Beyond Bulls & Bears


PODCAST Anatomy of a Recession Update: Profit margins and credit spreads improve

In May, the Recession Risk Dashboard saw two individual indicator upgrades, including a move from yellow to green.  In our latest “Talking Markets” podcast, we speak with ClearBridge Investments’ Jeff Schulze about the positive momentum we’ve seen in the dashboard and get his perspective on the current global landscape.


Host: Jeff, it’s great to be with you. In our last conversation, if I remember correctly, you were actually in Australia. I know I just stated that we focus on the US economy and capital markets, but I would love to start today’s conversation with perspective on the global landscape. What are your thoughts on the recovery in China?

Jeff Schulze:  Well, the Chinese recovery is strong, but it’s really been bifurcated if you look underneath the surface. It’s been dominated by strength in exports and manufacturing CapEx [capital expenditures]. And you’ve really seen a weaker element to the economy from a consumption standpoint and, of course, the property market.

Now, this has been the situation that you’ve had in China over the last couple of years, as China was very strong in exporting things to the global economy in the aftermath of the pandemic. And, at the time, Chinese leadership took that opportunity to really deflate the bubble that they had in the property sector. Now, unfortunately, I think that we’re going to continue to see this bifurcated economy as we look forward, because policymakers there are aiming for around a 5% growth target this year. And first quarter GDP came in at 5.3%. So there’s really no need for them to stimulate more than they already have.

However, you did see a recent pivot in property policy, which I think is just the beginning. So, China decided to provide some support to the tune of around 500 billion RMB in order to support the property market and take some of the supply off of the market and use that for social development. And that’s going to continue to decrease the supply and bring the property market into equilibrium.

But unfortunately, again, because they’re hitting their growth target, there’s really not an impetus for them to become more aggressive. But there will be a point where the export-driven model will start to slow and they’re going to have to stimulate in a more aggressive fashion. And I think at that point you’re going to see much more broader spillover effects to the global economy.

But, for now, I think we’re kind of in this situation where you just kind of have this bifurcated economic growth model and you’re not going to see a much greater growth impulse outside of China. But, again, this feels like a “do whatever it takes” moment for China like we had in the US back in the global financial crisis. But the size of that program that they just launched was about 0.4% of GDP. By contrast, TARP [Troubled Asset Relief Program] in 2008 was around 5% of GDP. So this is a good step in the right direction. But I think we’re going to need to see some more follow-through.

Host: Let’s move over to Europe. Are things starting to look brighter in the European landscape?

Jeff Schulze:  They are. It appears that Europe is coming out of a shallow recession for the region in late 2023 and early 2024. Assuming that inflation continues to move down, we’re likely going to see around 100 basis points of cuts this year. And that’s going to feed into a recovery that’s already clearly underway at the moment.

And if you look at Germany, Germany has been the biggest source of weakness in the European Union. And you did see a pretty strong rebound in the German economy in the first quarter. And we think that consumer spending will start to take the baton as we move into the second half of this year.

So, the markets have sniffed this out. They’ve been moving higher in the European Union for the last couple of quarters. But I do think as you see a more durable recovery, there’s going to be some more upside for the region.

Host: Now, let’s focus on the United States. As we drive to the midyear point of 2024, what’s the read on the ClearBridge Recession Risk Dashboard with the May 31st update?

Jeff Schulze: Well, we continued to see positive momentum. In May, we had two additional indicator upgrades. Profit margins moved from red to yellow. And credit spreads became the first indicator that we’ve seen in the dashboard for a long time to turn to green. And going back to 2022, credit spreads are one of the first indicators to flash a warning sign of the slowdown in the economy and the market turbulence. And it’s a really solid sign that it moved to green and the momentum right now is clearly moving towards an overall green signal. But at the moment, we still have an overall yellow caution signal on the dashboard. But I wouldn’t be surprised if we do see an overall green sometime over the next quarter.

Host: Terrific. Our first economic indicator turning green. You might have just answered this question, but how important is this particular change?

