High unemployment and consumer caution could limit the reopening of the U.S. economy -- delaying the formation of a durable market bottom and fostering near-term volatility.
- While only a matter of time until a recession is officially declared, the ClearBridge Recession Risk Dashboard worsened in April, sinking deeper into red territory signaling economic contraction.
- The phased reopening of the economy could be limited by high levels of unemployment and the reticence of at-risk consumers to resume spending, factors that could delay the formation of a durable market bottom and lead to near-term volatility.
- The ClearBridge Recovery Dashboard continues to flash an overall red or recessionary signal with two indicators improving and one worsening for the month.
Recession Conditions Have Been Met
With the U.S. economy contracting 4.8% in the first quarter, the official declaration of a recession is now a matter of when, not if. The National Bureau of Economic Research (NBER) defines a recession as “a significant decline in economy activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.” We believe these conditions have clearly been met, although the NBER has historically taken a more cautious approach, often announcing that the economy has troughed well after the fact. In the global financial crisis, their declaration came 11 months after the high-water mark.
By contrast, the ClearBridge Recession Risk Dashboard continues to signal that the economy is in a recession with an overall red signal. Two indicators worsened this month: Retail Sales went from green to red following an -8.7% decline in the month of March and Job Sentiment worsened from yellow to red. These changes suggest a clear deterioration in the health of the consumer following the record rise in unemployment claims due to COVID-19 business shutdowns.
ClearBridge Recession Risk Dashboard
Sources: ClearBridge Investments, Bureau of Labor Statistics (BLS), Federal Reserve, Census Bureau, Institute for Supply Management (ISM), Bureau of Economic Analysis (BEA), American Chemistry Council, American Trucking Association, Conference Board, and Bloomberg.
As several states begin to ease stay-at-home restrictions, investors have started to focus on the potential path of the economic recovery. These hopes may be premature, however, as the conditions that have historically indicated the formation of a durable economic and market bottom are not yet present. Specifically, the ClearBridge Recovery Dashboard continues to flash an overall red or recessionary signal.
However, three indicators changed this month, with two improving and one worsening. Investor Sentiment turned red from yellow, while Consumer Confidence and the Philly Fed both turned green. These latter two indicators are both “contrarian” in nature, in that they typically worsen to extremely pessimistic levels around major turning points. To that end, the Conference Board’s Consumer Confidence measure recorded its second-largest monthly decline on record, and the Philly Fed Manufacturing Business Outlook – a measure of regional activity in the Mid-Atlantic where early supply-chain basic materials flow through – is at its third-lowest level on record.
ClearBridge Recovery Dashboard
Source: ClearBridge Investments, FactSet, Bloomberg, Conference Board, Census Bureau, Federal Reserve, FRBPA, Chicago Fed, ISM, Dept. of Labor, Bloomberg/Barclays, AAII, Investors Intelligence, and Moody’s.
Markets Discounting a Rapid Recovery
We’ll only know in hindsight whether the market low has already been made but equities are pricing in an optimistic path forward. While the level of earnings growth has shifted down, the trajectory of growth later this year and into next year remains similar to what was expected before COVID-19. Put differently, many investors have simply deferred their expectations for growth, not altered them beyond a short-term pullback. As a result, the P/E of the market has risen considerably on depressed earnings. This suggests to us that a return to normal is priced in for some point between Labor Day and Halloween.
Earnings Forecasts Remain Bullish Over the Medium Term
Source: S&P, FactSet. 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.
Many bulls argue that the market is looking past near-term weakness and instead focusing further into the future. However, this would be atypical. Historically, equities have been much more near-sighted (6-month time horizon) and move more closely with the next quarter or two of earnings and economic growth. For example, the S&P 500 Index bottomed one month before the trough in earnings back in 2009.
Small Business Activity Could Take Time To Rebound
As economies reopen, we believe there will be ongoing labor market weakness and the potential for economic air pockets. This view is predicated upon the notion that many small businesses were under pressure even before COVID-19 first reached American shores. The ClearBridge Recession Risk Dashboard was flashing yellow prior to the outbreak and the corporate profit indicator was red. While the most-impacted businesses in areas like retail, travel, and leisure have undergone widescale layoffs, many businesses that are less impacted by the virus have also reduced headcounts.
