Transcript
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, welcome.
Jeff Schulze: Thanks for having me.
Host: Jeff, we’re always starting off these podcasts with a check on the health of the US economy through the lens of the ClearBridge Recession Risk Dashboard. Were there any indicator changes in the month of March, and have you changed your odds of a recession?
Jeff Schulze: Well, just as a reminder to everybody, the 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 we did have one indicator change last month in March with Manufacturing PMI, New Orders worsening to red, following the prior month’s deterioration to yellow. So if you’re just looking at the dashboard itself, the output would tell you that the probability of a recession over the next 12 months is around 35%.
But with the worse than expected tariff announcements from Liberation Day just a couple of days ago, our perception is an increase of an unfavorable economic and market outlook. So we’re subjectively increasing the odds of a recession instead of being 35%, which is what the model is saying, to 50% to reflect likely economic weakness as we look forward.
Host: Wow, 50% chance of recession over the next 12 months! That’s much higher than even a quarter ago. What were the odds coming into 2025? And have you ever deviated from what the dashboard’s output was when communicating recession odds behavior?
Jeff Schulze: Yeah, we moved a lot in a short period of time. Coming into the year, our odds of a recession over the next 12 months were 15%, which is really as low as it’s ever going to get. Really strong economy. You had consistent 3% real GDP growth quarters throughout the last year, but you had some weakness in the first quarter, which started to increase the odds of a recession. But with this shock, this is like a supply shock. And it’s something that’s exogenous, it hits the US economy, and it’s going to slow growth and it’s not being picked up in the data yet.
You had supply shocks that led to recession like the oil embargo in 1973. You had it with COVID in 2020. And we think it’s just a matter of time before this filters through into lower economic momentum. So that’s why we’ve moved up our odds of a recession to 50%. And mind you, you know, the situation is fluid as we get more visibility on retaliation or potential reductions of tariffs that have been announced, we may move this odds of recession higher or lower.
But as it stands right now, we’re expecting GDP growth to be in the half a percent range, maybe 75-basis-point range, which is notoriously low. And when you have an economy that’s growing at those levels, it becomes much more vulnerable to have a recession and even just a mild shock or maybe another sizable shock is just enough to tip the economy into a recession.
So yeah, it was pretty low coming into the year, but it’s moved up materially because of the tariff announcements and also some slower economic activity.
Host: So, Jeff, looking forward, where could we see changes on the Recession Risk Dashboard as this exogenous shock unfolds?
Jeff Schulze: Well, looking at the 12 indicators, there’s a couple that you’re already starting to see change with the sell-off that we’ve had in the markets over the last couple of days.
Credit spreads (top three ranked variable in the dashboard) were really well behaved for the first couple of months, month and a half, if you will, of this sell-off. But they’ve really started to move up in a more material fashion that’s reflecting potential default risk and lower economic momentum. So that’s an indicator that I could see moving to yellow and potentially even red as we move through this period of volatility.
Commodities is also another one. Commodities, when they move lower, usually indicates lower global and lower US GDP growth. And commodities have all been moving pretty dramatically lower over the course of the last couple of days. So, in thinking about what’s likely going to be the next to turn, those would really be at the top of the list for me.
Host: Quarter one GDP is tracking to be much lower than the second half of last year. Is the growth picture a little better than meets the eyes currently?
Jeff Schulze: It is. You know, a dynamic that a lot of people are not familiar with is that, usually Q1 is the weakest quarter of the year from a seasonality perspective. So if you go back to the Global Financial Crisis and we exclude COVID, because if you put those COVID numbers in there, it just distorts all of the data—but if you go back to the Global Financial Crisis, the first quarter usually sees annualized GDP growth of 2.1%. Q2, Q3, and Q4 are at 2.8, 2.8 and then 3%, right? So, materially higher than what you see in the first quarter. So you have a weak first quarter and you have a soft patch. And that’s usually a normal development.
