a hard landing, given where inflation is. If inflation’s already below target on the last six-month basis, the Fed can actually cut. And the markets are pricing such an outcome. In fact, if you look at Fed fund futures, they’re pricing over 75 basis points of cuts by July. They’re pricing over 140 basis points by December. Now, again, in a soft-landing scenario, that may be overly optimistic. In a recessionary scenario, that may be too little. But, nonetheless, the Fed has the latitude to cut rates and, instead of just focusing on price stability, they can now focus on the other half of their dual mandate, which is full employment. But this is a really important development, because if you look all the way back to the 1960s, whenever you’ve had a pretty sharp deceleration of real GDP [gross domestic product] growth, a sustained Fed cutting cycle of 75 basis points or greater was really instrumental in creating a strong, more positive growth impulse. And the Fed now has the latitude to do that.
But what I will say to the listeners here is that just because the Fed cuts doesn’t necessarily prevent a recession from occurring, right? Just like a strong labor market doesn’t. If you look back to the 2007 peak, heading into that recession, believe it or not the Fed had lowered rates by 100 basis points prior to that recessionary start. They had lowered it by 150 basis points prior to 1990’s recession. So, while the market has cheered a more accommodative Fed and this has certainly increased the odds of a soft landing, again, it doesn’t mean the economy is out of the woods quite yet. And we think that that point where we’re more confident about a soft landing is the middle part of the year.
Host: You just mentioned “soft landing” there a number of times. Can you walk us through why, what the reasons are as to how the soft-landing scenario could play out?
Jeff Schulze: Well, I think the fundamental question between the bulls and the bears when it comes to the economy is whether “this time is different.” And everyone knows those are the most dangerous four words in the financial industry. But if you kind of think about this dynamic and how we got here, it is different, right? You had a unique, pandemic-driven recession. You had unprecedented fiscal stimulus with drove a pretty strong recovery, all things considered.
But in kind of looking at the mosaic for a soft landing, the first piece of the puzzle comes back to better balance in the labor market. And you’re seeing this. You’re seeing softer demand with job openings moving lower. Job openings are down 3.3 million from the peak, but they’re still over 1.5 million above what we saw prior to the pandemic. So, job openings are moving lower, but you’re not actually seeing people laid off. So that’s a really good sign. Also, you’re seeing people come back into the labor market, so there’s improving labor supply. Over the last year, over 3.5 million workers have come back into the labor market, which is a really good sign, to put that labor market back into balance and cool wage growth and create a more durable recovery.
Another thing that’s important is that a lot of consumers have locked in long-term financing with their mortgages. The effective mortgage rate has actually moved up from 3.3% to 3.7%, so a lot of people don’t necessarily have vulnerabilities to higher interest rates because of this dynamic. And the one thing I’ll mention: although this is sheltering a large swath of Americans, about 36% of American households are renters. So, this doesn’t necessarily shield everybody. But this is a very different dynamic than what you traditionally see. And then last but not least, just given the unique nature of the pandemic and the fact that people bought goods early on in the pandemic and now they’ve been spending much more money on services, this is creating a much more durable picture of consumption in the United States, even though some of your more traditional recessionary signals, like manufacturing PMI, are signaling that an economic downturn is around the corner.
So, there’s a lot of things that are unique about this recovery, which all play into a higher probability of a soft landing than what you would normally expect at this point in the cycle.
Host: As I think about the Recession Risk Dashboard and your 12 indicators, is there any indicator in particular that you will have a keen eye on here in the coming weeks and months that could shed some light on the direction of this path that we’ll take?
Jeff Schulze: Yeah, if I had to pick one, it would be the economic canary in the coal mine, which is initial jobless claims. Top-three variable in the dashboard. Usually when it turns red, it coincides with the start of a recession. And when you look at initial jobless claims following a yield curve inversion (and the curve that we prefer is the 10-year/three-month yield curve), you look at recessionary periods, at the beginning of 2023 the rise in initial jobless claims was right at the edge of the historical range. So that’s a key reason why a lot of people felt that a recession was going to happen. However, initial jobless claims have gotten better over the course of the last nine months and they’re hovering around 200,000 per week, which is right at the bottom of the historical range at this point following a yield curve inversion, which has really kind of emboldened the soft-landing camp.
