Why a recession could be on the horizon

[00:00:00] Speaker 1: In the past week in particular, bad economic news was actually good news for investors. Stocks closed the week higher as cooler data from Friday's jobs report supported a narrative of a gradual job market slowdown that could signal an end to the Federal Reserve's rate hikes. But the positive reactions to softening data may soon end and bad news could end up being bad news again for the market. Here to discuss is Jeff Schultz, ClearBridge Investments, head of economic and market strategy. I mean, we kind of swing between those two, don't we, between the bad news is good news, bad news is bad news, good news is good news, etc. How are you sort of thinking about your framing of the economic data and how it relates to the [00:00:38] Jeff Schultz: markets right now? Well, last week was certainly a relief to those in the soft landing crowd. You saw rebalancing of the labor market. We've been waiting for it and waiting for it. And it finally appears to be happening. But I think if you look out on the horizon, you're going to continue to see the labor market weaken. And I'm not sure I see a catalyst to see a plateau and ultimately pause that soft landing outside of a Fed pivot. And I think the Fed is going to be reluctant to provide any type of stimulus to the economy because they don't want to repeat the sins of the late 1960s, which was the soft landing that they engineered and they loosened or cut rates into a very tight labor market. And corn inflation basically doubled going from three to six percent over the next couple of years and really kicked off that structurally higher 1970s inflation. So I think the Fed is going to be higher for longer policy. And I ultimately think, although we're seeing signs of a loosening labor market, that we're going to see this ultimately lead to layoffs and the recession that everybody's [00:01:34] Speaker 3: given up on. What does the Fed need to see in order for that pivot to be initiated then? [00:01:39] Jeff Schultz: Well, I think the Fed needs to see the unemployment rate get above four percent, maybe four and a half percent before they'd be comfortable cutting rates. I think you need to see wage growth move down to levels that are consistent with two percent inflation. And with average hourly earnings and the latest release, that's a positive step in the right direction. But if you look at the Atlanta Fed's wage tracker or the employment cost index, still well above where two percent would ultimately be. So I think you need to see a greater softening in the labor market. And we have come off a boil, but the labor market's still incredibly tight right now. [00:02:09] Speaker 1: So walk me through this then, because you have on the one hand what you're talking about with, yes, the recession is going to happen. You have on the other hand, the likes of Goldman Sachs saying, well, we're putting our probability of a recession down to 15 percent. And among other things, the case they're making is that the Fed tightening making its way through the economy will not be as severely felt as perhaps some had perceived. I assume you think that's wrong. And tell us how you're sort of modeling this versus maybe how they're modeling it. [00:02:38] Jeff Schultz: Well, if you think about Fed tightening, it works with notorious long lag times. It's hard to know when the rubber will hit the road with the economy. And it's important to remember that the economy was very hot coming into this Fed tightening cycle. And the Fed only got above forward-looking measures of inflation with the Fed funds rate in November of last year. So we've only been in restrictive territory for, call it, nine or 10 months. It's going to take more time for that to work its way through the plumbing of the economy overall. More importantly, if you look at lending standards, they've dropped pretty precipitously over the course of this year. And if you're looking at lending standards to businesses or consumers, we've rarely seen it this negative. So I think that's going to start to hit the economy in the fourth quarter into the first quarter of next year, ultimately provide that impetus for the layoff cycle and the start of the recession. But we're not there yet. And I will say that you're starting to see some tangible signs of weakening on the consumer front. And I think that's [00:03:34] Speaker 3: going to continue. So with all those factors at play, how deep of a recession are you forecasting? Because you're talking about a horizon for a recession over the next, what, two to three quarters now? [00:03:44] Jeff Schultz: I'm not anticipating a deep recession. I think it's going to be relatively mild because you don't have a lot of excesses in the economy that need to be wrung out. I do believe that as inflation comes down, it's getting to the point where the Fed could pivot a lot earlier than, say, inflation remains stickier to the upside. But on a scale of one to 10, one meaning a very shallow recession and 10 being a deep recession like the global financial crisis, I would imagine it'll probably be in the three or four range. So more of a moderate recession, given the fact that the Fed will be reluctant to cut as aggressively as what you've normally seen heading into economic downturns. [00:04:16] Speaker 1: Okay. So what does that imply for stocks then? [00:04:19] Jeff Schultz: Well, I think from the stock market's perspective, I think the path of least resistance is higher from here. We do get the CPI print in the middle of next week. I don't think the Fed is going to hike in September. And I know September historically is bad from a seasonality perspective. But I think at this point, bad news is good news when it comes to the labor market. And I think that's going to continue to be cheered by investors. But I think as we get to the fourth quarter and, you know, the later part of the fourth quarter, when it becomes evident that you are going to see more weakening and the consumers not as strong as initially appeared, I think bad news becomes bad news and investors will start to price in maybe some lower economic activity and also potentially that recession that, again, everybody knew was a foregone conclusion coming into the year. [00:04:58] Speaker 3: Is bad news really bad news when you have kind of other catalysts that investors point their attention to, whether that's AI or whether that's large chip companies potentially going public and perhaps opening up the opportunity or at least the pipeline therein? Because investors have picking and chosen their spots at this point. [00:05:17] Jeff Schultz: Well, the average recessionary drawdown in post-World War II history has been 30%. I don't think we're going to get anywhere near that because there's a lot of investors that have missed out on the move for the MAG-7, the AI beneficiaries. And I think there's going to be a lot of buying the dip as this recession materializes. I think ultimately it's going to be something similar to what we saw ahead of 1990s downturn, around 20% peak to trough decline. But I do think that there's going to be really good opportunities for active managers to be able to navigate this landscape. And from a sector standpoint, I really like the defensive sectors given how cheap they've become over the course of the last five months. So that's healthcare, utilities, and stables. [00:05:55] Speaker 1: I was going to ask, is defensive still defensive? Like the classically defensive groups like that? It sounds like you think that they are because you're naming the ones that are sort of classically defensive, right? [00:06:04] Jeff Schultz: Yeah, I think they are going to be more defensive. Utilities, one of the biggest gaps versus the S&P 500 that we've seen since the dot-com bubble burst. As interest rates fall and this recession's ultimately priced, I think they're going to fare a lot better. Also, I think when you have an uncertain earnings environment, those companies that provide a lot of visibility into that earnings stream will catch a bid. And we saw that coming into 2023, but we've seen a complete reversal of that. So I think that these stocks are pretty cheap and they're going to do well on a relative basis. But the last area that I actually think there's an opportunity in is energy. You know, you would think with the U.S. recession, that energy wouldn't fare that well. And that's typically the case. However, if China does do a bigger stimulus package than what they've done at this point, and I think that's going to be needed to take them out of the malaise that you're seeing over there, given the lack of supply that you're seeing in the discipline of shale producers and OPEC, I think energy can fare well in this environment and better coming out the other side of this.