Anatomy of a Recession: Not Your Father’s Energy Crisis
Key Takeaways
- Worries about an economic slowdown caused two market-focused recession indicators, Commodities and Credit Spreads, to worsen from green to yellow, yet the overall Recession Risk Dashboard remains green.
- Spiking oil prices have raised recessionary fears reflecting the experience of the 1973 Arab oil embargo. A review of the dashboard during that period provides a useful case study about what could turn the contraction experienced in the first quarter into a full-blown recession.
- While some elements of the 1973-75 period bear resemblance to the current environment -- higher fiscal spending, looser monetary policy and positive demographics -- there are several key differences. The magnitude of the current energy shock pales in comparison to 1973 and today’s economy is starting from a much stronger foundation.
Negative GDP Print More Anomaly Than Warning Sign
The U.S. economy contracted by 1.4% in the first quarter1, the first decline since the pandemic plunge during the second quarter of 2020. There is more to the story, however, given a -2.5% contribution from (stronger) imports as supply chain bottlenecks loosened. This paradox – a positive development (supply chain improvement) led to a negative headline outcome (a drag on gross domestic product (GDP)) – perhaps explains why financial markets treated the GDP report as “good news,” with equities rallying 2.5% that day. More stable core components of GDP, like consumption and investment, have accelerated over the past two quarters, which bodes favorably for a growth rebound in the current quarter. A negative GDP print outside of a recession is not unprecedented, with over 20% of such contractions occurring since 1950, the latest being in 2014 and 2011.2
The economic outlook bears little resemblance to the early pandemic, with consumption and business activity likely to slow from elevated levels but remain positive. Earnings are growing at a healthy clip. With approximately 75% of S&P 500 companies having reported so far, earnings beats have been robust and widespread, and guidance has been better than average.
Exhibit 1: ClearBridge Recession Risk Dashboard
Source: ClearBridge Investments.
Despite this, Credit Spreads widened as perceptions of an economic slowdown and rising geopolitical risks led investors to demand greater compensation for investing in lower-quality bonds. Commodities worsened to yellow due to Chinese lockdowns curbing demand for industrial commodities such as copper and steel, while the ongoing war in Ukraine helped sustain higher oil prices. However, the balance of indicators remain green, with strength in indicators such as Jobless Claims, which hit a 53-year low last month3, suggesting a robust jobs market will buoy consumption and economic activity.
Rising oil prices have raised the specter of 1970s style stagflation. However, we believe the current economy is better positioned to weather the storm from higher energy prices given rising incomes and efficiency gains, a dynamic we highlighted previously in our ‘Resilience in Wartime’ blog. Further, history shows that not all oil price shocks are created equal, with the starting point of the economy a crucial determinant as to whether a recession will follow, as mentioned previously in our ‘The Long View: When Doves Cry’ blog. Importantly, the U.S. economy was in a stronger place when oil prices spiked in the first quarter than it was when the 1973 Arab oil embargo began, with 10 green signals on the recession dashboard at the time compared to just three of 11 in 1973. This stronger starting point does not mean that cracks won’t emerge, which makes it useful to review the evolution of the dashboard during the 1973-75 recession for perspective.
Seeds of 1970s Inflation and Recession Built Up Over Time
While the oil embargo began in October 1973 following the Yom Kippur War between Israel and a coalition of Arab states led by Egypt and Syria, the origins of the recession and period of high inflation date back much further. Inflation began to accelerate in the mid-1960s during the Johnson administration, which pursued a greater fiscal spending agenda to finance the Vietnam War and expanded social welfare programs known as the Great Society. This coincided with positive demographic shifts, with baby boomers entering the workforce and driving demand (and prices) higher as they hit their peak earning and spending years. Meanwhile, the Federal Reserve (Fed) maintained very loose monetary policy to help finance these higher deficits, which led foreign investors to question the ability of the U.S. to maintain the gold standard. The resulting weakness and run on the U.S. dollar ultimately led the Nixon administration to move off the gold standard in 1971 which was followed by price and wage controls.
While there are some resemblances to the current environment -- chiefly higher fiscal spending, looser monetary policy, and positive demographics -- there are several key differences. Beyond the black swan of a global pandemic, the duration of elevated fiscal spending has been far shorter, with government deficits having come in substantially and on track to return to pre-pandemic levels this year. The Fed’s support has also been comparatively brief, with the initial interest rate hike of the current cycle having already occurred and many more expected in an effort to normalize policy “expeditiously.” Furthermore, the process of quantitative tightening expected to begin soon gives the Fed another lever to slow inflation.