But this quarter was a little bit more aggressive than usual in the sense that you had the coldest January since 1988. So that’s something that curtailed consumption in the beginning part of the quarter. You also had the worst flu season since 2010. So, the economy is probably facing a larger than normal soft patch. But, as the weather warms, you know, we think that things will normalize. And the growth picture is probably a little bit better than what people are thinking at the current moment.
Host: You mentioned going outside of the Recession Risk Dashboard. So, what are you monitoring currently to determine whether the recession odds are growing?
Jeff Schulze: Well, if I had to boil it down to one thing, I would say the health of the labor market. If you look at labor income, that is the most important driver of consumer spending, and consumer spending is 70% of the US economy. So getting the consumer right is very important. And the good news is, the labor market remains in good shape. We had payrolls today, came in at 228,000 for March, well above consensus expectations of 140,000. The three-month moving average is 152,000.
Those are pretty good numbers. Yes, the market didn’t care about that because the survey period for that payrolls number was in the beginning half of March. And this is something that’s likely going to slow growth and slow job creation, but it indicates that the labor market is on a healthy foundation, at least coming into this potential soft patch.
Another thing that I like to look at is initial jobless claims. How many people are filing for unemployment insurance for the first time in any given week continues to be in that 220,000 per week range. We’ve seen it for the last five weeks. Continues to be well behaved, and this is a top three ranked variable in the dashboard.
Usually when this starts to move higher, a recession materializes. But to see it be well behaved is a great indication. And as long as there’s no layoffs, you likely will continue to see a consumption picture that continues to be positive moving forward.
Host: How concerned are you, Jeff, about the large drop in sentiment that we’ve seen in the recent consumer surveys?
Jeff Schulze: Elevated policy uncertainty has begun to show up in what we call the quote unquote soft survey data. These are expectations, how people feel; and consumer sentiment has been hit particularly hard. And this has fueled fears of a recession, because the worry is that consumers are going to pull back on big ticket purchases like vehicles, for example, and discretionary purchases, like going out to eat or maybe shopping at the mall. And they save their money in anticipation of tougher times ahead. So precautionary savings is really the concern there.
And prior to the pandemic, we put a lot of stock in consumer sentiment because that did move into changes in spending behavior when you saw drops. But in the post-pandemic world, even with high inflation, consumer spending has been remarkably consistent over the last couple of years, even though you’ve had low and falling consumer sentiment in the University of Michigan’s Consumer Sentiment Survey.
So we’ve been advising investors and our clients to focus on what consumers do, not what they say, because actions speak louder than words. And it’s going to be interesting. If consumers know that higher prices are around the corner, will precautionary savings start to kick in? And the recent history would say no. But obviously that is going to potentially change. And it’s a key reason why we still have a 50% chance of a recession looking forward.
Host: Does consumer or investor confidence impact the equity markets positively or negatively when we are at these levels, Jeff?
Jeff Schulze: Well, believe it or not, when you have really low confidence, whether, again, you’re talking about consumer or investor confidence, it’s actually a contra-indicator. It’s usually a good time to get optimistic about putting money to work in US equities. For example, the University of Michigan Consumer Sentiment Survey. So, going back to the 1970s, you’ve had 11 major bottoms in sentiment. And if you had bought at the trough on a forward 12-month basis, the average S&P 500 [Index] return has been 25%. And at 57, that is some of the lowest readings that we’ve seen in the history of this survey. So, given that consumer sentiment is washed out, if this historical relationship holds, it may prove as an attractive entry point for longer-term investors.
Same thing with investor confidence. If you look at the American Association of Individual Investors that are known as the AAII survey, and you look at the number of people who are bullish minus the number of people that are bearish, when you have the most bearish reading (so there’s a lot more bears than bulls, people that are pessimistic versus optimistic for the market—we’re in that first decile, so the most bearish reading) your forward one-year returns for the S&P 500 is 13.5% on average, which is the best out of all of the other observations that you have in that survey. So, with investor sentiment washed out, with consumer confidence washed out, historically, these are pretty positive omens for forward market returns.
Host: Jeff, you mentioned tariffs. What’s your base case on tariff rates and their impact on the economy and inflation?
