AOR Update (Podcast): Soft patch ahead for US economy?

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. We are 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 current state of the US economy. Welcome to the show, Jeff.

Jeff Schulze: Thanks for having me, John.

John Przygocki: Jeff, as we approach the midpoint of the year, I'd like to check in on the health of the US economy. What is the ClearBridge Recession Risk Dashboard saying about today's economic backdrop?

Jeff Schulze: Well, there were no changes in the month of June. So you still have a very strong green expansion color coming from the dashboard. And as a reminder to the listeners, it's a stoplight analogy. Green is expansion, yellow is caution, and red is recession. And when you look at the 12 individual indicators, eight are green, two are yellow and two are red. But given this current output, our odds of a recession have actually gotten better over the course of the last month, and it's now 30% probability over the course of the next 12 months to the middle part of next year.

So, although we didn't see any positive changes this month, we did see some progress underneath the surface, which is always an encouraging development.

John Przygocki: Is there a particular indicator that we should be watching as we move forward into the second half of 2025?

Jeff Schulze: Well, there's a couple. The yield curve has been flirting back with inversion territory, but the one that I think may grab the attention of market participants is initial jobless claims. Now, as a reminder to the listeners, initial jobless claims, we like to call it our economic canary in the coal mine. Usually, it tells us when we're on the doorstep of a recession. And really what it measures, it measures the number of first-time filers for unemployment benefits. And it provides a good read on how many job losses may be occurring at any point in time.

And this is a top-ranked variable in the dashboard. It's 12%. And the reason why we place extra emphasis on initial jobless claims is because it has a really strong track record. Zero false positives since the 1960s. It's a high-frequency data release. It comes out weekly. And also, it only sees minor revisions. So when we get that data, we can largely take it at face value.

Now when you look at initial jobless claims, they followed an unusual seasonal pattern over the most recent years. They tend to pick up in the early part of the summer, and then they drop down as you get back-to-school hiring around the later part of August. And because of this seasonal distortion, we've been looking at non-seasonally adjusted data.

The reason why they seasonally adjust data—because if they didn't, you're going to have these huge peaks and valleys of data throughout the year based on spending trends. But when you look at it non-seasonally adjusted, yes, you're seeing this pickup of claims which you see every year. But when you go back to 2022, 2023, 2024, you see this happen year after year and it starts to drop as you move back to the end of August.

So, when you look at it through this lens, it's a much less concerning development. And if investors get nervous like they did in 2023 when claims started to pick up, we would fade that narrative and be putting money to work actively in equities should there be a little bit of a hiccup.

John Przygocki: So, Jeff, I believe we just had a terrific jobs report for the month of June. Can you tell us a little bit about that particular release and whether you expect strong prints to continue in the back half of 2025?  

Jeff Schulze: Now, that was a jobs report where it's really hard to poke some holes into. You had a trifecta of positives that sent the labor bears back in the hibernation. Right? You had a drop in the unemployment rate to 4.1%, where consensus was actually expecting it to pick up to 4.3%. So that's a good development.

You had a solid beat on the headline number. The beat was about 40,000 over consensus expectations. It came in at 147 all in. And you had positive revisions to the prior two months. You also had softer average hourly earnings, which suggests that wage inflation isn't going to be problematic from the Fed's vantage point down the road.

So, it set up a Goldilocks scenario. And the markets clearly liked it. And it was a good news event. But I want to caution everybody that looking forward, investors may need to recalibrate their views regarding what normal level of jobs growth is in the US. And when you look at job creation, it's been slowing since the pandemic.

You had an average of around 216,000 in 2023. That dropped to 168,000 last year, 130,000 per month in the first half of the year. And when you look at consensus expectations, people are expecting 74,000 average monthly job creation in the back half of this year. So, even just a couple of quarters ago, a drop below 100,000 would have been viewed as a pretty big negative. But I think consensus understands that there's a lot of headwinds out there. You have the DOGE-related layoffs that are starting to show up in the data. You have an aging population. You have reduced immigration flow. And that all suggests that below 100,000 may become the new normal.

So, when this does start to happen and it will happen, I want to just caution everybody to understand that this is not a negative dynamic. This is what you typically see as an economic cycle matures and the pace of labor creation shifts into a lower gear. And I think that this cycle is going to be no different. But initial jobless claims, job creation, job openings, these all suggest that the labor market is still on a pretty healthy foundation.