Jeff Schulze: I can’t stress how important it is. Again, with the dashboard, usually an object in motion tends to stay in motion. And the fact that we did see our first green signal to me suggests you’re likely going to see more turn green as we move into the back half of the year.

But with credit spreads, it is a top three variable in the Recession Risk Dashboard. So, when you have something turning green, you want it to be one of the higher weighted variables in the dashboard, and it’s an about 12% weighting in the dashboard overall. But as I mentioned, this is the first green indicator that we’ve had in the dashboard since March of 2023, right before initial jobless claims rolled over in Q2 of that year. So it’s good to actually see some green in the dashboard after a year hiatus.

Host: So, Jeff, what type of credit spreads do you measure with your indicator? Are all spreads created equal?

Jeff Schulze:  No, all spreads aren’t created equal. Some of them give us better information on what’s likely going to happen for the economy looking forward. And we like to look at the high yield index, because they are the most economically sensitive bonds that are out there and they typically start to price in higher recession risks as you start to see some momentum in the economy slow down. But the high yield index was only an asset class that was established in the early 1980s. So, prior to that, we looked at the most risky tranche of investment grade spreads, which is triple B’s, going back to the early 1960s.

But I think importantly, when you think about the high yield market, it has grown by leaps and bounds. In 1985 it was around $50 billion. Today it’s $1.3 trillion. So again, this is a huge marketplace. And I think maybe more importantly, it’s funded a lot of blue-chip companies that our listeners have heard of: Ford, Tesla, Twitter, better known as X, Netflix, Uber have all been funded by the high yield market and it’s helped launch entire industries like shale oil, gaming and cable.

So, the fact that spreads are narrowing here suggests that there’s less risk overall in the economy. And if there is a signal that I want to see green at the moment, credit spreads would be on the top of that list.

Host: Is the move in profit margins a good sign for businesses?

Jeff Schulze:  It’s a great sign for businesses and the economy. You know, if you think about the economy and equities, they really don’t get into much trouble when margins are expanding. If margins are expanding, that means a healthy corporate environment and less of an urge to really reduce headcount, which tends to be the catalyst for the start of a recession. So we’ve had a tough market environment, quite frankly, over the last couple of years. But to see margins trough and start to move higher is a great indication that this expansion and, quite frankly, the market momentum that we’ve seen is likely going to continue to move higher as we move through the next 12 to 24 months.

Host: Jeff, we’ve recently seen some softer data in the United States. How concerned are you with this?

Jeff Schulze:  You have seen some softer data. If you look at GDPNow, which is a nowcasting tool put down by the Atlanta Fed, it basically looks at all economic releases that have happened in a quarter, and that’s their best guess on what GDP would be if it was released today. GDPNow a month ago for the second quarter, was running at 4.2%. Today, it’s running at 1.8%. So it’s a pretty big drop than what we thought a month ago. But I think it’s important to recognize that 1.8% is still very healthy economic momentum. And looking at some of the misses, payrolls missed in April at 175,000. Expectations were for 240,000, but 175,000 is really strong. Just to keep up with population growth, it’s about 100,000 in the US. So again, you’re well above that threshold. So things like that are slowing. But it’s not indicating that we’re likely going to see a recession. Same could be said with job openings. Job openings just came out. Big miss to the downside. But at 8.1 million job openings, yes, it’s the lowest since February of 2021, but we’re still a million above where we were prior to the pandemic.

So this, in my opinion, is a really good sign that you’re seeing a softening economy, a softening labor market, not enough softening to cause a recession, but more importantly, it maybe can give the Fed the confidence to embark on a cutting cycle at the end of this year, which I think is going to go a long way of extending the cycle further than what we’ve already seen.

Host:  Jeff, is there anything else that you’re keeping a fine eye on that you may be concerned about in ’24 here that may have market implications, maybe the upcoming elections?

Jeff Schulze:  Well, the elections get quite a bit of airplay, and rightfully so. But thinking about it from a market perspective, there’s a strong possibility that there’s not going to be a governing majority in Congress regardless of who wins the election, right?