Jeff Schulze: Well there’s a wide range of assumptions that are out there. Obviously you’re going to have retaliation from our trading partners. Some of these tariffs will ultimately be rolled back as concessions are made and deals are forged. But if you take the middle point of a lot of these estimates, you know, the average effective tariff rate is probably in the 20 to maybe 22% range. The impact to GDP growth is probably around 1.5%. And you also have an impact on inflation, which would probably move that up closer to 1.5% as well. So, obviously a lot can change as we get more visibility over the course of the quarter, but this should lower growth and increase inflation, all things considered.
Now our baseline is really that the April 5th 10% universal tariff, which is going to go into effect for all of our trading partners, is something that is going to stay. That is not something that’s going to get negotiated away. The deadline is too short for a turnaround. It’s going to go into effect tomorrow, and it’s pretty simple and easy to implement. So I think that is at least a bottom baseline for consideration.
Next week, you have the reciprocal tariffs that are going to be implemented. Some of these are pretty big numbers: 20% on the EU, 24% on Japan, 34% on China. And that’s on top of the additional tariffs that have already been placed on China as well. I think a lot of these may be postponed or dialed back as deals are forged, but ultimately you’re probably looking at an average effective tariff rate when all is said and done in the mid-teens range (call it 13, 14, 15%), which is a pretty big step up from where we were at 2.5% coming into the Trump administration.
Now, there is a reason to be potentially optimistic. Since Inauguration Day, President Trump has made 20 trade-related threats whose announcement date has passed, and out of those 20 threats, 14 were punted or dropped, four were acted on and then two were acted on and then they were immediately walked back. And those two were actually Mexico and Canada’s 25% tariffs in early March.
So, if you kind of look at that, those threats, this would suggest that a lot of the things that have been announced may be dialed back as we move forward, and this is maybe part of the art of the deal or the style of negotiation that Trump likes to deliver. But, ultimately, you know, I think we’re going to see higher tariffs. I think that 10% universal tariff is here to stay. I think this will hurt economic activity. This will increase inflation, and it ultimately will bring economic growth sub 1%, which puts the economy more vulnerable for recession if more shocks start to percolate.
Host: Is there a circuit breaker to this trade-related shock? Or maybe, put differently, what could counteract the impact of this recent escalation of trade wars?
Jeff Schulze: You think about it, I think the one thing that could counteract this is obviously, if President Trump reverses the tariffs that have been announced, and I obviously don’t think that’s a high probability at this point, even with the market volatility that we’ve seen. But I think the other answer is probably a strong fiscal response. I think the countries that respond most forcefully (so they have the bigger packages and the quickest) to this trade shock are going to be the ones that see the most resilient activity and the best performance on a relative basis.
Right now, you know, obviously you have a fiscal package or a tax package that’s being discussed by Congress. I think because of the market turmoil that we’ve seen, this brings those conversations to the fore much quicker than what was initially considered. But there’s a pretty big gap between what the Senate wants and what the House of Representatives wants. The delta or gap is about $1.5 trillion.
But ultimately, I think the faster that we can get a fiscal package and the larger that fiscal package is, could help support the economy and financial markets. And I think a lot of the fiscal package, when it does pass, I think will be frontloaded to be prioritizing, helping, supporting growth here in 2025 than what was initially considered before we went through Liberation Day and we saw those new tariffs come forward from the Trump administration. So, my hope is that we can get some visibility on that front sometime over the course of the second quarter, which I think will go a long way to stabilizing markets and potentially putting in a durable bottom.
Host: With trade escalation moving very quickly, there’s a lot of uncertainty in the world today. Is this a bad thing from a historic perspective?
Jeff Schulze: It’s actually a really good thing. Now to be clear, we were expecting volatility in the first half of the year. We talked about this on the January podcast. Because we were going to get the spinach portion of the administration’s dinner first, which is the DOGE-related layoffs, immigration, tariffs, before getting the dessert aspect, which was tax cuts and deregulation, by no means we expect a tariff package as large as was discussed, but nonetheless we were expecting some volatility.
