AOR Update (Podcast): Is the AI era a repeat of the dot.com era?

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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 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, happy New Year, and welcome to the show.

Jeff Schulze: Happy New Year, John.

John Przygocki: Jeff, it feels great to be in the new year. Why don't we start our first conversation of 2026 off with your perspective on the health of the United States economy? How does the ClearBridge Recession Risk Dashboard look with the December 31st update?

Jeff Schulze: Well, John, we had a couple of changes in December: one positive, one negative. ISM Manufacturing PMI New Orders dropped to red after a second consecutive monthly reading below 48. But we did have an upgrade of the yield curve to green with the 10-year Treasury minus the three-month T-bill going above 50 basis points.

We still have a couple of missing data from the government shutdown, so we don't have the data for housing permits and retail sales. But I think the important takeaway, even with some of that movement and some lingering issues with those two indicators that are missing data, we still have a very healthy green expansion color for the ClearBridge Recession Risk Dashboard. So, we have a pretty healthy outlook for the economy in 2026.

John Przygocki: Terrific, Jeff. Terrific. So, in your quarterly long-view paper that's entitled “Party Like It's Not 1999,” you talked about the differences between today and the late 1990s. Is there anything related to the dashboard that you want to highlight?

Jeff Schulze: Yeah, I would say wage growth. Wage growth as you typically move through an economic expansion tends to move higher. And that creates a lot of inflationary pressure. And it invites a Fed that's tightening and usually when the Fed raises rates, they do it too much and inadvertently cause a recession. Now when you look over the past two, three, four years, average hourly earnings or wage growth has been moving lower, which is really encouraging from a macro perspective, a big picture perspective.

Yes, you see some strains on lower income segments, but ultimately this is a key reason why the Fed has been able to cut in 2025. They cut in 2024. And I think they're going to cut a couple more times as we look out on the horizon. So, a key difference not only from the late ‘90s, but from every economic expansion going back to the 1970s, is that wage growth is moving lower, which I think will prolong this cycle.

John Przygocki: Interesting. Isn't that a negative, though, for the consumer and the economy, considering consumer spending is approximately 75% of US GDP?

Jeff Schulze: Well, it is a negative. But if you think about the consumer, they spend what they make. So, when you have a no hire, no fire type of environment, as long as people still have their jobs, that is a good environment for consumer spending.

But I think an important difference also versus the late ‘90s—and something that's going to support the consumer here in 2026—is that you have the twin tailwinds of both a Fed that's cutting and fiscal easing. That's a combination that you only see typically coming out of recessions. So, with the One Big, Beautiful Bill that was passed in the middle of the summer last year, that bill is going to deliver about 1% of GDP and stimulus here in 2026.

And about half of that is going to be through supercharged tax refunds, providing an additional cash boost to both low- and middle-income households. And if this is anything like the COVID stimulus payments that were sent out a couple of years ago, most of that money is going to be spent in the quarters right after they receive it.

So, I think that is something that is going to support the consumer in 2026, even though you have seen this moderation of wage growth.

John Przygocki: So, Jeff, how about the status of the labor market and potential for disruption with artificial intelligence—and, you know, maybe it's an extension, but the connectivity to a recession?

Jeff Schulze: Well, the labor market has slowed, but you're starting to see a little bit of a pickup. Now, we're going to get a new labor release in a couple of days. But before we do get December's payrolls, ex. DOGE-related layoffs in October, if you exclude those, three-month average job creation has been about 76,000. So you’ve seen a pickup of job growth. I think we're going to stay in this 50,000 to 75,000 per month range as we move through 2026.

But I think what's more important is that when you look at AI [Artificial Intelligence] and its disruption of the labor market, believe it or not, we wrote a paper in December that showed that occupations where AI adoption has been the lowest (so industries where it really hasn't embraced AI), you've seen the greatest rise in the unemployment rate for those industries.

So that suggests that other factors have been driving recent labor weakness. And when you look at job growth for industries that have adopted AI the most rapidly, there's actually a positive relationship there. So, AI is augmenting labor rather than substituting for it. But ultimately, when I look to 2026, I think AI is going to have an effect in the labor market, but it's going to be much more akin to the jobless recovery that we saw coming out of the 2001 recession. You know, job creation in this 50,000, 75,000 per month range, which is enough to keep the economy moving forward, to keep consumption moving forward. But it's also going to be low enough where the Fed can continue to cut, which is again, a really potent combination for a continued move higher in financial markets.

John Przygocki: All right Jeff, let me follow up with one on artificial intelligence. How do corporate expenditures directly related to AI compare to the dot.com era of the late 1990s?

