by Jeffrey Schulze, CFA, Franklin Templeton Investments
Host: Jeff, let’s start, as we always do in these conversations, with the Recession Risk dashboard, that provides us with a great foundation for your economic outlook. Remind us how it works, and then what it looks like right now as we head into the second quarter of 2022.
Jeff Schulze: Well, as a reminder, the ClearBridge Recession Risk dashboard is a group of 12 indicators and it’s a stop light analogy, where green is expansion, yellow is caution, and red is recession. And as of the end of March, we have 10 green, one yellow and one red signal, but more importantly, that overall signal is still a healthy, green expansion. Now, this is important to note, because this is even dealing with the slowdown that we saw in the beginning of the year with Omicron. But importantly, the economy is now reaccelerating, and we’re seeing a particular amount of strength coming from our labour market indicators, specifically jobless claims, and then also job sentiment. With jobless claims, the recent reading that we got came in at 166,000. That was the lowest level that you’ve seen in the US since 1968. So, the lowest reading in over half a century, although the labour force is twice as big today as it was 50 years ago.
With job sentiment, we’re looking at the Conference Board’s Consumer Confidence Survey, and more specifically, we’re looking at the labour differential, the number of people that say that jobs are plentiful minus those that say that jobs are hard to get. And the most recent reading that we got from March came in at an all-time high of this reading at 47.4. So overall, we have a healthy labour market, and it’s hard to have a recession when the labour market is on fire.
Host: All right, so we have thriving labour market, and the dashboard is still signalling expansion. What about the yield curve spread between two-year and 10-year Treasury Bonds, any concern for you there?
Jeff Schulze: All yield curves aren’t created equally. Although the two-10 year is a good yield curve in signalling whether or not the economy is about to slow, and the US economy is going to slow as we reopen, and we move down towards trend GDP growth, and some of this Fed [US Federal Reserve] tightening does slow economic activity. We prefer the three-month, 10-year yield curve. It’s one of the indicators that we have on the Recession Risk dashboard because of its better track record. It’s had fewer false positives, but also it has a much longer history as the two-year Treasury was only introduced to the markets in the mid-1970s. And instead of being inverted, this yield curve that we follow is very steep, well north of 1.5%.
Now, Federal Reserve Chair Jerome Powell has mentioned several times that he’s not concerned with the two, 10 yield curve. He prefers the three-month, 10-year yield curve. And one of the reasons why that’s the case is that market participants control the two-year yield curve, and sometimes market participants aren’t accurate. A great example of this is, six months ago, in the middle of September, you had market participants pricing in only a half a rate hike for all of 2022. You fast forward to today, over nine rate hikes are priced for this year. So, market participants don’t always get it right, and it’s very conceivable that, as we reach the later part of 2022, if you get some sort of resolution on the Russia-Ukraine situation, you start to see energy prices, food prices, commodity prices all start to come down, and you start to see some goods deflation at the end of the year, could give the Fed some breathing room and ultimately how many rate hikes they’re going to put through over the course of 2022. So, we like the three-month, 10-year yield curve, because the Fed directly controls the three-month part of the yield curve. And, the Fed does not want to make a policy mistake at this point. They want to slow the economy, but they certainly don’t want to cause a recession. So, there’s a lot of reasons why I think the two-10 is a good metric to be able to tell whether the economy’s going to slow, but it doesn’t signal a recession, in our opinion.
Host: What about inflation, Jeff? We’re all seeing higher prices, especially with big spikes in energy, oil and gas. How much of a concern are those increasing prices?
Jeff Schulze: Not much of a concern. I know everybody’s hearing the common refrain that every recession has been preceded by an oil price spike, and while that’s true, correlation doesn’t necessarily equate to causation. And what that really means is, just because an event has historically preceded another, doesn’t mean that that first event was the cause of the second. And while it’s true that energy prices have spiked to levels consistent with shocks seen ahead of past recessions, the context of with that spike occurs is really critical in determining the economic outcome. So, if you go back to 1970, there’s been the same number of examples where an oil price spike year-over-year of 60% occurred that led to a recession, and the same number of examples that led to no recession.
And an important dynamic comes out when we cross reference these periods with the ClearBridge Recession Risk dashboard. When you’ve had a strong dashboard, you, generally speaking, did not fall into recession. And when you’ve had a frail economic backdrop, a majority of the indicators being yellow or red, a recession tended to occur. So, when you’ve had a green dashboard overall, five out of seven of those periods never materialized to a recession. In the two periods where you did see a recession, eight of those indicators were yellow or red, so we were borderline yellow at that point in 1973. Four of those indicators in 1999 were yellow or red. And the one thing I’ll mention about 1999, that first oil price spike happened in August of 1999. You didn’t have a recession until almost two years later in March of 2001. So today, with only two non-green indicators, we think the economy is on solid foundation right now to be able to shrug off this oil price spike.