John Przygocki: So it's on a healthy foundation, but it does sound like you expect for there to be a bit of a labor market slowdown. What are your views on the economy then, near-term, specifically thinking about the Q1 negative GDP [gross domestic product] print we experienced?

Jeff Schulze: There's no doubt that there's going to be a soft patch in activity over the next couple of quarters. You're seeing it in the consumption data. You're seeing it in housing. You're seeing it in Capex [capital expenditures]. A soft patch is coming, but also the economic data is going to be pretty choppy as well. And it's all because of the huge pull forward that you had in demand ahead of the “Liberation Day” tariffs. And with this pull forward, businesses and individuals are going to have to work through that extra stock, that extra inventory, which could create an air pocket in demand as you look forward.

So when you look at that first-quarter GDP print, it came in at negative 0.5%. But the reason why it was negative, because you had that surge of imports and imports subtract from GDP. And when you look at imports minus exports, net trade if you will, that contributed -4.7% to that Q1 number. So without that happening Q1 would have been broadly positive.

So you're going to have some choppiness. And what we've been advocating to our clients is that you want to look at core GDP concepts like real final sales to private domestic purchasers. Core GDP. They have core CPI. Core GDP is the same thing. Strip out volatile things like trade, imports, exports, inventories, government spending. And it's a much better reading on the health of the economy.

And although you did have a negative first-quarter GDP print, looking at this core GDP concept, it came in at 1.9%, which is at the lower end of the average for this measure that you've seen over the last three years at 2.6%. So, things are going to get choppy. We may have an air pocket in economic activity. But I would suggest looking through that air pocket because of the health of the Recession Risk Dashboard. But also, we're going to get some help from the Fed [Federal Reserve] and the government fiscal spending package next year, which should help the economic activity reaccelerate.

John Przygocki: So, Jeff, you mentioned tariffs there on the front end of that answer. Tariffs are now back, front and center after the Liberation Day pause was extended to August 1. And the Trump administration has sent out letters to at least 12+ trading partners. What are your thoughts on the trade front today?

Jeff Schulze: Well, just today I think another eight trading partners got letters so that the number is growing. And when you think about tariffs, it's really been a one-way street of positivity over the last three months. And I think we're at that point where it's going to be more of a two-way street, or it might be a little bit more hawkish.

You may have to ratchet higher expectations for what that effective tariff rate is going to be in the US. Now, right now the effective tariff rate is probably close to 14%. Given the deal that happened with Vietnam, the fact that Vietnam has 20% on all their imports to the US, 40% on any imports that are believed to be trans-shipped from areas like China, and 10% basically being the baseline for every country that the US is negotiating with, I think that tariffs are going to be higher than what consensus expected. So maybe the average effective tariff rate is going to be 16 or 17%. And with there still being not a lot of visibility right now until at least we get to August 1, I think the markets could be a little bit choppy in this environment.

But the good news is that there was extra road that was built. We went to the tariff pause date. That road was built to August, which gives the administration more time to work with countries to get concessions in order to come to a deal with a trade announcement. Also, letters weren't sent to the European Union, India, Taiwan, Switzerland, which account for a much larger share of US imports, which is a signal, at least from my vantage point, that a lot of these larger trading partners are likely to announce deals, or at least in a better position to avoid tariffs going forward.

John Przygocki: So it seems pretty obvious that tariffs present a headwind. Do we have potentially a positive counterbalance here with the signing of the US “One Big Beautiful Bill?” And how important will that bill be for next year's outlook?

Jeff Schulze: It's very important. Obviously tariffs are a headwind. The tailwind is going to be the One Big Beautiful Bill. It's also going to be deregulation. And when you look at the One Big Beautiful Bill's net fiscal impulse (So how much is it adding to economic growth? And the final score hasn't come in. What we're talking about are numbers that were from the Senate version. But we're relatively close to this. You're going to get the peak fiscal impulse or hit in a positive capacity to the economy next year of about $270 billion, which is close to 1% of GDP.

So not only did this tax package extend the Trump tax cuts from 2017, there's a lot more stimulus that's going to help the economy reaccelerate next year. Now some of it's on the individual side. Individuals are going to start to feel some of this benefit as early as this fall, when tax withholding tables are adjusted for individuals that have taxes on tips or overtime, now that there's no more taxes on certain individuals for that. The bulk of it on the individual side is going to come in the first half of next year when people file their tax returns. Corporates are already actually starting to feel this. The corporate tax filing season is September 15th, and many of the OBBB corporate tax provisions are retroactive to January 1 this year, which means these impacts are going to start to already occur here in Q3.

