Anatomy of a Recession Update: Threats to a Soft Landing
With lots of chatter in the United States around the potential for a soft landing, Jeff Schulze, Head of Economic and Market Strategy at ClearBridge Investments, shares his thoughts on the matter and the overall state of the US economy in our latest “Talking Markets” podcast.
Jeff Schulze: Thanks for having me.
Host: Jeff, we’ve kicked off the fourth quarter and are looking forward to your economic and market outlook. Let’s start with the US economy. There’s been quite a bit of optimistic chatter focused on this idea of a soft landing. Has your view on this topic changed?
Jeff Schulze: Well, obviously, with some resilient data, you were going to get this chatter about a soft landing. But the path to a hard landing, which is a recession, the first stop is always going to be a soft landing.
When you think about investing and mountain climbing, they’re both judged by the ability to move higher. And the journey higher is never smooth. Experienced climbers understand that heightened concentration is paramount once the crux, which is the toughest part of the route where the hardest moves and challenges are concentrated, is reached. And while the consequences of the failure in the stock market pales in comparison to an actual climber, we continue to believe that the crux for investors lies over the next two to three quarters as both fiscal stimulus and consumer resilience fades—and, at the same time, the lagged effects of monetary tightening start to take hold.
So we worry that many investors have fully embraced this soft landing narrative, potentially at the most dangerous part of this cycle’s climb. And if you look over corporate filings, transcripts and presentations going back to 1995, the term “soft landing” spiked a couple of quarters before the actual onsets of both the recessions in 2001 and 2007. So yes, you’re hearing a lot about a soft landing, but that always transpires before you head into a recession. So I think investors may be best served to remain skeptical that we’re out of the danger zone quite yet.
Host: So to this point, the economy has been holding on, remaining resilient. You’ve mentioned concerns. Can you talk more about those concerns?
Jeff Schulze: One of our biggest, the Leading Economic Indicators [LEIs], they tend to lead economic activity by a couple of quarters. You’ve never seen a drop of this magnitude or for this long of the LEIs without recession materializing. So that tells us that, yes, economic activity is okay today, but as we turn the page to 2024, that may not be the case. And that’s exactly what you see going into recessions. So, going back to the late ‘60s, the last eight recessions, GDP growth three quarters prior to the start of that recession, it averages 4.6%. Two quarters prior it drops, but it’s still a very healthy 3.5%. And then one quarter prior you have that recession contagion come over the economy, and the economy drops pretty substantially, barely growing at 0.8%. So, yes, the economy’s okay today, but I think a lot of these headwinds are going to start to coalesce into an economic downturn as we reach 2024.
Host: Okay. So we’ve got some serious headwinds. Let’s transition to the ClearBridge Recession Risk Dashboard. Any change with the September 30th update, Jeff?
Jeff Schulze: No changes. As a reminder, it’s a stoplight analogy where green is expansion, yellow is caution, and red is recession. And for the fifth consecutive month, we have the same exact output in the dashboard, which is zero green signals, two yellow, and 10 red. But again, we continue to have a very deep recessionary red signal.
Host: So Jeff, I know that you’re frequently analyzing past economic cycles and recessionary periods to develop your current insight. Is there a specific period that you’re leveraging today?
Jeff Schulze: Well, the output that we have today is really consistent with what you’ve seen going into the last eight recessions. But when we went red a little bit over a year ago, we had always felt from a timing perspective that this would resemble what transpired heading into the 1990 recession, which was the longest lead time that we had between an overall red signal and the start of a recession, which was 13 months. So we’ve always kind of had our eye on the end of the third quarter for the start of this recession. But given some of the economic resilience that we’ve seen, we’ve pushed that out. And it could be at the end of the year; it might be at the end of the first quarter; but nonetheless, we think it’s going to be a little bit longer than what you typically see, but we still see the economy starting to slow from here.
Host Okay. You’ve talked in the past about the time that it takes for the Fed’s action to take hold in the economy. Do you have any additional insight into those lags?
