AOR Update (Podcast): Two Macro Economic Risks Fading

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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 with Jeff Schulze for our monthly conversation focused on the state of the US economy.

Jeff is the Head of Economic and Market Strategy at ClearBridge Investments. ClearBridge is an active equity manager at Franklin Templeton, offering a broad range of strategies across global markets. Jeff, it's great to see you. Welcome to the show.

Jeff Schulze: Glad to be here, John.

John Przygocki: Jeff, as we typically do on the podcast, I want to start off our conversation talking about the economy in the United States. I was out of town for a couple days over the holiday weekend, and it seemed like the economy was firing on all cylinders for the 250th anniversary of the United States. How do you see the landscape through the lens of the ClearBridge Recession Risk Dashboard?

Jeff Schulze: Well, the US economy appears well positioned to remain resilient over the next year, because we still have a very strong overall green signal from the dashboard.

As a reminder to the listeners, it's a stoplight analogy where green is expansion, yellow is caution, and red is recession. And out of those 12 individual indicators, 11 of them are green, and we didn't have any changes last month. And, you know, with 11 green signals, our recession odds should be at 15% if there were no geopolitical considerations. But we've nudged that higher to 20% over the next 12 months, because we could have a potential re-escalation in the Middle East. But the key takeaway here is that the economy is on a pretty solid foundation right now.

John Przygocki: Okay, no indicator changes. Economy’s on a solid foundation. Let's focus on employment. The June jobs report was released last week, and I believe the results were weaker than stated expectations. What was your take on the results of that employment report?

Jeff Schulze: Well, it was weaker than consensus expectations. You did see some revisions downward for the May and April payrolls report, but it's still a healthy labor market overall. And it's a very different backdrop than what we saw in 2025.

Now, over the last three months, average monthly payrolls have been 111,000. And that may sound low. But when you go back to last year, throughout the entirety of 2025, the economy created 116,000 jobs. And we're seeing that every month here in the US.

So, you know, the labor market has gone from zero to hero here in 2026. But what I'm actually more excited about is that the unemployment rate dropped a little bit to 4.2%, but also, you're seeing a broader swath of payrolls being created. Breadth is increasing. A good stat there is that when you look at employment outside of health care, last year it was negative 271,000 jobs. This year—and this is only six months of 2026—it's positive 376,000 jobs. So, ultimately, I still view the labor market as a pretty healthy area of the economy. And, if anything, the weaker print that we saw here may encourage the Fed not to hike as you look out over the next 12 months.

John Przygocki: Okay. A weak labor market is one macroeconomic risk that seems like it's faded this year. Are there any other risks that were present but may have faded that make you more constructive on the potential opportunity in the second half of 2026?

Jeff Schulze: Yeah, if you think about the two macro risks that we've had over the last 12 months, we just talked about that weaker labor market. The other one is obviously higher oil prices. But following the MoU between the US and Iran, oil has reversed its entire spike that we saw over the last four months. And this decline comes at a really important time to help consumption, because that boost from those larger, One Big Beautiful Bill tax refunds are starting to fade. Also, when you look at credit and debit card bank data, there are signs that the K-shaped consumer that's been a feature of this economy over the last couple of years is starting to narrow. The lower-income individuals are starting to spend more.

And I think it really relates to a topic we just talked about, which is job growth is starting to broaden out into new areas. You're starting to see some positive payroll prints in manufacturing. Construction jobs are starting to increase. Last year, professional and business service jobs were negative consistently. They've been pretty consistently positive this year.

So that's a positive dynamic. It's obviously something that we're watching. But at a minimum, even if this is a temporary phenomenon with the labor market strength that we've seen, the lower oil prices and easing inflation, all of that is going to lift real income and support the consumer, broadly speaking, over the next two to four quarters.

John Przygocki: All right, Jeff, you mentioned oil in that previous answer. Let's dig a little bit deeper on the topic of oil. Are there any other potential implications that may come from lower oil prices?

Jeff Schulze: Well, yeah, obviously they support consumption. They support economic activity. They lower business costs. So, they're, generally speaking, good for business margins. But they also can set the stage for lower ten-year Treasury yields. So, when oil prices peak and they start to decline, headline inflation pressure eases, inflation expectations move lower and investors start to anticipate a less aggressive Fed. When you go back to 1990, after major Brent crude peaks (and there's been seven of those major peaks), the ten-year Treasury has fallen on average 28 basis points three months after that peak, 67 basis points six months after that peak, and then 81 basis points a year following those major peaks of Brent crude. And out of those seven observations, really only one of them saw rates rise. And that was in June of 2022.

