posted by Franklin Templeton
Key takeaways
- Differing dynamics have made historical recession guideposts somewhat less reliable lately, yet many parts of the economy are showing signs of increased strain, suggesting the economic cycle may have been elongated rather than eliminated.
- Several rays of light are showing through the macro clouds, including an increasing likelihood of a soft landing, with the Federal Reserve (Fed) being in a more flexible position as inflation moderates and three positive indicator changes for the ClearBridge Recession Risk Dashboard in the last quarter.
- Although we believe caution is warranted in the near term, positive economic momentum, broadening market leadership, and stocks on the doorstep of new all-time highs have all historically been favorable signs for long-term investors.
Will the consensus be wrong again?
The changing of the calendar affords a natural time to reflect on the previous year and imagine what could be different in the new one. Recent years have ended up differing substantially from consensus expectations. For example, investors could have been described as euphoric heading into 2022 with the S&P 500 Index trading at 21.3x next 12 months (NTM) EPS, a valuation that proved overly optimistic as generationally high inflation and the Fed’s aggressive tightening cycle led to a -25% intra-year drawdown. By contrast, expectations heading into 2023 were much more pessimistic, with the “most anticipated recession ever” giving way to robust economic growth and equity market returns. With a soft landing firmly entrenched as the consensus viewpoint heading into 2024, we are left wondering if the opposite may once again occur.
The fundamental question that divides bulls and bears is whether “this time is different,” perhaps the four most dangerous words on Wall Street. Several dynamics are in fact different, including the unique nature of the pandemic-driven recession and the unprecedented fiscal stimulus which drove a “checkmark” shaped recovery. The American consumer has shown staunch resilience, critical for the health of an economy where two-thirds of gross domestic product (GDP) is consumption. Demand for services has held up remarkably well even as goods demand wanes, which has short-circuited normally reliable recession indicators like the Institute for Supply Management (ISM) Manufacturing Purchasing Managers Index (PMI), which focuses on the smaller, but more volatile, manufacturing sector.
Exhibit 1: Services Holding Up
Data as of Sept. 30, 2023, latest available as of Dec. 31, 2023. Sources: BEA, FactSet.
Another key difference is that consumers (as well as corporations) are far less sensitive to changing interest rates. In the aftermath of the most aggressive Fed hiking cycle in over 40 years, the effective outstanding mortgage rate in the U.S. has risen to just 3.7% from a recent low of 3.3%. This is the result of homeowners taking advantage of the low rate environment early in the pandemic to term out their debt and lock in 15- and 30-year fixed rate mortgages. The unique structure of the U.S. mortgage industry has insulated many Americans from the bite of higher interest rates when it comes to their largest monthly outlay. Corporate America looks similar, with many companies locking in their borrowing needs for multiple years at low rates.
Exhibit 2: Consumers are Locked In
30-year fixed rate data as of Dec. 29, 2023, effective interest rate on mortgage debt outstanding as of Sept. 30, 2023, latest available as of Dec. 31, 2023. Sources: FactSet, BEA, Mortgage Bankers Association.
However, not all companies termed out and locked in fixed rates, and not all Americans own their homes. In fact, 36% of households rent according to the Census Bureau’s 2019 estimates, and the Consumer Price Index (CPI) rent sub-component has risen by 25% since 2019, which equates to a nearly $500/month increase for the national median monthly rental according to rent.com. Consumers are increasingly showing signs of balance sheet fatigue, with newly delinquent credit card and auto loans rising above pre-pandemic levels. The spike in delinquencies is notably higher for low-income households, which are feeling the pain of higher rents and credit card rates (+6% since 2019), as this cohort is the least likely to own their home and more likely to carry a balance on their credit card.
Exhibit 3: Delinquency Rates Rising
HELOC stands for Home Equity Line of Credit. Data as of Sept. 30, 2023, latest available as of Dec. 31, 2023. Sources: NY Fed, Equifax, NBER.
Importantly, other recessionary signals continue to flash warning signs, suggesting the economic cycle may have been elongated rather than eliminated. These include an inverted yield curve, contracting money supply, ongoing quantitative tightening, leading economic indicator weakness and a slowly but steadily softening labor market. While the overall pace of job creation remains healthy, the labor market is showing signs of deterioration beneath the surface.
One red flag for the labor market is downward revisions to the jobs report. Historically, labor revisions for the prior year turning negative indicates an economic downturn is on the horizon. Over the last 12 months, payrolls have seen a cumulative net revision of -329,000, firmly in the danger zone. Regardless of a hard or soft-landing emerging, we may look back at this period and realize that job creation was much weaker than initially thought when all the revisions have been made, a process that takes a few years to fully play out.
