AOR Update (Podcast): AI and the labor market

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Podcast transcript

Host/John Przygocki: Welcome to Talking Markets with Franklin Templeton. I'm your host, John Przygocki from the Franklin Templeton Global Marketing Organization. As a forward-thinking asset manager, Franklin Templeton leverages cutting-edge strategies and deep industry insights to unlock opportunities to help grow wealth. We are your trusted partner for what's ahead. We're here today with ClearBridge Investments Head of Economic and Market Strategy Jeff Schulze. ClearBridge is a specialist investment manager of Franklin Templeton, and Jeff is the architect of the Anatomy of a Recession program, a program designed to provide you with a thoughtful perspective on the state of the US economy. Jeff, welcome to the show.

Jeff Schulze: Excited to be here, John.

John Przygocki: Jeff, let's get started with the recent US government shutdown. It has officially ended. Last month, we were somewhat flying blind with five of our individual economic indicators on the ClearBridge Recession Risk Dashboard due to the lack of government data releases. Do we have a more transparent view of the US economy at this time?

Jeff Schulze: Well, it's a great question, John. And since last month's update, we have gotten some of the October data for three of the five missing dashboard indicators.

So we have data in October for jobless claims, retail sales and wage growth. And just as we had talked about last month, given the alternative data that we are monitoring, we weren't expecting any changes and we didn't see any changes from September. But in the current month of November, and unfortunately, we still don't have data for four total indicators, we're missing data for housing permits, retail sales, wage growth and profit margins.

But just as we had mentioned last month, when looking at those alternative data sources, we think trends will continue and we're not going to see any individual signal changes. But I think the important takeaway here is that the overall dashboard does remain firmly in green expansionary territory. And just like we said last month, our odds of a recession over the next 12 months are still only 30%. So we think that there's a really strong possibility that this expansion continues.

John Przygocki: One area that seems to have been under tremendous amount of scrutiny, at least in the media, is the labor market. I believe we now have the jobs report for September. Were there any important points from that particular release?

Jeff Schulze: Well, the September jobs report is backward-looking, admittedly, but it does offer reassurance that the labor market wasn't faltering before the government shutdown occurred.

So the number came in at 119,000. That was double consensus expectations. It's not all rainbows and sunshine. August's job growth was revised down to negative 4,000, but I think it was a bit of a Goldilocks report in the sense that it did show some strong job creation in September, but it kept the odds of a rate cut alive, because the unemployment rate rose to 4.4% and average hourly earnings, aka wage growth, was pretty modest, which suggests that the pass through from demand driven inflation really isn't strong at this point as we turn the page to 2026.

So ultimately, I think the labor market is doing okay. I think we may see some weaker jobs releases when we get to October's and November's data in the next couple of months. I think there's going to be a pretty big drag because of the DOGE-related layoffs. You're also likely going to see some retail hiring shift to December because of a late Thanksgiving.

But looking at the next year, you have the peak fiscal impulse of the One Big, Beautiful Bill hitting. You have the lagged effects of Fed rate cuts flowing through to the economy, and you're going to have better visibility on the trade front, which I think will create a more durable labor market. And just this morning, John, we got initial jobless claims, which is the top ranked variable on the dashboard. Lowest reading that we've seen since 2022. So layoffs aren't materializing, which is a pretty good indication that the labor market is stable.

John Przygocki: Jeff, you recently released your December commentary. It's entitled “Is AI a Clear and Present Danger?” In this particular commentary, you've highlighted the potential negative impact of artificial intelligence on the labor market in the United States. Can you share your concerns with us?

Jeff Schulze: One of the fears that we've heard frequently on the road is that clients are very concerned about widespread adoption of AI leading to less job creation and potentially a negative layoff cycle. And proponents of this narrative point to younger workers. They typically have more limited experience, they have narrower skill sets, and in theory, it allows for easier substitution of AI for labor.

And when you look at the unemployment rate for people that are 16 to 24 years old, it's jumped. It's gone from 6.6% in April of 2023 to 10.4%. And obviously this lines up with the release of ChatGPT. But we did a deeper dive into the labor data. And although AI is impacting the jobs market, it's at a much less degree than what's commonly perceived.

So, you know, some areas that you've seen this impact are call centers and software development. But when you evaluate job creation by industry and the degree that each industry has adopted AI, believe it or not, labor weakness has been most evident in the industries that have the lowest AI adoption rates. So that suggests that there's other dynamics that have played a larger role in this slowing job creation environment that we have.

