AOR Update (Podcast): Geopolitical conflict and the US economy

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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 show.

Jeff Schulze: Thanks for having me, John.

John Przygocki: Jeff, let's start today's conversation, as we typically do, with a view of the economic landscape here in the United States and the ClearBridge Recession Risk Dashboard.

We had a positive indicator upgrade last month with ISM Manufacturing PMI New Orders moving from yellow to green. Did any of that positive momentum carry forward through February?

Jeff Schulze: Well, unfortunately we did not have any other indicator upgrades in February. So, the overall dashboard stands as it did back at the end of January. But I think, more importantly, we did start to get a little bit more data on Housing Permits and Retail Sales, those two indicators. We're still waiting for full catch up following the shutdown of the US government in the fourth quarter of last year. But ultimately, when you take a look at this dashboard, this is really good news for the economy where you have one yellow, one red and the rest are green, which signals that the economy should be firing on all cylinders here in 2026.

John Przygocki: All right, Jeff, military action in the Middle East escalated between the United States, Israel and Iran. We'll get to the impact on the capital markets in a few minutes. But what I want to focus on first is the impact on the economy. Do you anticipate any change on the ClearBridge Recession Risk Dashboard as a result of this conflict?

Jeff Schulze: Well, we did nudge higher our odds of a recession from 20% to 25% because of the conflict. But when you look at all the individual indicators, really the one that I think will be impacted and will likely deteriorate in the coming months is our Commodity indicator. Generally speaking, higher oil prices is a bad thing for the US economy.

And, when you look at other indicators, you may see some movement on the yield curve or credit spreads. But at the higher level, it's a modest increase of the odds of a recession right now. But, ultimately, we don't think that this is going to impact the economy in a real meaningful way, especially if the current conflict is limited to the timeframe that's being discussed right now of maybe four to five weeks.

John Przygocki: Okay. But if oil prices go up and stay up, won't that hurt the US consumer and the economy overall, considering consumer spending is, I believe, approximately 70% of GDP?

Jeff Schulze: Well, Goldman Sachs estimates that every $10 increase of a barrel of oil, if sustained, will shave around 10 basis points off of 2026 GDP. So, there is going to be some impact. And you know, oil really is the most direct transmission mechanism from the current conflict to the global economy. But the good news, at least from a US perspective, is that relative to history, the US is a net producer of energy products, no longer a net consumer.

So, when you think about higher oil, it's kind of a mixed picture. Yes, you're going to have a drag on consumption, because it's going to lower real disposable income. But you're going to have some of that partially offset by the benefits of increased job creation and profits for the energy sector. Now, the shift from the US of being a net consumer to a net producer of oil is not the only key difference relative to history.

Americans today allocate a meaningfully smaller share of their wallets to energy goods and services today versus pretty much any point in history except for the one to two years following the pandemic. And the reason for this is that you've had decades of efficiency gains on things like miles per gallon when you drive your car from point A to point B. But, also, you've had a lot of growth of the overall wallet size.

John Przygocki: All right, Jeff, let's transition to financial markets. How concerning is this development in the Middle East for financial markets?

Jeff Schulze: Well, history shows that investors should take advantage of any opportunities that happen if you do see a selloff, because the S&P 500 [Index] generally has solid returns following geopolitical dips. So, when you go all the way back to the 1950s and you start with the Korean War, there's been over 20 geopolitical events that we can look at. And, following the start of that event on a forward one-month basis, the S&P 500 is up 1.4% on average. Over the next three months, the S&P 500 is up 2.8%, so double that one-month return. And over the next six months following that event, the markets are up 5.9% on average. So, usually, it's a buy the dip type of situation.

But when you dig into the numbers a little bit deeper, the poorer returns following larger conflicts that metastasize into wars—it's really kind of a mixed bag. What's the most important consideration is that the broader economic conditions in the US, they tend to supersede geopolitical risk for the markets. So, in some of the worst periods following military escalations were those periods that coincided with US recessions in 1973, 1979 and 1990.

So the key takeaway here, with the dashboard being strongly green at the moment, we think recession odds are pretty low at the moment, even if you do see a sustained spike in energy, which is why we think the market will likely follow that usual pattern of buying the geopolitical dip and the markets will ultimately grind higher as we look forward on a three- to six-month basis.

John Przygocki: So, Jeff, that's some great historical context, especially given, as you stated, the US economic backdrop being as strong as it is. Why are non-US markets selling off more aggressively?

Jeff Schulze: Well, it really comes down to one thing, which is oil, and the sensitivity and the exposure to natural gas and oil. The US is a net exporter of oil and energy. Areas like Europe and emerging markets, that's a very different scenario. And one of the key things here is the shutdown of the Strait of Hormuz. There's a lot of oil that moves through there. About 33% of global oil moves through that chokehold. You have about 15% of refined product seaborne trade that goes through that waterway and about 20% of global liquid natural gas flows.

