A review of recent US inflation data, the Recession Risk Dashboard, and thoughts on if we’ve reached the peak in the fed funds rate. Join us for this conversation with Jeff Schulze of ClearBridge Investments.
Transcript
Jeff Schulze: Thank you for having me.
Host: So Jeff, let’s start our conversation with your thoughts on the most recent inflation data.
Jeff Schulze: It’s been a welcome development for the Fed [US Federal Reserve], quite honestly. If you look at core PCE (Personal Consumption Expenditures), which is the Fed’s preferred measure of inflation, you look at the annualized three- and six-month rate of that, it came in at 2.5% and 2.6%, respectively. So not far off from the Fed’s 2% target. In fact, if you look at the October release on a month-over-month basis, it came in at 0.16. So, if you annualize it, you’re right at that 2% target. And more importantly, if you look within core PCE, core services ex-housing, which is the one that keeps the Fed up at night because it has a very high correlation with wage growth and inflation, [it] continues to show a moderating trend. So, inflation is basically at the Fed’s target here. This is a key reason why a lot of people are expecting the Fed to be done with its hiking cycle.
Host: So, you mentioned a lot of people expect the Fed to be done. Is that where you stand? Do you believe that we’ve reached the peak in the fed funds rate?
Jeff Schulze: I do. In fact, if you look at fed fund futures, there’s a 0% chance of additional hikes. Inflation is getting really close to target right now, the Fed’s restrictive policy is actively bringing down inflation and wage growth and slowing the economy. There’s really no reason for the Fed to take a chance and continue to hike from here with the success that it’s having. But the positive note with the hiking cycle being done is that we’ve likely seen the peak in the 10-year Treasury. So if you go back to the early 1970s, the last 10 hiking cycles (and that includes soft landings and hard landings), generally speaking, the last rate hike coincides with the peak 10-year Treasury. But looking at each of those 10 observations, sometimes the 10-year Treasury has peaked early (up to four months before that last rate hike), and sometimes it’s peaked later (up to five months after that last rate hike in 1981). And if July was indeed the last rate hike, which I strongly believe it was, that puts us firmly at the point where we’ve seen a peak in the 10-year Treasury. And not surprising, the 10-year Treasury has moved down about 70 basis points over the month of November, and it’s been a real catalyst for this rally that we’ve seen not only in equities but also in fixed income markets.
Host: If that’s the case, and we’ve seen the cycle stop as far as future hikes and we’ve hit that peak, it’s reasonable that investors’ attention will certainly now turn to “When will the Fed begin to cut rates?” Jeff, as a student of economic history, what does history tell you about a potential timeline for a cut?
Jeff Schulze: Well, yep. Cuts are front and center right now. And the Fed’s not really talking about cuts yet, because you could see a pickup of inflation like we saw the last couple of months outside of the core PCE reading that we just got. But when you look at the cut, surprisingly the first cut comes relatively quickly after the Fed is done hiking. Going back to the mid-1970s, the average pause is around five months before a cutting cycle begins. Sometimes it’s been a very short pause. It’s been one month in the 1980s. The longest pause that we saw was 15 months heading into the Global Financial Crisis. I think maybe more importantly though, if July was indeed the last rate hike and the Fed remains on hold at the FOMC meeting next week, the pause will already be at that five-month average. And looking at fed funds futures, they’re not pricing the first cut until the May meeting of 2024, which would represent a 10-month pause, which is on the longer end of the historical range.1 But it’s consistent with the Fed’s “higher-for-longer” messaging.
Host: Okay. So I guess the next step there would be: pause continues, Fed decides to let things kind of settle out here for a number of months. What type of criteria will the Open Market Committee utilize to determine when to cut the fed funds rate?
Jeff Schulze: Well, the Fed has a dual mandate: price stability first and foremost—and then full employment. And, if you think about each cycle, it’s unique, and the length of the pause is driven by conditions at the time. So, looking at the most recent hiking cycle, the bar for a pause was moderating inflation and a credible path towards 2%, which I think we’re at or we’re getting towards fairly quickly. But if you think about the criteria for a cut, it’s a very different animal. And there’s really two types of cuts that we can think about. The first one is fine-tuning: trying to get monetary policy closer to neutral. And the other one is a recessionary rate cut to accommodate the economy because you’re seeing an economic downturn. And when you think about monetary policy, the way that you can tell whether or not the Fed is accommodative or restrictive is to look at the fed funds rate and compare it to inflation.
