Consumer strength should avert recession as equity markets remain volatile
The S&P 500 Index made new all-time highs in 2019, as on-and-off trade tensions with China eased, the Federal Reserve (Fed) cut interest rates three times and corporate earnings held up better than anticipated. Strong market performance came against a backdrop of weakening economic activity, reflected in the overall signal for the ClearBridge Recession Risk Dashboard turning yellow in June, indicating caution. As we enter 2020, both the U.S. and global economies are clearly slowing; the key question is whether we are on the cusp of a recession or a late-cycle slowdown. The economy typically sees an inflection point six to nine months after the dashboard turns yellow, so we should have confirmation by early next year of the severity of the current soft patch.
Our base case is for a slowdown within an ongoing economic expansion. While we expect the contraction of the manufacturing sector to marginally worsen as the ongoing trade war hurts business confidence and slows capex, the consumer side of the economy should remain strong enough to avert recession. The labour market and wage growth are healthy - although wage pressure is mounting among lower paid employees - which should underpin consumer spending, while the Fed has joined with central banks around the world in ramping up monetary accommodation.
This consumer strength is reflected by all four consumer indicators in the dashboard flashing green, indicating expansion. After slowing in line with rising mortgage rates, housing permit growth has resumed since the Fed shifted its monetary policy stance and mortgage rates eased. Strong job numbers in October and November are consistent with jobless claims continuing to trend around 50-year lows while job sentiment has improved after a mid-year decline, with job openings outnumbering unemployed workers by a significant margin (Exhibit 1). The wildcard among our consumer indicators is retail sales, which posted a surprise decline in September before rebounding in October. Monthly sales numbers can be noisy, but a drop in spending – which accounts for 70% of the U.S. economy – would be a major concern.
Exhibit 1: Job openings vs. Unemployed
Sources: FactSet, U.S. Department of Labor and National Bureau of Economic Research. Data as of 8/31/2019, latest available as of Sept. 30, 2019. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
Cyclicals have gotten a bid from the Fed easing, but this rally could be short-lived as we do not believe the manufacturing side of the economy is out of the woods yet. For example, corporate credit spreads at the lowest quality ratings, which encompass energy, industrials and some retail names, are at their widest levels in over a year. Instead, the likelihood of continued volatility in 2020 steers us to high-quality growth companies with strong moats around their businesses and more defensive areas of the market that have tended to hold up well during turbulent periods. Consumer staples and utilities should continue to lead unless we see a clear resolution of the trade war and improving global growth. One of the benefits of these stocks is dividends. Through the third quarter of 2019, 42% of S&P 500 stocks had a higher dividend yield than the 30-year U.S. Treasury bond.
Exhibit 2: Dividend paying equities look attractive
Source: FactSet, as of 9/30/2019. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.
While volatility will likely remain elevated, a market drawdown next year is not imminent. In fact, over the last 19 U.S. presidential election cycles, stocks have suffered losses just twice in the 12 months leading up to election day, delivering an average return of 8%. Equities have also tended to do well in periods following a yield curve inversion, especially if no recession occurs, rising 13.5% on average in the subsequent 12 months. The 2-year/10-year U.S. Treasury yield curve inverted in August, suggesting that stocks could climb through most of next year.
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Jeff Schulze, CFA, Investment Strategist
Jeff is an Investment Strategist and oversees capital market and economic research, contributing thought leadership on these topics that is frequently quoted in the financial media, including the Wall Street Journal, CNBC and CNN. He joined ClearBridge Investments in 2014 and has 14 years of investment industry experience. Prior to joining ClearBridge, Jeffrey was a Portfolio Specialist at Lord Abbett & Co., LLC. He received a BS in Finance from Rutgers University. He is a member of the CFA Institute.
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