AOR Update (Podcast): Resilience

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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 in the studio with Jeff Schulze for our monthly conversation focused on the United States economy.

Jeff is the Head of Economic and Market Strategy at ClearBridge Investments. ClearBridge is an active equity manager offering a broad range of strategies across global markets. Jeff, welcome to the studio.

Jeff Schulze: I'm excited to be here, John.

John Przygocki: So, Jeff, let me start by mentioning that in your most recently published insight—you titled it “Resilience”—which you use to describe consumers, corporations and the economy in today's energy shock.

With that backdrop, I'd like to begin today's conversation with your current view on the state of the economy in the United States. Your team's foundation for determining the health of the economy is the ClearBridge Recession Risk Dashboard. Have we seen any movement with those 12 most important indicators that you follow with your May 31st analysis?

Jeff Schulze: Well, I'm really excited to say that we did see some movement in the positive direction. Profit margins improved from yellow to green. And, as a reminder to the listeners, it's a stoplight analogy where green is expansion, yellow is caution, and red is recession. And, at the moment, out of those 12 indicators, we have 11 green, zero yellow and only one red signal,  that signal being job sentiment. So, the dashboard has some broad strength emanating right now. And that's a pretty encouraging development from an economic perspective.

John Przygocki: So, Jeff, the Profit Margin indicator just turned green. That's really interesting. Why was it yellow over the past year or so, when the S&P 500 [Index] had clearly demonstrated very strong earnings growth and record profit margins?

Jeff Schulze: The reason why the profit margin indicator is yellow, or was yellow, I should say, is because we don't look at S&P 500 margins, but rather NIPA or economy-wide margins. And NIPA stands for National Income and Product Accounts. And it measures the profitability of US corporations based on their income earned from current production rather than standard financial accounting. So it differs from corporate profit  because NIPA strips out one-time accounting events, restructuring costs and purely financial assets. Now, when you look at NIPA profit margins, it's actually 100 basis points below its high in late 2021. And last year in the middle part of 2025, it was slipping, which drove that yellow caution signal. But it's improved materially over the past six months, which has triggered us to move it to a green signal. So, you know, it's a green signal. It's one of the more important variables in the dashboard. And it continues to suggest that the economy is going to be pretty resilient this year.

John Przygocki: In the opening there, I mentioned that in your insight from earlier this month, you entitled it “Resilience” and you highlighted the consumer, corporations, etc. Why has the consumer held up so well in the face of higher energy prices? And do you think that this trend can actually continue?

Jeff Schulze: Well, consumer resilience is being driven by a number of things. Now, first off, a lot of the consumption that we've seen in the US over the last couple of years has been from the high-income consumer. It's created that K-shaped economy that we've talked a number of times about on the podcast here. But wealth effects are helping support consumption not only because of the market rally, but the appreciation that you've seen in housing as well. So that's a key driver. The high-end consumer is healthy in spending.

Now, there was some concern that the savings rate dropped to 2.6% in the most recent release, which is the lowest since June 2022. So, to an extent, consumers are being squeezed by inflation. But I'm not really concerned about this drop, because the savings rate tends to be lower when the ratio of net worth to disposable income is above trend, which is the case today. If you put that differently, consumers don't need to save as much when they have greater wealth.

So a lower savings rate is driving some of this resilience. Also, you have the individual tax cuts from the One Big Beautiful Bill. It's going to be well over $100 billion through higher tax refunds and a reduction in taxes paid.

And then lastly, and we've talked about this a couple of times over the last three months, you have less energy intensity for the consumer. Consumers spend about 4% of their wallets on energy goods and services, which is down from over 9% in the late ‘70s and early 1980s. Now, I do think the consumer will be less resilient in the back half of the year as those tax refunds get spent. But ultimately, even though I'm expecting a slight deceleration, I still think it's going to be over 1%, which is going to be a nice tailwind to economic activity.

John Przygocki: So, Jeff, you're essentially saying you do believe higher oil will eventually start to impact the consumer as we move to the back of the year. Why has the oil market been so, I guess you'd say, well behaved, considering the Strait of Hormuz has been effectively closed now for three months, is it? And is there a point where oil will actually move higher?

Jeff Schulze: Yeah. If we were having this conversation three months ago and you said that the Strait of Hormuz would be closed today, I would tell you that the price of oil would be well over $100 a barrel. But the muted reaction is really a function of the oversupply that we had before the war. So, inventories were well above traditional levels, and we've been drawing down those inventories over the last three months. But we're still 200 million barrels higher than what you saw in early 2025. And we're going to get to early 2025 levels at the beginning part of June, so about a month away from now, and we're going to get to the 2022 trough levels, which was the last time you saw a large energy disruption (because of the invasion of the Ukraine) by early August.