But when you think back to then, very different scenario than where we currently sit, because inflation was going through the roof, the Fed was hiking 75 basis points per meeting. You also had a really tight labor market—a very different scenario than where we currently sit. Now, I know when you look at ten-year Treasury yields, they've remained elevated because the Fed's trying to restore credibility after overshooting their 2% inflation target over the last five years. But with how sharp of a drop that we've seen in oil, I do believe that inflation could moderate faster than anticipated and trigger that typical repricing that you see across the yield curve. And if that happens and we do have lower yields, that's going to be really good for equity markets, because lower yields supports equity valuations and overall returns.

John Przygocki: Okay, you just mentioned equity valuations potentially being supported by a drop in the ten-year Treasury yield. Is the historic relationship between stocks and bonds changing?

Jeff Schulze: Well, equity valuations are closely tied to interest rates and the level of bond yields. But that relationship tends to shift alongside whatever the dominant macroeconomic challenge is. So, when you go back to the ’80s and ’90s, inflation was the primary concern after that price surge that we saw in the 1970s. And that caused the relationship between the S&P 500 [Index] and the ten-year Treasury yield to be persistently negative, because higher rates signaled higher inflation, a more hawkish Fed, and eventually that would pressure earnings.

But that dynamic changed between 2000 and 2020 because deflation became the bigger global risk, pushing stock-bond correlations into positive territory. Now, since 2022, inflation again has become that major challenge for the economy. And we've seen that shift of correlations going back to the negative pattern that we saw prior to the year 2000.

Now, how long is this relationship going to last? It's hard to know. It's really going to depend on the persistence of above-trend inflation. But when you think about these shifts of positive and negative correlation, they tend to be secular in nature. They tend to be persistent in that regime over a 10-to-15-year period. And right now, this is the second time that we moved into negative correlation territory since that inflation surge in 2022. So obviously this is something that's worth monitoring as we look forward.

John Przygocki: Jeff, I know that your team has done some analysis on negative correlation regimes of stocks and bonds. What areas in the stock or equity space have historically done well during times like today?

Jeff Schulze: Well, we can go back to the late 1980s. That's when you have good index-level data to look at these negative correlation periods. And since the late 1980s, we've had five periods of negative correlation that lasted longer than a couple of days. Each one of these periods were 200 days or longer. And when you look at all of the different areas of the equity complex, the areas that did the best were emerging market and infrastructure equities. Emerging markets during periods of negative correlation have delivered 24% returns annualized. Infrastructure equities have delivered 20% return. So, we are in a new regime where we're going to have negative correlations. These are probably two areas that you may want to add to your asset allocation to give you protection should this be a persistent regime shift.

John Przygocki: Jeff, I want to stay on equity valuations for another minute or two. What would you say to someone if they said that the companies in the S&P 500 are expensive at the current time?

Jeff Schulze: There is probably broad agreement that valuations are elevated with the S&P 500 trading above 20 times forward earnings. But that said, you've had rich multiples really ever since the pandemic. It's been the norm. To put some numbers around it, the index has been above 20X 64% of the time since we first crossed that threshold in April of 2020. So, about two thirds of the time you're above 20X. But the key takeaway here is that, yes, we've had elevated valuations, but it has not derailed returns for the S&P 500. Over the past 75 months (so, since we first crossed that threshold), the S&P 500 is up 157%, which is 16.6% annualized, or roughly twice its long-term average. But when you think about that, strong earnings have been that key support, with forward earnings expectations up 155% cumulatively.

So, the S&P 500 is in a higher-valuation regime. But earnings are doing all of the heavy lifting. And we think that that's a dynamic that will continue to support the market in the second half, just as we had anticipated that in the first half, and we clearly saw that happen.

John Przygocki: Jeff, how about US-based growth stocks? Are they expensive as well?

Jeff Schulze: If you do the same analogy with the Russell 1000 Growth, this cycle, if you go back to the first time we crossed 25 times forward earnings, it was April of 2020, just like we just talked about in the S&P 500. The Russell 1000 Growth has been above that 25 forward P/E 76% of the time. More importantly though, index returns have been 188%. Forward earnings growth—they have returned a cumulative 188%. So it's been entirely an earnings story on the growth side of the ledger as well.

