AOR Update (Podcast): Are Current Strong Earnings a Bubble?

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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're your trusted partner for what's ahead.

I'm here today with Jeff Schulze for our monthly conversation focused on the state of the US economy. Jeff is the Head of Economic and Market Strategy at ClearBridge Investments. ClearBridge is an active equity manager at Franklin Templeton, offering a broad range of strategies across global markets. Jeff, welcome to the show.

Jeff Schulze: Excited to be here, John.

John Przygocki: Jeff, let's kick things off as we normally do with the US economy and the ClearBridge Recession Risk Dashboard. Have we witnessed any changes in the last month?

Jeff Schulze: Well, we haven't. If you look at the dashboard right now, out of those 12 individual indicators—and as a reminder, it's a stoplight analogy—11 out of 12 of those are currently green, zero are yellow, and only one is red. So, this is about as good of a dashboard as you're going to get. And this output is historically consistent with recession odds of only 15% over the course of the next 12 months. Now, given the unresolved issues in the Middle East, we've nudged that modestly higher to 20%. But the key takeaway here is that the economy has been on a solid foundation all year and continues to be so.

John Przygocki: Jeff, the labor market has taken a turn for the better this year, going from, you might say, zero to hero. Initial jobless claims came out today and we get the jobs report tomorrow. How are things looking on the employment front in the United States?

Jeff Schulze: Well, the labor market has gotten dramatically better over the course of the last couple of quarters, and initial jobless claims are still below 200,000 per week. And to put that number in perspective, just a couple of weeks ago, you saw the lowest initial jobless claims print since 1969, which is remarkable considering in 1969 that the labor force was a fraction of the size that we have today. So, we're in this low-fire environment. The labor market is healthy.

And more importantly, what you've seen this year compared to last year is a broadening out of the types of jobs that are being created. So, the labor market has broadened, it's gotten stronger, and I think that's ultimately a really positive development for the longevity of this expansion.

John Przygocki: The US consumer has really fared much better than expected, considering the spike in oil prices in the first half of 2026. Why is that? And frankly, can it continue with the stimulus from the One Big, Beautiful Bill in the rearview mirror?

Jeff Schulze: Well, we got a second-quarter GDP print here recently, and although the headline number was a little disappointing at 1.5% annualized, when you look underneath the surface, the composition was really strong. And what was really carrying second-quarter GDP was consumer spending. It rose at 3.2%. And that was partly because of the tailwinds of the One Big Beautiful Bill. People got larger tax refunds, and they got more in their paychecks because of lower tax-withholding tables. But you also did have a boost from the World Cup in June. But I think, more importantly, this came on the back of higher energy prices. And even though I'm expecting consumption to move back to, say, 2%, so a little bit lower than what we saw last quarter, that's still pretty good, all things considered.

And I think a key driver of that is no longer going to be stimulus, but it's going to be a resilient labor market with that broadening of job creation that I talked about before. But, also, with the stock market back near all-time highs, that's really going to support the upper households that have been a key driver of consumption over the course of the last couple of years.

So, the consumer has been resilient over the last six years against consensus expectations time and time again. And that's proving out yet again here in 2026.

John Przygocki: There have been some concerns of a K-shaped consumer in recent years. Is that still an issue?

Jeff Schulze: It is an issue. But the K-shape consumer is closing a little bit. And the reason why I say that is that Bank of America, they looked at all their credit and debit card data. And over the last two weeks, lower-income households have actually had stronger year-over-year spending ex gas than high-income households.

So, there's a couple of reasons for that. First, spending by lower-income households is much more sensitive to labor. And again, with that pickup of job growth, that's helping that cohort. And I see that continuing over the next couple of quarters. Secondly, you have more in your paychecks because of lower tax withholdings of the One Big Beautiful Bill. Third, lower-income households spend more of their paychecks on gasoline, and gas prices fell substantially in the back half of the quarter. And then, lastly, the gap between higher- and lower-income spending really gapped higher about a year ago. So, because of base effects, that gap is going to narrow and even reverse as we move through July. So, there's a number of different reasons why you're still going to have a K-shaped consumer, but it's not going to be as pronounced as what we've seen. And I think the labor market is a key driver of that.