So, I would imagine sometime in July when we're between those two thresholds, oil prices are going to start to move up in a more material fashion, because you do have a minimum level of inventories that are necessary to maintain the global system: oil in the pipes, refineries and the supply chains. And we will hit that when we get closer to Labor Day, when we'll probably see a more materially higher energy price.

So I think they'll start to move higher in about a month. They could move dramatically higher if we don't have a resolution by the end of the summer.

John Przygocki: So, we know that a key driver or key element of consumption is directly related to the labor market. We just got the May jobs report. What are your thoughts on the aftermath of that most recent release?

Jeff Schulze: I mean, it was a really strong print. May jobs came in at 172,000. Huge revisions to the prior two months. So now the three-month average jumped 100,000, and now it's 188,000 total compared to where it was prior to this release. So it was a strong print, and it's confirmation that the labor market has stabilized and accelerated this year, following 2025’s malaise.

Now, from the Fed's vantage point, though, it's a hawkish development because strong job creation and steady wage gains, along with that resilient US consumer that we just talked about, is going to start to drive some labor-driven inflationary concerns. And the Fed's not going to be able to ignore that given what's happened to energy in the Middle East.

So, it's going to push yields higher. And we're seeing that in the aftermath. Rate hike expectations are going to move higher. And that's going to pressure the valuations in equities. But it's also going to be a positive when you're looking out on a longer-term basis, because this labor resiliency is ultimately going to lift growth expectations.

So, it was a good print. The labor market is on a firm footing and accelerating. And one other thing that I saw from that print, which I thought was really encouraging, is that last year, the labor market outside of healthcare created negative 271,000 jobs. So it was only health care last year driving the labor markets. So far this year, and we're only five months in, labor ex healthcare has created positive 377,000 jobs. So you're seeing greater labor breadth, which ultimately is a good barometer of better economic momentum.

John Przygocki: Fantastic. Greater breadth. How about artificial intelligence? I think I'd be pretty remiss here if I didn't mention the recent AI CapEx strength. How durable is the spending there? And has CapEx just become the AI story?

Jeff Schulze: Quarter after quarter, year after year, consensus underestimates how much the five hyperscalers are going to spend. And you saw that again here in the first quarter earnings season.  Right now, after the most recent positive revisions, consensus expects those hyperscalers to spend $700 billion this year and $875 billion next year. So, this is a story that continues to evolve. And it's been a key support for the economy and the markets.

But I just want to highlight the point that the CapEx that we're seeing right now is not just AI. There's a lot of other positive green shoots that you're seeing that suggest it's a lot broader. So, manufacturing PMI has been about 50, which is expansion territory, over the last five months. And our ISM New Orders signal from the dashboard is even more green than the overall survey. So that is a really good development for a broader industrial cycle. Industrial production has moved higher. Core capital goods orders and shipments have moved higher. That's a good proxy for business investment. So, you're seeing, you know, CapEx move higher.

And it's, again, not just an AI story. And when you think about  CapEx cycles, you have three tailwinds going on right now. Strong earnings. Earnings and CapEx cycles are generally positively correlated. You have the tax incentives from the One Big Beautiful Bill that are kicking in this year. And then you're also seeing a manufacturing renaissance with a lot of reshoring that's occurring. So I'm pretty encouraged. I've been waiting for a real CapEx or industrial cycle for years. And it appears we are seeing it. And it's not just an AI story.

John Przygocki: Jeff, transitioning a little bit here. We've got some news out of Washington, DC. President Trump has announced some new developments on the tariff front earlier this week. What has he announced, and does it impact your constructive outlook on the economy?

Jeff Schulze: It does not impact my constructive outlook at all. Tariffs were a headwind in 2025. They are a tailwind this year. And even if the effective tariff rate goes back to 11%—  it’s at 7% today—I'm not concerned because you do have tariff refunds that are going out. And that's going to more than offset the increase of tariffs that you're going to see as those IEEPA tariffs get replaced.

Now, what was announced? The first of the two Section 301 tariff proposals. This is going to impose a 10 to 12.5% tariff on 60 economies through forced labor investigations that went on. And this is going to cover 60 economies and 99% of  US 2025 imports. There's a section investigation that's going on on excess capacity, and that's going to be used to increase tariffs on a subset of countries that had higher rates than that 10 to 12.5% baseline. So, you know, think of countries like China or Vietnam, for example.