But one thing that I'm optimistic about is that multiples for large-cap growth stocks have derated. In the second half of last year, forward P/Es were over 30. Today they're below 25 or that threshold that we just talked about. So, just like we're seeing with the S&P 500, it's entirely an earnings story. And, again, that's why we're pretty optimistic as we look towards the second half of the year—because there's no indication that earnings are close to rolling over at this point.

John Przygocki: So, Jeff, we've absolutely had periods of volatility in recent times. There's a potential catalyst I guess you'd say of volatility coming up here later this year with the midterm elections. What does history tell us during a period that we're entering into this year in the cycle compared to others in a four-year presidential cycle?

Jeff Schulze: Volatility is the norm when you think about midterm election seasonality. Midterm years are difficult because they introduce political uncertainty. Investors know control of Congress may shift. And we're unsure about the implications for taxes, for regulation, spending, deficits, different sectors. Also, the president's party typically loses seats, which increases the risk of gridlock or some sort of policy change. And because of that uncertainty, it's historically weighed on returns with the midterm election years, which is year two of the presidential cycle, delivering the weakest average performance of the four years, coming in at 4.6% on average. And this goes all the way back to 1950.

John Przygocki: So, should we be concerned about this midterm seasonality or is it overblown?

Jeff Schulze: Well, although equities have historically posted lower annualized returns in that second year of the presidential cycle, the business cycle backdrop ultimately matters more than the policy calendar. And today's earnings outlook is much stronger than typical midterm election year precedent. Sell-side right now, consensus expects 2026 earnings growth of 23.9%, which is nearly three times the historical midterm average of 8.3%. And in our view, that earnings strength should help offset that usual midterm seasonality headwind.

Also, we had close to a 10% first quarter drawdown tied to the Iran conflict, which may have pulled forward some of that volatility that's normally associated with the midterm elections. So, you know, we think that the business cycle backdrop is going to trump that seasonality that you typically see.

John Przygocki: Jeff, the S&P 500 had one of its best quarters ever in Q2 of 2026. How has the market done historically following strong runs like the one that we just experienced?

Jeff Schulze: Well, whenever you have strong gains, people get a little finicky. They think that the market is due to go down, but typically strength begets more strength. So, last quarter was the 12th strongest quarterly gain for the S&P 500 since 1950. It came in at 14.9% from a price-return perspective. And after similar rallies of the top 15, the market has typically advanced further, and average gains were 5.5% over the next three months, 10.4% over the next six months.

So, although markets may pause or maybe even correct a little bit, history suggests that these episodes are usually temporary and that the indices should move higher in the second half of this year.

John Przygocki: So, Jeff, as we look to conclude this afternoon's conversation, do you have a closing thought for our listeners?

Jeff Schulze: So, the Long View that we're going to be releasing this week, the title of it was called “Not a Straight Line.” And what I wanted to do there is I wanted to compare the stock market's climb to the trek to Everest Base Camp. Even though the destination is higher than the starting point, the path isn't a simple, steady climb upward. In Nepal, trekkers gain elevation, they descend into valleys, and then they climb again. And that's repeated many times, which is why the total vertical climb is almost double the difference in elevation between the trailhead and base camp.

Markets work in a similar way, with a journey that's higher that often includes pullbacks, rallies, pauses, and setbacks along the way. And just as a hiker must accept the switchbacks and the acclimatization stops required to reach base camp, investors must recognize that volatility is not an interruption of the journey, but part of the path forward.

Now, what I'm encouraged about is that this acclimatization period appears to have already begun. The S&P 500 has been flat over the past six weeks, which is remarkable considering how strong of a gain that we had in that second quarter. So, with the economy on solid footing as several of these headwinds fade, we think that the market's recent period of choppiness looks less like a warning sign and more like a normal part of the climb higher.

The improving fundamental backdrop is really supportive with strengthening job gains, lower prices, which should help boost corporate earnings. And we ultimately think that's going to continue to be the primary driver of the market's advance. So we think that the market's going to keep climbing. And we are continuing to be buyers of dips should any of them appear.

John Przygocki: Jeff, thank you for your time this afternoon and for today's update. To all of our listeners, thank you for spending your time with us. If you'd like to hear more Talking Markets with Franklin Templeton, please visit our archive of previous episodes and subscribe on Apple Podcasts, Spotify, Amazon Music, or just about any other major podcast provider.