Now, one thing I will say is, at the very low end of the spending spectrum, you could see some pain, because enrollment in the SNAP programs—so food stamps—it declined a lot more than what the Congressional Budget Office projected due to changes in the One Big Beautiful Bill. The CBO projected that it would drop by 2.8 million. It's actually declined by almost double that at 5 million people, the reason being changes to what is considered eligible for participation. Prior to the change, in order to be eligible for SNAP, you had to be in an area that had an unemployment rate of 10% or higher, or in an area that was seeing impacts to the insufficient job opportunities in a particular area. So, there's a subjective aspect to it. Now, you can only be eligible if you're in an area that has an unemployment rate north of 10%.

So, the K-shaped consumer is closing, but with the caveat that at the very, very bottom of the income spectrum, you could see some pain because of these changes in enrollment in the SNAP program.

John Przygocki: Jeff, I think it's a pretty fair statement to say that the artificial intelligence capital expenditure boom has been an important driver of the recent economic activity. Are there any signs of that spending slowing down?

Jeff Schulze: No. Quarter after quarter, that spending continues to ratchet higher. We saw it pretty consistently with the hyperscalers as we moved through second-quarter earnings. And right now, consensus expects the hyperscalers to spend $750 billion this year. Next year, that number is going to be north of $900 billion. So, this is an important dynamic, because it helps not only economic growth, but it helps that AI ecosystem from an earnings perspective.

Now, one issue is that the hyperscalers are no longer using free cash flow generation for all of that spending. They have more reliance on debt and equity financing. But, at this point, it's still pretty manageable overall. But when you look at major technological innovation cycles throughout history, this suggests that this spending cycle could continue at these levels or even a little bit higher into 2027 and into 2028.

So, overall, this has been something that has been underestimated by consensus on a fairly consistent basis. And I think that continues as we move through the next couple of quarters.

John Przygocki: From your vantage point, are you seeing any other positive drivers of economic growth?

Jeff Schulze: Well, we are seeing a genuine industrial cycle at this point. So, AI is obviously a key driver of that. But AI is not the only source of growth. When you look at corporate commentary from key industrial bellwethers, the broader capex cycle is finally underway. For example, Old Dominion Freight. They said that they're encouraged by the continued improvement in demand that began late last year. Illinois Tool Works, which is the company that produces engineered fasteners and components, noted that growth was pretty broad-based. Heavy truck manufacturer Packard said that reshoring for local efforts are happening in the industrial base right now for trucks. So, these are anecdotes that you're hearing pretty consistently from different subsectors of the industrial economy.

And this is not just an AI story. One of the most widely followed measures that we look at for business investment is non-defense capital goods ex aircraft orders and shipments, better known as core capital goods. That's been growing at a double-digit pace. So, this is a good dynamic. It's not just an AI story. It's not just a consumption story. You're starting to see a genuine inflection for manufacturing in the industrial economy. And I think that that's going to continue to hold true as you move through the next couple of quarters.

John Przygocki: Jeff, the S&P 500 index is once again approaching all-time highs after a multi-month period of consolidation. Is there anything that jumps out at you regarding this recent rally?

Jeff Schulze: Well, the rally that we've seen over the last couple of days has been breathtaking. You've seen the S&P 500 trading from a 20-day low to a fresh cycle high, which is one of the swiftest reversals you've seen in over 75 years’ worth of data. You've seen 90% of financials above their 200-day moving average. Tech is sporting the highest percent above the 200-day moving average all year. And the market has been super resilient with the hedge funds implosions that we've seen, the historic yen interventions, the breakout of yields following the FOMC meeting a couple of weeks ago. And ultimately it comes back to earnings. The earnings growth that we're seeing today has only been seen following major economic shocks in the Global Financial Crisis and the post-COVID reopening. It's been a resilient tape. And I think earnings are a key reason why. And it's a key reason why we're constructive as we look forward.

