Wednesday, January 26, 2022

Anatomy of a recession: Conditions changing, but the US economy remains strong

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By Jeffrey Schultz, Investment Strategist, Clearbridge Investments

In our latest “Talking Markets” podcast, Jeff Schultz, investment strategist at Clearbridge Investments, provides his latest look at the health of the US economy. We hear about the number one factor driving consumer sentiment to bearish levels, three reasons why inflation may not last long, and what happens next after the Federal Reserve cuts and raises interest rates. could.

Interviewer, Jeff, let’s start with the Recession Risk Dashboard, which gives us the foundation for your economic outlook. As always, remind us how the dashboard works and looks like in early 2022?

Jeff Schultz: Well, the ClearBridge Recession Risk Dashboard is a set of 12 variables that have done an excellent job of being able to foresee an impending recession. And this is a stoplight analogy, meaning green is expansion, yellow is caution, and red is bearish. And at the present time, we have 10 green, one yellow and one red signal, but the overall signal remains a very healthy, green extension color. But in the month of December we did two color changes. We had “Money Supply” go from green to yellow, and we had “Increment” go from yellow to red. Now, with the money supply, we are going from very, very high levels of the money supply to just higher levels. Therefore, there is still a lot of liquidity going to run out in the US financial system. So, I’m not really worried about that color change. But with pay raises, this is one of the earliest times we’ve ever seen “increment” turn red. And generally, when “wage growth” turns red, it stays red for the remainder of the expansion, because again, you’ve run out of labor supply, and wage growth continues to increase to attract the right workers. has been But due to pandemic-related disruptions, I could see the labor supply coming back into the economy in 2022, as we move past the virus and a lot of people burn through their cash cushions that have accumulated over the years. Therefore, this may be the first time that “wage growth” has actually gone back to yellow or perhaps even green in the middle of an economic cycle.

Interviewer, So, you mentioned two indicators that have changed, but I know there’s another indicator that you’re well aware of.

Jeff Schultz: We really wanted to highlight the “job sentiment” indicator this quarter. This is from the Conference Board’s Consumer Confidence Survey, and we’re looking for two specific responses by respondents: the number of people who say jobs are plentiful versus those who say jobs are hard to get. And in a general economic expansion, the gap widens as more and more people say that jobs are plentiful. But before every recession, that gap shrinks very aggressively and more people say it’s hard to find a job. Now, we are not at the record high for this series we saw in November, but we are only two points short of 42.6. So, there’s a pretty strong labor market out there. Now, our “job sentiment” indicator actually runs very closely with the University of Michigan Consumer Sentiment Survey. They lock and step with each other, which means that people’s confidence or their optimism is actually tied to labor markets. And when you have a weak labor market, the sentiment is usually pretty bad. But what we’ve seen here over the past year is a big gap between series, where you have very strong labor markets, but consumer sentiment is bearish. So, for the first time in my career, the labor market isn’t really driving emotion. Actually it is inflation.

Interviewer, Very unusual, Jeff, and a perfect debate, pun intended, for the hot topic of inflation. With inflation becoming so hot, we are seeing a rise in prices in our daily purchases of products and services. Break down what’s happening from your point of view, and what do you think we can expect going forward.

Jeff Schultz: Well, inflation is certainly running hotter than most people expect and I think we’ve officially dropped the word “transient”. But I think, to determine how persistent this inflation is going to be, it helps to try and see what inflation is really going on beneath the surface. Now, if you look at inflation compared to today’s pandemic trend, all the additional inflation is being driven by older cars and then goods pre-used cars. So, stuff in general. And among the G7 countries, the US is responsible for a 93% increase in consumption of goods since the start of the pandemic. And with goods inflation actually being the biggest driver of inflation, and the US being the largest consumer of goods, it should come as no surprise that the US has much higher inflation levels than the rest of the world. But I think that’s going to change in 2022, because I envision this year to be a more resilient year for the US economy, a more consistent year for economic growth, as I think we’ve had the last disruptive wave. Viewed version. And I think we’re going to see a handoff from consumption of goods back to consumption of services. It was a trend that was happening during delta, and once delta came in, it interrupted that transition, but I think it’s going to be a lot more sustainable, and that marginal dollar that’s going to come in the way of goods. What is being taken is now going into the services. But at the same time, if you have a global economy that is going to be less affected by variants, it means that a lot of these supply disruptions are no longer going to be part of the narrative for years to come. So, with less demand for goods and more supply, it is a very strong concoction for goods deflation later this year and in 2023 and 2024. Also, to mitigate a high inflationary environment, you need to look at the trend of commodity inflation. The change that we are actually seeing since the year 2000.