But when you put this together with the refunds that are likely going to be going out over the course of this year (They started to. It's going to be on pause probably for about 3 or 4 weeks.), that's going to be offsetting. And it's really not going to impact the economy like we saw in 2025.

John Przygocki: Let's try to pull this all together. There are a lot of folks who think that we are late-cycle. Would you agree with that assessment?

Jeff Schulze: I wouldn't. There's a debate on where we are. I would say we're mid-cycle. You look at different areas of the economy, and they're telling you different things.

For example, if you look at non-tech CapEx, consumer spending, housing, employment all feel very early cycle to me. You look at the earnings growth that we've seen in US equities in the S&P 500. That's early-cycle. You only typically see that off of recessionary lows, the strength that we're seeing. You look at something like tech CapEx—much more of a mid-cycle development. So, you know, I would say we're mid-cycle. And if there was a period that this reminds me of, I would say 1996—kind of right in the middle of that 1990s expansion.

So, we are eventually going to get a slowdown. But I would think it's going to be a mid-cycle slowdown rather than a recession that happens during late-cycle environments.

John Przygocki: All right, Jeff, I'd like to transition to the capital markets here, moving away from the economy. I'd like to stick with the theme that you've highlighted here today around resilience. The S&P 500 has been quite resilient of late despite the uncertainty in the Middle East. How does this rally off the late March lows compare to history?

Jeff Schulze: It has been a strong two-month rally off of the lows. Two months later, the S&P 500 has delivered 19.5% price returns, so it's the eighth strongest that we've seen going back to 1950. Now, there's not a reason to be nervous about this strength, although some of these two-month strong moves have occurred after recessions, a lot of others that have actually been firmly rooted within economic expansions—like 1997, 1998, 2019 and 2025.

And when we focus on those non-recessionary periods, because that's very similar to where we are today, stocks have continued to advance on a forward three- and six-month basis after those rallies. And it was a non-recessionary type of environment. The S&P 500 has delivered 5.3% and 8.5% returns respectively. So an object in motion tends to stay in motion. And when you look at those four non-recessionary periods on a forward three- and six-month basis, not in any instance did you see a negative return. So, I think the markets continue to climb higher like we've seen throughout history.

John Przygocki: We all know that earnings, earnings, earnings have been a key driver of the positive market action we've seen year to date. Can that continue?

Jeff Schulze: It can continue, and it is continuing. When you look at next 12-month earnings expectations for the S&P 500, we saw another chunky increase at the end of May. Right now, next 12-month earnings growth rates are above 25%. And the key question I think for investors is, are we approaching peak growth? And my answer is no—at least from what I'm seeing in the AI CapEx space and just CapEx trends in general. Those are going to be key drivers of earnings growth because one company's expenses, of course, is another company's revenues.

So I think earnings are going to continue to do the heavy lifting. And when you think about earnings, it's not just an AI CapEx story. You have positive operational leverage. What that means is costs are coming down as wage growth moderates and revenues are higher. Right? That is a really positive combination for strong earnings delivery. You have AI adoption—kind of this “run it lean” mentality where companies are doing more with less. Employees are becoming more productive. You have improved pricing power. So, valuations haven't really been a key driver of returns over the last year, over the last six years. And I think that they won't be a key driver. I think earnings are going to do the heavy lifting just like we're seeing here today.

And when you think about higher valuations, just a quick aside here. We've been above a 20 P/E over the last six years two thirds of the time. So, we're just in a higher-valuation regime. And that shouldn't be a reason to get nervous and not put money to work in equity markets.

John Przygocki: So, Jeff it's great to hear that you're really expecting potential further gains in the United States. But how about abroad, outside of the US? I know recently you were on a panel at an event that was hosted at Harvard. And in that session, you highlighted the opportunity in emerging markets. Why are you still so optimistic on that asset class?

Jeff Schulze: Comes back to earnings. Earnings are what drive markets over the intermediate and long term. And, believe it or not, 40% of the MSCI Emerging Market Index is tied to that EM CapEx trade.

A good way of looking at this is to look at how much 2026 earnings expectations have changed over the course of this year. So, January 1 compared to today—what is the difference in 2026 earnings expectations? Well, in the MSCI Emerging Market Index, earnings expectations have been revised higher by 28% through the end of May. Massive increase. The US has been doing well, but MSCI US has only increased by 7%, Europe and Japan 3% apiece. So this has been a key reason for emerging market strength. And I think that this will continue as that buildout moves forward.