And if the fed funds rate is below inflation, the Fed is accommodative, they’re helping economic activity, [if] it’s above inflation, the Fed is restrictive; it’s cooling the economy. Now, importantly, if inflation continues to cool from here, which is our expectation, and the Fed doesn’t do anything, just keeps the fed funds rate at 5.35%, the Fed’s actually going to be getting more restrictive. They’re going to be actively slowing the economy more because inflation cools. So in that type of situation, it makes sense for the Fed to cut maybe one or two times to make sure that they’re not actively getting tighter with monetary policy, slowing the economy more. So [it] really comes down to whether or not we’re in a soft-landing scenario where they’re going to need to fine-tune—or potentially have to cut a little bit more if growth takes a downturn lower than people are expecting.
Host: Okay. So I guess time will tell, but let me drill in on that in one regard, are there any drivers that would create the need for a substantial reduction to the fed funds rate in ‘24?
Jeff Schulze: Well, we talked about the dual mandate of the Fed. I think the key driver would be full employment and the catalyst for substantial rate cuts would be outright job losses. When you look at the labor market, there’s a lot of cracks even though the headline numbers are pretty good. But, again, if you don’t see outright job losses, the Fed’s not going to do a substantial rate cut. They are going to tweak and fine tune policy and do one or two cuts, but nothing more aggressive than that. But I think when you look at what’s being priced in the market right now, the market again is pricing that first rate cut in May of 2024. I don’t think that’s unreasonable. We may even get another rate cut as we talked about if inflation softens further, but the market is pricing another four-and-a-half rate cuts after that initial cut over the 10 months that follow that initial cut. So that’s a little bit aggressive absent a recession. So what the market’s pricing right now is a soft landing with some modest recession risk. But ultimately if a recession does materialize, we’re going to see a lot more rate cuts than that. And if the soft landing materializes, it’s probably going to only be one or maybe two rate cuts.
Host: Could we see a negative jobs print in the coming quarters?
Jeff Schulze: I think we could see negative job prints, and that would be a pretty big drop considering that in October you created 150,000 jobs. But if you look through that headline number and you look at the foundation and the leading labor indicators, it suggests that you’re going to see a step down in job creation and potentially a negative job print sometime in the first quarter of next year. Now, there’s a couple reasons why I say that. First off, you’re seeing downward labor revisions. The jobs that we thought were being created weren’t necessarily being created. So if you look at every month in the first half of this year, when you got that first job number, it ended up being a weaker number than what was initially anticipated. In fact, when you look at October’s payroll release, you had downward revisions to the prior two months of over 100,000. So, again, usually when you have inflection points and economic activity turns for the worse, you start to see these downward revisions. So this is a sign that the job creation that we’re thinking we’re seeing today may not be as strong as we initially thought.
Also, when you think about the payrolls number or “jobs day,” there are two releases that happen [within the US employment report]. The first one is the establishment survey, where they call businesses to ask about employment conditions. And that’s where we get the headline jobs number. The second survey is the household survey where they call households and ask individuals how labor conditions are. And importantly, with the latest household release, you saw -348,000 jobs. That was the biggest decline of the household employment that we’ve seen since April of 2020. And when you go into recessions, usually the household survey is more right than the establishment survey.
So you’ve seen a divergence there, and that’s something that bears monitoring. Also, when you look at the percentage of industries, private industries that are adding jobs, it was 52% last month. A year ago it was 85%. 52% is the lowest since April 2020. So when you’re seeing a narrowing of the payroll gains in industries, again, that’s a concerning trend that may lead to a negative jobs print. Also, leading indicators like weekly hours continue to fall. Temporary workers have been down in eight of the last nine months. These are leading labor indicators, because usually companies will cut back hours or cut back their temporary employees before they let go of full-time employees. The last thing I’ll mention here is that in the three soft landings that we saw in 1966, 1984 and 1995, on a three-month average, the unemployment rate only rose by 0.2%. We’re already at 0.3%. And when you look at the unemployment rate, on average, it starts to rise about 23 months after the Fed tightening cycle begins. Today it was only 14 months. So joblessness is rising much faster than usual. So I think there’s a possibility that we do see a first negative payroll print in the first quarter of next year or maybe the second quarter. And this is something that bears monitoring as we go into 2024.