But the key here is that when uncertainty is high, investors have been rewarded by embracing that uncertainty. So there’s an index that’s called the US Policy Uncertainty Index. It actually goes back to 1985. It’s a measure that’s compiled by financial economists from three leading universities. And when it’s been above 155, which is considered pretty high uncertainty, which is the case today, the S&P 500 has delivered an average return over the next six months of 9.3%—over the next 12 months, 18.1%.
So, investors have been rewarded by embracing uncertainty. And once things start to normalize, the markets tend to move higher along with it.
Host: Jeff, how about the Federal Reserve? Can they support the economy?
Jeff Schulze: The Fed’s in a little bit of a predicament. They’re in between a rock and a hard spot. Powell actually just spoke this morning. They are not looking to move before you start to see weakness in the labor market, right? We talked about the labor data coming in really solid today. So there’s really not a hurry from their vantage point. And the biggest concern from the Fed right now is they want to keep longer term inflation expectations anchored, because they want to make sure that the one-time increase in inflation that we’ll see from tariffs doesn’t become an ongoing inflation problem.
And the reason why the Fed is so concerned about inflation expectations is that was one of the biggest mistakes of the Fed in the 1970s. They eased policies well before inflation expectations came down and they became unanchored to the upside. And when that happened, workers demanded higher pay. And when they got those pay raises that filtered through to higher inflation. And you had this cycle that continued until Volcker ultimately broke the back of inflation in the early 1980s.
So, the Fed is going to wait and see, because, again, they want to make sure that inflation expectations are well anchored. And it’s not to say that they won’t act, but they’re going to act when you see material weakness in the labor market and the economy. And at that point, you probably are on your way to a potential economic downturn. So, that’s why I talked about before, I think the real important driver is really going to be fiscal policy to be able to short circuit some of the effects of trade shocks that we’re going to see.
Host: Jeff, diversification was a key theme in your recent commentary. Is diversification actually finally additive?
Jeff Schulze: It is. Diversification has returned to the fore. After a couple of years of not providing that free lunch that people like to talk about when it comes to diversification, right? Over the last couple of years, it’s really been a story about the S&P 500 and the Mag Seven1, but that has been a very different dynamic this year with the first quarter seeing the Mag Seven stocks fall by 16.4%, while the ACWI ex-U.S. index, which is the international index, rose by 4.6%. So the difference in performance between those two cohorts was 20% in just a quarter. So this is a really positive dynamic. You know, diversification is working. And it’s really not just a geographic allocation.
You also have market cap, so the size of the company you’re investing in. Investment style considerations. And we’ve been talking about this expectation for the Mag Seven rotation out of them and into areas that have been lagging, whether it’s the equally-weighted S&P 500 (or the average stock), value outperformed growth by 11.7% in the first quarter. These are all great trends that I think will continue as we move forward.
And we talked a little bit about the international space. And one thing that I’ll mention is that because the US has been leading for so long, a lot of people probably have a dramatic overweight to US equities, and they may want to rebalance their portfolio to bring it in line with their longer-term strategic allocation by increasing their international exposure at this point.
And one of the reasons why international equities could continue to lead is right now the ACWI ex-U.S., which is that international index, is trading at a 6.8 turn discount from a valuation standpoint compared to the S&P 500. And normally they trade at a discount of 2.8 turns. So this is a pretty remarkable statistic considering that they’ve had this outperformance that we’ve seen in the first quarter.
But, again, if you’re going to start to see more governmental spending, more fiscal spending in Europe, you’re going to get a larger fiscal package and support for China, that is going to go a long way to supporting not only those regions, but also regions that rely on growth from them. In particular, emerging markets are areas that tend to benefit when China is doing well.
So, we think that diversification is additive after being subtractive over the last couple of years. And you really want to look at your allocation and bring it back to your strategic long-term percentages if they’ve gotten out of whack from what we’ve seen from a performance standpoint over the last couple of years.
Host: So, additive. Should individuals think about diversification from an active management versus passive standpoint as well?
