AOR Update (Podcast): Conflict, volatility and opportunity

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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. We're here today in the studio 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 studio.

Jeff Schulze: Great to be here, John.

John Przygocki: So, Jeff, given the backdrop that we've got, let's start off the US economy. How did the ClearBridge Recession Risk Dashboard hold up last month?

Jeff Schulze: The green overall signal continues to give us comfort on the health of the US economy. We did get the return of the Retail Sales indicator, which was no longer on hold following the government shutdown-related disruptions. And importantly, it has maintained its pre-shutdown green reading.

And then we still do have one indicator that is being disrupted by the shutdown, which is Housing Permits. But we think that we will have Housing Permits up to date at the end of this month when we get the Census Bureau release schedule. So, when you look at the dashboard, no changes this month. We do again get Retail Sales back, and we're still waiting on Housing Permits. But out of those 12 indicators, nine are green, two are yellow, and one is red, which is consistent with a pretty healthy economy and low recession odds over the next 12 months.

John Przygocki: All right. So, Jeff, how about energy prices? They've spiked here due to the conflict in the Middle East. Can the dashboard give us any insight how disruptive this is or will be for the economy?

Jeff Schulze: Absolutely. So, a key barometer of the fate of the US economy during previous oil price spikes has been the overall signal of the ClearBridge Recession Risk Dashboard. For example, when the US economy has had an overall green signal at the time of an energy price spike (and we're looking at spikes of energy that are increasing in price 60% on a year-over-year basis, so massive or major energy price spikes), when you've had an overall green signal, only one of the eight observations where this happened going back to the 1960s metastasized into a recession. And the one that did move into a recession was 1999 jump in energy prices, which actually missed the downturn by only a couple of quarters.

Conversely, when you have an overall red signal, it indicates that the economic backdrop is vulnerable to some sort of recessionary catalyst. And, every time you've seen an oil price spike of that magnitude with a red signal, all four of those instances developed quickly into recession. So, with that in mind, the current green signal that we have with the dashboard (and it's a strong green signal) suggests that the economy should be able to hold up despite the recent surge in oil prices.

John Przygocki: How about a historical view? How sensitive is the US economy to energy price spikes today compared to days of past?

Jeff Schulze: Less sensitive. I know that there's a desire to compare the current energy price spike to the 1970s. But if you look at the US economy, it's just structurally very different today. And there's been three key shifts that I think make that happen.

First, the US is energy independent. We produce more energy than we consume. And this is courtesy of the shale revolution. Second, there's lower energy intensity. For each unit of economic growth, you just use less energy today than what you did 50 or 60 years ago. And then you have reduced bargaining power for labor. Back in the late 1970s, you had a lot more people that were in unions. So, as inflation moved higher, oil price spikes pushed that inflation higher because of that bargaining power that created a wage spike, inflationary environment. And you really just don't have that dynamic today. So, when you think about those three key differences—energy independence, low energy intensity, reduced bargaining power for labor—the impact from higher oils to growth and inflation today is just much more muted than what you've traditionally seen.

And maybe give you an example of this. Consumers are spending about 4%, a little bit less than 4% of their wallet on energy goods and services. When you go back to the Gulf War in 1990, that number was 6%. When you go back to the 1970s, that number was 8 or 9%. So, the pinch from higher energy is just a lot smaller today versus history, which suggests that the economy is just much more insulated than what we've traditionally seen.

John Przygocki: All right, Jeff, we are clearly experiencing some substantial volatility in capital markets. Historically, has it been worth it to invest in US equities when we experience this type of volatility and a corresponding pullback in equities due to geopolitical unrest of this magnitude?