John Przygocki: The companies that are commonly referred to as the hyperscalers—so, the very large tech firms—have been a part of this rally over the past week or so. Do you think that that will continue, or do you expect the broadening theme, as we've seen play out here over the last year or so, to continue?

Jeff Schulze: Yeah, you've seen Amazon break out. Meta's had a nice bounce following the selloff you saw following their results. Microsoft had its best five-day surge in over 40 years. So, the bounce that you've seen in the hyperscalers has been pretty robust. And I wouldn’t be surprised if they have a run over the next month or two.

But one reason to expect a broadening theme to continue comes back to expectations for 2027 earnings growth. Since 2023, the Mag Seven has been outgrowing the rest of the index or the S&P 493 by wide margins. It happened in 2023, 2024, 2025 and 2026. But when you look to next year, consensus expects the Mag Seven to grow their earnings by only 5%. The rest of the index, 17%. So, although you are seeing a nice bounce in the hyperscalers, I think you are going to see a return to that broadening theme. And a key reason is that the hyperscalers continue to spend at elevated levels with this winner-take-all type of investment cycle that you're seeing with AI. But also, that earnings picture is going to be drastically different than what we've seen over the last four years.

John Przygocki: Currently, we're about two thirds, you might say, through the Q2 2026 earnings season and results being posted. What are your key takeaways, Jeff, at this point?

Jeff Schulze: It was a high bar coming into this earnings season, and that bar was beaten yet again. Right now, the number of companies that are beating EPS is at 77%. Earnings are tracking 27% on a year-over-year basis if you exclude the investment markups, the one-time markups that you saw from Google and Amazon in investments like Anthropic and SpaceX.

So, this has been a really strong quarter overall. Revenues are beating at 72% of companies, which is an extremely high rate as well. And guidance has been really constructive. A lot of people felt that the bar was going to be too high this quarter. But, yet again, corporate America has delivered in an environment that you've had a lot of uncertainty and higher energy prices.

John Przygocki: So let me follow that up with maybe an obvious question, which is, are earnings in a bubble?

Jeff Schulze: I've heard this asked of me several times over the course of the last quarter, and the answer is no, because when you think about an asset bubble, it's a price concept, right? A bubble is when a price gets so high that you really can't justify the value of the underlying asset. And that asset could be a stock. It could be the commodities complex. It could be pretty much anything. Earnings is an income stream. It's not a price. So, an income stream really can't become a bubble.

And the way that you can say that maybe it's a bubble, or earnings are inflated, is if you have some sort of fraudulent activity. You saw that in the late ’90s with WorldCom. You saw it with Enron. But, you know, there's no evidence that that's happening right now. Another way that you could potentially have inflated earnings is companies are using leverage to temporarily boost their profits, but that's not what's happening right now. Corporate debt-to-GDP ratios have been trending lower.

So yes, earnings are good, but I don't think that there's any reason to doubt the earnings that we're seeing. And although you are getting some one-time boosts from companies like Google, like I mentioned before, the underlying fundamentals of this earnings cycle are strong. And you could take it at face value.

John Przygocki: So, Jeff, a couple of elements that could potentially short circuit the rally are inflation and the US Fed and their action. June's CPI report was well below consensus expectations. Can that be repeated again this month?

Jeff Schulze: It's not going to be repeated. I can say that pretty confidently. The reason why I say that is that core CPI declined in June. It's only the seventh time that core CPI has declined since 1985. So, 40 years, you've only seen a negative print seven times, so it's not going to be that weak.

And there was a lot of temporary factors that exaggerated that weakness. You saw a huge drop in wireless phone services, motor vehicle insurance and lodging. But ultimately, consensus is expecting 0.2% inflation on core on a sequential basis. And I think that's a pretty good estimate.