This was evident in a recent paper published by a team of professors from Harvard and the University of Chicago. The authors surveyed over 5,800 small businesses and found that employment was down 40% across all firms relative to January staffing levels. Importantly, even businesses that were still open had cut full time staff by 17.5%, on average. We believe many of these jobs will not come back when the economy reopens, leading to elevated unemployment and dampening consumer spending.
This will likely only compound headwinds from shifts in behavior until a vaccine or proven treatments for the virus emerge. The age 55+ portion of the population accounts for 40% of domestic spending, a group more at-risk from COVID-19 and more likely to stay at home. Further, early data from China, the first global economy to largely reopen after fighting the virus, suggests consumers are staying away from large crowds and are hesitant to engage in face-to-face transactions. Importantly, even though China has reopened, its borders are largely closed to foreigners and life does not appear to be back to normal. The challenges of reopening are abundant, with places like Hong Kong and Singapore seeing an uptick in cases as restrictions were lifted.
Older Consumers Unlikely to Get Out and Spend
As of Dec. 31, 2018. Source: Bureau of Labor Statistics.
Ultimately, we believe GDP has yet to find its trough. Policymakers have provided an important liquidity bridge that has buoyed financial markets and kept the economy on life support for the time being. However, many business models that rely on close-contact human interaction may remain challenged as the economy reopens. As such, we remain vigilant, particularly as history suggests bear markets tend to have three stages: 1) a swift decline, followed by 2) an oversold bounce, and then 3) an adjustment period likely frustrating to both bulls and bears. We believe the economy beginning to reopen could mark the start of the final stage. As a result, the coming months could be choppy, testing investor resolve. In the interim, we will continue to monitor the ClearBridge Recovery Dashboard for signs that a durable economic and market bottom has formed.
The National Bureau of Economic Research (NBER) is an American private nonprofit research organization "committed to undertaking and disseminating unbiased economic research among public policymakers, business professionals, and the academic community.
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
Gross Domestic Product (“GDP”) is an economic statistic which measures the market value of all final goods and services produced within a country in a given period of time.
The Institute for Supply Management (ISM) is an association of purchasing and supply management professionals, which conducts regular surveys of its membership to determine industry trends.
The Bureau of Labor Statistics (BLS) is an American government agency tasked with collecting and disseminating a range of economic and employment data.
The Conference Board is a US-based business membership and research association.
The S&P 500 Index is an unmanaged index of 500 stocks that is generally representative of the performance of larger companies in the U.S.
COVID-19 is the World Health Organization's official designation of the current coronavirus.
The Philly Fed Manufacturing Business Outlook Survey is also called the Philadelphia Federal Index (or Philly Fed Survey), which is a regional federal-reserve-bank index measuring changes in business growth
A bear market typically describes a condition in which securities prices fall 20% or more from recent highs amid widespread pessimism and negative investor sentiment.
The price-to-earnings (P/E) ratio is a stock's price divided by its earnings per share.
Earnings per share (EPS) is the portion of a company's profit allocated to each outstanding share of common stock. An index EPS is an aggregation of the EPS of its component companies.
A credit spread is the difference in yield between two different types of fixed income securities with similar maturities, where the spread is due to a difference in creditworthiness.
The Bureau of Economic Analysis (BEA) is an agency within the Department of Commerce's Economic and Statistics Administration, responsible for collecting and publishing economic data, research and analysis, and estimation methodologies.
The United States Census Bureau (USCB) is a principal agency of the U.S. Federal Statistical System, responsible for producing data about the American people and economy.
The Chicago Board Options Exchange (CBOE) Volatility Index (VIX) is a measure of market expectations of near-term volatility as conveyed by S&P 500 stock index option prices.
The ClearBridge Recession Risk Dashboard includes 12 leading economic, financial and market indicators that can provide information about the direction of the U.S. economy.
Yield curve refers to the graphical depiction of the relationship between the yield on bonds of the same credit quality but different maturities.