By Jeffrey Schulze, CFA, Investment Strategist, ClearBridge Investments.
We speak with ClearBridge Investments’ Jeff Schulze about a topic on many investors’ minds: the 10-year US Treasury yield and the path of monetary policy. He also shares his views on the latest US retail sales data and whether consumer resilience will last into 2024.
Transcript
Host: Welcome, Jeff. We’re excited to have you here in the studio today.
Jeff Schulze: Thank you for having me.
Host: Jeff, let’s start off by talking about one topic that is on every investor’s mind today, the 10-year Treasury yield. Over the past four months, yields have risen dramatically in response to better-than-expected economic numbers but have cooled in the last week or so. Have bond yields in the US peaked?
Jeff Schulze: Well, obviously that’s an interesting question. It’s been driving the returns that you’ve seen in fixed income. It’s been driving the equity markets really since late July. I do believe that we’ve seen the peak of the 10-year Treasury. Now the reason why I say that is, if you look back to the prior 10 tightening cycles, back to 1971, unlike the dollar or equities or credit, no matter what happens with the economy, the 10-year Treasury tends to peak in line with that last Fed [Federal Reserve] hike. Now, sometimes it’s a little bit earlier; sometimes it’s a little bit later. And the latest that the 10-year Treasury peaked after that last rate hike was five months after the 1981 tightening cycle. But it tends to peak with where we are currently at. And if we look at July as the last rate hike (and I do believe that that is the case given the slowing economic momentum that you just mentioned with manufacturing and services PMIs [Purchasing Managers’ Indexes] surprising to the downside, a weaker employment number that we got here with October), we’re really kind of at that extreme level of where you’d see the 10-year Treasury peak. So, with our expectations of weaker economic activity as we look out on the horizon, I think the path is likely going to be lower for the 10-year Treasury, which will be obviously a nice tailwind for fixed income portfolios, but also a nice tailwind to equities.
Host: Okay. So Jeff, we just moved through the November FOMC [Federal Open Market Committee] meeting with another pause. You just mentioned that you believe that that is the last hike that we’ll experience. Do you think it’s too premature at this time to even be talking about cuts?
Jeff Schulze: I do. Although the Fed is going to be higher for longer, they want to see what all of their hiking has done to the economy, and we’re just starting to see the economy slow. I think it’s premature to talk about cuts because, quite frankly, the Fed did not want to repeat the policy era that you saw in the late 1960s when they created a soft landing and they pivoted with a really tight labor market. That really kind of kicked off the structurally higher inflationary period that you saw in the 1970s.
So, if you go back to late 1966, when the Fed cut rates, core CPI [Consumer Price Index] basically doubled going from three to 6% in the following three years, and the unemployment rate at that time was 3.8%, which is a hair lower than what we currently sit at 3.9%. So I think given the fact that we’ve seen generational high inflation here recently, we have a really tight labor market here in the US [United States], I believe that the Fed’s reaction function is going to be blunted compared to what we’ve seen over the last 40 years. So they’re going to cut a little bit later than people anticipate, but also when they eventually do cut, I think it’s going to be much more mild, because they want to hit 2% inflation on a sustained basis. So, while I believe that the Fed is really going to be on the sidelines here as we go into 2024, I think it’s clearly premature to talk about a cutting cycle.
Host: Usually, the consumer is sensitive to moves in interest rates, but we haven’t seen that yet, Jeff. With the last retail sales number blowing out expectations, when will we see them starting to affect consumer demand and behavior?
Jeff Schulze: Nothing short of spectacular to say about the last retail sales print that we got. If you look at the control group, which actually feeds into the GDP [gross domestic product] calculation, came in at a 0.6 on a month-over-month basis. If you times that by 12 and annualize it, that’s over 7%. That is a rock solid number. So the consumer is still spending very aggressively. But there’s a couple things that are supporting the consumer that I don’t necessarily think is going to continue when we get to the first half of next year. First off, you saw a pretty strong revision to the personal income and savings data at the end of September versus what we previously thought. There was a much bigger excess savings hoard, because consumers accumulated more and they spent down less of it in the aftermath of the pandemic. And, depending on whose estimate you use, that added anywhere to a half a trillion to a trillion dollars to that excess savings number. And I think that that’s one reason why consumers have been resilient.