So what we’re going to be watching very closely in the first half of this year is whether or not initial jobless claims move higher from here, more consistent with what you see in a recession. And if they don’t, that really plays into a higher probability of a soft landing. But although there’s clear evidence that a lot of employers are labor hoarding and they don’t want to let go off their employees, if you look at continuing claims, they’re up almost 15% on a year-over-year basis, which is consistent with recession. So, while people aren’t getting let go, it’s getting harder and harder to actually find a new job. So, if I was to pick one indicator to watch, I would say initial jobless claims over the next couple of quarters.
Host: So, Jeff, just transitioning here to capital markets, we saw quite a rally in the equity markets here late in the fourth quarter. When I think about the S&P 500, NASDAQ 100, common indexes that people follow really seemed to hit quite a tear there in the fourth quarter. Do you have any insight on what may have occurred and driven that performance?
Jeff Schulze: The rally really has coincided with more hopes of a soft landing. The data has been very amenable to a soft landing. The labor market’s holding up. Inflation’s coming down. The Fed has an opportunity to cut.
And what I think is really interesting is that everybody’s going to remember 2023 as the Year of the Magnificent Seven.1 And that was really true up until October 27th’s low. The Mag Seven was responsible for all of the returns in the S&P 500. If you look at the Russell 2000, the Russell Midcap, the S&P 493, the Russell Value Index on the large-cap side, all were flirting with zero or had negative returns year to date. But since that low, you’ve seen a broadening out of participation. And the Russell 2000 and the Russell Midcap Index have actually outperformed the Magnificent Seven into the end of the year. And the S&P 493 and the Russell 1000 Value were right behind the Magnificent Seven.
So, this is a very good dynamic. This is what you want to see when you think about market breadth and participation. When a lot of stocks are moving higher with one another, that means that there’s wide breadth. That’s a good sign for the health of a rally and continued gains. And to see the breadth move higher again, a broader participation: great sign for 2024 and the prospects of some future gains. So, it’s been a very different story over the last two months of the year versus the prior 10.
Host: Very, very interesting. So, Jeff, as we look to close out today’s conversation, do you have any final thoughts for our listeners?
Jeff Schulze: Yeah, we think that the markets are pretty lofty at the moment. They’re embedding some strong expectations for a soft landing. There could be a little bit of choppiness in the beginning part of this year, regardless of whatever economic outcome occurs.
However, we would take any market weakness as an opportunity for long-term investors to put money to work. Because if you look at cash on the sidelines—very elevated at the moment. And if you look at every major market low since 1990 and the year following that low, you saw the largest increase in money market funds since the October 2022 lows. And to put some numbers around it, US$1.1 trillion went into money markets following the October lows in 2022. That was an increase of over 24%. So, if the Fed is going to cut and if they cut, say, 50 or 75 basis points in a soft landing (or even if they cut a couple hundred basis points in a recessionary environment), I think that a lot of this money is going to move out of money markets and into risk assets and equities and really could provide the fuel for the next leg higher as we look to the back half of 2024 and into 2025.
And the last thing I’ll mention here is that usually when you have a new all-time high in the S&P 500 after not having an all-time high for over a year, it’s a very bullish development. So, since 1954, this has occurred 14 times. In 13 out of 14 of those instances, a year later the markets were positive. Average return was 13.9%. And although nothing is foolproof (because the one time where you weren’t positive is in mid-07 right before the global financial crisis), history tends to be on the side of long-term investors at junctions similar to today. And the S&P 500 hasn’t hit an all-time high yet but it very easily could sometime over the first quarter.
So I think long story short, even though we’re expecting some volatility and some potential downside to the market’s near term, we would be advocating for long-term investors to take advantage of that.
Host: Jeff, thank you for your terrific insight today as we continue to navigate the capital markets here in the new year 2024. To our listeners, thank you for spending your valuable time with us. 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 or Spotify.
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