Another reason why we’re optimistic is that the US consumer is far more resilient to oil price shocks today compared to history. Today, percent of consumption or wallet share that’s spent on energy is 2.5%. And then when you compare this to the last time that we saw triple digit oil from 2011 to 2014, the percent of consumption or wallet share spent on energy was 3.7%. So, 2.5%, much less of people’s income is going to the energy complex. And this is because of more fuel-efficient cars, but also median incomes today are 30% higher than what we saw a decade ago. So there’s a bigger pie to draw from.
Also on the consumer front, in the fourth quarter of last year, household net worth jumped by $5.3 trillion. Over the full year of 2021, household net worth jumped $18.9 trillion, an increase of 14% year-over-year. And to put this number in context, for every dollar increase in the price of gasoline, for a full year, costs households an estimated $140 billion, or less than 1% of last year’s increase of household net worth. And while not every household has participated equally in that increase, if you look at the data recently, all deciles of income earners have higher savings or excess savings from when we went into the pandemic, and let’s not forget those individuals at the lower decile of incomes are making the highest wage increases right now. So, they better are in a better position than they have been historically to deal with higher energy prices. So, given the health of the consumer right now, I’m not really concerned about this price spike of energy that we’ve seen hurting the economic momentum that we have in the economy.
Host: All right. What about the Fed? With how much inflation has increased, over a pretty sustained period of time now, can the Fed even effectively bring down inflation with unemployment at or near historic lows?
Jeff Schulze: I think the Fed can be successful, but they’re going to have to walk a tight rope because the Fed, more than often, has caused recessions because of overtight policy, maybe except for the COVID-19 recession that we just had. And with the Fed fully focused on inflation, now that they’ve fulfilled the employment side of their mandate, you’re starting to see a very hawkish pivot for the Fed. Noted doves, Neel Kashkari and Mary Daly, have changed their tune, and they’ve been advocating a greater emphasis on price stability. And when doves cry, naming inflation public enemy number one, investors are well served to listen and really take the Fed seriously.
So, what we’ve been talking about is this idea that the Fed put that was alive and well last cycle is now going to be replaced by the Fed call. And the reason why you’ve had this change of response function is because today’s situation is very different than the last cycle, where you had anaemic inflation, anaemic economic growth, and then also high unemployment. So, in that type of scenario, any pressure on financial markets could have easily pushed the economy into a recession, which meant the Fed needed to reverse course during market selloff, hence the birth of the Fed put. You contrast that with today, the economy doesn’t need the Fed to keep the training wheels on as economic growth is well above trend. You have high inflation and also a really tight labour market. And last month, Jerome Powell mentioned that monetary policy is transmitted through financial conditions, meaning tighter policy is going to allow inflation to come down because of wider credit spreads, higher interest rates and lower equity prices. And even though you’ve seen a hawkish turn from the Fed, you’ve seen financial conditions loosen as equity markets and credit markets rallied, which is the exact opposite of what the Fed desires.
So, with the Fed call, the birth of it, the Fed’s going to actively want to cool down the economy by adopting a more aggressive policy stance, given the low near-term recession risk. So, the key here is that the Fed is going to have to be diligent. They’re going to front-load a lot of tightening here to tamp down inflation, but there are cracks that start to form as we get to the later part of this year or into early 2023, the Fed is going to have to be diligent and reverse course. But, I do believe that the Fed can tamp down inflation even with a low unemployment rate, but they’re going to have to move quickly if things start to change.
Host: Jeff, we also hear a lot of concerns about stagflation? What’s your view on it?
Jeff Schulze: I think that this is maybe one of the most misused terms that are being thrown around in financial media. We are not in a stagflationary environment in the US. A stagflationary environment is what you saw in the 1970s, an environment that’s characterized by lower negative, real gross domestic product (GDP) growth, really high inflation, and also stubbornly high unemployment. And the only thing that checks that box in the US right now is high inflation. If you think back to the 1970s, as you moved through that decade, the unemployment rate kept getting higher and higher. And today, the unemployment rate is at 3.6%, down from 14.7% in April of 2020. And the unemployment rate continues to drop month after month as we get more job creation. So, this isn’t a stagflationary environment. Job creation continues to be very robust. You’re seeing a huge increase of the labour force participation rate.
And if you look at expectations for growth this year in the US, 2022 is expected to see growth around 2.7%, and inflation, by the end of the year, around 4.5%, nowhere close to a stagflationary environment. It’s not to say that it can’t happen but, given the strength of the labour markets and the continued economic momentum that we expect, and the expectation of lower inflation as we move further away from these supply chain issues and we hopefully get some normalization in the energy and commodity markets, we think that stagflation risks are going to continue to be low as we progress to the end of this cycle.
Host: A very clear view, from your perspective, on why stagflation is not currently a threat, and a lot of other great perspective, as always, Jeff. That’s Jeff Schulze, Investment Strategist with ClearBridge Investments and also the author of Anatomy of a Recession. You can get more of Jeff’s thoughts and check out the full Anatomy of a Recession program at franklintempleton.com. And, if you’d like to hear more Talking Markets with Franklin Templeton, visit our archive of previous episodes and subscribe on iTunes, Google Play, Spotify, or just about any other major podcast provider. And we hope you’ll join us next time when we uncover more insights from our on the ground investment professionals.
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