Exhibit 4: Labor Revisions Raise Alarm
Data as of Nov. 30, 2023, latest available as of Dec. 31, 2023. Sources: BLS, NBER, Federal Reserve Bank of St. Louis.
Although the fourth quarter saw mostly encouraging economic data, in our view, this does not rule out a recession. Historically, the economy tends to turn down non-linearly as a slowdown builds steam. This can be seen near cycle peaks in the labor market, with the economy quickly transitioning from strong job formation to outright losses. Since 1948, the average job creation is 180,000 per month (adjusted for the current size of the labor force) in the three months leading up to the cycle peak, and -213,000 per month in the three months after. Over the past three months, job creation has averaged 203,667, consistent with what has been seen ahead of past recessions. Put differently, strength in the labor market—a notoriously lagging indicator—does not mean we are out of the woods just yet.
Exhibit 5: Job Market Can Turn Quickly
*Average monthly non-farm payrolls (NFP) change based on three-month historical average change (relative to cycle peaks as defined by NBER) as a percentage of total NFP adjusted for the current size of the labor force. Data as of Nov. 30, 2023, latest available as of Dec. 31, 2023. Sources: BLS, NBER, and Bloomberg. Note: 1948-present; 2020 recovery excluded due to pandemic distortions.
This is not to say that a soft landing can’t, or won’t, occur. In fact, we believe the odds of a soft landing have increased over the last quarter on the back of improving economic data, a faster pace of disinflation and a potentially less restrictive Federal Reserve. Core PCE—the Fed’s preferred measure of inflation—has come in at 1.9% on an annualized basis over the last six months, indicating that the Fed is on track to return inflation to its 2% target in 2024. This gives the Fed much more latitude to focus once again on its dual mandate of price stability and maximum sustainable employment. After last year’s rapid progress on the inflation front, the Fed is now in a position to cut rates from their currently restrictive level, which should help support the economy. With inflation nearing target, the Fed has additional flexibility to cut rates even further in the case of outright job losses (Exhibit 6).
However, just like a strong labor market doesn’t necessarily prevent a recession from occurring, rate cuts don’t either. The Fed lowered policy rates by 100 basis points (bps) before the economy slipped into a recession in 2007 and 150 bps prior to the cycle’s peak in 1990. While the market has cheered a more accommodative Fed recently because it increases the chances of a soft landing, we believe the economy is not fully clear of recession risk quite yet.
Exhibit 6: Inflation No Longer Primary Consideration
Data as of Dec. 31, 2023. Sources: FactSet, BLS, BEA, FOMC, Bloomberg.
The skies are clearing…slightly
Our guarded optimism comes back to our belief that the crux of this cycle’s journey lies ahead, with the economy still feeling the lagged effects of the tightening cycle and the previous support from fiscal policy fading. Although we have upgraded our assessment of the economic outlook, we continue to believe a recession is more likely than a soft landing, although only slightly more so. As we move through the next six months, we expect a clearer picture to emerge regarding trend growth.
The ClearBridge Recession Risk Dashboard continues to improve both under the surface and above it, with December experiencing two positive indicator upgrades with both Credit Spreads and Commodities improving from red to yellow. With these changes, the dashboard has seen three individual indicator upgrades during the fourth quarter, and the overall signal is moving closer to yellow territory. While it’s still too soon to waive the all-clear flag, it would not be a surprise to see the overall signal move from red to yellow should recent momentum continue. We are closely watching for continued improvement of additional underlying indicators such as the ISM New Orders and Housing Permits. However, economic growth is expected to slow in 2024, which could halt or even reverse the recent progress. We will continue to monitor these trends closely.
Exhibit 7: ClearBridge Recession Risk Dashboard
Data as of Dec. 31, 2023. Source: BLS, Federal Reserve, Census Bureau, ISM, BEA, American Chemistry Council, American Trucking Association, Conference Board, and Bloomberg. The ClearBridge Recession Risk Dashboard was created in January 2016. References to the signals it would have sent in the years prior to January 2016 are based on how the underlying data was reflected in the component indicators at the time.
The recent uptick in the dashboard has coincided with a strong run for the stock market, which has now fully priced in a soft landing. The S&P 500 Index is currently trading at 19.5x NTM earnings per share (EPS), and those EPS expectations imply double-digit growth in 2024. With forecasts leaving little margin for error, the market may need a digestion period regardless of the economic outcome. One positive sign has been the broader participation across equity markets since the October 27 lows, with the Russell 2000 and Russell Midcap indices outperforming the Magnificent Seven that dominated market performance for most of 2023. Encouragingly, everyone else (the S&P 493) as well as the Russell 1000 Value have not been far behind during the recent period of improving market breadth.
