A $750 billion investing giant says there's a 50% chance of a US recession in a year - and the smallest companies will reveal its fate

Brendan McDermid/Reuters

• Experts at the asset management firm Legg Mason say there's a 50% chance the US will go into a recession in the next year based on shaky US corporate profits and the recent yield curve inversion.
• Strategists Jeffrey Schulze and Kim Catechis say the smallest US companies are feeling enormous pain as the trade war drags on, and investors don't appreciate its significance.
• The pair each detailed their investment recommendations and said traders don't need to get out of the stock market.
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Investors have grown more optimistic about the fate of the US economy in the last month or so, but asset manager Legg Mason says there's now a 50% chance of a recession in the next year.

The firm, which handles about $750 billion in assets, says the odds of that recession have increased even as stocks have rallied because Wall Street thinks the threat of a major slowdown is fading. Jeffrey Schulze, an investment strategist at the firm's ClearBridge business, says he's expecting a recession scare in the first half of 2020.

He offers two reasons for the 50-50 recession call.

One is that corporate profits are in deep trouble. While S&P 500 profits have been weak this year, Schulze says investors don't recognize how serious the situation is.

Instead of focusing on the S&P 500 index, he's evaluating National Income and Product Accounts profits, which put more emphasis on smaller firms. Schulze notes that most US workers are employed by firms with fewer than 1,000 employees, and the average small-cap company has about four times that many.

"It's a much better barometer of what's going on in the US economy," he said at a media event. "We don't look at S&P 500 profit margins or operating margins because usually you'll see cracks in the foundations of those companies last."

When smaller companies are included, Schulze says corporate profit margins have been flat for about three years, and now they're under even more pressure because of rising labor costs and the trade war. If earnings don't improve, those companies will start cutting employees' hours - and if that doesn't help, they'll start eliminating jobs. That's one of the last things that typically happens right before a recession.

Kim Catechis, the head of investment strategy for Legg Mason's Martin Currie equities business, says he thinks the situation is worse than it looks.

"The damage that has been done already is under the surface," he said. "The damage done in that sector is underreported. The damage done at the sector above, the Russell 2000, is also underreported."

They're not the first to raise similar concerns. Albert Edwards, the co-head of global strategy at Societe Generale, also recently pointed out that US company profits are ailing even as earnings for the smaller slice of companies listed on the stock market remain fairly stable.

The second key piece of evidence is that in August, long-term interest rates dipped below short-term rates. That yield-curve inversion has preceded the last seven US recessions - and while some experts think its signal isn't relevant today, Schulze warns that ignoring the yield curve's warnings and being wrong can be devastating.

"Maybe the four most dangerous words in finance is 'This time is different,' because anybody that's ever uttered those words has probably lost a lot of money," he said. "What we think has been happening with the Treasury market is, it's been following slower US growth and rising recession risk, and a Fed policy that's too tight."

What they're doing

Schulze says he doesn't trust the recent stock market rotation away from high-growth stocks and into "value" counterparts. But even if the odds of continued economic growth are no better than the probability of a coin flip coming up heads, he explains that investors should stay in the stock market.

"We're going back into growth leadership and I think that persists for the rest of this cycle," he said. "The last stages of a bull market can be some of your strongest returns. Typically in the final year of a bull market, the equities are up 26.9%, so it typically ends in euphoria."

Catechis, meanwhile, says he believes green energy is a good investment theme today, and adds that the average US investor should shift some money into companies overseas, which have lagged throughout the current bull market.

"Europe looks pretty uninspiring. But when you look under the bonnet, there's a hell of a lot of good, attractive companies there," he says, singling out Ferrari as an example.

"Based on what the typical asset allocation is, you can do a lot worse on the 10-year view than putting money abroad. It almost doesn't matter where."

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