If you have a slim margin of victory in both chambers or a divided government, you’re really going to have a limited legislative agenda that can be produced. And the impact that you’re going to see from a market perspective is really going to come from regulatory changes and tariffs, which are areas where the president can act unilaterally.

So, on the margin, Biden victory would be more supportive of green energy at the expense of traditional energy. And you likely are going to see some greater regulation, but not a lot, in big pharma, financials and industrials. And Trump, if he would be victorious, it’s going to be the reverse of that scenario. But I think maybe more importantly for the listeners, the sector tailwinds and headwinds are going to be very minor, and the bigger driver is really going to be the broader economic environment that you’re operating in.

For example, energy and financials were expected to do really well under a Trump presidency, but it was an unfavorable macro environment, and they were laggards compared to the market. Conversely, if you look at Obama, it was expected to be a pretty big headwind for health care, and that’s a sector that actually did pretty well during his time in the office.

So given that backdrop, I’m not really concerned from a regulatory standpoint on whoever wins the White House, but there may be a repricing in the markets based on potential tariffs. And both Biden and Trump have shown some pretty tough postures to China because it’s obviously a critical issue in the polls right now.

And Biden has already raised tariffs very recently. But his approach is going to be much more strategic, much more surgical. And you look at a couple weeks ago, you saw a quadrupling of the EV duties to 102%. You also saw some increase of tariffs on semiconductors, medical products, batteries, what have you. But I don’t think you’re going to see large increases on tariffs because obviously inflation is a big concern of the Biden administration. And to put in greater tariffs probably is going to aggravate the inflation issue further. So you’re thinking about that from Biden’s perspective, probably a little bit more bark than bite, relatively minor impact to the markets.

Under Trump, tariff policy may be a little bit more aggressive based on what he’s said here over the last couple of months, possibility of a 60% tariff on Chinese goods, possibility of a 10% across the board tariff on all US imports. And if that goes into effect, you’re likely going to see some sort of retaliation from our trading partners, which would weigh on companies that are multinationals and have a bigger footprint from a revenue perspective outside of the US.

But again, just thinking about these things, these are going to cause maybe some minor pockets of dislocation. It’s not uncommon to see some equity volatility as you lead up to the election. But traditionally, regardless of who wins the election, usually the markets will rally once you get through Election Day. So, again, these are things that we’re watching very closely, but I don’t think any of them have the capability of really dislodging the market momentum that we’ve seen.

Host: Any final thoughts as we wrap up today’s conversation?

Jeff Schulze: I think that the data has weakened, which is a good sign, right? We’re normalizing. This isn’t stepping down into a potential recessionary type of environment. And also when we got April’s PCE inflation reading, it was soft. It does confirm that the increase of inflation we saw in the first quarter was probably just a bump on the road towards the Fed’s 2% target. And you’re starting to see the markets price in a greater probability of a September rate cut and a rate-cutting cycle would be a welcome development. It would extend this cycle. And it would also probably be a nice tailwind to US equities. If you look at the two soft landings that the Fed has been able to engineer during cut cycles going back to 1980, the two soft landings were 1984 and 1995. On average, a year following that first cut, you had Russell 1000 Growth up on average 16% in that year. But the Russell 1000 Value, which is large-cap value, Russell MidCap Index and the Russell 2000, which are small caps, were all up anywhere from 13 to 14% as well in that year. So the data is suggesting that the Fed can cut later this year, which we think will be a positive tailwind to further equity gains.

So if we do see some volatility, especially related to the election in the summer, we’re advocating for long-term investors to take advantage of some of that weakness.

Host: Thank you, Jeff, for your terrific insight as we continue to navigate the capital markets as we near the midpoint here in 2024.

To our listeners, thank you for spending your valuable time with us for today’s update. 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 any other major podcast provider.

This material reflects the analysis and opinions of the speakers as of June 4, 2024, and may differ from the opinions of portfolio managers, investment teams or platforms at Franklin Templeton. It is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.

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