the anatomy of a recession: what to look for and where we ... · 5 for institutional investors...

1

For institutional investors only,

Not for distribution to the general public.

Confidential and proprietary information.




The Anatomy of a Recession:

What to Look for

and Where We’re Headed

Jeff Schulze, CFA

Director, Investment Strategist

January 19, 2017

2




Probabilities vs. Possibilities There’s a long list of risks

Japan’s problems intensify

China hard landing

Breakup of Eurozone

Trump’s policy agenda

Dollar strengthens

Central bankers out of bullets

S&P earnings continue to decline

Fed tightens

EM problems intensify

U.S. economy slows

Unwinding QEs

3




S&P 500 & Panic Attacks

As of Nov. 11, 2016.

Source: Standard & Poor’s Companies.

“The definition of insanity is doing the same thing over and over again and expecting a different result.”

- Attributed to Albert Einstein

1,700

1,800

1,900

2,000

2,100

2,200

Jan. 2014 Apr. 2014 Jul. 2014 Oct. 2014 Jan. 2015 Apr. 2015 Jul. 2015 Oct. 2015 Jan. 2016 Apr. 2016 Jul. 2016 Oct. 2016

Emerging Markets

Mini Crisis

Malaysian Jet Crisis &

Portuguese Bank Panic

Global

Growth and

Ebola ScaresRate-Hike Scare &

Momentum Stocks

Meltdown

Brent Drops

Below $70Renewed

Grexit Scare

Yuan Devalued &

ETF Flash Crash

Oil Falls,

Dollar Rises

Greece Sets

7/5 Vote

Third Ave

Blows Up

Endgame Panic

Brent Bottoms at $27.88

Japan Goes NIRP

WTI Bottoms

Brexit

Rate hike

scare

4




Investment Returns

Effects of Panic Attacks on Average Investors 30-Year Annualized Returns % (1985-2014)

Source: Bloomberg. Dec. 31, 2014. Average asset allocation investor return is based on an analysis by DALBAR, Inc. which

utilizes the net of aggregate mutual fund sales, redemptions and exchanges each month as a measure of investor behavior.

Indices shown are as follows: REITs are represented by the FTSE NAREIT Equity REIT Index. U.S. Stocks are represented by

the S&P 500 Index, International Equities are represented by the MSCI EAFE Index, Government-Related Bonds are

represented by the Barclays U.S. Aggregate Bond Index, Homes are represented by U.S. existing home sales median price.

Gold is represented by the U.S. dollar spot of one troy ounce. Inflation is represented by the Consumer Price Index. Indices

are unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and

does not predict the performance of any investment. Past performance does not guarantee future results.

11.2% 11.1%

9.0%

7.4%

5.5%

4.4%

2.7% 2.5%

REITs U.S. Stocks International

Equities

Government-

Related Bonds

Homes Gold Inflation Average Investor

5




Noise vs. Signal

• A market crash is a drop of 20% or more that lasts longer than 12 months

• Market crashes are typically the largest and longest market drawdowns

• Over the past 35 years, only one market crash hasn’t been accompanied by a recession

Source: Bloomberg.

0

10

20

30

40

50

60

70

80

90

100

-60

-40

-20

0

20

40

60

80

Jan

. 1981

Jan

. 1982

Jan

. 1983

Jan

. 1984

Jan

. 1985

Jan

. 1986

Jan

. 1987

Jan

. 1988

Jan

. 1989

Jan

. 1990

Jan

. 1991

Jan

. 1992

Jan

. 1993

Jan

. 1994

Jan

. 1995

Jan

. 1996

Jan

. 1997

Jan

. 1998

Jan

. 1999

Jan

. 2000

Jan

. 2001

Jan

. 2002

Jan

. 2003

Jan

. 2004

Jan

. 2005

Jan

. 2006

Jan

. 2007

Jan

. 2008

Jan

. 2009

Jan

. 2010

Jan

. 2011

Jan

. 2012

Jan

. 2013

Jan

. 2014

Jan

. 2015

Jan

. 2016

S&P 500 (Year-Over-Year %) Recession

6




1929 vs. 1987

Black Monday: Truly an Outlier? The Great Depression: 1929

7




• Recoveries (1960-2007) averaged 27 quarters

• Low-inflation expansions tend to be longer than high-inflation expansions

• Currently recovery is still shorter than average low-inflation expansion

Recovery/Expansion U.S. Real GDP

Data as of Sept. 30, 2016.

Source: http://www.bea.gov/national/.