Jeff Schulze: Well, believe it or not, we're well below the levels that you see during prior US innovation technology cycles. And that includes the 1990s. So, when you go back to the 1880s, you look at the railroads, you look at the electric motor in the 1920s, auto infrastructure 1910s, and then, of course, the tech and telecom boom in the 1990s, typically, the peak spending during those technology cycles was anywhere from 2% to 3.5% of GDP. And generative AI right now is less than 1% of GDP. So that suggests that, you know, history repeats itself, which it tends to do when you go through these technology cycles, that AI investment could surprise to the upside. And again, you mentioned the late ‘90s. About 3% of GDP was that peak investment impulse, which is about three times larger than where we currently sit. So, I think there's room for upside from where we currently reside at this point.

John Przygocki: It's commonly known that the hyperscalers Amazon, Google, Meta, Microsoft and Oracle are the companies driving quite a bit of this capital expense. Is there anything that we should focus on related to these firms and their massive investments?

Jeff Schulze: There's no doubt that the AI investment boom is going to create some excesses, especially with the hyperscaler investments. But the size and leverage, as I just mentioned, aren't extreme from our vantage point at this moment. And when you look at the hyperscaler capex [capital expenditure], it's going to increase expected at least to $533 billion in 2026. And every year analysts have been too cautious on how much spending was going to happen for the hyperscalers.

And in the third quarter alone, hyperscaler capex expectations jumped by over 60 billion. So I think that the capex cycle is alive and well. And even though on a year-over-year basis, the percentage increase isn't going to be as much, these are still really large numbers in the scheme of things, which is not only going to help the economy continue to grow, but it's also going to help financial markets move higher with better earnings delivery.

John Przygocki: All right, Jeff, how about any risks that might be below the surface related to all of this investment in artificial intelligence that we should be thinking about?

Jeff Schulze: Well, there are risks. Circular financing is something that people talk a lot about that happened in the 1990s with the fiber companies, the optical fiber companies investing in one another. And you're seeing some of that right now with open AI making deals with chipmakers and cloud computing companies. Nvidia has invested $100 billion in OpenAI.

So there is some of this circular financing that's going on at the moment. But ultimately, when you think about AI firms acting as major investors in their clients and suppliers, they really want to create closer, more integrated AI ecosystems and network effects overall. So, I think this does increase correlation, volatility and contagion risk within AI.

But this isn't an immediate red flag, and it's not nearly to the scope and scale that we saw 25 years ago at the end of the dot.com. So that's obviously one risk that I'm monitoring. But something that is not nearly as big of a risk as what we saw at the end of the dot.com bubble is the financing that's being used for this investment cycle.

So, when you look at the technology sector and you look at capex as a percent of free cash flow, during the late ‘90s and early 2000s, companies were spending 55 to 60, 70% of their free cash flow to fund their capex. And a lot of these companies were going to the capital markets for equity and debt in order to build out that ecosystem.

Today, capex to free cash flow is around 40%, and a vast majority of that spending is coming from free cash flow generation overall. So today's leaders with AI capex are flush with cash. And, although debt financing is becoming a little bit more prevalent (You saw it with Meta. Investors did punish Meta for tapping the debt markets with the latest earnings season.), We're not really near concerning levels from our vantage point.

John
So Jeff, let's transition the conversation. Now let's talk a little bit about the capital markets. With the close of 2025, the S&P 500 [Index] narrowly missed three consecutive years of delivering plus 20% total return. The last time that we saw that rare feat was, I believe, back during that dot.com tech bubble era that you just mentioned. Does something stand out to you about last year's returns compared to the end of the 1990s?

Jeff Schulze: Yeah, there's a very stark contrast between the last year heading into the peak in March of 2000 and 2025, and that big difference is what drove the market return. So when you think about market returns, there's two things that drive it: P/Es (so how much each investor is willing to pay for a dollar of earnings, so multiples moving higher or lower) and then earnings. That's the only two things that drive the market.

And when you look at the technology sector for example, leading up to the dot.com bubble, 87% of that year's returns were driven by multiples moving higher. This year, earnings drove over 100% of earnings. Multiples actually moved down for the tech sector. So that's a really good sign that market participants are engaging in less speculative and less exuberant behavior as compared to what we saw with the dot.com bubble.  And when you look at that at an index level, everybody thinks that it's been valuations that have been driving the markets. But when you look at 2025, earnings drove 82.5% of last year's return.

Multiples were responsible for less than 20%. And P/Es rose by less than one turn over the course of 2025. So, for me, that's a really good backdrop. That means that fundamentals, a/k/a earnings, are driving the markets, which is ultimately what we want to see. And it leads me away from that bubble narrative that a lot of people like to throw out there.

John Przygocki: Let me ask you about your outlook for US equities for 2026. Let's use the S&P 500 as a proxy.

Jeff Schulze: I'm positive. I think that we could see some choppiness. But we're buyers of dips, because, even though multiples are high (And, again, that's where you get this comparison to the dot.com era), I think earnings are going to be in the driver's seat yet again in 2026, and multiples don't need to move higher from here in order to have a really successful year.