And when you think about the three major buckets of inflation, you have goods inflation. And I think goods inflation is negligible. I think the peak passthrough of tariffs has already happened, and the year-over-year comps are going to be more difficult. You have shelter inflation. That's going to continue to move lower. And then super core, which is services inflation ex shelter, which the Fed looks at really closely because it is tied to demand, I think is going to be relatively intact because the labor market, although strong, you're not seeing a big pickup of wage growth. So, I think inflation is going to be tame, and it potentially could keep the Fed on hold as we move closer to that September FOMC meeting.

John Przygocki: Interesting. We all know that Kevin Warsh is the new chair of the US Federal Reserve and that capital markets have had some indigestion regarding the path of US Fed policy. Why is that?

Jeff Schulze: It's important to remember that when you have a new Fed chair, the stock market likes to test them, right? The average drawdown in the first year of a new chair is 17%. When you look at all calendar years, it's 14%. But, you know, the reason why the markets have been giving some pushback to Kevin Warsh is Kevin Warsh has not defined the Fed's reaction function. He's talking about moving back to the inflation target of 2%, but he really hasn't talked about how to get there. So the markets don't have the clarity. And that's what's really pushing up yields and creating a little bit of market volatility.

Now, ultimately, I think that we will potentially see a move from the Fed over the next couple of quarters. But given the strength in the economy, even if the Fed needs to tweak policy at the margin—hike by 25 basis points, hike by 50 basis points, maybe cut by 25 basis points—it's not really that important because of the strength of the economy that we talked about earlier. The Fed really starts to come into play more critically when you're in a downturn and you need a more aggressive Fed policy response.

And that's not really what we're seeing right now. So, although you have seen some volatility regarding Kevin Warsh, because you don't have visibility on that reaction function, I don't think that this is a reason to be concerned about the trajectory of the markets in the near term.

Jeff Przygocki: So, Jeff, how do you feel about Chair Warsh’s stance on providing less forward guidance?

Jeff Schulze: I like it. If you think about why forward guidance came out, it came out in the aftermath of the Global Financial Crisis. The Fed was out of options. Rates were at zero. They were doing balance sheet policy, but they needed to ease financial conditions further. And the way to do that was to overcommunicate their intentions to the public. And it worked really well.

But you fast forward 15 years, which is where we are today. Very different scenario, right? We have above-trend inflation. You have a healthy growing economy. Earnings are booming. And that policy prescription really just isn't good for this type of environment. By providing forward guidance it locks them into a predetermined path and it's harder to pivot.

So, I think we're at the right point in time where you need to eliminate that forward guidance. We're in a different regime, and although you will see higher volatility because of the lack of transparency, ultimately, I think it's going to be healthier for the markets and you're going to get clearer signals from the markets on the direction of the economy going forward.

So, I agree that forward guidance is no longer needed. But I also think that the Fed needs to provide a clearer idea of what the reaction function is going to be in regard to inflation and different economic shocks.

John Przygocki: Jeff, as we look to conclude this afternoon's conversation, I want to ask you for a closing thought for our listeners.

Jeff Schulze: Well, today we have a firm economic backdrop. You have a strengthening industrial cycle, stable labor market, resilient consumer. And that really supports the case for broader earnings leadership in the second half of 2026 and into next year. If you look at the equally-weighted S&P 500, it's outpaced the cap-weighted version of the S&P 500 by 3% over the first seven months of the year.

I think that there's more room to run there, especially considering that divergence in earnings that I talked about for the Mag Seven and the S&P 493 that's expected next year. So I think that this is going to be a great environment for active managers that can sidestep some of that concentration risk. But, also, we're buyers of dips should they materialize. And I know I sound like a broken record because I end every one of these podcasts over the last quarter or two with that statement. But given this strong earnings environment and how the market has been able to shrug off a dramatic change in Fed funds pricings, a dramatic move in oil, dramatic move higher in yields, I think that is very indicative of a healthy market environment. And I think earnings are going to continue to pave the way as we move through the back half of this year.

John Przygocki: Jeff, thank you for your thoughtful insight. 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, Spotify, or just about any other major podcast provider.