35 Quarters 12 Quarters 20 Quarters 31 Quarters 40 Quarters 24 Quarters 29 Quarters

as of 3Q16

These “low inflation” recoveries averaged 33 quarters

-6

-4

-2

0

2

4

6

8

10

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

8




All About Context

PAIR: Two corresponding

persons or items, similar

in form or function and

matched or associated

Example:

A pair of shoes

PARE: To remove the outer

covering or skin with a

knife or similar

instrument

Example:

Pare an apple

PEAR: A fruit with a spherical

base and a tapered top,

as well as the tree that

bears this fruit

Example:

Eat pears

9




U.S. Recession Risk Indicators

• 11 indicators have historically foreshadowed a looming recession

• Only corporate profits signal risk right now

As of Dec. 31, 2016.

Recession Signal

Average Hourly Earnings (3 Mo. Avg. Y/Y%) No

PCE Deflator (12 Mo. Avg. Y/Y%) No

CPI Energy (12 Mo. Avg. Y/Y%) No

10-Year Treasury and 3-Month T-Bill Spread (3 Mo. Avg.) No

Consumer Non-Mtge. Delinquency Rate (ABA) No

Corp Profits Fin and Nonfin % GDP (2 Yr. Avg.) Yes

High Yield Spread No

Housing Permits No

Dollar Strength No

Temporary Worker Trend No

Four-Week Average of Initial Claims No

10




LEI Suggests U.S. Recession Years Out

Source: Bloomberg.

U.S. Leading Economic Indicators

0

50

100

150

200

250

300

350

400

450

500

0

20

40

60

80

100

120

140

Jan

. 1975

Jan

. 1976

Jan

. 1977

Jan

. 1978

Jan

. 1979

Jan

. 1980

Jan

. 1981

Jan

. 1982

Jan

. 1983

Jan

. 1984

Jan

. 1985

Jan

. 1986

Jan

. 1987

Jan

. 1988

Jan

. 1989

Jan

. 1990

Jan

. 1991

Jan

. 1992

Jan

. 1993

Jan

. 1994

Jan

. 1995

Jan

. 1996

Jan

. 1997

Jan

. 1998

Jan

. 1999

Jan

. 2000

Jan

. 2001

Jan

. 2002

Jan

. 2003

Jan

. 2004

Jan

. 2005

Jan

. 2006

Jan

. 2007

Jan

. 2008

Jan

. 2009

Jan

. 2010

Jan

. 2011

Jan

. 2012

Jan

. 2013

Jan

. 2014

Jan

. 2015

Jan

. 2016

LEI Recession

7 Years

8 Years

4 Years

Average of 6.33 years to the next recession

11




0

500

1,000

1,500

2,000

2,500

Jan. 1975 Jan. 1982 Jan. 1989 Jan. 1996 Jan. 2003 Jan. 2010

Recession Building Permits

Building Permits for New Private Housing Units

Source: U.S. Bureau of Census, retrieved from FRED. Compiled: econpi.com

Thousands of Units

Moderation may

be due to

housing bubble

which began

prior to this time.

12




Yield Curve Spread

Source: Fed Reserve Bank of St. Louis, retrieved from FRED. Compiled: econpi.com

10-Year Treasury Bonds Minus 3-Month T Bills

Yield curve spread less than zero (inverted)

occurs prior to recessions.

Yield Curve Spread Recession

0

50

100

150

200

250

300

350

400

450

500

-300

-200

-100

0

100

200

300

400

500

13




No Oil Price Spike

Data as of Oct. 31, 2016.

Source: Bloomberg.

West Texas Intermediate Crude Oil

Recession

3

30

1970 1974 1978 1982 1986 1990 1994 1998 2002 2006 2010 2014

$/B

arr

el

13

25

50

75

100

125

14




0

500

1,000

1,500

2,000

2,500

3,000

3,500

125,000

127,000

129,000

131,000

133,000

135,000

137,000

139,000

141,000

143,000

145,000Ja

n. 2000

Jul.

200

0

Jan. 2001

Jul.

200

1

Jan. 2002

Jul.

200

2

Jan. 2003

Jul.

200

3

Jan. 2004

Jul.

200

4

Jan. 2005

Jul.

200

5

Jan. 2006

Jul.

200

6

Jan. 2007

Jul.

200

7

Jan. 2008

Jul.

200

8

Jan. 2009

Jul.

200

9

Jan. 2010

Jul.

201

0

Jan. 2011

Jul.

201

1

Jan. 2012

Jul.

201

2

Jan. 2013

Jul.

201

3

Jan. 2014

Jul.

201

4

Jan. 2015

Jul.