Jeff Schulze: To put it simply, it has paid to buy geopolitical dips historically. So, there's about 22 military conflicts that we've seen over the last 75 years. Korean War in 1950 is the first one that we looked at, and we wanted to put a chart together that looked at what happens after that conflict begins on a forward-looking basis one, three and six months ahead. And when you look three and six months ahead, the S&P 500 [Index] is up 2.9% and 6%, respectively. So, traditionally, it has paid to buy the geopolitical dip, embrace some of that uncertainty as these skirmishes are starting to develop. Now, importantly, you do have some poorer returns over the course of the last 20 observations, but those have tended to come during periods we've had larger conflicts that escalated into major wars. But, more importantly, broader economic conditions tended to supersede the geopolitical risk for markets, because a lot of the worst periods were military escalations that coincided with US recessions, like we saw in 1973 and 1990.

And, as I just mentioned, John, given the health of the dashboard right now, we do not think that this is going to be a situation where it's going to impact the market in a meaningful way over the course of the next six to 12 months.

John Przygocki: So, Jeff, in your quarterly Long View commentary, you discuss the wall of worry and many of the fears investors are harboring. One brick in that wall is the recent rise of unemployment and a weak labor market. Why is the unemployment rate rising? And does this foreshadow more trouble ahead?

Jeff Schulze: Well, the unemployment rate is rising for a couple of different reasons. First off, you've had massive changes in immigration policy and in trade policy. That is certainly bringing down the amount of labor coming into the US economy, especially compared to the last couple of years. You have an aging US population. So, the boomers continue to retire and exit the workforce. And then also, you had DOGE-related efforts to shrink the federal workforce. So, when you take all of these things in totality, this is a key reason why job creation is a lot lower than what we've seen over the last couple of years. But it's also a reason why you continue to see that unemployment rate continue to rise.

Now, due to the combination of factors that I just talked about, the unemployment rate has risen 100 basis points since April of 2023. That was the low point of unemployment at 3.4%. Now, what's notable about that is that this rise, 100 basis points, never happens outside of recessions. It's literally unprecedented since World War II.

An object in motion tends to stay in motion. It's the Sahm Rule. When the unemployment rate moves up in a durable fashion over a three-month period, you always have a recession. But that didn't transpire this time around. And when you look back to the last number of recessions, the longest lag between that low in the unemployment rate and the start of recession is 16 months. It's been 35 months since the low that we saw in 2023.

So, just due to a unique set of circumstances that we talked about with labor supply, aging US population, we think comparisons for the labor market today versus history are a lot less useful than typical. And I'm not really concerned about the labor market rolling over because there is still labor demand out there. But what I can say is that this time truly has been different for the labor market.

But I know we're seeing some weak prints here in February that took a lot of shine off of January's payroll print, but, ultimately, I see job creation moving up to 50 to 75,000 per month as we move into the back half of this year.

John Przygocki: Over the course of the last couple of years, you've talked quite a bit about artificial intelligence and the labor market. Few questions here. Any update on your view there? Many do fear that it could create this so-called “job apocalypse.” Is there any merit to that idea?

Jeff Schulze: The AI-induced job apocalypse fear is a considerable debate that's out there, and the fear is understandable. If AI displaces workers faster than it creates new workers, household income is going to fall, demand is going to weaken, corporate earnings are going to drop, and that's going to result in a recession.

But I think, when you take a step back, we already talked about the drivers of the higher unemployment rate. That's not related to AI. But I think when you look throughout history, with each major technological advance, there's been significant value created, but there's also been disrupted business models of existing companies that are out there. And AI is going to be no exception to that rule.

And although AI-driven displacement can lead to income loss and economic challenges for some, it's going to create job opportunities. For example, the investments in AI infrastructure that are already helping to create employment. Furthermore, if we do get productivity enhancements, which you traditionally do from these technological advances, that adds capacity. That reduces costs, which ultimately supports job growth in industry, where demand can really start to ramp up.

So, technological change usually drives job growth. And a key stat that a lot of people might not be aware of is that only 40% of jobs today existed 85 years ago. That is a shocking statistic. And really what that suggests is that these technological advances create more jobs than the jobs they ultimately displaced. And I don't think AI is going to be any different.

