AOR Update (Podcast): Bubble or Boom?

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Host/John Przygocki: Welcome to Talking Markets with Franklin Templeton. I'm your host, John Przygocki from the Franklin Templeton Global Marketing organization. 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, welcome to the show.

Jeff Schulze: Thanks for having me, John.

John Przygocki: Jeff, let's get right to it. And let's start with where we typically start these conversations and the ClearBridge Recession Risk Dashboard. Summer seems to have been fairly tame as far as the Recession Risk Dashboard is concerned. Did we have any movement in September?

Jeff Schulze: Well, you're right, John, it was a tame summer. We didn't have any indicator changes in July and August, but September we did. It was a little bit more of a mixed month where we had one positive upgrade with manufacturing PMI, new orders moving from red to yellow, but we also had one negative downgrade with housing permits moving from green to yellow. So we haven't had a downgrade in quite some time.

But overall, when you look at the dashboard signal, we have seven green, four yellow and one red signal. But that overall green expansion color is really strong and our odds of a recession over the next 12 months have not changed, even with this movement, at 30%. So, a little bit of movement. But overall, the outlook does not change.

John Przygocki: Interesting. So, as you stated, we haven't had many downgrades in recent months. Does that downgrade of housing permits concern you at all?

Jeff Schulze: It doesn't. You look at the housing market; it's been a bit of a wild ride over the last couple of years. You had price returns that were screaming higher when we came out of the pandemic. You had a correction in the housing market in 2022 and 2023 when rates spiked and mortgages along with it, and then price appreciation over the last couple of years has been more muted because affordability is pretty low. When you look at the Case-Shiller National Home Price Index, it fell for the fifth consecutive month in a row with July's latest release.

But, although we would love to kind of see more activity from residential construction, we're not too concerned. And when we look at housing permits, the reason why we do so is it's a leading economic indicator. It moves ahead of actual shovels-in-the-ground metrics like housing starts by a couple of months, and it often falls well ahead of recessions. And since 2023, permits have been steady but choppy around 1.5 million on an annualized basis. And over the last three months, it's slipped to about 1.3 million. So we've moved it to yellow. But I want to stress here that the backdrop is a lot different than the one preceding the global financial crisis.

Underwriting standards have been really stringent. Homeowners’ equity has literally skyrocketed. It's at $35.8 trillion, which is a massive number when you consider that mortgage liabilities are just $13.5 trillion. So, you know, that gives consumers a lot of ability to tap home equity lines of credit as a source of funds if things are needed.

So, when you kind of paint this picture, yes, residential construction is weak. It's probably going to be weak for the next 12 to 18 months. But overall, because of home equity growing to the levels that it has, we think that that is a healthy dynamic that can keep the consumption outlook positive going forward.

John Przygocki: $35.8 trillion in homeowners’ equity. Wow, that is a massive number. How is the US consumer holding up?

Jeff Schulze: Well, the US consumer is doing great. I think the spending data that we've seen here recently shows that it's a bad idea to bet against the consumer. When we got the August spending data, it was really strong to the upside. But it does show that the consumer is a little bit more bifurcated. A lot of the strength that we're seeing is at the top of the income distribution, with market gains kind of fueling the consumer overall.

Same message that we got from retail sales earlier in the month. And when you got second quarter real GDP, it was just revised higher. And the key to that revision was consumption growth moving up to 2.5%, up almost a full percentage point. So, yes, the consumer continues to defy gravity. It's been more of a bifurcated type of experience.

But I do think that that's going to change next year, because when you get the refunds from a tax perspective, from the One Big Beautiful Bill, a lot of the increase of tax refunds are going to be to the low-income consumer. So I see a really robust consumption outlook next year, especially when tax refunds start to come into play.

John Przygocki: Jeff, I know in the past you've stated that the key to a strong consumer is the health of the US labor market. How concerned are you about the labor market in the United States?

Jeff Schulze: Now we're kind of flying blind, right? We had the government shut down. So, data releases from the BEA [Bureau of Economic Analysis], the BLS [Bureau of Labor Statistics] are no longer coming out. But the labor market is slow. There's no way to paint a different picture. The latest three-month average job creation has been around 29,000. And we did get in the middle of September a big revision downward of jobs over the prior year. So, every year we get a preliminary benchmark revision. And we got this one from April 2024 to March of 2025. So it's a little bit more backward looking, but you saw the biggest negative revision in history of about 911,000 jobs.