Now, 100% of Core CPI [Consumer Price Index] Service is driven by inflation. And commodity inflation, until the pandemic, has been virtually zero. So, I know people talk about deglobalization, but there has been no meaningful deglobalization in the last few years. So as these supply disruptions ease themselves, and we go back to a more normal economic environment. Again, I think the trend of goods inflation will be similar to what we’ve seen over the past few decades.

And the last reason I’m not really concerned about inflation is if you look at the 5-year, 5-year forward inflation, this metric is really trading in the same trading range that it has been in the last decade , which means the market has not and never will have expected a meaningful change in inflation over the long term. And it’s really hard to see if a global pandemic, unprecedented financial and monetary expansion, countless supply disruptions and inflation are approaching 7%, if that can’t get inflation to hit the market again in the long run. That ‘s what could be a change in expectations . Therefore, we are of the view that inflation is going to peak at the end of the first quarter, assuming Omicron does not cause supply disruptions as we saw with Delta over the next coming months and inflation will move back to the Fed [US Federal Reserve] 2% target by the end of 2023.

Interviewer: Of course, it’s all about the consumer. Do you feel like this is happening or will it have a major impact?

Jeff Schultz: Well, with high inflation, you have to be concerned about the consumer because one of the reasons for this recession we had in the 1970s is that compensation was not commensurate with inflation, and you had a disruption in demand because consumers were able to make their purchases. Were leaving, hoping they would drop in price in future months and years. This time, we don’t have that problem. If you look at the total weekly payroll, which is the pay benefit you saw in this year, the increase in the number of hours you worked, a compensation of 9.5% compared to a year ago. And with the CPI a little less than 7%, even in this high inflationary backdrop, consumers are still taking home 2.5% more in real income, which means that demand destruction isn’t going to happen, and it’s going to be a healthy consumption. environment in 2022. And there’s a very strong connection between what people make and what they spend. So, it’s a really cool dynamic. And as inflation eases in the back half of the year, it’s going to outnumber how much compensation people are bringing home. Even from a consumer perspective, household net worth is $28 trillion, where we were at the end of 2019. So, that’s an increase of about 24%, and it’s a combination of more additional savings, stronger home prices, but also very strong. financial markets. So, the consumer, the lifeblood of the American economy, the engine is in great condition and arguably, in the best shape we’ve seen in the last five decades, if you will.

Interviewer: Obviously, the Federal Reserve (Fed) plays a big role in the direction we’re headed. And Fed Chairman Jerome Powell has shifted his thoughts and actions. How do you see the Fed’s plans to cut and raise rates?

Jeff Schultz: Now, a named Powell is a different Powell. Powell and the FOMC [Federal Open Market Committee] There was a pretty hawkish pivot in December. No surprise because clearly inflation is way ahead of where the Fed expected it to be in the year. But the important question is how much rate hike is going to happen in 2022 and whether there will be quantitative strictness or not. Now, the Fed wants to see substantial progress on its targets on maximum employment, and with the most recent unemployment rate coming in at 3.9%, which is well below the Fed’s long-term expectation of 4%, I think the Fed’s rate will likely Follow up with a lift-off in March and two more rate hikes in 2022. The other thing that I think is likely to happen next year, whether it’s the second quarter or the third quarter, is the quantitative tightening. Now, since we have already experienced quantitative tightening and the Fed has done so before at the end of last cycle, this version of quantitative tightening is going to be much faster, but also much more aggressive. And I think the economy has been able to handle all this tightness, especially given all the positive tailwinds that we have in 2022. Now, one thing I would like to mention is that the financials have not turned out to be stronger than before. During the last few months, as the prices have risen in the markets, there have also been three rate hikes. [Former Chair of the US Federal Reserve Alan] Greenspan had a similar conundrum in the 2000s when it was raising rates, the financials never getting tighter. So, if this is the kind of situation that continues into the back half of 2022, and Powell wants to throw some cold water on the warming economy, he may have to be a little more rigid than market pricing, which will eventually hit the markets. Causes some volatility and potentially some downward pressure. But then again, we’re not at that point yet, but it’s something that’s going to be closely monitored going forward during the course of the year.

Interviewer: Great insight, as always Jeff.

He is Jeff Schultz, investment strategist with Clearbridge Investments and author of Anatomy of a Recession Program.

Jeff Schultz: Thanks.

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Editor’s Note: The summary bullets for this article were selected by Seeking Alpha editors.

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