However, as we kind of turn the page to 2024, I believe a lot of that cash hoard remains in the hands of upper-income households that are likely going to treat that savings as extra wealth rather than extra spending power. So I think that’s one reason why we’ve seen some resilience, but that may not be the case as we look forward.
Also, lending standards remain extremely tight for consumers. If you look at the most recent New York Fed Survey of Consumer Expectations released, 60% of respondents reported credit harder to obtain versus a year ago. And, when you look at the Senior Loan Survey by the Fed, willingness to make loans to consumers went net negative at the beginning of 2023. And that usually has a lagged effect on credit growth and consumption of anywhere from nine to 18 months. So that means it’s really starting to hit the economy here today.
So, while you’ve seen a resilient consumer, I’m not expecting that resilience to last as we again go through the next three quarters. And just to kind of throw some numbers quickly out at you: Right now, mortgage rates are 8%. Not too long ago they were at 3%. The average monthly car payment for a new car today versus 2019 has increased by 40%. Average used car payment is up 35% versus 2019. Credit card rates are 600 basis points above where we were pre-COVID at record highs at around 23%. So, although the consumer has kind of hung in there, we think that you’re going to really start to feel it on the consumption side. And with recent company commentaries—whether it’s Dollar General, Yum! Brands, Macy’s, AutoZone, Target—they’re all saying that consumers are being a lot more thoughtful with their spending preferences for value, especially in the lower income cohorts. So I think it’s starting to hit, and we’re going to feel it much more acutely again as we move through the next couple of quarters.
Host: Okay, so just to touch on that point, again, sales have been very strong at the retail level. You expect for that to change here in the coming months. I did want to reference the ClearBridge Recession Risk Dashboard with the October 31st update. That indicator did change from red to yellow. Is it unusual to see an indicator improve after an overall red signal occurs on the dashboard signaling recession?
Jeff Schulze: It’s not unusual. And just as a reminder to the listeners, the dashboard is a stoplight analogy where green is expansion, yellow is caution, red is recession. We went red back in September of last year. And this is really the first positive signal change that we’ve seen since conditions began to deteriorate in the dashboard about a year and a half ago. But to your question, it’s not unprecedented for the dashboard to improve from a deeper red signal to a lesser red signal, only to worsen later on as recession takes hold. And a prime example was back in 1990. Now we’ve been using 1990 as a reference point, because that was the longest lead time from a red signal to the start of a recession, which was 13 months prior. But also during and leading up to the 1990 recession, the worst reading for the dashboard actually came in the fourth quarter of 1989. And although the overall signal didn’t change, and you didn’t see individual indicators change signals, in early 1990 you started to get less red underneath the surface. But ultimately when that recession happened in the middle of 1990, the dashboard deteriorated again and got deeper red, finally putting in the lows for the dashboard in early 1991. So, the fact that you’re starting to see things get a little bit better underneath the surface is actually just in line with the 1990 recession that we had about 32 years ago.
Host: Alright, I do have one more I want to go to on the consumer. Sorry for kind of hammering you on this, but is the strong job market enough for people to keep spending?
Jeff Schulze: It might be, but I have my concerns. I’ll talk about the labor market here in just a second. There’s some cracks in the foundation there. But one thing that has me pretty concerned right now is if you look at delinquency rates, you look at auto delinquencies, other credit delinquencies, credit card delinquencies, even mortgage delinquencies are rising today. And that’s with a strong housing market. They’re all rising in tandem with one another. And although we’re back to pre-pandemic levels, usually when they all rise together, you have a recession. And this is happening with a really strong labor market. So if the labor market starts to get weaker, which I think the trend is clearly moving in that direction, an already stressed consumer is going to be more stressed.
Now if you look at the most recent jobs report that we saw, we saw a really strong number for September, but that was outside of the trend of what we’ve seen over the course of 2023. So I was a little bit concerned. Maybe the labor market will be able to hold up, but when we just got October’s releases, you saw the number move back down to 150,000 per month. But also, for the prior two months, those numbers were revised down by over 100,000 total jobs, right? So payrolls continue to slow. The September jobs release was kind of the aberration.