Jeff Schulze: I think so. You know, the Mag Seven has turned into the Lag Seven to start the year. A great example of this: first three months of the year, 59.8% of active managers in the large cap core space have outperformed. That’s the highest percentage that we’ve seen since 2022, when nearly 62% outperformed over the full year. And a key reason for that is the concentration risk that you have in the large cap equity space. So that’s really where you want to look at active management if you have a lot of passive exposure.
Now, if you look at the S&P 500, for example, top 10 names in the index make up 35% of the index, which is near an all-time high at least over the last 40 years. Now, usually when you have market concentration at these levels, it’s coincided with the average stock outperforming as you look forward. And that has been the case this year. In fact, if you look at the equally-weighted S&P 500, it has outperformed the cap-weighted version by 3.5%. And we think there’s probably more of that to go. Actually, if you put some numbers around it, you go back to 1989, when market concentration was north of 24% (and mind you we’re at 35%. So we’re well above that threshold), the equally-weighted S&P 500, which is better known as the average stock, outperformed the cap-weighted version of the S&P 500 (so, the index)—so, the average stock has outperformed the index by 6.3% per year on average over the next five years. And the hit rate of that average stock outperforming over that five-year period is 89%. So we think that active managers have a competitive advantage to sidestep that concentration risk. It’s not saying that we can’t invest in any of the largest companies, but they can be much more selective on which of those companies have a durable competitive advantage, which one of them have embedded expectations that are attainable, and which one of those are overvalued. And because of this dynamic, we think that active managers are going to be in a very good position on a relative basis as we move through the next couple of years.
Host: Jeff, is there an equity asset class that you think of when we face times like we are currently, where we may be looking at a recession, we may have further downside in equity markets?
Jeff Schulze: There is. One way to navigate through periods of elevated uncertainty is to focus on higher quality companies with proven track records of being able to manage through periods of turmoil. And one approach to do this is to focus on companies that have consistently been able to increase their dividends. They usually have really reliable profits that are pretty consistent, regardless of the ups and downs of the cycle.
And these equities have been out of favor in the US, and they’ve experienced a large period of underperformance relative to the S&P 500 on a 12-month rolling period. In fact, when you’ve had underperformance to the levels that we’ve seen over the last couple of years (and you saw these same periods of underperformance or magnitude of underperformance in the late 90s and the early 2000s), dividend growers went on to pull ahead of the S&P 500 over the next couple of years. And they’ve had a nice run recently, and history would suggest that there may be more to that run. So, if you’re nervous about a recession or volatility, this is the type of asset class that does well in this type of environment. And given their recent underperformance and what we saw in the late 90s and the early 2020s, history suggests that that this may be an asset class that may do well as we look forward over the next couple of years.
Host: So, Jeff, any closing thoughts or comments for our audience?
Jeff Schulze: I think a closing thought that I really think is powerful is that we’ve had a correction in the S&P 500, which is -10% returns. If you go back to 1950, you’ve had 34 instances where you’ve had a 10% pullback or more. If you had bought at that point of correction, if we had no recession, your forward six-month returns were 9.2% on average. Your forward 12-month returns were 13.9% on average, right. So obviously no recession materializes—really good dynamic to buy that correction.
But even if you had a recession (a lot of people are shocked about this), on a forward six- and 12-month basis, your average returns were positive at 2.8% and 1.2%, respectively. So again, there’s a lot of pessimism priced into the market. The S&P 500 as of today’s close is down over 17%. So we’re well through that correction threshold of -10%.
Longer-term investors should be taking advantage of this. And we think dollar cost averaging makes a lot of sense considering what is priced in the market, but also what we’ve seen following both recession and non-recessionary periods. And the last thing I’ll mention, just because if you have a recession doesn’t mean that you have to have the big drawdown that you saw in 2009 of 57%, or the drawdown you saw in 2001, of 49%. In 1990, and 1980’s recessions, believe it or not, the S&P 500 peak to trough fell 20% and 17%, respectively. So, with no clear signs of excesses in the US economy, even if we do have a recession, I think it ultimately will be mild at the end of the day.
Host: Jeff, thank you for your time today. To all of 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 at any other major podcast provider.
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1. The “Magnificent Seven” are Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla.