Jeff Schulze: Well, if you look at all the persistent hiking cycles since the late ‘50s and those cycles that started in the middle or the end of an expansion, on average between that first hike and the start of a recession, it takes about 23 months for that to transpire on average. So close to two years. It’s been almost 18 months as we currently sit here today, so we’re not even at that average mark.
But one thing that I think a lot of investors underestimate is that the Fed had to dig themselves out of a very deep hole with policy being very accommodative at the beginning of their hiking cycle back in March of 2022. So a good way to tell whether or not the Fed is being restrictive—or helping or hurting the economy—is to compare the Fed funds rate to inflation plus an additional 50 basis points, which we call the neutral rate, the rate where the Fed’s neither helping or hurting the economy.
But we don’t want to look at backward-looking inflation because people and businesses don’t make decisions on what’s happened over the last 12 months. They make decisions based on what they expect will happen over the next year. “Will I buy a new car or a new house because I think prices are going higher?” “Do I want to invest in my business, because I think it’s going to be cheaper today and I’m going to get that payoff based on where inflation is going?” So we like to use the one-year inflation swap as a good proxy for inflation. And when you look at the Fed funds rate, when the Fed did their initial hike back in March of last year, the Fed was arguably the most accommodative they’ve ever been in history. And it took them until the end of 2022 for monetary policy to get above that forward-looking level of inflation and that neutral rate and actually get restrictive, actually start to slow the economy.
So the Fed has only really been in restrictive territory for the last nine months, so it really shouldn’t be a surprise that we haven’t had a recession quite yet. But when you look out over the course of the rest of this quarter and into the first half of 2024, that restrictive policy is going to continue to be a headwind to the economy, and that lag that everybody talks about is going to finally start to catch up with the economic data.
Host: Okay. How about the impact of federal spending?
Jeff Schulze: Well, one of the more underappreciated elements of why you’ve seen some resilience here is the surge in fiscal spending that we’ve seen. Now historically, the budget deficit has tracked the unemployment rate. Usually, it’ll shrink in good times as you have more tax receipts and fewer people need to tap into the social safety nets. So, smaller unemployment rate, smaller deficits. And when you have recessions, you know the deficit expands, tax receipts fall, and Congress usually does some moves to bolster the economy. And that comes with a higher unemployment rate. But a different dynamic has emerged over the last decade. Recently, the deficit has moved opposite to the unemployment rate. So as the unemployment rate has gone down, you’ve seen bigger deficits, not only at the tail end of last cycle, but you’ve also seen this transpire since the middle part of 2022.
To put some numbers around this, the budget deficit increased by over 4% from the summer of last year to the summer of this year, which is over a trillion dollars. Now, obviously some of that’s higher interest expense that the federal government has to pay on their debt. Some of that is actually lower tax receipts from last year’s selloff. But nonetheless, that is a key reason why the economy has been resilient. But with the debt ceiling agreement being reached earlier this year, you’ve seen agreements to cap discretionary spending in 2024 and 2025, and the Congressional Budget Office projects that that spending is going to shrink the deficit by about $170 billion. So this fiscal tailwind to economic activity is now over. And again, if that’s no longer going to be supporting economic activity, it’s a reason why growth will likely shift down into a lower gear.
Host: Jeff, in your comments earlier you mentioned that the economy can turn quite quickly. Do you have any perspective on when that might be?
Jeff Schulze: Well, it’s really hard to know when the rubber will hit the road. Again, we talked about the long and variable lags in monetary policy. Maybe a way of trying to flush this out is to look at what happens after the last rate hike for the Fed (i.e., they pause) to when a recession starts. On average, it takes about eight and a half months for that to transpire. Now, over the last four recessions, it’s actually been a lot longer. It’s been closer to 15 months. But in the prior four recessions, in the late ‘60s through the early ‘80s, the pause was two months. And that was an environment where you had high inflation, which is a similar dynamic to where we are today.