So, if you go back to the 1990s internet revolution, these same fears were present 25 years ago. But new occupations were created in areas that were previously thought of as unimaginable. Computer-related occupations, the e-commerce, content creation, influencers. I mean, who would have thought an influencer was a job 25 years ago? And these jobs really couldn't have been anticipated as the technology was being deployed. And we think the same could hold true with AI as we look back 10 or maybe 20 years from now.

So, we put this all together: creative destruction is a feature rather than a bug of technological change. And history suggests that the outlook for the labor market is probably going to be a lot less dire than what's initially feared. But this is a normal feeling for investors as new technology gets deployed.

John Przygocki: So, Jeff, stepping back and thinking about current headlines in the financial media, one that strikes me is private credit. The asset class has been in the headlines quite a bit. Do you have a view on the asset class? And, if you do, any concerns about what we're hearing about?

Jeff Schulze: Yeah, this is the big brick in the wall for investors. One of the key reasons for that is the opaqueness of that asset class. It's led a lot of people to conclude that the asset class is ripe to be the next shadow banking accident. But when you do a deeper analysis, yes, risk certainly exists, but they're unlikely to generate substantial macroeconomic spillovers that will cause a recession in the near term.

So, at its core, private credit utilizes long-term funding that's dated, which really limits the risk of a problematic run on the bank type of dynamic where all the investors look to exit at the same time. Furthermore, leverage in the asset class is pretty moderate, and the IMF research recently suggested that aggregate bank exposure to the industry is only about $300 billion, or less than 2% of overall loan books.

So, if you have some issues there, it's really not going to disrupt the banking system. So, although the asset class has witnessed the pickup of defaults recently, the overall size is a fraction of what the mortgage-backed security business was heading into the GFC, with private credit equivalent to about 6% of GDP, whereas mortgage-backed back in ’07 was around 30% of GDP.

So, there's some issues in there. A lot of the bankruptcies that we've seen have been from fraudulent activities. I think some of that could be from some sloppy due diligence that was done, given the rapid growth of the sector. But I don't think it's something that is economically driven, these credit problems. So, when the economy turns, we may see some more issues.

But I think just given the size of private credit and the issues that we've seen pop up, you could have some idiosyncratic issues that ultimately materialize, some disruptions in parts of the market. But from a macroeconomic perspective, we don't think the spillovers are going to be enough to meaningfully dent the economy overall.

John Przygocki: So, Jeff, in your recent commentary, the last brick in that wall of worry that you addressed was the high degree of market concentration in the S&P 500. Why do you view this as more of a risk for passive indices as opposed to active managers?

Jeff Schulze: Yeah. Market concentration does pose a potential challenge, especially for passive indices. So, when you look at the 10 largest companies in the S&P 500, right now they account for 38% of the benchmark and trade at a 5.4 turn, or multiple premium, based on the next 12 months’ earnings. So, on a forward P/E [price-to-earnings] basis.

So, given this backdrop, passive large cap benchmarking no longer offers broadly diversified and balanced portfolios, but rather an increasing concentrated exposure to the most richly valued part of the index. By contrast, active managers can do things to mitigate some of this concentration risk. They can limit single name exposure. They can rebalance into laggards, and then they can overweight compelling opportunities further down the cap structure.

And I think it's important, because history shows that a company's performance profile shifts substantially once it becomes one of the top 10 largest constituents in the benchmark. So, given where current market concentration levels are at this point, we just think active managers are going to be much more nimble and have a competitive advantage versus the passive indices that are out there.

John Przygocki: So, Jeff, I noticed that your team recently came out with some terrific research on what happens to a company's performance pre and post becoming one of the largest names in the S&P 500. Can you tell us a little bit more about that research?