Furthermore, if you get some sort of resolution in the Middle East, emerging market economies are very heavily exposed. Most of them are energy importers rather than energy exporters. If you do get a resolution in the Middle East, the US dollar will likely weaken. Some of that geopolitical strength that you've seen is going to be reversing. You could see lower bond yields. Valuations aren't demanding. So there's a lot of reasons to be optimistic in that space. And part of them are tied to EM. But there's a lot of other things, like a change in developments in the Middle East or valuations re-rating higher, which could make this run continue that we've seen over the last year.

John Przygocki: You just touched a little bit on this, but I'll ask you for maybe some further clarification. Are there any particular regions that look attractive to you in the emerging market space?

Jeff Schulze: Yeah. So if you're talking about that kind of EM trade, if you will, Taiwan and South Korea are going to be the areas of opportunities there. It's going to be very volatile. We're clearly seeing that with the selloff that we had with Broadcom yesterday. But, ultimately, you're not going to see a meaningful chip response until 2028. So pricing is going to remain firm. And that should drive the earnings of those two regions.

I'm also optimistic on a commodity cycle. Metals in particular are moving higher. So that should benefit areas like Chile, Brazil, Indonesia. So I do think that there's opportunities within EM. But I ultimately think, just given the fact that you have a lot of inefficiencies in the emerging market space, this is going to be an area where active managers can provide some durable alpha compared to some passive benchmarks.

John Przygocki: Jeff, it really seems like every time non-US equities have led in recent years, it's been for very short periods of time. And then there's kind of a bit of a reversal. What are the catalysts that are out there for a more durable, long standing non-US outperformance going forward?

Jeff Schulze: Well, I have a lot of different potential catalysts. First is the weaker dollar. There is a 0.6 correlation between the rolling five-year performance of the S&P 500 versus ACWI ex US. So, if the dollar is strengthening, that has coincided with US outperformance. If the dollar is weakening, it’s coincided with non-US outperformance. And I'm of the opinion over the next five or 10 years that the dollar is going to get structurally weaker as a lot of global central banks start to diversify their dollar holdings. The administration wants a weaker dollar. You may see some higher inflation due to debt sustainability. There's a number of reasons why I think the dollar will weaken structurally.

Second is if you have a higher inflation or interest rate regime, right? Higher interest rates isn't going to be good for growth equities or defensive equities. It's going to increase the cost of capital. But it does benefit more cyclical areas of the market, because when you have higher inflation you have higher nominal GDP, you have higher revenues. And that really supercharges the earnings potential of cyclical areas like financials, industrials, materials and energy. And they are much more prevalent overseas.

Same thing with the commodity supercycle—and particularly metals. You hit the AI build out. This desire for renewable energy, to diversify away from oil and natural gas. The electrical grid upgrades. Again, that's going to be much more prevalent overseas.

You have much more of an ability for government spending overseas. The US has deficits of 5%, 6% of GDP. That's not going to move higher, but a lot of other countries have much more fiscal flexibility.

You can have the return of the Chinese consumer. You can also have the democratization of AI as these models get more efficient and they get broadly deployed. That's going to create a lot of cost savings from less efficient business models. That's the small cap space in the US. That's emerging markets and non-US companies. And then, lastly, valuations are pretty compelling.

So if you get two, three, four of these catalysts that are working at the same time, I think that could be a recipe for more sustainable outperformance than what we've seen.

John Przygocki: Jeff, let's go to your closing thought for our listeners.

Jeff Schulze: I think the closing thought is that the equity markets have been remarkably resilient over the course of the last four months. If we go back to late February, the markets were pricing in three rate cuts through the middle part of 2027. Through the release that we have over payrolls, the markets are pricing one and a half rate hikes. So you've seen a shift in Fed funds futures by over 100 basis points. Markets haven't flinched. You've seen the 10-year Treasury rise back up to 4.5%. Markets haven't budged. Energy prices higher. Markets have been resilient. And I think the markets are sending us an invaluable signal that we're going to get a large positive productivity shock and you're going to have really strong earnings growth as we move forward. And that's going to happen not only because of that productivity shock, but deregulation and pro-business policies from the One Big Beautiful Bill.

So we continue to be constructive on the markets. If we do see a dip, we're in the buy-the-dip camp, and we think the markets will melt higher as we move through the back half of the year.

John Przygocki: Jeff, thank you for your time and your wonderful commentary here today along the lines of the theme that you've driven out. Resiliency—resilient US consumer, corporations and economy driving opportunity here in the United States. Also, some wonderful perspective on the opportunities outside of the US in the emerging market landscape.

To our listeners, thank you for spending your valuable time with us today for the 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.