AOR Update (Podcast): The rotation continues

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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 are 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 United States economy. Jeff, welcome to the show.

Jeff Schulze: Great to be here, John.

John Przygocki: Jeff, let's start today's conversation with your view on the US economy and the current state of the ClearBridge Investments Recession Risk Dashboard. Are there any changes with your update at the end of January?

Jeff Schulze: Well, John, we did have Manufacturing PMI, New Orders move from red (recession) all the way up to green (expansion). Very rare for an indicator to jump two notches. But New Orders jumped by 10 points, and it now reads at 57, which is well into green territory. Now, this is a positive development, because manufacturing has been languishing in the economy over the last couple of years. And this could signal that this is an area that could drive better economic activity in the year ahead.

But when you look at the 12 signals from the ClearBridge Recession Risk Dashboard, you have one red, two yellow, and the rest are green. And, importantly, the odds of a recession over the course of the next 12 months has dropped to 20%. So, the dashboard continues to improve, and I think that that will be something that materializes even further as you move through the course of this year.

John Przygocki: So the dashboard is clearly signaling an all-clear, expansionary view. What do you think will drive the economy in 2026? 

Jeff Schulze: I think consumer spending is going to be a big part of this year's story. And I also think you're going to see a boost from business investment, and it's going to move still into AI [artificial intelligence], but it's going to be a lot broader than what we've seen.

So, when you think about consumer spending, I think the consumer is going to be well supported for a number of different reasons. First off, in the next couple of quarters, most lower- and middle-income consumers are going to get a large boost in their tax refunds from the One Big Beautiful Bill. So that should create much more of a uniform consumption picture than what we've seen over the last year or two.

And you are going to continue to see the wealth effect support upper income Americans and their spending habits this year. And, although wage growth is moderating, it's moderating at a slower pace than inflation. So real wage gains are going to increase affordability and purchasing power. The consumer has always been the bedrock of the US economy. I think that that will continue this year.

Now, looking at business investment, the new tax incentives from the One Big Beautiful Bill should create a much broader capex [capital expenditures] cycle than what we've seen. If you put on top of that reduced policy uncertainty and easier financing conditions, I think that this is going to be a really good year from an economic perspective.

And right now, consensus expects about 2.1% real GDP growth. I think that the economy is going to come in comfortably above those levels.

John Przygocki: So, Jeff, there definitely have been some pretty high profile layoff announcements this earnings season in the headlines. How concerned are you with that?

Jeff Schulze: Well, there has been. UPS announced 30,000 job cuts in operational roles. They're winding down the Amazon delivery volume, and they're right-sizing their headcount. Amazon continues to normalize their headcount after over-hiring in the aftermath of the pandemic. Nike and Pinterest announced about 800 cuts each. This isn't necessarily related to AI adoption, which is the big fear that's out there. It's really a mix of cost cutting, post-pandemic adjustments and restructuring.

I think we're going to go from around 30,000 jobs created per month, which is the three-month average that we have right now, up to 60,000 or maybe 75,000 per month, which is going to be enough to support the consumer. But it's also going to be catnip for corporate earnings, because compensation is one of the largest costs in a company's cost structure.

And the one thing to really monitor, as we've talked about on this podcast time and time again, is Initial Jobless Claims, which is the number one variable in the ClearBridge Recession Risk Dashboard. Claims continue to be in the low 200,000 range, which is a really good development.

John Przygocki: Jeff, the Conference Board's Consumer Confidence Survey plummeted last month and is now at levels last seen, I believe, in 2014. Why is there such a disconnect between the confidence surveys and actual consumer spending?

Jeff Schulze: Well, the low-hire, low-fire environment isn't helping confidence in the labor market. Our job sentiment measure is at levels that are consistent with a recession because of this low-churn type of labor environment. But when you look at the decline in that survey, it was across all demographic groups. There's not only concerns about the labor market, but there's higher prices and tariffs. And there's been a disconnect with these confidence surveys and economic growth for about a decade. There really hasn't been a relationship with the two of them, really since the middle part of the 2010s. And I think it comes back to a number of different reasons.

First off, whether you're looking at the Conference Board Survey, which we've been talking about, or the other survey, which is the University of Michigan survey, both of them changed their data collection methodology. It's online now, when it used to be either by phone call or by mail. So, I think that is probably distorting the data to some degree.

