Beyond Bulls & Bears


PODCAST Anatomy of a Recession Update: Economic growth ahead?

We speak with Jeff Schulze of ClearBridge Investments about the dramatic improvement within the Recession Risk Dashboard, delving into the individual indicator changes. And, he shares his thoughts on when we may see a Fed rate cut and addresses concerns about US equity valuations.


Host: Welcome to Talking Markets with Franklin Templeton. We’re here today 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, a program designed to provide you with a thoughtful perspective on the state of the US economy. Jeff, good morning.

Jeff Schulze: Good morning.

Host: Jeff, it’s great to be with you. I really appreciate you taking some time this morning to be with us in the studio. Let’s get started. Over the last six months, Jeff, we’ve seen substantial improvement in the US economy, and that has certainly been reflected in the ClearBridge Recession Risk Dashboard. Has there been any change with the June 30th update to the dashboard?

Jeff Schulze: There has. So, the momentum that we’ve seen in 2024, that clearly continued in June with three additional individual indicator upgrades. Profit margins and wage growth were two more that went from yellow to green following credit spreads last month. And money supply went from red to yellow. But I think, more importantly, given the eight individual signal changes that we’ve seen so far this year, this month’s moves have been enough to trigger the overall signal going from yellow/caution to green/expansion. So it’s been a dramatic improvement and we’re finally back to a green territory.

Host: Wow. I mean, the overall signal now turning green, that’s tremendous. Was that expected?

Jeff Schulze: It was. We’ve been expecting this for a couple months. Now, the speed and the magnitude of the move has taken us by surprise. I would’ve thought it would’ve been later in the third quarter when we turned green, maybe August or September. But we reached it here in July. And even though we are fully anticipating a soft patch in economic activity (you’ve seen economic surprises missed broadly to the downside here recently, and I think that that’s going to continue), we believe that this soft patch is going to be more of a normalization from elevated post-pandemic growth. So it’s going to be a growth scare. People may actually bring out the R word, recession, which we haven’t heard in a little while. But, ultimately, we think that this is a soft patch, and we think that we’re probably going to see some continued strength in the dashboard as we move through the back half of the year.

Host: Jeff, I believe in the past you’ve highlighted that manufacturing is an important leading indicator of future economic growth. Do you have any specific insight on this important sector of the economy?

Jeff Schulze: Yeah, manufacturing is very sensitive to changes in economic momentum. That’s why a lot of people look towards manufacturing for potential growth downturns and recessions—because it’ll usually turn very quickly, even though it’s a much smaller sector as a percent of the US economy. And I think perspective matters at this juncture, not only in looking at manufacturing, but in looking at labor and other facets of the US economy—because again, things are slowing or going through a soft patch. And when you look at manufacturing PMI, yes, this is a very useful leading indicator of manufacturing activity. And 50 is the level where you cross over to expansion above 50 or contraction below 50. And it appears that manufacturing has stalled. If you’re looking at this from a short-term perspective, we got above 50 in March and now we are below 50, and we’re kind of treading water.

But when you zoom out, you take a longer-term perspective and you look at manufacturing PMI going back to the mid-1960s, you can clearly see that history suggests that once a bottom is formed, which happened last year, manufacturing PMI, that you’re going to see much more upward momentum, which is our expectation as we look into the back half of the year and into 2025. And you know, with the most recent manufacturing PMI release that we got just a day ago, yes, it moved down, but it moved down for the right reasons. Prices paid dropped. That’s going to be likely filtering through into lower inflation and new orders, which is the most leading component of this survey, which is in our dashboard, actually jumped four points back up to a 49 level. So you’ve seen some treading of water and manufacturing, but we think that we’re going to see this sector accelerate when looking out on a 12-month basis.

Host: Jeff, you briefly mentioned labor. I think that the data regarding labor has been, I’ll say, mixed recently. How has employment been holding up?

Jeff Schulze: Mixed is a really good word for labor right now. On a positive note, you have really strong payroll creation. The three-month average job creation in the US before we get to Friday’s payroll print has been 249,000. And that’s about 150,000 more than what you need just to keep up with population growth. So jobs are being created in a pretty robust manner. But there are some concerns when looking at the increase of the unemployment rate. And then also we’ve seen a pretty large drop of job openings. And when looking at the unemployment rate, yes, it’s moved higher and it’s close to violating what’s called the “Sahm Rule,” which is a recessionary indicator. What it states is that when the unemployment rate rises by a half a percent or more versus its low over the last 12 months on a three-month average basis, you’ve always had a recession. An object in motion stays in motion, becomes self-fulfilling. And right now the unemployment rate has risen by 0.37%. So we’re getting closer to that trigger.

