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 designed to provide you with thoughtful perspective on the state of the US economy. Jeff, thank you for joining us today in the studio.
Jeff Schulze: Great to be here.
Host: Jeff, you were just over in Europe talking with clients in the UK, Spain and Switzerland last week. You mentioned that many of our clients were concerned about the health of the US economy. Did the ClearBridge Recession Risk Dashboard for the month of February have any changes that have reflected recent weakness?
Jeff Schulze: Well, that was a topic of conversation in almost every meeting. And it really hasn’t been a great start for a lot of the economic data that we’ve seen, a lot of the sentiment survey data as well. And some of this weakness has been picked up by the ClearBridge Recession Risk Dashboard. In the month of February, we did have two indicator changes for the worse.
So, the yield curve went from yellow to red. And as a reminder we’re looking at the 10-year Treasury minus the three-month T-bill as our proxy of the yield curve. It’s the Fed’s [US Federal Reserve] preferred proxy as well in being able to identify a recession. But it inverted at the end of last month, and it is now a red color.
And the other change was, manufacturing PMI New Orders went from green to yellow. That subcomponent, which is the most forward-looking aspect of that survey, went from 55 all the way down to 48.6.
So we took a step backwards in some of these indicators that had seen improvements in recent months. And it’s a good reminder that economic conditions don’t move in a straight line. But importantly, if you look at the overall signal, it remains solidly in green territory. Out of those 12 indicators, eight are green, two are yellow, and two are red.
But overall, with the slowdown that we’ve seen in the US economy, the weakness in the dashboard, we’ve modestly increased our odds of a recession from 15% over the next 12 months to 25%. But as a reminder to everybody, 25% is still extremely low odds of a recession in the coming year.
Host: Okay, definitely some change there to keep our eyes on. Jeff, consumer confidence dropped fairly aggressively over the course of the last month. How much does that concern you?
Jeff Schulze: Well, if we were talking prior to COVID, it would concern me quite a bit. Usually when you see a big drop of confidence, you get concerned. Are consumers going to stop buying cars? Or are they going to stop going on vacation? Stop going to restaurants? And then also, are companies going to stop hiring and stop doing CapEx [Capital expenditures], right?
So, obviously, this is something that bears monitoring, historically speaking. But you’ve seen a change with consumer confidence after the pandemic. Consumer confidence has been low and has remained low over the last 4-5 years. And even though consumers haven’t been optimistic, they’ve spent in a very robust manner, and the consumer really has been the workhorse of this economic expansion.
So what I’ve been saying is watch what consumers do, not necessarily what they say. And even though confidence has dropped, that hasn’t translated to weaker spending over the last four or five years. And really, the biggest driver of a change in consumption patterns has and continues to be whether or not people are losing their jobs. And with the jobs report that we recently got with jobless claims kind of hanging in there and remaining strong, we think that the odds of higher unemployment and a potential recession are fairly low right now, and we think that the consumer backdrop is still very much robust, with a solid labor market. And then also household balance sheets are in fantastic shape, with household net worth up over US$50 trillion over the last five years.
So, it certainly bears monitoring. But it’s not setting off the alarm bells for us on a change of the economy.
Host: Okay, let me take a slightly different angle on this. It just wasn’t consumer confidence. I think that retail sales also came in pretty weak for the same period. What does that mean for the health of that US consumer?
Jeff Schulze: Well, you always want to be wary of making too many excuses for some bad data points, but there’s some very plausible explanations for the weak retail sales print that we got. First off, people forget this, but retail sales were unsustainably strong in December. You had a really strong holiday shopping season, and you got a little bit of payback here in January. So this is just more of a normalized spending environment.
Also, we think that there were some consumers that frontloaded spending because they were concerned about higher prices due to increased tariffs. So you got a little bit of a payback here in January, and you’re probably going to get some more payback when you get the February number as well.