But looking at some other things, weekly hours fell. That is a leading labor indicator. Usually employers will cut back on weekly hours instead of firing employees to be able to cut back costs. Although temporary workers jumped a little bit last month, they declined over the previous eight months. And again, similar concept: if you’re going to let go of people and you’re trying to cut costs, you’re going to let go of temporary workers first before you let go of full-time employees. But the other thing that really concerns me is, if you look at continuing claims, they’re up 30% on a year-over-year basis. So, although you’re not seeing job layoffs, people are having a more difficult time actually finding that job. So, you know, there’s some cracks in the foundation. And looking at these leading labor indicators suggests that you’re likely going to see a weaker labor market looking out on the horizon. And again, that’s going to filter through into a consumer that’s already showing some signs of strain.
Host: So, Jeff, thinking about the concerns that you have that really consolidate your view of today’s macroeconomic environment here in the US, how are you thinking about current US stock valuations and potentially future opportunities?
Jeff Schulze: Valuations aren’t that demanding, quite frankly, in the US. They’ve come in quite a bit. Now, obviously with last week’s rally, the forward P/E [price/earnings] of the S&P 500 went back above 18. But again, before the rally, it was at 17 times forward earnings. Looking at the last three bear markets going back to 2002, the average trough multiple, or lowest P/E that you saw in those bear markets was around 14.5 turns. So at 17, 18, you’re not meaningfully above those levels. So I think a maybe important context to this is, if you strip out the Magnificent Seven, the average stock P/E in the S&P 500 is at long-term averages. So your average stock really isn’t very expensive overall, which is really good from an active management perspective and a stock picker’s perspective. But if you look at other areas of the equity market landscape and you look at small caps, you look at mid caps, their forward multiples are below their long-term averages. So they’re actually outright cheap at the moment. So, you know, I don’t think valuations are going to be really much of a headwind if we do have a recession, which is still our base case. Maybe the valuations get cheaper by a turn or two, but really the downside is really going to be on earnings expectations and how much lower earnings need to go from here.
Now, with that being said, where are the opportunities in this type of environment? Again, I don’t think we’re going to see a deep recessionary selloff. The average recessionary selloff post-World War II has been around 30%. I don’t think we’re going to get anywhere near those levels, but I think from a style perspective, you want to lean into growth over value. If you look at the last three recessions, growth tends to outperform value as the recession starts. And it continues to outperform as you move through into the early stages of a recovery. So I think, although growth has had a fantastic 2023 relative performance versus value, I think that will continue.
I also like dividend growers. Dividend growers have gotten a lot cheaper this year as you’ve seen a stronger growth impulse from the US. So there’s been a move into cyclicality and away from quality. Also dividend growers, they tend to do well in a choppier environment. They don’t need to access capital markets, so they have, you know, rock solid balance sheets. But lastly, they have a high degree of earnings visibility and if earnings are potentially going to be under pressure, these are the types of companies that tend to get a valuation premium put on them. So, thinking about it from an opportunity standpoint, I think growth from a style standpoint. But also dividend growers look like pretty good opportunities on a multi-year time horizon.
Host: So Jeff, how about some perspective on equities outside of the United States? Is it fair to say that they’re less expensive from a P/E point of view?
Jeff Schulze: Oh, they are. And they’ve been less expensive from a P/E perspective. And I’m talking about the ACWI ex US [MSCI ACWI ex USA Index] versus the S&P 500, really since 2016. But today, that valuation gap has grown even further. So the current forward P/E of the S&P 500 is at 18 times earnings. The 20-year average P/E has been around 15.6 times earnings. So you know, it’s about 2.5 turns rich compared to what we’ve seen over the last two decades. If you look at the ACWI ex US, it’s actually about one turn cheaper than its 20-year average. So there’s definitely a valuation discount that you’re seeing in international markets. And when you think about the US versus international outperformance or underperformance, usually every decade the baton shifts to the other side outperforming.
So it kind of starts with international outperformance in the eighties with the Japan bubble, a big tailwind to the outperformance of international stocks in that decade. Then came the nineties with the bursting of that bubble and the rise of the tech run that you had in the US, where the US leadership really outperformed by a wide margin. Then when the tech bubble burst, China joined the World Trade Organization in the late nineties, a nice driver for international outperformance really through the global financial crisis, where kind of subdued growth, secular stagnation really kicked off US outperformance as investors sought companies that didn’t need a cyclical lift and instead grew organically. And usually these were companies that weren’t capital intensive, a lot of the mega tech-cap names that we hear today. So, the US has been outperforming really for the majority of the last 13 years. And historical evidence would suggest that you’re likely going to see a catalyst shift toward international outperformance this decade.
