AOR Update (Podcast): Three Fed rate cuts likely by year’s end

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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. I'm 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 studio.

Jeff Schulze: Thanks for having me, John.

John Przygocki: Jeff, let's kick off things today with the current health of the US economy. It seems like there's quite a bit of noise out there. How do you see it when viewing this month's update to the ClearBridge Recession Risk Dashboard?

Jeff Schulze: Well, it was a pretty quiet summer from a dashboard standpoint. We had no changes in July. We had no changes in August. There were some moves underneath the surface, but overall, out of the 12 indicators that make up the dashboard, [we] still have eight of them that are green; two yellow, which is caution; and then two that are red, recession. But overall still have that strong green expansion color, which is consistent with odds of a recession over the course of the next 12 months of around 30%.

So although it's been a softer summer than what we've seen over the last couple of years, the economy, per the dashboard, continues to hold up.

John Przygocki: Jeff, one potential fly in the economic ointment is the labor market. July's payroll report was very disappointing. We just got the August payroll numbers this morning. What's your take on that release?

Jeff Schulze: Yeah, we just got it a couple of hours ago and not going to sugarcoat it, it was not a great report overall. Payrolls were 22,000. The unemployment rate ticked up to 4.3%. And the unemployment rate is becoming much more important because there's some questions on what breakeven level of job creation is with the lower immigration that we're seeing this year. So a lot of the Fed officials, a lot of people who watch the labor markets, like myself, are really gauging the unemployment rate as a better barometer of what's happening in the labor market.

But I think also, you did see revisions to the prior months of July and June. And, although it was nowhere near the levels that we saw in July, which is good, you looked at June and June right now has outright negative job creation, which was the first time that we've seen a negative month since 2020. So to put some numbers around it, over the first four months of the year, monthly average job creation in the US was 123,000 per month.

Over the last four months, total job creation. So not monthly, but total over those four months was 107,000. So we've gone from around 123,000 per month to about 27,000 per month. So a huge drop in job creation. The labor market right now is at a standstill.

When we look out to 2026 reasons for optimism, we do have the fiscal stimulus from the One Big Beautiful Bill coming into effect and that peak fiscal impulse for the consumer is going to hit in the first half of next year when tax refunds come out. I think we get some Fed cuts. We're going to get visibility on the trade front. But if you're looking at the labor market right now, labor markets at standstill levels, and I think that's probably going to create a little bit of market volatility near term.

John Przygocki: So Jeff let me go back to the ClearBridge Recession Risk Dashboard. Are there any indicators on the dashboard that follow the labor market specifically? And what's the message that they're telling us?

Jeff Schulze: Yeah. So obviously the labor market is a key determinant of the health of the economy. So we do allocate quite a bit of the dashboard to focusing on the labor market. In fact, out of those 12 indicators, three focus on the labor market. So you have jobless claims, you have a job sentiment and you have wage growth.

So two of these are positive right now. Initial jobless claims. The latest release came in at 237,000. That's very low from a historical perspective. It's consistent with this low fire, low hire type of environment. So although it's hard to get a job, a lot of people aren’t actually losing their job. And with initial jobless claims at these levels, a really good sign because when the initial jobless claims turns red, it usually coincides with the start of a recession and right now it's firmly in green territory.

So initial jobless claims is looking good. Wage growth is green as well. And as a reminder to the listeners, when we look at wage growth, we want lower wage growth. That's actually consistent with the green output. Because when you have high wage growth, it means you have higher inflation, a more hawkish Fed, and it means that you're probably closer to the end of the cycle. And with today's release, average hourly earnings on a year-over-year basis dropped to 3.7%. So that's in a pretty healthy green level.

And then the last one is in red territory. That is our job sentiment measure. And what we're looking at there is data from the Conference Board's Consumer Confidence Report. And within that report, we're looking for the difference in the number of people that are saying jobs are plentiful, minus those that are saying jobs are hard to get. And the reason why this is important is because when you see a deterioration in consumer perceptions of the labor market, it tends to proceed slowdowns in consumption as individuals hold off on marginal purchases, given less confidence in their ability to find work. Now, the key here is that this metric has been in red territory for over two years. And normally I'd be really concerned about this, but we believe that this indicator has suffered from the post-pandemic vibecession, where a lot of these sentiment surveys have been biased negatively without translating into actual changes of behavior.

So, you know, in a high inflationary environment, people aren't very optimistic. They don't like paying higher prices. But at the end of the day, as long as the labor market continues to be healthy, people have continued to spend. So this metric is at the lowest level that we've seen since March 2021. But we aren’t as concerned with the metric than we traditionally would be.

So it's a little bit of a mixed bag. But overall, you know, the labor indicators are showing that the labor market is holding in there.