201

5

Jan. 2016

Total Nonfarm Workers (left) Temporary Workers (right)

(Thousands)

Temporary Workers Employment Trend

Source: Bureau of Labor Statistics, retrieved from FRED. Compiled: econpi.com

Temp workers show marked

decline prior to recessions

Recession

15




The Consumer is King in the U.S.

16




The Consumer is King in the U.S.

• U.S. consumer spending is larger than the next 4 largest countries (China, Japan, U.K., Germany) combined

U.S. Consumer Spending Is Largest in the World

Source: Cornerstone Macro.

$12.3

$4.2

$2.4

$1.9

$1.8

$0 $2 $4 $6 $8 $10 $12 $14

United States

China

Japan

U.K.

Germany

$ Trillion

Nominal Consumer Spending 2015

17




One Year Outlook Themes That Will Drive the Market Over the Next 12 Months

Trump’s

Presidential Agenda China Europe

U.S Dollar Corporate QE Interest Rates

%

18




Market Perspective

Industrials

• Increased infrastructure spending to spur demand for construction and engineering firms

• Greater defense spending is a short-term positive for defense contractors

• Commitment to American shale revolution should spark renewed business for suppliers to energy industry

Health Care

• Worst-case drug pricing legislation off the table, eliminating major risk for biopharmaceuticals

• Repeal/reform of Affordable Care Act should expand opportunities for managed care

• Changes at DoJ could pave way for proposed managed care mergers to be completed

• Coverage rollbacks would hurt hospitals and Medicaid managed care

Financials

• Simplified regulation should lower costs, boost loan growth for all banks

• Regional banks would benefit most from lower regulatory burden

• Higher interest rates due to better growth would benefit insurers, spread-oriented lenders

Negatives

• Trump’s advocacy of fossil fuels a headwind for utilities and renewable energy producers

• Protectionist agenda impacting trade and immigration could hurt sales for multinationals in the technology

and consumer sectors; IT hiring

Post-Election Sector Winners and Losers

19




0

50

100

150

200

250

300

350

400

450

500

-2

-1

0

1

2

3

4

5

6

1960 1965 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015

% C

han

ge

Fresh Faces in White House Met by Recession in First Year

As of Mar. 31, 1960 through Sept. 30, 2016.

Source: Morgan Creek.

Gross Domestic Product

20




Manufacturing PMI and S&P 500 EPS

Data as of Sept. 30, 2016.

Source: Bloomberg.

-50%

-40%

-30%

-20%

-10%

0%

10%

20%

30%

40%

50%

30

40

50

60

70

Jun

. 1991

Jun

. 1992

Jun

. 1993

Jun

. 1994

Jun

. 1995

Jun

. 1996

Jun

. 1997

Jun

. 1998

Jun

. 1999

Jun

. 2000

Jun

. 2001

Jun

. 2002

Jun

. 2003

Jun

. 2004

Jun

. 2005

Jun

. 2006

Jun

. 2007

Jun

. 2008

Jun

. 2009

Jun

. 2010

Jun

. 2011

Jun

. 2012

Jun

. 2013

Jun

. 2014

Jun

. 2015

Jun

. 2016

ISM Manufacturing PMI, Shifted 6 Months Forward (left)

S&P 500 EPS Year over Year % Change, 4 Quarter Avg. (right)

21




• Number of millennials in China is larger than the working populations of U.S., Canada and Western Europe combined

• More than one-quarter of China’s millennials are college graduates

• As 400 million new Chinese people enter the spending class, implications are huge

Long-Term Growth Prospects for China

Source: VisualCapitalist.com.

415

207

87

22

0 50 100 150 200 250 300 350 400 450

China

Western

Europe

U.S.

Canada

Population (Millions)

Number of Millennials (16-35 Years Old)

22




Bank Loans: China & U.S.

Source: Board of Governors of the Federal Reserve and People’s Bank of China.

Per year, > the economy

of Brazil

(The world’s 9th largest

economy)

23




European Union

24




Next Domino to Fall?

As of Nov. 24, 2016.

Source: Societe Generale.

Centre-right

Primaries in France

Nov. 27, 2016

Italian referendum on

constitutional reform

Dec. 4, 2016

Austrian

Presidential election

Dec. 4, 2016

Target Greek

debt restructuring

End of 2016

General Election

in the Netherlands

Mar. 15, 2017

U.K. to trigger

Article 50

End of Mar. 2017

Socialist primaries

in France

Jan. 22-29, 2017

German State election

in Saarland

Mar. 26, 2017

Presidential and

general election

in France

Apr. 23 – May 7, 2017

State elections in

Schleswig Holstein

May 7, 2017

State elections in

Nordrhein-Westfalen

May 14, 2017

General election

in France

Jun. 11-18, 2017

General election

in Italy

May 2018 (latest)

General election

in Germany

Oct. 2017 (latest)

Catalonia plans

independence

referendum

Sept. 2017

…

25




U.S. 10-Year Treasury Bond

Data as of Dec. 10, 2016 - Jan. 3, 2017.