Also, in the aftermath of the global financial crisis, the US has become increasingly politically divided. So, when one party is in control of the White House, the opposite party tends to be much more negative. So, for example, if you have a Republican president, Democrats are much more negative in their responses and Republicans are much more positive and vice versa. So I think that is playing in here.

And then, lastly, I think social media does impact how consumers view the economy. It creates a warped view of reality. Everybody kind of posts their stunning milestone or vacation that they're on. Rarely do people post bad days. And it creates this warped image of reality. And the uncommon seems more common today, which really weighs on how people view the economy. And it results in a negative skew to the sentiment surveys.

But what we've been saying is that the number one driver of consumer spending is the labor market. And the labor market continues to hang in there. And as long as that's the case, even with some of these negative consumer sentiment surveys, we think the consumer and their spending is going to be just fine.

John Przygocki: So, Jeff, let's transition to the capital markets. If I recall correctly, you were pretty constructive on your outlook for equities in our last podcast. Is that still the case?

Jeff Schulze: Yeah, we are still constructive. If you think about the policy backdrop that we have right now, this is something that you rarely see. You have the twin tailwinds of both monetary and fiscal policy support this year.

That is a combination that you rarely see outside of a recession. You know, the economy is going to get about $300 billion worth of additional governmental spending this year. The Fed [US Federal Reserve] has cut [interest rates] 75 basis points over the last four months, and the Fed is now expanding its balance sheet. And when you look at the tariff side of the equation, you're likely going to have peak tariffs with the year-over-year comps going negative in the middle of the year.

And that's even before the Supreme Court decision comes into play about the legality of the IEEPA [International Emergency Economic Powers Act] tariffs. So, you have all of this stimulus happening in an environment where earnings are accelerating here in the US and overseas. So, yeah, we're still pretty constructive on the markets this year. Although you're seeing some volatility here to start off the year, we think that the path of least resistance is higher.

John Przygocki: So, Jeff, after three consecutive years of 15+ returns for the S&P 500 [Index], I mean, is it possible we're overdue here for a bad year?

Jeff Schulze: I understand that mentality. You know, people always think that mean reversion has to happen and you need to have a negative year.

But when having three consecutive 15+ percent returns in a row, that's actually happened four additional times if we go back to 1940. So, this is year four, following those three years of really strong returns. When you look at year four, at those other periods, three out of four of those times, the market delivered another 15+ percent return. That happened in 1945, 1952 and then in 1998. The only year where you actually had a negative return was in 2022. So, an object in motion tends to stay in motion. And, given all of those supports that I talked about a second ago, I think we're going to have another positive year in the markets. I think 15% may be a stretch, but I do think that we can hit the high single digits or low double digits when all is said and done.

John Przygocki: Let's talk a little bit about a theme that you've been anticipating for quite some time: broadening in the equity market. Over the past two and a half months or so, there's been a strong rotation from the former leaders to the laggards across the US equity complex. Can that continue?

Jeff Schulze: It can continue. If you look over the last two and a half months, it's been a pretty strong rotation away from the Mag Seven¹ and mega-cap tech, and again into some areas that haven't fared so well since 2023.

In January, the Russell 1000 Value [Index] outpaced Growth by 6%. The Russell 2000 [Index], which are small caps, outperformed the Russell 1000, which are large caps, by 6.9%. And the Mag Seven returned just 0.6%. So, you're seeing a rotation. And a key dynamic here is that the Magnificent Seven stocks are no longer the only game in town when it comes to earnings growth.

When you look at earnings expectations for 2026, the Mag Seven is expected to deliver earnings similar to small and mid-cap stocks. And that gap between the Mag Seven and the rest of the S&P 500 has narrowed dramatically. And when you have broad earnings delivery, investors will go to those cheaper sources of earnings growth, which is the rest of the US equity landscape.

And to talk about valuations, typically, small-mid-cap stocks trade at valuation levels similar to the S&P 500 going back to 2002. Today, they trade at a discount of about six turns. So, this is one thing that's been driving this rotation, this earnings and relative valuations. And, ultimately, I think that will continue here in 2026 for at least the next 6 to 12 months.

John Przygocki: Jeff, thinking about the importance of earnings growth, what are your takeaways so far from the Q4 earnings season?

Jeff Schulze: Well, it's been a great season so far. Not as good as Q3, but it's been pretty solid from a results standpoint and from a guidance standpoint as well.

