Transcript
Host: Welcome to talking Markets with Franklin Templeton. 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 that is designed to provide you with thoughtful perspective on the state of the US economy.
Jeff, thank you for joining us today.
Jeff Schulze: Glad to be here.
Host: Jeff, let’s start by telling us a bit about the Clear Bridge Recession Risk Dashboard. Did we continue to see progress in the month of January?
Jeff Schulze: Well, I’m happy to say that we did. And as a reminder to the listeners, back in December we had four individual indicator upgrades with manufacturing PMI New Orders, and the [Treasury} yield curve moving from red to yellow and retail sales and building permits moving from yellow to green.
So it was a lot of movement in one month. And we’ve seen a continuation of that here in January with two additional indicator upgrades. Manufacturing PMI New Orders had another upgrade going from yellow to green and money supply went to green as well. So, as it currently stands, out of the 12 indicators that we have on the dashboard—stoplight analogy, green expansion, yellow caution, red recession—out of those 12, nine are currently green, which is very reflective of the healthy economic backdrop that we currently have today. So, I’m really excited that we continue to see some followthrough on the dashboard.
Host: So, Jeff nine are green. That is fantastic. You mentioned the upgrade of the manufacturing PMI New Orders indicator. Is manufacturing an area you are expecting continued strength from this year?
Jeff Schulze: We are. Manufacturing has had some tough times over the last couple of years. Manufacturing PMI is a survey given to manufacturers asking them how business conditions are and how they look to be in the future. So it’s a good proxy of what’s happening in manufacturing. And this survey has been below 50, which is contraction, since November of 2022. So this is one of the longer manufacturing recessions that we’ve had in the US. And New Orders, which is a more forward-looking component, which is why it’s in the dashboard, surged to 55.1, which is the highest reading that we’ve seen since the middle of 2022. So over two and a half years. But some of this increase in new orders is likely a pull forward of activity in anticipation of rising tariffs. So this is probably going to be choppy over the next couple of months. But ultimately, we think that the conditions for a manufacturing rebound are very much in place.
And, quite frankly, the situation with manufacturing is pretty similar to what we saw in 2016 when Trump was elected for the first time. You know, you had a manufacturing lull in 2015 and 2016. And then once Trump was elected, it really unleashed some animal spirits through a combination of deregulation, a friendlier tax code, and a release of pent-up demand that had been building for a long period of time.
And you could see a friendlier tax code this time around for domestic manufacturers. Trump has floated the idea of dropping the tax rate to 15% from 21%. And I do think that that has a high probability of moving into place. But also, you’ve had a lull in goods demand in the US over the last couple of years. And as a reminder to everybody, in the early days of the pandemic, people bought goods instead of services because of the restrictions that were in place. And over the last couple of years, people have moved into the services more durably at the expense of goods. But we’re finally getting to the point where we are going to see a more sustained rebound in the goods sector. Now, one of the overhangs potentially are tariffs. But today the manufacturing sector is much in better position to respond to tariffs than what we saw back in 2016.
So, while you are expecting a little bit of choppiness because of tariffs, I think the elements are in place for a sustained rebound in manufacturing. But as a reminder to everybody, the manufacturing recession that we had over the last couple of years didn’t cause the economy to be really weak, and a rebound shouldn’t cause the economy to re-accelerate, but it is going to help at the margin as we look forward into 2025.
Host: Okay, Jeff, you brought up there a number of times a topic that is a hot topic that has rattled markets recently, and that’s the topic of tariffs. It seems like you mentioned your perspective on concern with these recent developments. But maybe you could touch on your expectations going forward from a country-specific perspective.
Jeff Schulze: Well, to be clear, this is a very fluid situation, so things can change pretty drastically. But, you know, I was very relieved to see that the tariffs on Mexico and Canada were pushed back by 30 days. You know, the reason why you had 25% tariffs on those two trading partners is that that was an area where the US had leverage. Both of those economies have about 70% to 80% of their exports coming to the US.
So there is a lot more leverage for negotiation with those countries. And with immigration and drugs being key talking points on the campaign trail, this was an easy win for Trump to be able to tell his constituents that he took some action and there’s progress being made on both of those areas. So the fact that we did have an extension of tariffs moving out 30 days is a really good sign that both sides, whether it’s Mexico and the US, Canada and the US, want to come to some sort of agreement.
And I don’t think a broad-based tariff will go into effect on those two trading partners. If you do see some tariffs move forward, it’s probably going to be much more targeted. But I don’t think it’s going to be disruptive, even though the markets may have some trepidation as we move through the next 30-day window.
