Transcript
Jeff Schulze: Great to be here.
Host: Jeff, last month this podcast focused on the US election and its potential implications on the capital markets, which I would highly recommend our listeners check out if they haven’t already done so. We did not, however, talk about the economy. So Jeff, can you tell us what’s happened with the ClearBridge Recession Risk Dashboard over the past two months? Has it continued to improve, or has it turned more cautious on the prospects of the US economy?
Jeff Schulze: Well, we had a dashboard that was flat in September, so we didn’t have any changes last month. But the month prior, in August, we had two positive indicator changes with commodities and jobless claims both moving from yellow to green. But we had one downgrade with manufacturing PMI [Purchasing Managers Index], New Orders moving from yellow to red. But overall, you continue to see positive momentum in the dashboard, and you saw that continue in September, even though there wasn’t an actual indicator change. But in looking at our 12 indicators, if there is one that I’m happy about moving to green, it is initial jobless claims. We call it our economic ‘canary in the coal mine.’ Usually when it turns red, it coincides with the start of a recession. And part of the reason for the selloff in equity markets over the summer was that you were getting weaker jobs numbers, but you were also seeing an increase of initial jobless claims. So there was real concern about the health of the labor market. But since peaking in the beginning part of August, over the last two months, initial jobless claims have moved down dramatically, which improves the prospects of this soft landing. But overall, we’ve seen continued progress in the dashboard since we last did an update.
Host: So you still expect the expansion to continue and you’ve been advocating that actually all year. Did anything happen last month to give you more confidence that the US can avoid a recession?
Jeff Schulze: Well, as the listeners are well aware, we’ve been in the soft-landing camp for all of 2024. We’ve had a 75% probability of a soft landing, and we’ve increased that to 80% because of a couple of key developments. First off, you saw upward revisions showing a healthier US consumer, but also healthier corporate America. You saw the Fed rate-cutting cycle finally get kicked off in September with a 50-basis point rate cut, which surprised a lot of investors. And then finally, we’ve been waiting for this for a couple of years, but we got an aggressive Chinese policy pivot, which really should start to support their economy and hopefully bring them out of the deflation that they’ve seen over the last three quarters. So if you put all three of these together, you know, this really does increase the probability that the Fed is going to be able to stick the landing and we’re going to be able to continue to see this expansion move forward.
And the one thing I’ll mention, to be clear, I don’t think any of these developments necessarily would’ve been needed to prolong this expansion. GDP last quarter was 3%. If you look at the Atlanta Fed’s GDPNow-casting model, it’s projecting third-quarter GDP to be 2.5 percent. So this isn’t an economy that’s losing momentum. But given these developments, again, I think this is a good thing. It’s good that the Fed’s being proactive, and it continues to increase the odds that the economy’s going to be able to continue to move forward next year.
Host: Jeff, it seems like we’re starting to hear a bit of chirping, a bit of noise that the US consumer may be tapped out to the point where their spending will be reined in a bit. What are your thoughts on the strength of the US consumer?
Jeff Schulze: Well, over the last several quarters, a narrative has developed that the US consumer was on its last legs. Consumers were having to tap credit cards and were spending down savings in order to make ends meet. But we got some data recently that refutes that notion. You saw, again, really strong positive annual revisions to US GDP, and it showed that the economy had been growing faster than what was previously thought, but it was really driven by strong upward revisions to personal incomes and consumption. And because of those really strong upward revisions, the savings rate has jumped from 2.8% to 4.8%. So again, that’s in line with historical norms. It’s a positive sign that the consumer is not as stretched as what was previously believed. So we think the consumer’s in a really good spot right now. They’ve been de-leveraging for the decade following the global financial crisis.
And right now, if you’re looking at US household debt to disposable income ratios, it’s at 97%. It’s declined by about 40% since ‘08. Debt service costs as a percent of disposable income are rivaling some of the lowest that we’ve seen pre-pandemic. Consumers have really been shielded from rising interest rates due to the prevalence of fixed rate mortgages. And if you look at the consumer debt total, a lot of people talk about credit card debt. That’s only about 6% of the consumer debt total. Mortgage debt is 70% of that pie. So again, a lot of people haven’t seen increases of their largest monthly outlay. And one more stat I’ll throw out to you because I love statistics: household net worth is up about 47 trillion since the beginning of 2020. So if you put that all together, that’s a really healthy consumer, and it’s a consumer that can continue to spend in a fashion like we’ve seen over the last couple of years. And with the savings rate jumping back up, more aligned with historical norms, that means that the consumer’s on much better footing as we look forward.