Exhibit 8: The Mag 7 and Everyone Else
*Magnificent 7 data is cap weighted and refers to the following set of stocks: Microsoft (MSFT), Amazon (AMZN), Meta (META), Apple (AAPL), Google parent Alphabet (GOOGL), Nvidia (NVDA), and Tesla (TSLA). Data as of Dec. 31, 2023. Sources: FactSet, Russell, S&P. Investors cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not a guarantee of future results.
Broader leadership is typically a good sign for the health of a bull market, and we expect a continued rotation into smaller cap stocks and more cyclical names should a soft landing materialize. We believe active managers are well-positioned to capitalize on rotations such as these due to the extreme concentration in the S&P 500, with the top five names representing nearly a quarter of the benchmark. Although index concentration could get more severe, history suggests the more likely outcome is a reversion to the mean with relative outperformance of the average stock in the coming years.
Exhibit 9: Trouble Concentrating?
Data as of Dec. 31, 2023. Sources: S&P, FactSet, and Bloomberg.
After a strong Santa Claus rally, it would not be surprising to see the markets undergo a period of digestion in the new year. We believe this could coincide with a soft patch of economic data which may lead to a growth scare or perhaps even signal the start of a recession. Given the lack of excess in the economy and a Fed that is no longer hamstrung by inflation, we believe any downturn and corresponding market selloff could be benign as the markets “look through” a potential soft patch in favor of greener pastures later in 2024.
As such, we believe long-term investors should take advantage of any significant equity weakness that emerges. Although heightened caution may be warranted near term, the S&P 500 is on the doorstep of eclipsing its all-time highs for the first time in over a year. In the previous 14 instances when the S&P 500 set a new all-time high for the first time in over a year, the rally continued over the subsequent 12 months 93% of the time with an average return of 13.9%. Like anything, this is not foolproof—one instance occurred ahead of the Global Financial Crisis in mid-2007—however, history has been on the side of long-term investors at past junctions similar to today.
Exhibit 10: Strength Begets Strength
Data as of Dec. 31, 2023. Sources: FactSet, S&P. Investors cannot invest directly in an index, and unmanaged index returns do not reflect any fees, expenses or sales charges. Past performance is not a guarantee of future results.
Definitions
The ClearBridge Recession Risk Dashboard is a group of 12 indicators that examine the health of the U.S. economy and the likelihood of a downturn.
The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.
S&P 493 is known as the S&P 500 Index excluding the seven technology stocks (Magnificent Seven).
The Magnificent Seven stocks are Amazon.com (AMZN), Apple (AAPL), Google parent Alphabet (GOOGL), Meta Platforms (META), Microsoft (MSFT), Nvidia (NVDA) and Tesla (TSLA).
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The Global Financial Crisis (GFC) refers to the economic disruption that followed the collapse of prominent investment banks in 2007-2008, marked by a general loss of liquidity in the credit markets and declines in stock prices.
Gross Domestic Product (GDP) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.
The Consumer Price Index (CPI) measures the average change in U.S. consumer prices over time in a fixed market basket of goods and services determined by the U.S. Bureau of Labor Statistics.
The Institute for Supply Management (ISM) is an association of purchasing and supply management professionals, which conducts regular surveys of its membership to determine industry trends.
The ISM Purchasing Managers Index (PMI) for the US manufacturing sector measures sentiment based on survey data collected from a representative panel of manufacturing and services firms. PMI levels greater than 50 indicate expansion; below 50, contraction.
Earnings per share (EPS) is the portion of a company's profit allocated to each outstanding share of common stock. An index EPS is an aggregation of the EPS of its component companies.
Personal Consumption Expenditures (PCE) is a measure of prices that people living in the United States, or those buying on their behalf, pay for goods and services. It's sometimes called the core PCE price index, because two categories that can have price swings—food and energy—are left out to make underlying inflation easier to see.
The Russell 1000 Value Index measures the performance of the large cap value segment of the US equity universe.
The Russell 2000 Index is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded US companies in the Russell 3000 Index.
The Russell Midcap Index measures the performance of the 800 smallest companies in the Russell 1000 Index.
WHAT ARE THE RISKS?
All investments involve risks, including possible loss of principal. Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Equity securities are subject to price fluctuation and possible loss of principal.
Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
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