And, when you think about the fact that Europe is really exposed to natural gas and Qatar is the world's second largest liquid natural gas exporter that has no alternative routes but to go through that strait, there could be a lot of disruptions, and there's going to be large increases on the price of oil and natural gas as a consequence, which is really going to hurt a lot of these regions overseas.

Furthermore, you've seen the dollar gather some strength over the last couple of trading sessions because that is a risk-off currency, which tends to be kryptonite to emerging markets. So, if this is a relatively short disruption, I think that you're going to see a pretty strong rebound in the non-US markets. But if this is more sustained, I think we are going to see some more volatility, because that could potentially weigh on the growth prospects of those regions.

John Przygocki: So, Jeff, taking a look at some of the other asset classes: the US dollar strengthened, US Treasury yields moved higher, Fed fund futures are removing cuts from the expectations for the remainder of 2026. How do you reconcile those moves?

Jeff Schulze: Yeah. Investors have responded to developments in the Middle East by, as you mentioned, bidding up the US dollar. And I said this a second ago, but that's more of a kind of a safe haven trade, if you will. But what was unique is that US Treasuries sold off. Yields went higher. And 10-year Treasuries are up about ten basis points since the end of February. And they're back above 4%. And, usually, you don't see that together. You don't see a stronger dollar and yields move higher on the 10-year Treasury.

And I think this combination reflects the risk of higher inflation from this pickup of energy prices. Now, Fed fund futures have now taken out about a half a rate cut from 2026 expectations. Because, you know, with a higher inflationary environment that does reduce the urgency of the Fed to potentially create more support for the US economy. So, when you're looking at this move, I think the US dollar strengthens because there's less rate cuts potentially coming into the economy this year. So that's a more favorable interest rate differential from the US versus the rest of the world. But, also, you've seen higher yields because of that higher inflation risk. And investors wanted some additional compensation because of that.

John Przygocki: So, how problematic is this for inflation?

Jeff Schulze: Well, if you have a persistent spike in oil prices, materially higher than where we're currently at, you do have the risk of stagflation. And there's really three uncertainties at this moment. How long will the Strait of Hormuz be closed for? Will energy infrastructure in some of the surrounding countries be destroyed by Iran? (So, any energy infrastructure in Saudi Arabia, the UAE, Kuwait.) And then, lastly, does Iranian oil still continue to stay online?

So, we don't really know how it's going to affect inflation. But a rule of thumb for inflation is that if you have a sustained increase of 10% on oil prices, that will boost core CPI [Consumer Price Index] by about five basis points. It'll boost headline CPI, which includes both food and energy, by closer to 30 basis points. So, it should pick up inflation this year. But I think the key takeaway is that when you look at inflation’s trend coming into this situation, there was a lot of reasons to suggest that inflation was going to continue to moderate in 2026.

So, I like to look at core CPI. That's what the Fed looks at. It's a better measure of where trend inflation is going. And core CPI is really broken down into three components. You have goods inflation. So that's buying a car or furniture or toys or something of that nature. You have shelter inflation. And then you also have services ex. shelter, better known as supercore. So that's like, you know, what you pay for a haircut, for example, or going out to dinner.

Now, when you look at those three components, there were some encouraging trends. Shelter inflation has been moderating over the last couple of years. And that's a really big difference versus the inflationary spike that we saw in 2022. And that's the largest calculation that you have in core CPI. Goods prices have been pretty much flatlined. And with tariffs being reduced recently because of the Supreme Court decision, I don't really see a lot of inflation strength coming from that area. And although supercore did have a pretty strong print in January, which is the latest release that we got, it has a strong relationship with wage growth. And wage growth has continued to moderate, which suggests that that tick higher is probably something more temporary rather than something more structural.

So, yes, inflation is going to pick up, especially headline inflation. But when you look at the underlying trend of inflation coming into this, even if we do get a little bit of a boost here, we're expecting continued moderation as we move through the back half of this year.

John Przygocki: How about the Fed's path forward for 2026?

Jeff Schulze: Higher inflation may spook the Fed from continuing to ease in the back half of this year. But I think that these fears are probably a little overblown. Let's remember that the FOMC will likely view this pickup of inflation as supply driven. Now, when you think about tariffs or this pickup of inflation from oil price spikes or some of the supply chain disruptions that we saw back in 2021, in 2022 because of the pandemic, monetary policy can't influence that.

Monetary policy can influence demand-driven inflation, make rates higher so people consume less. So, I don't think that this is really going to deviate the path of where the Fed is going to go moving forward. And I think market pricing right now is probably pretty accurate. Markets are pricing close to 1.9 rate cuts this year. I think that that's probably pretty close to what my expectation is.