You have, again, trade and immigration policy, aging US population, DOGE-related layoffs; and ultimately, I do think that this is going to lead to some disruption, but it's probably going to be less than what people commonly perceive. Job losses from AI are only half the story. When you think about creative destruction, it also entails job creation. New businesses, new industries are going to sprout from technological progress.

And if you look at business formations over the past few years, and in particular last year, it's surged, which suggests that you're going to see tomorrow's leading companies potentially being in their infancy today. So, I think there will be some routine jobs that are shed in the years ahead. But when you look at the data, it really doesn't suggest that AI is being as disruptive as what's commonly being perceived by investors.

John Przygocki: So, Jeff, let me ask you a couple follow ups on that previous answer. you mentioned right at the tail end, “routine” occupations. I'd like more detail on what is meant by jobs that are in routine occupations. And then the second thing is, in this deep dive, you said you went back over a period of years. How big of a drop have we seen in this particular area since the 1970s?

Jeff Schulze: Define a routine occupation, is one that has a relatively small set of specific activities, yet well-defined instructions and procedures. And a job that is non-routine would be one that has a large number of tasks that require creativity, problem solving, flexibility, human interaction skills. So a good example of a non-routine job is a physician, public relations manager, maybe an economist. A routine job would be office and administrative support, maybe a bank teller or retail salesperson.

So when you break it down into those two buckets, if you go back to the late 1970s, about 40% of the US population was employed in routine occupations. That has been lowering over the last four decades, and it's now closer to 24%. So this has been a trend that's been moving lower, but I think I will continue this trend moving lower over the next 5 to 10 years. So there is going to be disruption. But I think the key here is, a lot of people will have to update their skills and transition from one industry from another, which is something that you've seen historically with technological progress over time.

John Przygocki: That makes sense. It’s very interesting. One more follow up on that is, will there be kind of a point where we have a day of reckoning in the labor markets directly related to artificial intelligence?

Jeff Schulze: There will be, in my opinion, you've seen a pattern play out over past technological shifts dating back to the steam engine. And history shows that most job losses in areas impacted by technological development occur during recessions, not expansions. So when you have economic strength, you usually have more of a slow bleed in these routine jobs. And the big shifts happen when you do have economic weakness, and corporate managers have to face a hard choice to either protect their margins and resulting in a proper layoff cycle, or not protecting their margins. And usually they will choose to protect their margins.

I think a good parallel of what may lie ahead when this economic cycle eventually ends is the period following the tech bubble, known as the jobless recovery. It took a lot of years for total employment in the US to get back to levels that were there prior to that recession.

So I think there will be weakness, but I certainly don't think that that's going to be the case over the next couple of years with the economy being relatively strong.

John Przygocki: Jeff, let's stay on the artificial intelligence topic, but pivot a bit and talk about all the news related to current corporate capital expenditures that we continue to hear about. Can all of these companies continue to spend at these astronomical levels?

Jeff Schulze: They can. You've seen a huge move higher for consensus 2026 capex expectations for the hyperscalers just over the course of the third quarter earnings season. And as a reminder to the listeners, the hyperscalers are Amazon, Google, Meta, Microsoft. And now we have Oracle, part of that group.

And over the course of the two months, so as we made our way through the third quarter earnings season, expectations for next year’s capex for these companies rose from $467 billion to about $530 billion, which is a massive move over a short period of time. This is something that we've seen over the last couple of years. Analysts have been consistently too conservative. I think that that's probably going to continue in 2026 and in 2027.

Now, I think this is great news for AI infrastructure stocks. I think there is a concern that some of this capex is going to have to continue in order to stay competitive for the hyperscalers, which will prolong the capex cycle overall, but this will eventually lead to tears. There's going to be overcapacity. There's going to be double and triple ordering for chips, just like we saw in the later part of the tech bubble for that emerging technology.

John Przygocki: Jeff, so during the month of November, investors really seem to experience some whiplash with the odds of a December US federal funds rate cut oscillating from cut to no cut back to cut. What are your expectations for this December's FOMC committee meeting? And quite honestly, for 2026 from the Fed?

Jeff Schulze: Well, it's been a bit of a rollercoaster ride, this to say the least. But right now if you look at Fed fund futures, they're pricing in a 98% chance of a rate cut at the next FOMC meeting next week.

And I agree with that. You've seen a pretty big jump of the unemployment rate over the last three months. That is a better barometer of labor market slack, if you will. Williams from the FOMC has endorsed a rate cut after that September jobs release. You've had some weakness in ADP jobs data. The Beige Book had some labor market weakness. Also, I think importantly Powell has not pushed back on the markets basically pricing in a cut next week going into the blackout period. So when you put that mosaic together, I think the Fed will cut. And looking to 2026, it's really going to be contingent on the data. I really don't see another cut coming until we potentially get a new Fed chair, towards the middle part of the year.