That's full expensing for manufacturing structures, factories, larger R&D credits. And these are the types of things that are going to help spur economic growth through greater Capex. So obviously this is the dessert portion of the Trump administration's agenda. It's here front and center and, rightfully so, the markets are reacting to that. And I think that is going to be a key driver of economic momentum, coupled with a Fed rate cutting cycle sometime in Q4 or Q1 next year.

John Przygocki: All right, Jeff, one follow-up on the One Big Beautiful Bill. With that now being signed into law, are you concerned with the US debt situation and you expect bond vigilantes to return?

Jeff Schulze: You know, I'm going to fade the bond vigilantes narrative. I know it gets a lot of press and a lot of headlines, but when you look at the OBBB, the Congressional Budget Office estimated that the Senate version would add about $3.3 trillion to the deficit over the next 10 years. Now, I'm not saying that's a small number, but the CBO also scored that tariff revenue was going to be $2.8 trillion over the next 10 years.

So, yes, it's going to add to the deficit and those numbers will change. So it's going to marginally add to the deficit, but not in a meaningful way. But what the OBBB does, is it basically normalizes 6% budget deficits for the foreseeable future. So government debt is going to rise. And you know, this is something that I think the US can accommodate.

And I don't necessarily think we're at a level where it's a crisis. You look at areas like Treasury auctions, there's no sign of weakness in demand. Bid-to-cover ratios are stable. Credit default swaps are doing very well. Inflation break-evens are doing fine. You're not seeing any stress in any of these areas where you would think they would pop up if there was real concern about debt sustainability.

The US is the largest economy, has the deepest financial markets, the dollar's the world's reserve currency, has the biggest military. There's a lot of reasons why the US can accumulate debt a lot higher and a lot longer than a lot of other countries that are out there.

John Przygocki: All right, Jeff. Another risk that investors clearly face are additional geopolitical issues, concerns. Does history tell us anything about these types of events as it relates to investing?

Jeff Schulze: History tells us a very clear message. Believe it or not, you look at all military skirmishes going back to the Korean War in 1950, if you had bought the day of that geopolitical event starting, on a forward one-, three- and six-month basis, your average returns were 1.4% positive, positive 2.8% and positive 5.9%. So, although these disruptions appear to be becoming more commonplace as we live in the post-pandemic world, history shows that these disruptions tend to be short lived as far as their market impact is concerned.

So, I don't think we've seen the last of geopolitical disruptions in the next couple of years. But should that happen, history shows that buying the dip has been a good move for longer-term investors.

John Przygocki: Alright Jeff, US equity markets have rebounded substantially here coming off the April 2025 lows. Do you have any perspective for investors as it relates to that experience and what we may see on a go-forward basis?

Jeff Schulze: The speed at which positive changes for the outlooks for both trade policy and geopolitics, how fast that can occur isn't really the only thing that has taken a lot of people by surprise.

Look at the S&P 500 [Index]. It fully recovered to its previous highs in just 55 trading days. That's the fastest rebound that you've seen in the past 75 years after you've had a 15% drawdown. And that's left a lot of people on the sidelines, right? It has been a furious rally, so a lot of people feel like you got to have mean reversion. You got to have some negative price action. And I am expecting some choppiness.

But I think people underestimate the potential for continued upside. So when you go back to 1950 and we look at the 10 largest 50 trading day rallies for the S&P 500, and today would have actually ranked number 10. But we look at those 10 largest. Average returns following that 50 day rally has been 6%, 10.5% and 16.5% over the next three, six and 12 months.

So, you've had this huge continuation of market strength, even though it may appear that the markets are pretty fully valued. And this threshold, that 50-day trigger happened on June 20. So I think the bigger surprise, looking down on a six- or 12-month basis, is that we may get stronger than anticipated gains in the year ahead.

John Przygocki: All right. So gains in the year ahead. How about getting a little bit more specific here? Where do you see the opportunities in US equity markets over the course of the next 12 months?

Jeff Schulze: Well we've been pounding the table that diversification is going to be much more helpful going forward than it has been in 2023 and 2024, where it was really a Mag Seven¹ world and everybody else was living in it. And it's been a bumpy ride so far in 2025. You've seen leadership oscillate. For example, value outperformed growth in the large-cap space by over 11% in the first quarter. It lagged growth by 14% in the second quarter. So you've had this kind of yin and yang type of experience.