Notably, the U.S. is not on the gold standard, leading to an entirely different dynamic, as the dollar has strengthened due to a more aggressive Fed. The demographic backdrop is different as well, with the positive impulse from the millennials hitting their peak earnings and spending years being partially offset by ongoing retirement of the boomers. Finally, and perhaps most importantly, the magnitude of the current energy shock pales in comparison to the 1973 spike, an environment where oil prices jumped from $3.07 per barrel to $11.65 in a span of five months.4 While oil prices have spiked 58% since the beginning of the year5, this increase is much more modest and less damaging than the 279% increase at the onset of the 1973 recession.
There are crucial differences in the dashboard leadup to the recession as well, with the Yield Curve inverting in June 1973, five months before the oil price spike and seven months before the start of the recession. Prior to that oil price spike, the Yield Curve, ISM New Orders and Housing Permits all flashed a red signal, compared to all being currently green. Profit Margins and Retail Sales were both yellow at the start of the 1973 spike, whereas both are currently green. However, there are some similarities, with Wage Growth red both then and today, and Money Supply yellow at both junctures.
Exhibit 2: 1973-75 Dashboard Evolution
Source: BLS, Federal Reserve, Census Bureau, ISM, BEA, American Chemistry Council, American Trucking Association, Conference Board, and Bloomberg. The ClearBridge Recession Risk Dashboard was created in January 2016. References to the signals it would have sent in the years prior to January 2016 are based on how the underlying data was reflected in the component indicators at the time.
The dashboard was less healthy in 1973 before the oil price spike, despite the overall green signal. The shock from oil, combined with the aforementioned challenges, led to a rapid deterioration to an overall yellow signal and the beginning of the recession, before a drop to red in early 1974. In some ways this is similar to the rapid onset of COVID-19 in 2020, which caused a rapid deterioration of the dashboard and near instantaneous start of a recession, although the overall signal was already yellow and had been since mid-2019.
We are now two months into the current oil price spike. Despite some weakening, the overall dashboard signal remains green. While there are similarities to the experience of 1973, there are many more differences, the most crucial being a stronger starting economy. While further worsening in the dashboard is likely in coming months, recent data suggests an overall red signal is not in the cards.
Endnotes
- Source: Reuters.
- Source: Ibid.
- Source: Ibid.
- Source: Federal Reserve.
- Source: Reuters.
Definitions
The ClearBridge Recession Risk Dashboard is a group of 12 indicators that examine the health of the U.S. economy and the likelihood of a downturn.
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.
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 Economic Analysis (BEA) is an agency of the Department of Commerce that produces economic accounts statistics that enable government and business decision-makers, researchers, and the American public to follow and understand the performance of the Nation's economy. To do this, BEA collects source data, conducts research and analysis, develops and implements estimation methodologies, and disseminates statistics to the public.
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.
WHAT ARE THE RISKS?
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls. International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets. Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
U.S. Treasuries are direct debt obligations issued and backed by the “full faith and credit” of the U.S. government. The U.S. government guarantees the principal and interest payments on U.S. Treasuries when the securities are held to maturity. Unlike U.S. Treasuries, debt securities issued by the federal agencies and instrumentalities and related investments may or may not be backed by the full faith and credit of the U.S. government. Even when the U.S. government guarantees principal and interest payments on securities, this guarantee does not apply to losses resulting from declines in the market value of these securities.
CONTRIBUTORS
Jeffrey Schulze, CFA
Director, Investment Strategist
Josh Jamner, CFA
Vice President, Investment Strategy Analyst
Related Content
Explore ClearBridge Investments Insights
IMPORTANT LEGAL INFORMATION
This material is intended to be of general interest only and should not be construed as individual investment advice or a recommendation or solicitation to buy, sell or hold any security or to adopt any investment strategy. It does not constitute legal or tax advice.
The views expressed are those of the investment manager and the comments, opinions and analyses are rendered as at publication date and may change without notice. The information provided in this material is not intended as a complete analysis of every material fact regarding any country, region or market. All investments involve risks, including possible loss of principal.
Data from third party sources may have been used in the preparation of this material and Franklin Templeton ("FT") has not independently verified, validated or audited such data. FT accepts no liability whatsoever for any loss arising from use of this information and reliance upon the comments opinions and analyses in the material is at the sole discretion of the user.
Products, services and information may not be available in all jurisdictions and are offered outside the U.S. by other FT affiliates and/or their distributors as local laws and regulation permits. Please consult your own financial professional or Franklin Templeton institutional contact for further information on availability of products and services in your jurisdiction.
Issued in the U.S. by Franklin Templeton Distributors, Inc., One Franklin Parkway, San Mateo, California 94403-1906, (800) DIAL BEN/342-5236, franklintempleton.com - Franklin Templeton Distributors, Inc. is the principal distributor of Franklin Templeton U.S. registered products, which are not FDIC insured; may lose value; and are not bank guaranteed and are available only in jurisdictions where an offer or solicitation of such products is permitted under applicable laws and regulation.
You need Adobe Acrobat Reader to view and print PDF documents. Download a free version from Adobe's website.
Franklin Templeton Distributors, Inc.