I think we get one cut probably closer to September and another cut—I don't know if it's going to be December or January, but we're going to get another cut close to the end of the year. And, ultimately, I think that's going to be positive for the economy and financial markets. But we're pushing out our expectations for that first cut because of this dislocation.

John Przygocki: Okay, Jeff, let's transition a bit here. I know we talked earlier about markets from a geopolitical point of view, but prior to the military conflict, the artificial intelligence doom trade was front and center on investors’ minds. What are your thoughts on the AI disruption that is being priced in?

Jeff Schulze: Well, it was a bit like whack-a-mole. As we moved through February, different industry groups were getting hit because there's a perception that AI was going to make them obsolete.

It started off with software, and then it moved over to different areas like travel, logistics, office real estate, credit cards, consulting, data brokerage, wealth. I mean, there was a lot of industries that were hit. And, you know, I understand the thought process. There are going to be industries that are going to be displaced. It happens with every major technological breakthrough. It creates enormous value for those new companies, and it destroys old business models.

But I think that we need to realize that it's going to create opportunities for active managers, because a lot of these companies have really strong moats. And they're going to adjust their businesses, they're going to use AI tools, and they're going to extract even greater value from this new technology.

And some of these stronger-moat companies are being thrown out with those shallower-moat companies that will be disrupted. So, yeah, we think that this is a great environment for active managers that understand the fundamentals of these businesses and how this technology ultimately will change what these businesses will be doing going forward.

And I’ll use software as a quick example. When you think about enterprise software, it's very deeply embedded into corporations. High switching costs. A lot of these companies have multi-year contracts so that disintermediation is not going to happen over the next couple of years. But more likely, though, AI will then allow these software companies to be more productive. And when you think about software fundamentals, you know, software is one of the strongest growing areas from a revenue and earnings standpoint. And they have really strong earnings revisions.

So, ultimately, I think there are going to be disruptions. But at the end of the day, this is going to create opportunities for active managers that can sidestep some of those companies that ultimately will be disintermediated.

John Przygocki: A couple more here. Your call for a market rotation from the leaders, the mega-cap tech firms into some of the laggards like small, mid and value has been occurring over the past three to four months. Can that continue?

Jeff Schulze: Well, you've seen a little bit of a reversal of some of these trends. I mentioned before, non-US has been underperforming the US since the military strikes. Value is outperforming growth. So that trend is still intact. And small and large caps are roughly in line over the last couple of days. But I think there's more room to run with this trade. And it all comes back to earnings delivery.

For a long time, the Mag Seven¹ and mega-cap tech were the only games in town when it came to earnings growth. And if you look at expectations for this year, earnings growth is much more democratized. A lot of these struggling areas are coming out of their earnings recessions. And, given the valuation discrepancies between mega-cap tech and some of these bigger, AI-focused companies and small caps and value and the average stock in the S&P 500, even the non-US based investors will flock to those cheaper sources of earnings growth. So, although value has outperformed growth this year by about 10%, small caps have outperformed large caps by about 6%, the non-US space has outperformed the US by (depending on what you're talking about) 7 to 10%, I still think that there's more room to run with this broadening theme that we've been talking about for quite a long time, and it has been happening. And I think those fundamentals are still in place for that rotation to continue.

John Przygocki: All right, Jeff, let's close today's conversation with a final thought for our listeners.

Jeff Schulze: You've seen oil price spikes before throughout history. And a lot of times there's some conditions that need to be met in order to have a more sustained risk-off move in the markets. Right? Usually oil price spikes of 50 to 100% that have been sustained over a quarter or two—that is what will create a big dislocation in the S&P 500.

Another thing that's important is where you are in the economic cycle. If you're late-cycle and your economy's already slowing as this event happens, that usually causes a recession and a large selloff. You saw it in the 1990 Gulf War. You saw it in 1973. And with the dashboard being largely green and pretty strongly green compared to those periods, I don't see that being a big risk.

And then the last thing is that, if you have a big move of oil prices and inflation is going to spike, what do central banks do? Do they turn hawkish? Do they start to raise rates to fight inflation, or do they not? In looking at Fed fund futures, yes, a half a rate cut has come out of the market over the last couple of days. But participants are still expecting two rate cuts this year overall.

So, with the US being a lot more insulated to large price spikes of energy because it is now a net exporter rather than importer, you know, I would be a buyer of dips, just like we've seen historically throughout geopolitical shocks.

John Przygocki: Jeff, thank you for joining me today in the studio. To all of our listeners, thank you for spending your valuable time with us for today's March 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 with any other major podcast provider.