Now, the beat rate (we're about halfway through earnings season) is 6%. If you look at the number of companies that are beating on earnings, revenues—in both metrics above the average that you see at this point in the earnings season. Commentary has been upbeat. Guidance has been strong. And I think that this is something that can continue to drive markets here in 2026. And, as I mentioned on last month's podcast, I think this year is going to be a year that's driven by earnings growth rather than valuations.

John Przygocki: Jeff, how about the non-US equity space? How are the overseas markets doing so far here in 2026?

Jeff Schulze: Well, as we currently speak, the S&P 500 is up a little bit less than 1%. But if you look at the EAFE, which is developed non-US, or emerging markets in the MSCI indices, they're up close to 6% and 9% respectively. So, you've seen a rotation not only from a market-cap perspective and a style perspective here in the US, but you're seeing it from a geographic perspective as well.

And, just like I talked about, investors will go to those cheaper sources of earnings growth with mid-caps and the rest of the S&P 500. Same thing is true with global equities. Global equities trade at a huge discount to the US. I think from a longer-term perspective, it may make sense to add to your non-US exposure.

John Przygocki: Is there anything out there that could derail your fairly bullish outlook?

Jeff Schulze: There's always something, John, that can derail a bullish outlook. You know, people talk about the “sell America” trade. You know, whenever you have any geopolitical events that pop up (anything on trade, some of the wars that are going on here), you have seen the US dollar sell off, long bond yields sell off, US stock market sell off. But, again, I think at the end of the day, capital flows to the places where returns are the highest, and US assets have and continue to be the most profitable in the world.

There was a term that we used to use, TINA: “There Is No Alternative” to owning American assets. I think that's still true to some degree. But again, I do think that the non-US space, given valuations and that market concentration, makes sense to have an allocation to. So, you know, I'm not necessarily a believer in this big allocation away from US assets on a sustained basis.

What could derail our view, though, is reinflation coming back in a strong way in the second half of the year. You know, you have a lot of stimulus coming into the economy. Commodity prices are broadly higher. And if inflation does become problematic, that would create a situation where the Fed won't cut in the back half of the year and potentially could start to raise rates, which would pressure valuations in the equity markets.

But my view is: that's not going to transpire. I think inflation will continue to move lower and may get close to the Fed's 2% target by the end of the year.

John Przygocki: Jeff, the equity markets initially sold off when the announcement was made of Kevin Warsh as the nominee for the US Fed chair, but then they rallied back after that initial, somewhat knee-jerk reaction. Do you think that he is hawkish or dovish for equity markets?

Jeff Schulze: Well, the markets certainly thought that he was hawkish in the very beginning of the release of that news. But the markets actually closed the day flat. If you look forward to the following trading day the markets were up pretty substantially. So, although Kevin Warsh is known as a balance sheet hawk (And this is because when he was on the FOMC back in 2011, he disagreed with QE2. He thought that would cause inflation, and he ended up stepping down because of that. And over the last 15 years he's criticized the Fed on the size of their balance sheet.), he is dovish on the rates side of things. He's been advocating for lower interest rates for about three years.

But ultimately the FOMC is 12 voting members when it comes to monetary policy. It’s not just one individual vote. And given the fact that the FOMC recently decided to start to increase the balance sheet again through reserve management purchases because of some of the volatility that you saw in short-term funding markets and there weren't any dissents with that vote back in December, I think that this is going to be a very tough situation for Kevin Warsh to bring down the balance sheet in a meaningful way. So, he's going to be advocating for more rate cuts. And the balance sheet isn't really going to change that much. I think that that's going to be a Fed chair that's going to be supportive of risk assets as we look forward.

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

Jeff Schulze: I think the market is going to be volatile this year. Usually, the market is volatile when you have high valuations, but we continue to be buyers of dips. Yes, today looks like the late 1990s. You have high valuations. You have had a really good run for the markets. There's an infatuation with growth stocks. But I think there's a lot more differences than similarities, given the policy supports that are in place right now and the earnings growth that you're seeing in the market more broadly speaking. So, we continue to believe that this rotation, this broadening, will occur.

So, diversification is going to be much more additive to your portfolios.

John Przygocki: Jeff, thank you for spending your time with us this afternoon in the studio. To all of our listeners, thank you for spending your valuable time with us for this update today. We hope you've enjoyed it. 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.