Source: Bloomberg Financial Services, DoubleLine Capital LP.

1

2

3

4

Dec. 2010 Dec. 2011 Dec. 2012 Dec. 2013 Dec. 2014 Dec. 2015 Dec. 2016

Yie

ld (

%)

2.45%

1.39%

26




Bond Markets to Stock Markets

• Since the U.S. election in November, roughly $3 trillion have moved from bond markets to stock markets

Source: Bloomberg Finance LP, DB Global Markets Research.

27




Short-Term Risk for Bonds

Source: Strategas Research Partners. Data as of Dec. 2016.

Domestic Equity

Years Mutual Fund ETF Bond

2009 -27.6 30.9 417.2

2010 -81.1 46.7 262.0

2011 -133.3 47.3 163.7

2012 -159.1 80.9 358.5

2013 18.1 104.0 -59.0

2014 -60.2 143.0 94.5

2015 -170.8 63.1 29.5

2016 YTD -181.3 91.5 207.4

Total -795.2 607.4 1473.8

Net Flows into Mutual Funds + ETFs ($ Billions)

28




Global Bond Duration

Barclays World Ex-Japan is an index of government bonds from investment grade countries, excluding Japan.

As of Jan. 1, 1990 – Dec. 31, 2015.

Source: IMF Financial Stability Report.

Assets Under Management

by Mutual Funds, ($ Billions)

8.5

9.0

9.5

10.0

10.5

11.0

11.5

12.0

12.5

13.0

13.5

1997 2002 2007 2012 2017

World Bond Indices Have Been a Surge in Duration

Barclays World Ex-Japan All Maturities

Average Modified Duration

Years

As of Jan. 1, 1997– Jan. 3, 2017.

Source: Bloomberg, SG Cross Asset Research/Rates.

50%

29




Corporate QE - M&A Activity

* Excludes spinoffs.

Source: Dealogic.

United States

30




S&P 500 Forward Earnings Yield & Corporate Bond Yield

and S&P 500 Buybacks

31




Buybacks & Dividends

Source: Standard & Poor’s Corporation.

32




Dollar Might Not Rise

• The easy assumption that the dollar will rise with Fed tightening is not validated by history, as in only one of the last seven

tightening cycles did the dollar clearly rise (1983). Here are four examples where the dollar declined in a tightening cycle.

Source: Bloomberg.

080

85

90

95

100

105

110

Jul. 1976 Jan. 1977 Jul. 1977 Jan. 1978 Jul. 1978

DX

Y

1976

Fir

st R

ate

Hik

e

-23% 090

95

100

105

110

115

120

Aug. 1971 Feb. 1972 Aug. 1972 Feb. 1973 Aug. 1973

DX

Y

1972

Fir

st R

ate

Hik

e

-17%

080

85

90

95

100

Aug. 1993 Feb. 1994 Aug. 1994 Feb. 1995 Aug. 1995

DX

Y

1994

Fir

st R

ate

Hik

e

-15%

080

85

90

95

Jan. 2004 Jan. 2005 Jan. 2006 Jan. 2007

DX

Y

2004

Fir

st R

ate

Hik

e

-8%

33

For institutional investors only.



Additional Important Information

Past performance is no guarantee of future results.

Copyright © 2017 ClearBridge Investments.

©2016 Legg Mason Investor Services, LLC, member FINRA, SIPC. Legg Mason Investor Services, LLC and ClearBridge Investments, LLC are subsidiaries of

Legg Mason, Inc.

All opinions and data included in this commentary are as of Jan. 10, 2017 unless noted otherwise and are subject to change. The opinions and views

expressed herein are of the presenter and may differ from other managers, or the firm as a whole, and are not intended to be a forecast of future

events, a guarantee of future results or investment advice. This information should not be used as the sole basis to make any investment decision. The

statistics have been obtained from sources believed to be reliable, but the accuracy and completeness of this information cannot be guaranteed.

Neither ClearBridge Investments nor its information providers are responsible for any damages or losses arising from any use of this information.

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the anatomy of a recession: what to look for and where we ... · 5 for institutional investors...

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