Now if you equate that to monthly job creation, that basically lowered that year's worth of job creation each month by about 76,000. So, again, the labor market's been weak for a while. If you apply those evenly to the first quarter, that means that the economy is creating only 35,000 jobs in the first quarter, which is in line with what we've seen over the last three months.

So we've been in this kind of weak labor market environment for a while. Part of that is lower immigration. Part of that is lower labor demand with the uncertainty from trade. But again, looking out to next year with the Fed cutting, with the One Big Beautiful Bill’s stimulus coming into the economic bloodstream, more visibility on the trade front, we think that labor creation or job creation is going to increase.

And although it's likely going to be an environment where we have jobs that are being created each month under 100,000, we still think that it's still a healthy labor market and one that can keep the economy moving forward.

John Przygocki: Jeff, on the topic of a US federal government shutdown, we know that this has happened before. To what degree does a government shutdown disrupt the US economy and the capital markets?

Jeff Schulze: A lot less than people think. Although there's obviously a lot of headlines around it, it doesn't really change my outlook for the economy. It does lend a little bit to some downside risk for fourth quarter GDP. And a rule of thumb is that a government shutdown reduces GDP by about 15 basis points per week. You do get a little bit of that back when the government reopens, and those government employees start to spend some of the paychecks that they get back.

But, ultimately, the markets have pretty much yawned when it comes to government shutdowns. And if you look so far here in October, the market has been moving higher as well. But to give you some statistics, the average government shutdown lasts around eight days. The longest ones were in 2018 at 34 days, in 1995 at 21 days. But ultimately, I really don't see this being an event that changes our outlook for the economy and the markets, because one of the things that could disrupt the markets is not being able to increase the debt limit.

Now, this time around, with the One Big Beautiful Bill, they did increase the debt ceiling, so we don't have that potential threat to the US government’s funding. But ultimately, you know, as an investor, I'd be looking through this, even though this may be one of the longer shutdowns that we've typically seen.

John Przygocki: Okay, Jeff. So, the US Federal Reserve's Open Market Committee cut the fed funds rate at their last meeting in mid-September. Couple questions here. First, were you surprised? And then second, what's your expectation for future interest rate cuts from the US Federal Reserve?

Jeff Schulze: Well, I was not surprised at all. Again, weak labor market, full employment is one half of the Fed's dual mandate. With the lags of monetary policy, the Fed needs to cut now if we are going to see the labor market weaken further from here.

When you look at the Fed's dot plot or their expectations for what they see themselves doing from an interest rate perspective, they see themselves cutting in October and December, and they have one more cut on the docket for next year. I'm actually a little bit more hawkish than that. I think the Fed is going to cut in October and December, because usually when you have a cutting cycle, the Fed cuts at every meeting. So I think the Fed will want to lower the fed funds rate in a fairly short order. But I don't see any more cuts because I do expect a pretty resilient economy next year. And when you look at Fed fund futures, what market participants are pricing in for the Fed, they're pricing in a total of five and a half cuts by the end of next year. And, you know, I think that it's going to be three total cuts.

Now, I want to be clear, three total cuts is actually a lot. That was what you saw in the 1995 soft- landing cutting cycle. In the 1998 soft-landing cutting cycle, that was more than enough to keep that expansion going. But I think it's just a really good development that the Fed is lowering rates at the moment. And it's a key reason why markets have screamed higher.

John Przygocki: So, Jeff, I know you've done a lot of research and analysis on previous US Federal Reserve interest-rate cutting cycles and the impact on capital markets. What roadmap does history paint for us during times like today?

Jeff Schulze: A pretty positive one. Now, when you look at all Fed cutting cycles of 75 basis points or more since 1980, we really kind of bucket them into economic outcome. Did it go into a recession, the economy, or did we have a soft landing? And a key determinant of soft landing or recession was forward earnings growth. So when you look one year after that first rate cut, if earnings growth was negative, you had a recession. And on average earnings growth was -10.3%. If earnings growth was positive, you had a soft landing.