But the one thing I want to note is that not all increases in the unemployment rate are equal. Some of the rise, when you peel back the onion here, is attributed to an increase of the prime age labor force participation rate. These are people who are ages 25 through 54. This is a really positive dynamic, right? This doesn’t lead to a recession. This usually leads to more job creation and a stronger economy. Another part of the story is that you’ve seen a big rise of the unemployment rate in individuals who are 16 through 24. Now some of this is, you know, kids being let out from school. I think there’s a mismeasurement issue there, but also the 20- to 24-year age cohort is very hard and volatile to be able to measure. So I’m not reading much into that.

But the last part of the story is it’s taking longer for people who have been laid off recently to find work. And normally I would think this is a warning sign, but the gap between this unemployment rate of these job losers and their prior 12-month trough has actually narrowed, which means most of this pressure is already being felt and reflected in the unemployment rate.

And the reason why it’s taken people longer to find a job is that you’ve seen job openings drop by 4 million from the peak in 2022. But even with that drop, as I mentioned earlier—I keep coming out to this word normalization—job openings right now at 8.1 million, right in line with the pre-pandemic trend, meaning that we’ve seen a full rebalancing of labor demand. So, again, there are some signs of cooling, but job creation continues to be strong, and the rise of unemployment rates and the drop of job openings really doesn’t have me concerned right now. Again, I view this more as normalization.

Host: Okay, normalization in the employment area. It seems like in our conversations when we’re talking about the health of the economy, it always comes down to the almighty consumer. Is the consumer in the United States still strong?

Jeff Schulze: Depends on which consumer you’re talking about. But, yes, in aggregate the consumer in the US has low debt levels, low debt servicing costs, low credit utilizations. So the consumer in aggregate is doing well. But there is an area of concern, which is consumer delinquencies. Delinquencies have been rising since late 2021. And a lot of the rise in riskier categories like autos and credit cards have actually just got above pre-COVID levels. And usually, a rise of this magnitude would, you know, lead to recession concerns. But if you look inside the data, a lot of the deterioration really comes from loans that were made in 2020 and 2021, the subprime borrowers. And the reason why those loans were made is that they had greater access to credit than they would’ve otherwise, because their credit profiles were being boosted by all of that stimulus. You had loan and rent forbearance programs, you had repayment pauses, and you had really strong income wage growth from the lower earners that were out there.

So a big part of these delinquencies is that cohort and loans that were made three to four years ago. But when you look at delinquency rates, they’re modestly rising right now. But the rate of acceleration peaked over a year ago. And in listening to comments from banks, from consumer finance companies, they’re expecting delinquencies to plateau and even fall over the next 12 months. So, if you kind of frame this differently after falling to abnormally low levels, due to all of that government support in the aftermath of COVID, delinquency rates have basically normalized right now and they’re leveling off, which is going to create less of a spending headwind than a lot of people perceive.

Host: Okay. You mentioned in that previous comment there, it depends on what consumer you’re talking about. Are there any nuances among the spectrum of consumers in the United States that we should be focused on?

Jeff Schulze: There are. You know, not all consumers are created equal when it comes to their impact on economic activity. So while the low end consumer is vulnerable to inflation in food, shelter, energy, because it makes up a larger percentage of their budget, these individuals have actually experienced the strongest cumulative wage gains since the pandemic. And the bottom 20% of earners have actually seen a 31% cumulative increase in their wages, which has outpaced CPI, or inflation, by over 12.5%. Furthermore, the bottom 20% of earners make up less than 9% of the overall consumption bucket in the US. More importantly, the top 20%, they make up four and a half times that at 38.6%. In fact, the top 20%, their share of consumption is equal to the bottom 60% of earners. So when you look at that top 20%, they are in good shape. You’ve got strong asset appreciation for that cohort, healthy labor markets. You have strong income because of rates being higher, low debt loads, you put this all together, it really provides upper income households with ample ability to keep spending at a healthy level. And even if you do see some headwinds from the lower end of the spectrum, we think that upper income households are going to be able to overwhelm that weakness and still create a positive consumption backdrop.

Host: Earlier, you highlighted the wage growth indicator turning green this month. Can you provide some context for that upgrade?

Jeff Schulze: Yeah, this is unique. We don’t see this very often without a recession. In fact, usually when it turns red wage growth, that is, it stays red until a recession happens—because the only way that wage growth comes down is you see layoffs, see much more labor supply hit the US economy. But we’ve seen it come down because you had that dramatic increase of labor demand and that demand has cooled, like we talked about earlier with job openings. But we’ve also seen a lot of immigration here in the US that people weren’t anticipating. And you go back to January, the Congressional Budget Office increased their estimates of net immigration for 2022 to 2026 (so a five-year window)—increased their estimates by 7.8 million people. So you’ve had a huge amount of labor supply come in and meet that excess labor demand, and you’re seeing wage growth cool without the Fed [US Federal Reserve] having to create a recession.