And then the last one was really related to natural disasters and the weather. You had the Los Angeles wildfires that were prevalent in January. And then also January was the coldest January that we had here in the US since 1988. So that obviously disrupted retail spending overall. So, when you think of all three of those factors, those are more idiosyncratic or temporary in our view, and it really doesn’t change the trajectory of spending that we’re expecting as we look to the second and third quarter of this year.
Host: Okay. You’ve mentioned jobs a couple times in your comments already this afternoon. We recently got the February jobs report. What were your key takeaways there?
Jeff Schulze: It was a pretty solid report all things considered. That’s why the markets were up on Friday when we got the payrolls report. Came in at 151,000 right around consensus expectations. Looking at it from a three- or six-month moving average basis, which kind of smooths out some jumpy prints that you can get from month to month, still very healthy—200,000 on a three-month average basis, 191,000 on a six-month average basis. More importantly, if you look at income growth, still well above inflation right now, which should continue to support consumption looking forward.
But what I will note is that the government layoffs that have been talked about with DOGE, the reduction of the federal workforce did not impact the report that we just got for February. That’s going to start to show up in March and April. So the next couple of payroll prints are going to be a little bit more bumpier than what we’ve been accustomed to over the last quarter or two. But overall, it was a pretty solid jobs report. And it’s a key reason why the markets did rally on Friday.
Host: You just mentioned DOGE or the Department of Government Efficiency. And there clearly is concern in the marketplace around layoffs that have been announced that that department has driven. How does this affect your view of the health of the expansionary environment?
Jeff Schulze: We’re going to hear about the DOGE quite a bit over the next couple of quarters, and it’s really not going away. And there are downside risks to the economy. You have the actual impact of the layoffs from DOGE. You do have uncertainty that could weigh on maybe some Capex spending decisions and hiring decisions for corporations. But it’s important to look at the number of layoffs in context of the overall employment picture in the US. The US employs about 160 million people. Seven million people are unemployed. Five million people change jobs every single month. So these are pretty big numbers. The DOGE has announced around 100,000 job cuts, and that may get to about 200,000. And even if it does, 200,000 is less than the weekly initial jobless claims number that we get in the US, which is right around 225,000, 250,000. So, yes, this is certainly going to cause some disruptions.
It is going to create some bumpy payroll reports and some modest pullback of consumer spending as we look out on a six- or 12-month basis. But the numbers that we’re talking about just aren’t big enough to really drive a change in our view of the trajectory of the US economy. And I know that the federal workforce is big, but it makes up less than 2% of overall jobs here in the US.
So, again, this is something that we’re going to hear about on the news flow pretty consistently over the next couple of months, but it doesn’t really alter our view of how healthy the economy is and how healthy the labor market is in 2025.
Host: The Atlanta Fed’s GDPNow tool is currently flashing a -2.4% reading for quarter one. Two questions. First, what is that GDPNow tool? And then second, do you think a negative GDP print is coming for this quarter?
Jeff Schulze: Well, the Atlanta Fed GDPNow tool is a nowcasting tool that looks at all of the data releases that you’ve had for a quarter (for example, Q1 that we’re in), and it’s their best guess of what GDP would be if it was released today.
So it’s a good way of kind of gauging how the quarter is going before we get the actual GDP release a month after the quarter’s over. And GDPNow went from positive 2.3% to negative 2.4% over the course of around a week and a half. So that’s a pretty big swing. It’s a 5% swing, all things considered. And the one thing I want to caution people on in looking into this model too closely, is that when you’re in the beginning of a quarter (and we’ve only gotten about a month’s worth of Q1’s data releases), GDPNow can jump very aggressively. I mean, we obviously have seen that here, but when you look at why it’s jumped, it becomes much less concerning. Yes, you had a slowdown in consumption, but as we talked about earlier, a lot of that was a pull forward and strong spending that we got from December. And you had some pretty cold weather in the US. But also part of it was higher imports in the US, which subtract from GDP. That’s the frontloading ahead of tariffs. You actually had a lot of gold imports trying to avoid tariffs as well.