And out of the four soft landing cutting cycles that we've had, which are 1984, 1995, 1998 and then 2024, average one year forward earnings growth was about 6.8%. Now, the good news is, when you look today, consensus expects forward earnings growth over the next year to be 12.9%. And if that's realized, there's probably potential upside for the S&P 500, because when you look two years forward from those soft-landing cutting cycles, the cumulative S&P 500 returns on average were 48.6%.

So massive, massive upside. And I think we may have stolen a little bit of that upside from the market action that we've seen today. But history would suggest that the S&P 500, should we have a soft landing, should these earnings be realized, probably has more upside to go.

John Przygocki: Jeff, in our last conversation on the Talking Markets podcast back in September, you had mentioned that this current time period reminds you of the late 1990s. Is that still the case?

Jeff Schulze: Absolutely. Back then you had the internet boom. Today you have AI [Artificial Intelligence]. You had a lot of investment. You had productivity growth. You have a ton of investment right now. And I think we are going to get that big productivity increase.

And when you look at productivity and you just think about GDP growth—let me take a step back there. GDP growth is a function of two things. The increase of the labor force. So how many more people are working in the economy and then how much more productivity that you have. So how many more widgets can I make in my factory today versus last year with the same inputs? Now if you look at labor productivity, it's increased by about 1.5% on a year-over-year basis.

But if we get a wave of productivity like we saw in the late ‘90s and early 2000s, that would substantially increase not only productivity growth, but GDP growth and earnings as well. So I think there's a pretty good parallel to the late ‘90s. And let's not forget, in late 1990s, 1998, specifically, the Fed cut 75 basis points, which really kind of kicked off that last leg higher of the equity markets into the 2000 peak.

So I still think that the 1990s are the roadmap. I don't necessarily think we're ‘98 per se. Maybe we're ‘97 or ‘96, but there's a lot of similarities today to what we saw back then.

John Przygocki: Okay, a lot of similarities. Anything in particular on the technology sector comparison to the ‘90s that you want to highlight?

Jeff Schulze: Today as in the 1990s, the stock market was highly bifurcated, with the technology sector having the most inflated multiples. Back then it was the “Four Horsemen.” So Intel, Cisco, Microsoft and Dell kind of leading that charge. And today it's the Mag Seven.¹ So yes, there are some similarities to then versus now, but there's also some pretty stark differences. So when you look at the valuations for AI beneficiaries, they've expanded rapidly. But the technology sector’s P/E [price-to-earnings ratio] or valuation is well below levels that we saw in March of 2000 at the height of the dot.com bubble.

Today, forward multiples or forward P/Es for technology is at 30.4 times earnings. In March of 2000 it was at 51 times forward earnings. So P/Es are about 20 turns lower today versus then. But I think an important distinction or difference is that the companies today are 50% more profitable in the technology sector, looking at it through the lens of return on equity versus what we saw in March of 2000. So that can provide a little bit of a buffer against maybe some potential disappointments on the earnings front, should they develop as we look forward.

John Przygocki: Jeff, you mentioned the Magnificent Seven. Do you still think that the companies commonly referred to as the Magnificent Seven will lead US equities over the course of the next 12 months?

Jeff Schulze: Well, although the Magnificent Seven has outperformed the market by a healthy margin over the last several years, really three years, I think the next 12 months may be different because the fundamental driver of their outperformance is normalizing, which is superior earnings growth.

Now, the Mag Seven delivered superior earnings growth versus the rest of the S&P 500 and SMID-caps in 2023, 2024 and 2025. Basically, it delivered better earnings growth by 30%, 30% more earnings growth in 2023 and 2024, and about 15% better earnings growth in 2025 expected. But when you look out to expectations for next year, it's a much more even environment.

So, the Magnificent Seven is expected to grow their earnings by close to 17% next year, the S&P 493 (so the rest of the index) is around 12.5%. And then small mid-cap stocks are at 17.4%. So, when you have broader earnings delivery, which we really haven't had in a long time, that means a lot of the laggards of this cycle [are] probably due for a catch up.

So small caps, midcaps and value. And I think the key driver there is going to be better earnings growth relative to the Magnificent Seven stocks. But also, these different areas of the equity market have much cheaper valuations. So, again, I think it may be a little bit of a different environment than what we've witnessed since the beginning of 2023.