Host: Jeff, I think you mentioned Corporate America saw some upward revisions with some of the recent data releases. What did you mean by making that particular point?
Jeff Schulze: Yeah, so when you looked at last week’s GDP revisions, it also revealed that the corporate sector was healthier than previously assumed. Profit margins were revised higher, which really bodes well not only for the continuation of this economic expansion, but for higher equity market gains as we look out on the horizon. Typically when you have healthy and expanding profit margins, it suggests that corporations are under less pressure to reduce costs and lay off workers. And when you look at profit cycles going back to the 1960s, ahead of recessions, typically profits begin to plateau about a year before the start of a recession and they start to decline two years prior to the recession materializing. And then again, profits and profit margins are moving down, they want to cut costs, and a lot of those costs end up being headcount. But if you look at profits today and profit margins, we’ve seen them rising, and it really reduces the urge of a layoff cycle. So again, this is a positive development, and it’s a reason why we think that this expansion has some room to run as we look out over the next couple of years.
Host: Jeff, I think you mentioned China’s aggressive policy pivot was the second development as to why we should be more optimistic. What happened over the past week with the China capital markets and why is that so important?
Jeff Schulze: Well, the Chinese equity markets are up over 25% since the announcement. There’s really no bull market like a Chinese equity market bull. But it’s really because policymakers finally made a paradigm shift in their strategic priorities. They’re moving away from trying to deflate their property bubble. They’re now trying to stabilize housing, and they want to restore consumer and business confidence. And if you think about why this is the case, back in 2021 when a lot of the global economy was stimulating because of the aftermath of COVID, Chinese policymakers saw an opportunity to prop up growth through higher exports and green energy exports as well. And they were able to start deflating their housing bubble. But they’ve finally come to the realization that they can’t deflate anymore and they really need to start supporting not only housing, but start supporting local business confidence and consumers as well, because China has been in deflation over the last three quarters. And if they continue to go down this road, they run the risk of repeating the same scenario that played out in Japan with deflation in the ‘90s and the 2000s. So China had a very aggressive U-turn when it comes to monetary and fiscal stimulus, and that has created some upward pressure in their local equities, but more importantly, it could provide a more positive impulse to the global economy as well as US companies who operate there. Now, to be very clear, I think that more is going to be needed, but this U-turn in policy is a very positive development overall.
Host: The long-anticipated Fed rate-cutting cycle has begun. How different is this cutting cycle compared to other soft landings?
Jeff Schulze: Very different. As I mentioned earlier, consumption, economic activity continue to hold up. But because of the softness in the labor markets, it really refocused the Fed’s attention towards the full employment side of its dual mandate. And the Fed opted for a more aggressive 50-basis point move because they understand the risks. Usually when you have a recession, labor market weakness comes on very suddenly and you have a non-linear move down and the Fed really wants to make sure that that doesn’t happen. So by front-loading cuts, it makes sense from a risk management standpoint. But in thinking about this cutting cycle, if you look at the Fed’s ‘dot plots,’ their expectations for their cutting over the next couple of years, the Fed expects to cut another six times by the end of 2025. That’s a total of about 200 basis points in easing, and if delivered, that’s going to dwarf the 75 basis points in relief that was provided in 1995’s soft landing—in 1998’s soft landing as well.
And the reason why the Fed can be so aggressive with a relatively strong economic environment right now just comes back to how different this cycle has been from an inflation standpoint. So typically inflation only falls after the Fed has kept rates in restrictive territory for a long time to cool demand, but oftentimes they’re too late to retrench and cut, and you end up having a recession. So they overstay their welcome. This time around, though, supply-side disruptions were a key driver behind that post-pandemic inflation spike. And as the US economy normalized, as supply chains healed, inflation has moved down in a durable manner without the Fed having to stay in higher for longer territory longer than they need to. So you’ve seen the largest non-recessionary drop in inflation really since the mid-1950s. And CPI [Consumer Price Index], headline CPI over the last three months is running at an annualized pace well below the Fed’s target.