Jeff Schulze: Yeah. This is again a very important piece of the puzzle when talking about active and passive in market concentration. So, historically, stocks that become one of the 10 largest S&P 500 companies have strongly outpaced the benchmark on the way up to becoming a top 10 company. But, once they become a top 10 company, they run out of steam once that milestone is achieved.

So, I'm going to throw some numbers at you. So, before entering into the top 10 and the decade leading up to it, companies on average outperform the benchmark by 16.7% per year over the 10 years as you head into being a top 10 company. So, massive outperformance of that company.

Once you're in the top 10, things change pretty dramatically. The largest stocks underperform the S&P 500 over the next 10 years going forward by 5.8% per year on average. So, you have this strong outperformance going in. You have this strong underperformance coming out.

And an adage comes to mind that trees unfortunately don't grow to the sky. So, you know, this is a pretty important dynamic, especially considering how big the largest companies are from a market-cap perspective in the index right now in the S&P 500.

John Przygocki: I'm sure you'll get some pushback on the notion that Nvidia and many of the other top names today won't continue to outperform the S&P 500 index in coming years. Do you have any additional historical context to share with us?

Jeff Schulze: Admittedly, it's hard to imagine a world where the world's largest companies are not the most dominant force in markets over the next decade, but a myriad of factors are going to alter the earnings trajectory of the current leaders as AI matures and the competitive landscape changes.

A good example of this is the aftermath of the tech bubble. And I like that case study, because it does coincide with the last period we had elevated S&P 500 market concentration. So, when you look at the top 10 largest companies at the peak of the tech bubble (that was March of 2000), their performance has widely varied over the course of the last 26 years.

So, out of the top 10, four have had negative price returns over two and a half decades, which is a shocking statistic. Three and only three have outperformed the S&P 500. That's Walmart, Microsoft and ExxonMobil. But what's really notable is that none of them have outpaced the equally-weighted version of the S&P 500, which is kind of a proxy of how active managers can be much more nimble in these types of environments.

So, while today is certainly different than the dot.com era, we believe that this case study is a helpful reminder of the dynamic that may play out in the coming years, and it illustrates the opportunity for active managers that can accurately assess the changing competitive landscape as AI evolves, but also understand the embedded valuations of today's leaders.

John Przygocki: So, Jeff, today we've covered a lot of ground. You've gone across the current wall of worry addressing many of the risks facing investors. Do you have a closing thought or two for our listeners?

Jeff Schulze: Yeah. There's an old adage out there. “Bull markets climb a wall of worry. Bear markets slide down a river of hope.” Very, very important to think about at this juncture of an economic cycle. Strong market entry points are rarely found during moments of comfort or clarity. The most attractive buying opportunities are typically associated with periods of market stress. And from there, equities tend to climb up the wall of worry, advancing in the face of issues like recessions, inflation spikes, geopolitical tensions, valuations.

But this dynamic exists because of what matters most for financial markets. It's whether reality turns out better or worse than what's already been priced in. And, as a result, when expectations are low, which is the case today, stocks can push higher if those events turn out better than what was feared. And from this perspective, skepticism is not a barrier to a bull market, but rather part of its foundation. Doubts will eventually be assuaged and the sentiment will improve. And that's going to lead to cash coming off the sidelines and a lot of these hedges being unwound.

And there's a lot of times where investors think that some sort of brick in the wall of worry is going to be the tipping point for the next crisis. We have comparisons today of higher oil and stagflation in the 1970s. Another example is private credit and its relationship to the mortgage-backed security shadow banking system in 2007. But when you dig deeper, many of these issues are more nuanced than is typically understood. So, we think that these worries are forming the foundation of a continued rally. And as fears subside, which is a typical feature of a bull market, markets are going to continue to move higher.

And we still have a constructive economic and market outlook. And we think that the market is going to climb the wall of worry as we get more visibility. So, we're continuing to advocate that any pullbacks that we have should be embraced as an opportunity to deploy capital for longer-term investors.

John Przygocki: Thank you, Jeff. And, 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.