So, when you look at sell side consensus expectations, they think that the S&P 500 is going to deliver 15% earnings growth in 2026. Now, if that comes to fruition, that has a really important implication for investors, because when you look at the S&P 500, we've had above average earnings growth, which is 9%. 15% is well above that threshold. So, when you have above average earnings growth, your return in the S&P 500 has been 12.6%. When you're below average with earnings growth, you basically cut that in half, 6.7% returns on average. So, with earnings surprising to the upside over the last couple of quarters and expected to be double digits next year, I'm thinking that the S&P 500 is going to have a pretty good year, even though you could see a little bit of choppiness, but it's not going to be valuations that drive the market once again.

John Przygocki: You just mentioned valuations not really being a big driver for market performance. But what about the stocks commonly referred to as the Magnificent Seven?¹ Their valuations are materially higher than some. And now we're calling it a bit of a bubble. How do their valuations stack up compared to previous market darlings?

Jeff Schulze: We've done a lot of research here, and I know there's a lot of concerns about the Mag Seven, today's leading stocks. But when you do look back to the Nifty 50, you look back to the dot.com darlings, the Mag Seven, yes, is in line with their valuations. But if you remove Tesla from the equation and you look at the Mag Six or the Mag Seven ex. Tesla, whatever you want to call it, forward earnings for those six companies is 27.4, which is a pretty steep discount compared to the Nifty 50 or the dot.com darlings.

So, one important variable, though, that I think investors should consider is that what popped those prior market bubbles is that the Fed was tightening towards the peak in December of 1972 with the Nifty 50, and into the peak of March of 2000. The Fed is in easing mode. They've actually dropped the Fed funds rate by 75 basis points over the last 12 months, and the markets are pricing another two and a half cuts through the end of 2026. So I think that this current rally that we're seeing in the S&P 500 has further room to run, despite having some elevated P/Es with some of the market leaders of today.

John Przygocki: All right Jeff, so, given the outlook that you've just shared with us, where do you see some areas of opportunity in the year ahead?

Jeff Schulze: Although I don't think that valuations for the Mag Seven are a big impediment for this market, I do think that the Mag Seven are going to lag as a group in 2026, because the reason why they've been in the leadership position is that they've been the only game in town in earnings for 2023, 2024 and 2025. But when you look out to 2026’s expectations, yes, the Mag Seven are expected to have about 22% in earnings growth. But if you look at the rest of the S&P 500, that's at 12.4%. And if you look at small and mid-cap stocks, that's at 18.1%. And given those valuations that we just talked about, investors will go to the cheaper sources of earnings growth, which is basically the rest of your portfolio, whether it's value, small caps or mid-caps.

You've started to see this priced by investors. Believe it or not, if you look at 2025, there's only two of the Mag Seven stocks that outperformed the S&P 500, which were Google and Nvidia. So this is becoming much more of an individual stock story rather than a group story moving up and down. And I think that there's more room to run with this trade. And I really think that it’s going to be a tailwind for active stock pickers who can mitigate some of this concentration risk that you have with the Mag Seven.

John Przygocki: So, Jeff, as we look to bring today's conversation to a close, do you have a final thought for our listeners?

Jeff Schulze: Well, when you look at today's backdrop versus the final hurrah in the dot.com era, I think that there's more differences than similarities at this point. Yes, valuations are elevated, but I really think that equities are going to grow into the multiple in 2026, fueled by strong earnings, strong capex growth. You have that twin tailwind of fiscal and monetary stimulus blowing on the US economy and financial markets. You're going to have deregulation, especially in the financial sector, AI-related productivity gains, and you're going to have further cost reductions. And when you think about wage growth moving down, as I mentioned earlier, I think that just opens the door to additional Fed easing, which you typically don't see at this point in the cycle.

And, although AI is going to disrupt the labor market to some degree, again, I think it's going to be more like the jobless recovery that happened after the dot.com bubble, where you have job creation in that 50,000 to 75,000 per month range, as opposed to a recession. And that's going to put less pressure on inflation. And it's ultimately going to be bullish for financial assets.

And, although it does feel like the markets are partying like it's 1999, I think that the eventual hangover that will follow, like we had in 2000 to 2003, remains a lot further out on the horizon.

And when I wrote my quarterly paper, I think there was a really good quote that the listeners should embody. It was by a famous investor named William O'Neal. The quote is, “It is one of the great paradoxes of the stock market, that what seems too high usually goes higher, and what seems too low usually goes lower.” And while the dot.com bubble does have some parallels to the present, it's important to also consider the risks of sitting on the sidelines during periods of large technological changes like we're going through right now.

So, if we do have dips as we move through the next couple of quarters, we're buyers because we're still very constructive on the markets in the economy.

John Przygocki: Jeff, that's a wonderful quote. Thank you for your time. 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 just about any other major podcast provider.