Host: Okay. Something definitely to keep a sharp eye on.
Slight transition here, connecting to the capital markets. We’re in a period here of a pause and expectation is that this will continue, as you’ve stated. How should we be thinking or how are you thinking about the potential performance of the S&P 500 [Index] as a proxy for equities during a period like this?
Jeff Schulze: Well, the good news is, regardless of when that first cut occurs, the pause is a favorable environment for equities. So the S&P 500 has typically rallied 5.1% on average during the Fed’s pause.2 And that suggests that there could be some upside to the index, because the index is essentially flat since the last rate hike in July. You had the late July peak of the S&P 500. That fell over 10%, but now we’ve kind of rallied back to where we were back in late July. So it’s been a flat period over the last five months. But with no obvious risks on the horizon outside of maybe a weaker-than-anticipated jobs print and the third-quarter earnings season coming in pretty solid, I think that there’s going to be some performance chasing and the Santa Claus rally that we’ve seen could continue.
But in looking at the recent rally, one thing that gives me a little bit of trepidation is that you haven’t really seen an advantage of small versus large companies. You haven’t really seen a big advantage from companies with high short interest. And usually when you have these liquidity-driven rallies, everything rallies, especially the weaker names, at least initially. And that really hasn’t been the case here. But nonetheless, I think the path of least resistance for the next, call it, one to two months is up. Because right now, bad news is good news. And I think there will be a period potentially where bad news becomes bad news. But we’re not there quite yet.
Host: So Jeff, as I think about the perspective you’ve shared with us here today, I’m left with a couple questions. Did we see any change with the ClearBridge Investments Recession Risk Dashboard with the November 30th update?
Jeff Schulze: No change from our economic “North Star.” As a reminder, it’s a stoplight analogy where green is expansion, yellow is caution, and red is recession. Out of the 12 variables, we continue to have nine red, three yellow and zero green signals. But importantly, we did upgrade for the first time in a long time, one of the indicators last month, which was retail sales. But if you look at the retail sales print that we got for October since then, [it] came in at negative 0.1% on a month-over-month basis. So that really strong spending that you saw in September and August looks like it’s coming back down to earth. And it’s not uncommon for the dashboard when you have a long period between a red signal and the start of recession to see some strength after some initial weakening only to weaken once a recession materializes. And that appears to be the dynamic that we’re seeing here today.
Host: Okay. And now the million-dollar question. Do you think the economy is going to avoid a recession in 2024?
Jeff Schulze: It’s early to say. Our base case is still a recession for 2024 until we can get through the crux of this journey. The toughest part of the climb, we believe, is the next two to three quarters because we’re going to fully feel the effects of Fed tightening. A lot of that stimulus and spending that happened from last summer to this summer is now over—with the debt ceiling agreement that we saw in September that caps discretionary spending. So Fed tightening is really going to hit more acutely over the next two to three quarters. Also, with the traditional lags in lending standards, it’s going to start to curtail lending activity over the next two to three quarters. So, again, I think these next two to three quarters are going to be pivotal on whether a recession happens or can be avoided. And until we can get through the next two to three quarters, we still believe that a recession is our base case. And let’s not forget, there’s a lot of areas of the economy that are in recessionary type of situations. And if you look at manufacturing, manufacturing PMI [Purchasing Managers Index] has been in contraction territory for 13 consecutive months, which is longer than what we saw in the Global Financial Crisis. If you look at the beige book that was recently released, out of the 12 districts in the US, six are noting slight declines in activity. And that’s a picture that’s painting a slowing economy, again, that’s at risk of having a potential negative payroll print. So I think that we really need to get through the next, call it, six to nine months to really see what the Fed has done in order to know whether or not a recession can be avoided.
Host: With that, thank you Jeff for a great conversation today and terrific insight as we all continue to navigate the capital markets. To our listeners, thank you for spending your time with us today. 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, and Spotify.
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