So this has opened up the door for the Fed to begin normalizing policy. And if you think about rate- cutting cycles, again, if this is going to be a rate-cutting cycle that’s, you know, call it 150 basis points (maybe we do get to 200 basis points), that’s going to create a re-acceleration of economic momentum next year and ultimately extend this cycle. But from my vantage point, I think once the Fed recognizes that the economy’s on a solid foundation, maybe they only deliver five or six total cuts over the course of the next, call it 15 months. But again, that’s going to be double what you saw during both of those 1990 cutting cycles. So this is a positive development ultimately for the longevity of this expansion.
Host: So how about the implications for leadership within the US equity complex?
Jeff Schulze: The markets have sniffed out this coming shift in Fed policy. You’ve actually seen a leadership rotation beginning to unfold since mid-July, and that leadership rotation started because you had a very favorable June CPI release. It came in much weaker than anticipated, and investors recognized that that cutting cycle was going to be coming sometime over the next couple of months. And from a leadership perspective over the last two and a half months, very different than what we saw in the first half of 2024 and 2023. Investors have moved into areas that are going to benefit from that economic reacceleration that I talked about earlier, as well as lower interest rates. So that’s value, that’s small caps, that’s equally-weighted S&P 500 over the cap-weighted and the S&P 493 over the Mag Seven. So basically, the rest of the S&P 500 Index.
And in fact, if you look at the Magnificent Seven, they’ve underperformed the S&P 493 or the rest of the index by about 11% since that release. So overall, if this soft landing does develop like we’re anticipating, we think this leadership rotation will continue as we look out over the next, call it six to nine months, because if earnings growth is not scarce anymore, it’s much more abundant, investors are going to move into those areas where that earnings growth is much cheaper. And that’s small cap. That’s value. That’s the rest of the S&P 500 at the expense of the Magnificent Seven.
Host: Jeff, I think you just answered this question, but I’ll ask, can US equities actually move higher from here if the Magnificent Seven isn’t leading the charge?
Jeff Schulze: Well, you could certainly see it in smaller-capitalization indices, but you can see it in the S&P 500 as well. Actually, if you go back to July 11th, which is when we got that soft CPI release for June, the S&P 500 today is actually up 1%. But again, as I just mentioned, the Mag Seven has underperformed the rest of the index, the S&P 493 by double digits over that timeframe. So what may happen is you may have an index that doesn’t move up as aggressively as what we’ve seen over the course of this year. You may see it inch ahead instead of, you know, being as robust as what we’ve seen in the first three quarters. But ultimately, we think that this is a great environment for active managers to be able to sidestep some of that high expectation, that concentration risk that you have in those large mega-cap names that have been beneficiaries over the course of the last couple of years.
Host: Jeff, you just mentioned expectations. It seems like the market has very high expectations for the S&P right now. What would your views be on the next, let’s say six to 12 months?
Jeff Schulze: Yeah, as I mentioned at the index level, probably going to be moving higher in a slower capacity as we see this rotation happen. But ultimately on a longer-term basis, the economy’s going to reaccelerate. You’re going to have better earnings delivery across the broader equity universe. That equity should continue to move higher from here. In fact, when you’ve had all-time highs and the Fed has cut, going back to 1980, the market was positive a year later 95% of the time, and your average return was 13%. So again, rate cuts, all-time highs, usually a really positive combination. And although I think some digestion may be needed over the next quarter or two, we think that the path of least resistance is higher. But ultimately we think that this is a great advantage for active managers over passive indexes that are out there.
Host: Jeff, as we look to wrap up today’s conversation, any closing thoughts for our listeners?
Jeff Schulze: Yeah, the market’s moved up quite a bit here in 2024. One thing I will say, and when we did mention this on the election podcast that you referenced earlier, we may see some choppiness in October. I mean, usually you see a lot of choppiness ahead of the election, but if we do get any type of selloff in the markets, especially election related selloffs, it’s usually paid to buy the dip because no matter who wins the election, whether it’s the opposition party or the incumbent party, historically, there’s a relief rally after the elections are over and visibility is restored on the political front. So if we do see some choppiness, I would advocate for long-term investors to take advantage of it.
Host: Jeff, thank you for your terrific insight as we continue to navigate the landscape here in 2024. Enjoy your brief time in the Windy City over the next couple days. And 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 any other major podcast provider.
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