Now what could that catalyst be? I think the catalyst may ultimately be higher rates and higher inflation structurally in the back half of this decade into the early parts of the 2030s. If that indeed is the case, international markets have a much higher weighting in companies that do better in those regimes, more specifically cyclical companies and value companies.
Host: That’s exactly what I was just going to ask you. When you were speaking to US companies, you made a point of value versus growth. Is that also an important consideration when reviewing international companies?
Jeff Schulze: Absolutely. If you look at the S&P 500 over the last hundred years, the weighting of what we call cyclical areas of the economy (financials, industrials, materials, energy), that’s consistently gone down over the last 100 years—while the areas that have more growth and stability and defensive (technology, health care, staples, discretionary utilities, REITs [real estate investment trusts]), these are areas that typically have a higher P/E and they do better in lower growth regimes, because growth is going to be more coveted when there’s not an abundance of it out there. So if we’re moving into a period where you’re going to have higher inflation, higher interest rates (and that usually supports, you know, stronger revenue growth and what’s called operational leverage, where that each additional dollar of revenue that you get really kind of supercharges your earnings potentials—and that’s a feature that a lot of cyclical companies have), that’s going to be a tailwind for the international space at the expense of the more growth and defensive US equity markets.
And then the other consideration really is whether or not we’re going to be in a weaker dollar regime as we move forward. Going back to 1984, if you look at the rolling annualized returns of when the dollar was up versus when the dollar is down, it doesn’t really matter for your gross return on the S&P 500 or investment-grade bonds. But if you look at the EAFE [MSCI EAFE Index], when the dollar is down, the average return has been 18.8%. When the dollar is up, that’s 5%. So the dollar has a huge impact on international underperformance or outperformance. So it really comes back to whether one believes the dollar will weaken as we move through the next five to 10 years—and then, you know, whether or not we’re going to be in a higher inflation and rates regime. And if you think that the dollar will be down and we’re going to a higher-rates-and-inflation regime, you probably want to have more exposure to international markets because they’re going to fare a lot better than what we’ve seen over the last 13 years.
Host : Okay, Jeff, so today I’d like to wrap the podcast really with your final comments on the macro environment, specifically in the US—talking about topics like elections, federal debt issues, impact of higher interest rates, and then outside the US with respect to Russia, Ukraine, the Middle East, and the potential tensions in the South China Sea. These are the known unknowns as they’ve been referred to. How do you consider and integrate them into your outlook?
Jeff Schulze: Once an issue pops up, we need to update our probabilities and the potential global implications should things continue to escalate. So every time that that happens, we need to reevaluate how we’re reviewing the world from a macro and market perspective.
But I’m actually more concerned today with the unknown unknowns. After a decade of easy money, there’s a lot of unknowns that have yet to surface. The cost of capital has gone up dramatically. And to maybe put that in perspective, if you look at the two-year change of the 10-year Treasury before this recent drop, it’s jumped over 300 basis points over the last two years. I mean, that’s the biggest jump that you’ve seen since the eighties. And usually when the 10-year Treasury moves up by, you know, 150 basis points or 200 basis points, you have some sort of crisis. So, given the move that we’ve seen, I don’t think that we’ve seen the last crisis, which was the regional banking issues that you saw in March and April.
And now it’s hard to say where that crisis will emerge. There’s a couple of candidates out there, like maybe commercial real estate, more specifically the office segment. Maybe it’s high-yield and leveraged loan markets. And although you don’t have much of a maturity wall next year, as you move out to 2025 and 2026, you’re going to see a much bigger pickup in issuance. And a lot of people forget that companies come to market a year or two early before they actually need to issue new debt. So that’s maybe a potential issue of concern.
Maybe private credit is an issue of concern. You’ve seen a rise of bankruptcies, but high-yield spreads have been relatively well-behaved. So maybe you’re seeing some issues in private credit that aren’t necessarily being seen in financial markets. So it could be a myriad of different things and maybe something I didn’t even mention. But what I will say is that usually when you’ve had a move in the long end of this magnitude, issues have been boiled to the surface. And I think with this higher for longer policy that we’re going to get from the Fed, I think we’re going to have a couple of surprises that weren’t on a lot of people’s radar screens in the last couple of quarters.
Host: Jeff, thank you for your terrific insight today as we continue to navigate the markets. To our listeners, thank you for spending your time with us. 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 or Spotify.
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