But between December and January's FOMC meeting, we have three payroll prints and two CPI prints, which could really kind of change that calculus. But in my view, I think it's three cuts and a pause for the FOMC. Again, we've had two cuts and we're going to get another one in December.

John Przygocki: All right, Jeff. You mentioned there that we will have a new chair of the US Federal Reserve. Do you have an opinion on who that will be?

Jeff Schulze: I think it's Kevin Hassett’s to lose. He's the White House NEC director. I think, you know, when you look back to Trump appointing Powell, although Powell has been a very dovish FOMC chair, I think that he would like to put someone in that position that's going to be more supportive of the administration's policies, which would be lower interest rates.

And I think Kevin Hassett will be the most likely to do that from the president's perspective. If Hassett’s the next Fed chair, I think that's going to be really good for risk assets. It means stocks are likely going to move higher. Front-end rates are going to be lower. The curve is going to steepen. And, ultimately, I think it's a Goldilocks environment where Hassett is dovish enough to create this move in risk assets to the upside, but he's going to be constrained enough by some of the Fed hawks out there to prevent yields from moving too much higher and inflation expectations moving higher as well.

And people forget just because you have a Fed chair in there, you still have a committee of 12 people that make monetary policy. So, while the chair may lean dovish and more cuts, ultimately it's the committee that's going to decide the fate of short-term interest rates. So, again, we're not going to find out who that chair is until January. But I think once we do get a new chair, I think we get one or two more rate cuts in the back half of the year, and I think that's probably about it.

John Przygocki: So, rate cuts are obviously one way that the Fed can help the economy. Quantitative easing, more commonly referred to as QE, is the other. Will the Fed change its balance sheets stance?

Jeff Schulze: I think the Fed has to. If you look at just the last couple of weeks, you've seen repo rates experience some strong upward pressure, moving through the upward bound of the target range of the Fed. So the Fed needs to expand the balance sheet to go from a scarce reserves environment to a more ample reserves environment. So I think they're going to do reserve management purchases, which is different than QE.

QE is meant to stimulate the economy. When you do reserve management purchases, that's increasing the balance sheet, so money markets and short rates and repo rates can function appropriately. So I think the Fed's probably going to be, you know, increasing their balance sheet by $20 to $25 billion per month net as we move into 2026. But I don't think it's going to be enough to really move the needle when it comes to increasing financial conditions and making them a little bit more easy. I think this is a positive dynamic for risk assets. And I think this is going to become much more into the spotlight once we get past the December FOMC meeting.

John Przygocki: All right. So, let's transition our conversation to the capital markets. Surprisingly the S&P 500 finished up for the month of November, even though we had some strong selling pressure to start off the month. What's the market telling us?

Jeff Schulze: We've had a little bit of a chop here in early December, but when you look at risk barometers, they're all broadly positive. Consumer discretionary is outperforming consumer staples. Travel stocks, the airlines, transportation is all doing well.

You have this reflationary vibe from copper. Global rates are moving up on the back end across the globe right now. Basic materials are doing well. The Bloomberg Commodity Index is close to a three-year high. I mean, these are really positive signals that participants globally think that reflation is going to occur rather than inflation, which would be a very different outcome for the equity markets generally speaking.

So this is a good dynamic. And I'm really happy about the cyclicality that we're seeing in leadership. And I think that that will persist over the next couple of quarters.

John Przygocki: Jeff, we're now through third quarter earnings season. As you reflect, what are your key takeaways?

Jeff Schulze: It was a blockbuster earnings season. Earnings surprise was 7%, which is the best that we've seen in a couple of years. Overall earnings delivery on a year-over-year basis was the best in four years. Revenue growth was great. The revenue surprise that we've seen was double the historical averages. Guidance was really strong. When you put all of this together, this is a reason why the markets have been resilient. And, ultimately, when you look toward future quarters, you really haven't seen a revision lower in expectations.

Usually as you move toward a quarter's earnings delivery expectations move down and companies beat a lower bar. That didn't happen in Q3. It's not happening so far in Q4. And, ultimately, I think that this is a reason why the markets can continue to rally as we turn the page to 2026.

John Przygocki: You mentioned that you were expecting a broadening of performance last month, where the laggards of the past couple years do much better compared to the Magnificent Seven¹ stocks. How has that been playing out?

