Jeffrey Schulze

Investing and mountain climbing are both judged by the ability to move higher, notes Jeff Schulze, Director and Head of Economic and Market Strategy at ClearBridge Investments, a global investment manager.

“The journey higher is never smooth and experienced climbers understand that heightened concentration is paramount once the crux, the toughest part of a route where the hardest moves and challenges are concentrated, is reached.

“While the consequences of failure in the stock market pale in comparison, we believe the crux for investors lies in the coming quarters as fiscal stimulus and consumer resilience fade while the lagged effects of monetary tightening take hold.

“We worry that many investors have fully embraced the soft landing narrative and are facing potentially the most dangerous part of this cycle’s climb with their guard down,” Schulze says.

In his third quarter market outlook Schulze notes “Any tailwind from higher fiscal spending could be weakened or non-existent should government spending caps go into effect. The other lever to stave off a slowdown, monetary easing, also appears to be off the table as the Fed remains hamstrung by inflation and a tight labor market.

“As supportive macro tailwinds fade, cracks in the economy continue to appear. Consumer balance sheets continue to show increasing signs of strain, with delinquency rates for credit card, auto and other loans on the rise. An economic bull would note that these rates may be normalising from very low levels. However, a pessimist would point out that auto and credit card delinquency rates are already above the peaks seen during the last economic expansion, and student loan delinquencies are poised to rise as the repayment moratorium has expired. Given the challenges consumers are facing, these strains could grow worse in the coming quarters.

“Another crack is evident in the labor market itself. While the economy continues to add jobs, every payroll release this year has been revised lower, and the preliminary benchmark revision last month reduced the March baseline by a further -306,000 jobs. Put differently, 2023 employment growth has not been as strong as initially thought. Large downward revisions to the labor report have historically clustered around economic inflection points, with a similar streak of negative revisions occurring in 2007 in the run-up to the Global Financial Crisis. This data should not set off an immediate recession alarm, but rather is a sign that the labor market may be weaker than perceived.

“We believe the path of the labor market will determine whether the economy continues along the soft landing path or slips into recession.

“Despite headwinds gathering, the Fed appears firmly committed to a higher for longer policy path. This is a shift from the recent, low inflation past when the central bank was quick to deliver accommodative policy at the first sign of macro strain. This is important because history shows the Fed has been instrumental in re-accelerating GDP growth regardless of whether the economy was headed for a soft landing or a recession.

“The economy has never meaningfully picked up until after the Fed started easing,” he says.

Schulze adds “Today, generationally high inflation and a tight labor market leave the Fed hamstrung and likely slower to react to unfavourable data and more targeted when it does. A frozen Fed presents a significant risk to economic growth, elevates the chances of a recession, and could even allow what might have otherwise been a mild recession to metastasize into something worse.

“Unusually narrow market breadth and tepid small cap performance a year removed from recent market lows suggest the current rally could be short lived, leading us to favour growth and defensive equity positioning until more economic clarity emerges.

“In summary, widening cracks across the economy and capital markets could short circuit the current rally. That path should become clearer in the coming quarters as we move through the crux.

“In the meantime, we continue to recommend tilts toward growth and defensive positioning until more clarity emerges on the economic path forward,” he says.

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