When it comes to China, they did respond to the tariffs that were put into place. But the response was relatively limited—15% tariff on US coal, 10% tariff on cars, US agricultural machinery and some export controls on some key minerals. There is an investigation into Google from an antitrust perspective, but ultimately the markets are looking at this as a pretty benign outcome. It’s not going to be really that disruptive to the US economically speaking. And it’s a key reason why Chinese equity markets are up this morning.
But ultimately, I do think that there is a window for negotiation between the US and China. These things don’t move into effect on the Chinese side until February 10th. So that does allow an opportunity for President Trump and Xi [Jinping] to talk. And they could come to some sort of agreement and maybe some of the Phase One trade deal that was agreed upon back in 2019 will come back into play. China had agreed to increase US imports by quite a bit, especially on the agricultural side. So that’s an area that could thaw some of the relations that we’re seeing. So there is an opportunity for a catch-up for that Phase One trade agreement where that 10% doesn’t come into play. But even if it does come into play, it’s not going to be overly disruptive for the US economy even though there are going to be some areas of the economy that are going to see some dislocations.
And then some areas that haven’t been talked about—some tariffs on Europe and Japan—likely you will see some tariffs move forward, especially with Europe, as Trump has talked about his dislike for the trade deficit that the US does have with the European Union. But ultimately, we think that any escalation in tariffs will be in the 10% range, which will ultimately not be too disruptive for markets.
Host: So, you mentioned a number of different areas of the economy there, Jeff. I mean, are there particular areas in US equities that may be more exposed than others?
Jeff Schulze: There are. There’s going to be winners and losers here. The goods sector could be a relative loser. Obviously, if you’re going to be importing things from countries outside of the US, goods are going to be the ones that feel the brunt of that. So domestic manufacturers are going to benefit, as we talked about earlier about manufacturing. But goods importers are likely going to see some pain because—think about autos, for example. Autos, you can either eat the cost of those tariffs, which is going to hurt your margins, or if you pass it through to consumers, it’s probably going to hurt demand and you’re going to end up selling less vehicles in the US. So, autos are an area that are particularly sensitive in this type of backdrop, but you can use that same framework with a lot of other importers on the goods side.
So the tariff uncertainty really does reinforce our preference for the services side of the economy. This is an area that has had some pricing power over the last year. They’ve had some pretty positive earnings revisions. And they’re going to be able to sidestep some of the tariffs that are being discussed right now.
But talking more broadly about the market, an area that is actually disproportionately vulnerable to an increase of tariffs and potential retaliation from our trading partners is the Magnificent Seven[1] stocks. They have about 55% of their revenues that are generated outside of the US. A lot of that revenue is in China. If you look at the S&P 493, which is the rest of the S&P 500 minus those seven stocks, they only have 35% of their revenues overseas. And when you look at small caps and mid-caps, less than 25% a piece of revenue overseas.
So we think that smaller companies are less exposed to the effects of trade. We think that the average stock in the S&P 500 is less exposed. And because of that, that could be one of several catalysts for a rotation that we’ve been calling for more broadly over the last couple of months.
Host: Very interesting. Jeff, are there any other catalysts that might drive a rotation into other areas of the US equity complex?
Jeff Schulze: Yeah, a lot of catalysts are known. Tariffs have been known. What’s unknown is how large they’re going to be, what they’re going to be on, and which countries are going to see those tariffs. And obviously that’s creating some choppiness in the markets. But another catalyst here that’s pretty well understood by investors but has been ignored because you really haven’t seen price action reposition aggressively into them has been better earnings growth.
And when earnings growth is scarce investors tend to pile into those companies that can deliver superior earnings growth. You usually see that during an earnings recession. And we’ve had an earnings recession in the US over the last couple of years, and people piled into the Magnificent Seven stocks as a consequence. But when the opposite occurs, when you have earnings growth that’s relatively abundant, investors move into the cheaper sources of earnings growth.
And today that’s going to be value. That’s going to be small caps. It’s going to be mid-cap stocks. It’s going to be the average stock. And although this is highly anticipated, we don’t think it’s fully priced. And it’s been deferred over the last couple of quarters until you have a “show me” moment. And we think that that is going to arrive here in 2025.
And to put some numbers around that, in 2023 and 2024, the Mag Seven grew their earnings in both of those years by over 34%. The rest of the S&P 500, S&P 493 had -4% and positive 4%, respectively. So kind of flatlining. And then small caps evidenced by the Russell 2000 [Index], had negative double-digit earnings growth over the last couple of years.