I like to think of the average because we don’t know what regime we’re in. So at eight and a half months, if the Fed did do its last rate hike in July, we’re probably looking at sometime in the first quarter for the recession to materialize. If the Fed does end up hiking in November or maybe December, we may be looking closer towards the middle part of 2024. But again, as we move through the crux of this cycle, which is the next three quarters, we do think that a recession is going to materialize.
Host: So, as we move through that crux, what specific data will be important to keep an eye on?
Jeff Schulze: The data point that we look very closely at is lending standards by the Senior Loan Survey by the Fed. Lending standards are clearly in restrictive territory, recessionary territory, whether it’s willingness to make consumer loans or whether it’s willingness to lend to businesses themselves. And I think the key part is that lending standards act with a lag on not only employment, but loan growth anywhere from three to six quarters. And this went net negative at the beginning of 2023. If you put that lag into perspective, that means credit creation is going to start to be curtailed over the next nine months. So although we haven’t seen a huge step back in lending quite yet, history would suggest that that’s going to start to materialize here over the next couple of quarters.
Host: So that, Jeff, is a perfect lead-in to my next question, which is, can the US consumer remain strong?
Jeff Schulze: Well, the consumer has certainly surprised me with their resilience, and they could surprise for a little bit longer. But there’s increasing signs of strain with the consumer, and we think that the consumer is experiencing balance sheet fatigue. If you look at delinquency rates for credit cards, autos, and other loans, up pretty substantially from the lows. Now, an economic bull would note that these rates are maybe normalizing because they’re back at pre-pandemic levels. However, my take on it is when you usually see these rates rise in tandem with one another, it usually leads to a recession. And let’s not forget, student loan repayments are going to begin this quarter, which is going to put a strain on anywhere from 15 to 20 million Americans. You have gasoline prices up almost 20% year to date. And we think that if you’re seeing rising delinquencies with a pretty strong labor market now, if the labor market cools further from here, we think that puts even more pressure on delinquencies and the health of the consumer. So again, the consumer’s been resilient. Those excess savings have been helpful in sustaining consumption. But if that excess savings hoard is now diminished, coupled with those other headwinds, we think that consumption’s not going to be as robust as we look towards 2024.
Host: Okay. You just mentioned, Jeff, labor. How are you viewing current data on the [US] labor market?
Jeff Schulze: Well, if you’re just scratching the surface, it looks fine. But if you look underneath the surface, there are some troubling signs. So one of the indicators that we have in the dashboard is our job sentiment indicator. It’s from the Conference Board’s Consumer Confidence Survey. And we’re looking at the number of respondents that say jobs are plentiful, minus the number of respondents that say jobs are hard to get. And you’ve seen a meaningful hook down in this measure. And every time that you’ve seen this since the late ‘60s, you’ve had a recession. So this is evidence that consumers are not as optimistic about the labor market as they once were. Also, generally speaking, as you go into a recession, savings rates increase. If job prospects are starting to dim, the savings rate may move higher from here, which may be a headwind to consumption.
Also, if you’re looking at temporary worker trends, they’ve rolled over very aggressively. They’ve been down for the last seven consecutive months. Usually, companies are going to fire temporary workers first—because it’s easy to hire and fire them—rather than full-time employees, because getting that full-time employee back can be a pretty expensive proposition. And then lastly, if you look at labor revisions versus their initial release, every month this year through July, that initial release was revised downward. And usually labor revisions happen at inflection points. And the last time that we saw this in the later part of an expansion was in 2007—right before the run-up to the Global Financial Crisis. So even though labor revisions shouldn’t set off an immediate recession alarm, it’s a sign that the labor market may be weaker than perceived when we look back at these numbers on a six- or 12-month basis. So, long story short, there’s some cracks in the foundation for the labor market, even though it’s not evident in the surface numbers.
Host: Okay. So certainly seem to be on the path here of economic contraction. Is there any way to alter that path?