John Przygocki: Jeff, how about some perspective on equities outside of the United States over the next year?

Jeff Schulze: I think they’re going to do better than what we've seen over the last decade. It's been a tough time for non-US stocks. But, you know, the stars are kind of aligning for better relative performance. So, a lot of global central banks have been cutting all this year. That's going to flow through into better economic growth next year. You're getting better visibility on the trade front, which has been a headwind for a lot of areas in the non-US space. You also have materially lower valuations than US equities.

You also have the return of some fiscal spending. Germany is a prime example of this, where they're expected to increase their fiscal spending by about 20% of GDP over the course of the next 10 years. So that's going to be a big driver for their economy and the companies that operate in that economy.

But I think there's also another driver that doesn't get a lot of airplay, which is the Fed cutting cycle. Now, again, kind of looking at all rate-cutting cycles of 75 basis points or more since 1980, when you look at those four soft landings that we talked about earlier, 12 months after that first rate cut, the MSCI EAFE,² which is developed non-US, had an average return of 24.3%, and emerging markets had an average one year forward return of 27.6%.

So, if we follow kind of this similar path that we've seen several times since the early 1980s, I think non-US stocks could do much better than what we've witnessed over the last couple of years.

John Przygocki: In recent weeks, the concept of an equity market bubble has begun to surface again. Do you have any perspective on that idea, that concept?

Jeff Schulze: Look, I understand. The S&P 500’s up over 35% from the early April lows. It's taken a lot of people by surprise. Valuations are stretched. But I think we're not at the point yet of unsustainable speculation that we've seen in past bubbles. What I think is happening right now is a reflection of a policy mix that's only seen after an economic downturn, right? You have the combination of a Fed cutting cycle, and you have very stimulative fiscal easing coming from the One Big Beautiful Bill with that peak impulse hitting in 2026. So I think that is really what the markets are pricing. The markets are pricing out a run-hot economy over the next 12 months and better earnings delivery overall.

Now, it's not to say that we might not eventually evolve into a bubble. You know, there's a lot of cash that is sitting on the sidelines. There's a lot of people that are starting to get more optimistic about the markets, but I don't think we're there quite yet. I think there's some fundamental drivers that are really driving market price action over the last six months.

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

Jeff Schulze: Look, there's no rule that says that today's bull market must replicate the scale of the past tech bubble that we saw in the ‘90s, or when you actually start to see valuations come down. But I think there's an adage that I think is really important at this point: “A bull market doesn't die of old age. It's always slaughtered by the central bank.” And with the Fed starting a new cutting cycle in September, the turning point for the economic cycle is probably a couple years away. So we see a lot of opportunities in some of the areas that have lagged: small caps, mid-caps, value, the rest of the S&P 500. We think the non-US space could do well on a relative basis as well.

And if you think about this backdrop, you don't see it very often. I talked about having monetary and fiscal stimulus when we haven't had a recession. But what also is very unique is you have strong economic growth right now, and jobs are weak. Usually, those two don't go together.

And you can have strong corporate profits and lower job demand if AI is potentially boosting productivity, increasing economic growth, lowering inflation and limiting payroll increases. And when you think about those four things—higher productivity growth, higher economic growth, lower inflation, lower payroll growth—that is a really good combination for equity markets.

Why? Lower inflation after this initial increase that we see from tariffs gives the Fed flexibility to ease rates lower. Higher economic growth leads to more revenues. And then payroll increases that are more limited keeps compensation costs in check. So, higher revenues, lower costs. That's a pretty good combination for corporate earnings.

So I think there's a plausible scenario where the market's just sniffing out a better earnings environment and has started to price it accordingly. So you know I think the trend is still higher for the markets. I think there's a strong possibility of a pullback or maybe even two because it's been such a great year off the lows. But, you know, looking ahead we remain buyers of dips, because you do have the tailwinds of fiscal and monetary policy blowing strongly on the back of the economy in markets right now, although leadership may look a little bit more different than what we've seen over the last couple of years.

John Przygocki: Jeff, thank you for sharing your insight with us today. 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 at any other major podcast provider.