John Przygocki: All right, Jeff, well, given the importance of the labor market, I want to ask one more question. Are there any additional data points worth mentioning at this time on the labor market to help paint a proper mosaic?

Jeff Schulze: Yeah, we got a job openings release. It's called the JOLTS release earlier this week as well. And that showed, again, signs that were consistent with a softening labor market. Job openings were at the lowest point that we've seen since September 2024. If you look at job openings to the unemployed ratio, it's a good way to understand how balanced the labor market is.

It fell below one for the first time since April of 2021. So there's less demand for workers overall. The quits rate is low, and workers are staying put. As I mentioned before, the hire rate was low. Layoff rate is low, so there's not a lot of movement in the labor market. But again, when you put all of this together, it shows, yes, the labor market is weakening. It's not cracking quite now, but obviously it does introduce some risks on that front for the economy as we look forward.

John Przygocki: All right. So let's transition now to what this all means for the US Federal Reserve. Do you think that the Fed's open market committee will cut the Fed funds rate later this month? And if yes, is this the beginning of a rate cutting cycle?

Jeff Schulze: Oh yeah. Especially after today's labor release, the Fed is likely cutting (I can say that confidently) in September. If you look at fed fund futures, the markets are actually pricing the Fed cutting 1.2 cuts, in September, which means there's a chance of a 50-basis point rate cut.

Now, I think the numbers today weren't that bad that a 50 [bp cut] is on the table. But ultimately the markets now see a cut in September, in October and in December. So three cuts to close out the year overall. And I think that that feels about right. I think we probably do three cuts. I don't think we need more than that.

I think three cuts is consistent with what you saw in 1995’s soft landing or recalibration. Same thing in 1998. And I think that coupled with, again, the peak fiscal impulse from the One Big Beautiful Bill, which is going to be around 1% of GDP and most of that hitting in the first half of next year. Also, greater visibility on the trade front, unlocking some animal spirits from corporations. You're going to see more capex [capital expenditures] because of the immediate expensing provisions in the One Big Beautiful Bill. So that has given the corporates the incentive to invest in the US from a structures or an equipment standpoint. I also think when you get more visibility and we get through this soft patch that's going to create more hiring.

So I think we get a cut in September. I think we probably get follow through on that in October and December. But after that, I think we're probably going to see the end of the Fed cutting cycle. But obviously that's going to be contingent on the data.

John Przygocki: I don't want to lead the witness here, but, so let me think about how I ask this question. It seems like the Federal Reserve isn't really overly concerned about inflation, given the tariff situation. Is that accurate? Should they be more concerned?

Jeff Schulze: Look, the Fed would love to have more time to assess the inflation situation with tariffs over the course of the rest of this year, but they don't have the luxury of doing that anymore. The three-month average job creation is 28,000 per month. It's 27,000 per month if we're looking at this over the last four months. So with the labor market at stall speed levels, the Fed can't wait. And they need to start lowering rates now, given the lag that monetary policy has in hitting the economy. So inflation's going to be picking up. You've started to see goods inflation turn positive. Usually goods inflation is flat or negative. You're going to see more of an inflationary impulse as more and more companies start to pass along those price increases. And when you look at companies in Q2 that discussed mitigation strategies for increased cost of goods from tariffs, about half of them said that they would be passing on costs to consumers.

But that's not the only lever that companies have to pull. Three quarters of those companies said that they were negotiating with suppliers, or they're going to be adjusting their supply chain. So exporters are going to eat some of this; businesses are going to eat some of this; and consumers are going to eat some of this. And really, when you pass it through to consumers, that's what shows up on inflation.

So although inflation is moving higher it's important to realize that tariffs are like a tax. It's a one-time increase of prices to consumers. And that's ultimately going to take away the ability for the consumer to spend some of that money on other things. Right? If you're spending more on an automobile or furniture, that means that there's less money to spend on going out to eat or maybe back to school supplies.

So while the Fed is concerned about inflation, labor markets are just more in front and center in the greater risk at this point to their dual mandate.

John Przygocki: Okay, one more on the US Federal Reserve. I guess it's a two-part question here. Is the Federal Reserve's independence important and are you concerned, given some of the recent activities between the administration and the Fed, that that independence might be in jeopardy?

Jeff Schulze: Fed independence is paramount. You know, the reason why we have lower borrowing costs, whether it's to 10-year Treasury, 30-year Treasury, tighter credit spreads, higher equity markets, is that the Federal Reserve does have its independence. The White House hijacks the Federal Reserve, that means lower rates, higher inflation and higher risk premiums that are going to be embedded into all of those assets.

So Fed independence is really important. Now, obviously there's some concern as the administration has attempted to fire Fed Governor Cook for cause on the basis of alleged mortgage misrepresentation. And when you go back to the Fed's founding in 1913, no president has attempted to fire a Fed governor. So we're in unmarked territory at the moment. But I think this case is going to end up at the Supreme Court.