But going forward, I think value is positioned pretty well in 2026. We may have a give and take in the back half of 2025. I could easily see growth outperforming in Q3. You have a growth slowdown. You have some volatility on the tariff front. The investors move to those higher quality mega-cap tech names. But in Q4, I think the markets may start to sniff out better economic momentum next year, Fed cutting cycle, clarity on the tariff front, that One Big Beautiful Bill fiscal impulse which is going to create better earnings, broader earnings, which is going to help a lot of these areas that haven't done so well over the last two and a half years. So there's a fundamental reason to like value, to like small and mid-caps as we move closer to 2026.

John Przygocki: So Jeff, do you see opportunity outside of the United States?

Jeff Schulze: I do. I do. I think, again, diversification is clutch. The international space or non-US stocks strongly outperformed in Q1. In Q2, it was more of a mixed bag, more of an equal performance profile. But if you look at global equity leadership, US versus non-US, usually one will lead from 3 to 14 years and then the pendulum will swing back to the other side and the other will lead for a prolonged period of time.

And the US has been leading since 2011, average annualized outperformance of 7.3%, which is about a 14-year period. So, we're probably getting close to a point where you may see that pendulum swing back to the other side.

John Przygocki: What about valuation in the non-US stocks? Do you think that that will be a—or maybe the—catalyst driving that performance?

Jeff Schulze: For long-time listeners, I've said this, for my entire career, valuations can stay cheap or expensive for a really long time. But you need a catalyst. And when you have that catalyst, valuations come sharply into focus.

And when you look at ACWI ex-US [MSCI All Country World Index] versus the S&P 500, generally speaking, the S&P 500 trades at a premium of 2.9 on the P/E [price-earnings ratio]. So it usually trades a little bit more expensive. Makes sense. The S&P 500 is more growthy and defensive. So it should trade at a higher P/E. Today it trades at a P/E premium of close to eight turns.

So we're well above the average that we've seen going back to the early 2000s. So even with ACWI outperformance in the first half, you still have a pretty big discount of global equities versus the US. So that certainly could be fuel for some relative outperformance.

But the real catalyst I think may be from this valuation standpoint and for non-US standpoint is the dollar. You go back and you look at those global leadership regimes. It's been heavily influenced by what the dollar has done. The correlation between the dollar and global leadership is around 0.64, which is a pretty strong relationship. And if you think the dollar is in the midst of a longer-term down cycle, you're probably going to want to have more non-US exposure than you've had, because going back to 1974 (we'll put some numbers around it), when you look at quarterly total returns, when the dollar was down, the S&P 500 on a total return basis returned 4.5% on average during that quarter. So pretty good. When the dollar was down, if you look at the IFA (so that's the developed international index), dollar was down, 6.9%. But you look at emerging markets when the dollar is down, 7.9%.

So although a weaker dollar is good for all equities, it really does supercharge non-US performance. And I could see the dollar strengthen here near term because everybody is bearish the dollar. Literally everybody. When everybody's on one side of the boat the opposite tends to happen. But looking out on a multi-year time horizon, I do see some dollar weakness. And I think that's going to be an underappreciated tailwind to the non-US space that, quite frankly, we haven't seen over the last 10 to 15 years.

John Przygocki: So, Jeff, as we move to the close of today's terrific conversation, do you have any closing thoughts for our listeners?

Jeff Schulze: I do, I think that we're going to have a soft patch of economic activity. The path for tariffs is going to get a little bit bumpier as we move forward. There are going to be countries that are going to see materially higher tariffs, and they may be the example that the administration wants to make with other countries. So it's not going to be all roses and sunshine on that front. But looking forward to 2026—and the markets always look forward—there's a lot of reasons to expect the economy to reaccelerate, whether that's the fiscal impulse from the tax bill that just passed, the Fed finally embarking on the rate-cutting cycle, visibility being restored on the tariff front, which will unlock animal spirits, whether that's better consumption on the consumer side, more Capex on the business side, and that all three should filter through to better earnings potential for US stocks.

And I think you're going to see a broader array of areas of the US equity complex do better than what we've seen in 2023 and 2024, when it was really narrow and focused on those mega-cap tech stocks. So I think that's an excellent environment for diversification. But given that I think it's going to be a broadening of the market, I think it's a really good environment for active managers that can sidestep some of that concentration risk that's embedded in the large indices.

John Przygocki: Thank you, Jeff, for your participation in today's conversation. To all of our listeners, thank you for spending your valuable time with us for today's update. 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 any other major podcast provider.