Jeff Schulze: Well, there is. Usually when you see a re-acceleration of US economic activity, it’s because of one of two things. You either get some fiscal stimulus to be able to boost economic activity, or you get it from the Fed doing a rate cutting cycle. Now, given, again, the agreement that was reached with the debt ceiling, we don’t see fiscal being a tailwind to economic activity going forward, especially with the election looming in 2024. So it leaves us with the Fed, and if you look at every strong re-acceleration of economic activity since the mid-1960s, a sustained cutting cycle that didn’t happen within a broader hiking cycle was needed for the economy to hook higher. And again, given where inflation has been, given how tight the labor market is, we think the Fed is hamstrung and likely is going to react slower to unfavorable data and they’re going to be much more targeted with the response when it does start to move lower. So, absent a Fed pivot (and it’s going to be really tough for that to happen, given inflation and how tight the labor markets are), we think that the path of least resistance is a little bit lower for economic activity.
Host: What might this mean for US equities?
Jeff Schulze: We think US equities are pricing in a softer landing scenario. You’ve seen some volatility and downward pressure with the rise of the 10-year Treasury. This makes sense as that tends to pressure valuations. With a higher discount rate, all things being equal, PEs [price/earnings ratios] will move down.
But there’s also reasons to suggest that things may be not as good with the markets as initially seen. Now, although the S&P 500 [Index] is up strongly this year, if you look at the Russell 2000 [Index], which is a small-cap index, with every bear market low that we’ve seen since 1982, the average return of the Russell 2000 (or small caps) has been 75% on average in that first year of a new bull market.1 As of the end of the third quarter, small caps are only up around 6%. And small caps are much more focused domestically, get much more of the revenue domestically, than the multinationals in the S&P 500. So this is a reason why there may be some concern about the sustainability of this expansion. But ultimately, we do think that equities are pricing in a soft landing and we may see some volatility as the economy shifts down into a lower gear.
Host: Some volatility. So you do think that there’s potential here for US equities or the S&P 500 as a proxy to see a pullback in the near or midterm?
Jeff Schulze: We do. If you look at the post-World War II era, the average recessionary drawdown was 29.9%. I don’t think we’re going to get anywhere near that should a recession materialize. I think that there’s a lot of buy-the-dip opportunities out there, especially for those who have missed out on the move higher for the “Magnificent Seven.” And a lot of people say that, you know, we’re in the dot.com bubble 2.0 with the information technology sector, but if you look at that sector compared to March 2000, the sector is 50% more profitable. And given that higher profitability, even if AI turns out to be less of a game changer than people think, we think that’s going to help support those companies even in a recessionary type of environment.
But when thinking about AI, I would make the argument that we’re in the honeymoon phase of that story. I think there’s a lot of money on the sidelines interested in getting involved with that theme. And I think because of that buy-the-dip type of mentality and the fact that the average stock really isn’t priced very aggressively, I think that you may see a selloff in the 15 to 20% range all things considered. But there’s not a lot of excesses in the economy that makes me think that we’re even going to get to that average recessionary drawdown that you traditionally see.
Host: So it certainly sounds like given this perspective that a defensive position with an equities allocation may be prudent. Any thoughts on that?
Jeff Schulze: Well, we’re really strongly advocating dividend growers. Dividend growers tend to outperform the S&P 500 and the three, six and 12 months after that last rate hike, which we may have already seen or will be approaching. Dividend growers have underperformed here year-to-date as a lot of the momentum that you saw over the first seven months of the year was into more cyclical, less defensive areas of the marketplace. But dividend growers have all the attributes that you want in an uncertain environment. They have rock solid balance sheets. They don’t need the capital markets. They have a high earnings visibility, which is an attribute that investors put a premium on. And if the Fed has to do more rate hikes, and they very well may, depending on where inflation goes and how the economy holds up, that dividend growth is going to help negate some of the duration effects that you have from those higher interest rates. So we like dividend growers, and we think that’s an area of opportunity as we look through the next 12 to 24 months.
Host: Jeff, thank you for your terrific insight today as we continue to navigate the markets. To all of our listeners, thank you for spending your 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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