And the one thing that I’d mention is while I agree with the direction of travel of the revision (yes, GDP growth is going to be slower than what we’ve witnessed in Q4 and Q3 and Q2 of last year), the magnitude is very much overstated. So, could we have a negative GDP print in the coming quarter? I’m never going to say no because anything’s a possibility. But I think it’s a very, very small possibility. And my expectation for Q1’s GDP is probably closer to 1% to 1.5%, which is obviously higher than where we currently sit right now.
And the last thing I want to mention here, a lot of people don’t know this, but Q1 traditionally is seasonally depressed. And even though the data is adjusted for different changes of weather and different patterns in economic activity, Q1 historically is much lower than Q2, Q3, and Q4. You saw it last year. We had a weak Q1. This year is probably not going to be any different.
So there’s a lot of reasons why, you know, we’re looking through some of the weaker data, and in particular the readings that we’re getting right now from the Atlanta Fed’s GDP now-casting tool.
Host: Let’s transition the conversation to the capital markets with a focus on equities. It wasn’t just the consumer confidence that has recently dropped. I believe we saw some information recently that spoke to investor confidence also taking a dip down. Is this a negative or a positive for investors? Perspective here?
Jeff Schulze: It’s a positive. Investor sentiment has dropped pretty dramatically. One of my favorite ways of gauging retail investor sentiment is the AAII Bull-Bear Spread. So basically this is a survey that looks at the number of bulls minus the number of bears. And just two weeks ago, we had one of the 10 worst readings in this survey’s weekly history, going back almost 40 years. Top 10 worst.
And usually when everybody’s extremely bearish like we are today, it’s actually led to really strong forward returns. So, on a three-month moving average, when the AAII Bull-Bear Spread is in its bottom ten percentile (so bottom decile) worst readings, the most bearish like we are today), your forward one-year S&P 500 [Index] return has been 13.6% on average, which is the best reading out of all of the deciles that you have in this observation.
So, this usually signals a major market bottom. And it wouldn’t be a surprise to me if you start to see the markets move higher near term because investor sentiment is washed out. So, believe it or not, investor sentiment actually is a contra indicator. And when everybody’s really bearish, that usually has some bullish forward-looking implications.
Host: So, Jeff, US equity markets have been choppy or volatile over the course of the last month. What’s driving this recent price action? And where do you see opportunities?
Jeff Schulze: Well, coming into 2025, you know, when we go back to the podcast a couple of months ago, we had always felt that the first half of this year was going to be choppy with some downward pressure on equities because of policy sequencing. This time around, with the new administration, we’re going to be dealing with some of the market-unfriendly aspects of the new administration, like immigration, like DOGE, like tariffs. We’re going to deal with those first before visibility starts to come from more of the market-friendly aspects of the administration, like tax cuts and deregulation.
So we’ve been anticipating this volatility. And obviously this is something that has created the market choppiness here over the last couple of months, which is not only just a growth scare, but it’s also the uncertainty due to the tariff picture.
There’s also a seasonality that’s in play right now. Usually, you see some market choppiness in the first few months following the inauguration of a new president. Also, in year three of a bull market, it tends to be a little bit more challenging on the front end than what you see in years two and three. And we entered into year three of this new bull market, in October of last year, and then from February to July, you usually see more defensive leadership in the market overall.
So there’s a couple of things that are weighing on the equity markets. But ultimately, where are the opportunities? As we just mentioned, with investor sentiment being washed out, for longer-term investors we’re advocating to buy the dip. We think that there is a good long-term opportunity in US equities, given the strength of the US economic backdrop. We also are going to get the more positive aspects of the administration, like tax cuts and deregulation in the back half of the year.