Jeff Schulze: Well, since the end of October, the Magnificent Seven has underperformed the S&P 500 by about 2%. And it's underperformed the equally weighted S&P 500 by close to 4%. So this is a positive dynamic. And I think it comes back to earnings delivery. It's been a “show me” moment where we've been waiting for this broadening out of earnings to the rest of the S&P 500, small and mid-cap stocks.

And you've started to get a really good glimpse at that starting to take place. And investors are starting to price that appropriately. And with valuations in the Mag Seven and the largest companies in the world being so much more elevated versus the rest of the US equity complex, investors are going to go to those cheaper sources of earnings growth.

And when you look out to 2026 expectations, the Magnificent Seven does not have a durable advantage on expected earnings delivery versus small, mid- and the rest of the US equity landscape. So I think that this broadening of participation will continue. And a surprising stat that I came across here recently is that only two of the Magnificent Seven stocks so far year to date are outperforming the S&P 500, which is Google and Nvidia.

So this is a great dynamic. I think that this will continue as again we look forward to next year.

John Przygocki: As 2025 comes to a close and we move into the new year, the continual debate of active versus passive management is out there. Do you have any thoughts as we move into the new calendar year?

Jeff Schulze: I think active managers have a competitive advantage that we have not seen in a long time over passive indices.

You have the top 10 names in the S&P 500 making up over 40% of the index, which is at historic highs. And what that really means is that there's a lot of embedded expectations into those largest companies, and things are going to change. Just earlier this week, Open AI CEO Sam Altman declared a code red because of intensifying competition from Google and Anthropic.

This is an example of how quickly things can change in the AI space, and that no one's lead is safe. And I can't help but think back to the internet era when you had the browser wars. There were some questions on who would win the browser wars, and believe it or not, Google Chrome now dominates the browser space with about 70% market share, and this wasn't even released until 2008, which was almost a decade after the internet bubble burst.

So, what this tells me is that the battle for AI supremacy, there's a lot more to the story, and there's a lot of runway; and, ultimately, there could be winners and losers that aren't being reflected right now in the equity markets. And I think that active managers that understand this evolving technology, that understand the embedded expectations, I think they're going to have a competitive advantage over the passive indices just given where that concentration of risk currently lies.

John Przygocki: So, Jeff, a couple final questions for you. How about the S&P 500? Can it move higher with a forward P/E [price–earnings ratio] of 22.4 times earnings?

Jeff Schulze: I think the S&P 500 can move higher. And you just look to this year alone. The S&P 500 as of yesterday's close was up around 17%. Believe it or not, coming into 2025, the forward P/E of the S&P 500 was 21.5 times earnings. Today, it's less than one turn higher. It's only 22.4 times forward earnings. So the vast majority of this year's performance has not been multiple expansion. The vast majority has been earnings delivery. And when you look out to next year, I think earnings delivery is going to be strong. And it's going to create more positive momentum for gains in the S&P 500.

So, while I don't think multiples are moving lower from here, because traditionally when you have a Fed that's cutting and you have double-digit earnings growth, multiples don't move lower. They actually move higher in that environment. I don't think that is going to preclude the S&P 500 from having a good year in 2026, because at the end of the day, earnings have driven this year's performance. And I think that's going to be the case again next year.

John Przygocki: All right, Jeff, so as we look to conclude today's conversation, last question. Do you have a closing thought for our listeners?

Jeff Schulze: I think the US soft patch is ending. We've had the shutdown come to a close. Now the government is reopened. You've had fears of an AI bubble. You've had some private credit cockroach concerns. You've had a wobbly labor market. But when you look at the holiday sales reports, you look at the fact that initial jobless claims came in at the lowest that we’ve seen since 2022 today, I think that soft patch is ending. And when we look to next year, with the Fed cutting rates, with the peak fiscal impulse of the One Big Beautiful Bill, with better visibility on the trade front, and I think importantly, the fact that businesses can start to immediately deduct capital expenses on equipment and R&D, I think that creates much broader capex outside of the AI space, which is going to drive the economy and ultimately drive good earnings delivery for US equity. So, we continue to be in the buy-the-dip camp. We have been, and we're not changing that for 2026. But I think something that is important is that diversification is going to be much more helpful.

And I do think the laggards that have seen some life here on a relative basis versus the Mag Seven are going to do better and continue that relative performance next year.

John Przygocki: Jeff, thank you for your time here today. To all of our listeners, thank you for spending your valuable time with us for today's update on the US economy and capital markets. If you'd like to hear more Talking Markets with Franklin Templeton, please visit our archive of previous episodes and subscribe on Apple Podcasts, Google Podcasts, Spotify or just about any other major podcast provider.