But when you’ve looked at expectations for this year, that Magnificent Seven earnings advantage has dissipated versus the rest of the index. It’s only an advantage of around 8%. If you look at small caps, they’re expected to outgrow the Mag Seven by over 20% this year.[2] So I think that this is a catalyst that’s been in plain view. And as we move through this year and we deliver on those earnings expectations, I think a more durable rotation into these areas that have lagged will occur.
Host: How about the recent news? I mean, it was only last week that we had the breaking news relative to DeepSeek on the AI front. How does that play into your view at this point?
Jeff Schulze: Well, some catalysts are known, right? And it takes a little while for investors to recognize that and price it. And there’s other catalysts that come out of nowhere and really kind of change the investment landscape. And really it’s unknowable until after the fact.
And DeepSeek is a potential unknown variable, because that AI model, it’s really kind of cast some doubt on the magnitude of the AI investment cycle and the cost to train AI models. So this is having people question the demand that’s being embedded into the prices for semiconductor companies, data center capacity, power generation. And when you have lofty expectations that are embedded into some of these perceived bulletproof companies, it creates a vulnerability as people assess what future earnings paths ultimately will be.
And it’s a key reason why, you know, you’ve seen some volatility in these areas. Now, while DeepSeek raises some risks on the individual company side, there is some upside from an overall macroeconomic perspective. Now when you think about the DeepSeek open-source AI model, that’s the classic example of creative destruction. Competition always drives down costs. And it’s only a matter of time before costs for AI training essentially go to zero.
You saw this with solar costs—dropped 90 plus percent since 2005. You saw transmission costs of the internet plunged 99% between the late 90s and 2015. And it’s going to likely happen in AI as well. But when costs drop dramatically, that is going to encourage broad-based adoption for a lot of areas in the US economy. It’s going to help increase their productivity and increase their bottom line in a lot of those areas that are going to benefit from these efficiency gains are highly concentrated in the service areas.
So software, consumer services, health care equipment and services is a couple of industries that we think are likely going to benefit and ultimately that’s going to be better for the economy and for the earnings picture for the US market overall. Again, you’re going to have some winners and losers, but I think this is broadly a positive development.
Host: Any considerations for investors with long-term time horizon regarding the next 12 months?
Jeff Schulze: If history is any guide, some of the perceived market winners will deliver on that promise and become key players in tomorrow’s landscape, while others are going to fall by the wayside. If you think about the Magnificent Seven, things change. Some of those stories aren’t going to be as bulletproof as we thought, but some of those stories will be.
So I think this presents a really good opportunity for active managers in the large-cap space that can sidestep some of the potential mean reversion that we think will occur. Now, as a reminder to everybody listening, the top 10 weights in the S&P 500 make up 38% of the benchmark. And historically, when the top 10 weights have made up over 24% of the benchmark (so not 38%, where we’re at—24%) the equally weighted S&P 500 (so, the average stock) has outperformed the cap weighted index (so, the index) by an average of 7% annualized over the next five years, since 1989. That’s a pretty strong relative outperformance for the average stock.
So we think active management in the large-cap space makes a lot of sense. But I also think there’s a really good opportunity for large cap value. A lot of portfolios are overweight growth right now, just based on the price action that we’ve seen over the last couple of years. And if that is the case, it may make sense to reposition back to your strategic long-term allocation, because when value has been this cheap relative to growth, from a P/E [price-earnings] perspective, when you’ve been in the cheapest quintile of 20% of observations, value has outperformed growth by 11.3% per year over the next five years annualized—hit rate of value outperforming growth 100% of the time. So this is the time where you really see that snap back. So it’s not just going to be the average stock, but you also you should see a snap back for value relative to growth. So I think there’s a couple of opportunities that are out there for investors at the moment.
Host: Jeff, as we look to conclude this morning’s conversation, do you have any closing thoughts for our listeners?
Jeff Schulze: I do. It’s going to be a choppy couple of quarters in our opinion due to tariffs.
There’s going to be a lot of uncertainty. So the markets are probably going to be a little bit more volatile than what we’ve experienced over the last couple of years. But ultimately this is going to give way to the green shoots of deregulation and likely tax cuts as we move to the back half of 2025. So it’s important to keep that in perspective.
So even though we are seeing some market gyrations because of policy, ultimately with the economy on a firm foundation, the consumer is rock solid. Productivity growth is robust in the US. You still have monetary and fiscal support. We think that ultimately will drive markets as you look out on a longer-term basis.
Host: Jeff, once again, thank you for your time and your insightful perspective here on the US economy and capital markets. I’m already looking forward to our next conversation. To all of our listeners, thank you for spending your valuable time with us for today’s update.
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[1] The “Magnificent Seven” are Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla.
[2] There is no assurance that any estimate, forecast or projection will be realized.