But I think very importantly, even though average hourly earnings has moved down dramatically, the Atlanta Fed’s wage tracker has moved down (again, key measures of wage growth), that really hasn’t affected the consumer that much—because although wage growth is cooling, inflation is cooling to a greater degree, which means Americans have better real wage gains.

Host: Okay, Jeff, so I want to come back to the overall dashboard signal turning green. You know, in the past we’ve discussed the depth of the signal—in particular, when we were moving in the other direction into a recessionary period going red. I think the obvious question right now is how green is this overall signal?

Jeff Schulze: Well, it’s shallow. You know, we’re just barely into green territory. If we have some bad data points, we might be back in yellow territory. But again, as I mentioned earlier, given the momentum and the progress that we’ve seen across a lot of areas of the dashboard, I think that we’re going to get in deeper into green territory. But as I mentioned earlier, we’re expecting an economic soft patch to occur in the quarters ahead—it could create a little bit of a growth scare and more importantly maybe some volatility in the markets. But we believe that this is just a step function lower in economic activity going back to a more normalized environment. And ultimately if we do see any market volatility or a selloff, we think it’s going to be an opportunity because we see this expansion continuing into next year.

Host: Let me follow up on that. So you mentioned potentially some volatility and a choppy patch here. Anything else to add as it relates to US equity markets for the second half of 2024?

Jeff Schulze: Yeah, a couple thoughts. You always see volatility pick up ahead of an election and that volatility starts to pick up in August and it peaks in October. Importantly, once you get through election day, it doesn’t matter who wins, the incumbent party or the opposition party, you usually see a relief rally after the election. So should higher volatility come this summer into the fall, again, it’s usually a buying opportunity for longer term investors. But I think what’s really going to propel the markets higher and likely lead to the next up leg of performance is going to be a Fed cutting cycle. Now, some people think that the Fed can’t cut because it’s going to be a questioning of their political independence, but if you go back to 1956 and the election year, the Fed has adjusted the fed funds rate in every single year except for 2012.

And in 2012 rates were pinned at zero, so the Fed couldn’t cut anymore. They announced QE3 [quantitative easing] in September, which was a huge bond-buying program ahead of the election. So I think the Fed understands that if they wait too long and you see broad-based labor market weakness, it’s going to be too late and they’re likely going to behind the ball, if you will, and potentially add to a recession. So I think the Fed is going to cut in September, and I think that could be the reason why you start to see the markets move higher from a period of digestion. And when looking at all the cutting cycles since 1980, the two that created soft landings were 1984 and 1995. The key takeaway when you look at the year following that first rate cut and those soft landings is long-term investors were rewarded by moving out of cash and into equities. You know, there’s broad outperformance across the entire equity spectrum, small caps, mid-caps, value, growth, but growth was the best performer, the Russell 1000 Growth, in those two periods, returning an average of 16%.1 So expecting a little bit of choppiness here, but I do think that the Fed will be able to cut and ultimately that could lead to really the next leg higher of this equity bull market that we’ve seen over the last couple of years.

Host: Jeff, as we begin to wrap up today’s conversation, do you have any final thoughts for our listeners?

Jeff Schulze: Well, the one thought that I would love to share is that I know that there’s some concern from a valuation standpoint in US equities and in particular large-cap US equities. The S&P 500’s trading at a forward multiple of 21 times earnings, which if you look back to the mid-90s, the multiple on average is about 16.5. So it looks really expensive. But valuations are in line with historic averages when you look at small caps, when you look at mid-caps, and when you look at the average stock in the S&P 500. In fact, the equal-weighted S&P 500’s PE is right in line with its long-term average, coming in at 15.8 times earnings when historically it’s been 15.4 times earnings going back to 1994, so the last 30 years.

So, there are some stocks in the index that are fairly expensive. These are the largest constituents in the stock market. But again, although some of those stocks may get more expensive, we think active managers really have an opportunity, should we have a soft landing, a Fed cutting cycle, and the broadening out of the market, which is our expectation as we look towards 2025.

Host: Jeff, thank you for your terrific insight as we look forward to the second half of 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, please visit our archive of previous episodes and subscribe on Apple Podcasts, Google Podcasts, Spotify, or just about any other major podcast provider.

This material reflects the analysis and opinions of the speakers as of July 2, 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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