But we’ve been advocating that investors really want to look at active managers in the large-cap space because of the market concentration that you have in the S&P 500. So, right now, the top 10 stocks make up about 37% of the index. And when market concentration of those top 10 names has been above 24% of the index (so, well below where we are right now), your forward returns of the equally weighted index or the average stock versus the cap-weighted version, the equal stock has outperformed by close to 7% per year each year over the next five years, with the hit rate of the average stock or the equally weighted index outperforming close to 92% of the time. So, you saw the equally weighted version of the S&P 500 outperform in February. The Mag Seven’s1 total return last month was -8.8%. And we think that this rotation out of these large mega-cap tech stocks and into the average stock is going to continue as we look forward in 2025, which is going to be a nice tailwind to active managers that can sidestep some of that concentration risk.
So, you know, we think it’s going to be a fluid environment. We think it’s going to be choppy. But ultimately with the economy still intact, we think that there’s more upside as we look forward on a 12- to 24- month basis.
Host: So, Jeff, you did mention there the word “tariffs” as a potential or key driver of this uncertainty and volatility. Just wanted to give you an opportunity to provide maybe any additional perspective you have for us to think about on a go forward basis.
Jeff Schulze: This was probably the biggest topic of conversation in Europe last week. Obviously, the tariff picture is a very fluid situation. In a lot of meetings I was advocating that I would think that the tariffs on Mexico and Canada, the 25% across-the-board tariff, would be postponed to April. It was postponed to April. But once we get to April, you’re going to have the reciprocal tariffs come into play. You’re going to potentially have some European Union tariffs come into play. So there’s going to be a lot of noise that’s going to be coming out on the tariff front. And I think that’s a key reason why the markets are going to be choppy over the next three months, give or take, until we can actually size up the scope and the depth of what tariffs are coming to fruition.
But ultimately, I don’t think large tariffs are going to go forward on Mexico and Canada. Both countries have made concessions and shored up the border to reduce immigration and fentanyl flows. Mexico has even extradited a number of drug cartel members to the US as well. But I think because of tariffs, ultimately this is going to create some choppiness in the markets over the next couple of months.
And while I do believe it is a negotiation tactic by the administration to get better trade terms and concessions from our trading partner, and I don’t think it’s going to weigh on economic growth as much as people fear, it doesn’t mean that there aren’t going to be some pockets of volatility as we go through this period and we eventually get to the back half of the year where deregulation and tax cuts are going to come into focus.
Host: Jeff, any closing thoughts or comments for our listeners today as we look to conclude this afternoon’s conversation?
Jeff Schulze: Yeah, the markets don’t go up in a straight line. You know, we had some really good returns in the S&P 500 in 2024 and 2023. And we are going to get some more positive elements from the administration in the back half of the year.
And my expectation is for a tax package that’s going to be more stimulative than what the Street expects. And then obviously deregulation will be front and center. So, even though we are going to have a digestion period here and we are going through that, this is very common for year three of a bull market. It’s very common in the beginning portion of a new president’s administration.
But ultimately, given the strength of the US economy, given the earnings delivery that you’ve seen from the US equities, we think that this bull market has further to run, and we’d be advocating taking advantage of any weakness that you do have for your portfolio allocation decisions.
And then lastly, the Magnificent Seven has been the only game in town over the last couple of years. We think there’s a number of catalysts for rotation into small caps, into mid-caps, the average stock in the S&P 500. Into value. And we talked a little bit about one of those catalysts potentially being that the Magnificent Seven has more international revenue than small, mid and the rest of the S&P 500. But in the back half of the year, there’s going to be much better earnings delivery from these areas that have lagged, which should create much better relative performance.
So, while diversification has been subtractive when it’s come to US equities in 2023 and 2024, we think that this is the year where diversification is going to be additive to your portfolio returns.
Host: Jeff, thank you for your time and your insight. To all of our listeners, thank you for spending your valuable time with us for today’s update. And 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 any other major podcast provider.
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1. The “Magnificent Seven” are Alphabet, Amazon, Apple, Meta, Microsoft, Nvidia and Tesla.