Now, the key is that if the Supreme Court decides that the president can make the determination of what actually constitutes cause for dismissal, and there isn't any independent judicial determination, that could be something that weakens Fed independence, and ultimately will probably weigh on financial markets. But when you look to the Wilcox case, which was when Trump tried to fire regulators earlier this year, the Supreme Court said that Trump could fire regulators or head of regulatory agencies without cause. But they carved out the Fed and said that the Fed is different. You need to have cause in order to do so.

So, we're not going to get visibility on this for quite some time. Ultimately, this could undermine Fed independence at the margin, but ultimately, it's not going to have any real risk on the near-term path of policy, because if you look at the Fed Governor Cook, she was biased on the dovish side. And anybody that would potentially replace her would probably be on the dovish side as well. But ultimately, this is something that bears monitoring. But the markets really haven't priced any real risk premium into this because it's an evolving situation.

John Przygocki: All right. We've got another bit of a hot topic here. The Court of Appeals for the Federal Circuit ruled earlier this week that some of the current tariffs were illegal. What does this mean for the trade policy going forward? And is this a positive development?

Jeff Schulze: Well, it's blocking the president's use of the International Economic Emergency Powers Act tariffs. I like IEEPA better. It's much more brief. It's easier to say.

But if you're not familiar with which tariffs fall under that statute, it's really the part of the tariffs that were announced on fentanyl, tariffs against Mexico, Canada and then all the tariffs that were announced on Liberation Day. So this is about 70% of the increase of the effective tariff rate that we've seen to date.

And now this is going to get kicked up to the Supreme Court. And if it does, we're likely not going to get a ruling until June of 2026. So we've got about nine months before we ultimately see whether or not these tariffs are able to be used. Now, the key here is even if it's not able to be used by the Trump administration, the Trump administration can stitch together those tariffs in a similar fashion.

Trump could use section 301, which are the tariffs that were used against China in 2018 and 2019. Section 232, which are those sectorial tariffs that we've all heard about: tariffs on autos, auto parts, pharmaceuticals, semiconductors, copper. And also the president can use section 122 or 338. But the key takeaway here is that tariffs aren't necessarily going away. They may just look and feel a little bit different and be a different flavor than what we currently have.

Now, one of the things that could be positive is that if the courts do determine that those tariffs are illegal and they must be terminated, the administration will be forced to issue retroactive refunds for all the tariffs that have been paid up until then.

Now, if they issue those refunds back, it's about $100 billion worth of revenue through today. If those tariffs are allowed to stay in place until the middle part of 2026, until this decision is rendered, that's going to be closer to 200, or maybe $225 billion worth of tariff revenue. And that's going to act like a big stimulus check going to US companies that have paid tariffs, which would ultimately be good for financial markets, but also that could help those companies do more Capex, do more hiring, and ultimately push up economic growth in 2026.

So obviously, this is a fluid situation, but there is a silver lining where this ultimately could be good for economic momentum in the markets, generally speaking.

John Przygocki: All right, Jeff, thank you for that answer. Let's transition now quickly over to the capital markets. Thinking about US equities. The S&P [500 Index] seems to be hitting all-time highs every week. Can it continue to move higher from here?

Jeff Schulze: Well, I think with the weaker [employment] report that we got today we're going to see some volatility. We're probably going to see a growth scare. Markets are likely going to be choppy. And this is normal. Markets have had a long and great run over the last couple of months. But looking forward we see higher highs ahead.

One of the reasons why we're optimistic: if you look at the year-over-year change in the next year's earnings expectations, they started to move higher. They were decelerating, which is usually a bad dynamic for the markets. But this is after a really strong second quarter earnings season. They've started to move higher again. And that's one of the reasons why we've had this market rally. And I think that could be a reason why the markets continue to rally going forward.

Operating margins for the S&P 500 are now close to the all-time highs that we saw at the end of 2024. And then also we have a weaker dollar, which helps earnings. We have AI adoption. You have tax cash savings, which is a lower tax rate because of the One Big Beautiful Bill. And wages are moving down, which tends to create better earnings for companies and gives them positive operational leverage. So you kind of put all of this together—a Fed cutting, fiscal stimulus, better visibility, animal spirits—again a really good concoction for equity markets that are going to move higher, even though I could easily see a situation where we have some near-term volatility as we move through the next couple of months.

John Przygocki: How about small-cap stocks? US small-cap stocks have finally clawed back some of the relative performance compared to US large cap stocks in August. Is this a bit of a head fake, or do you see more upside for the small caps?

Jeff Schulze: I see more upside, like over the last month, through the middle part of today, the Russell 2000, which is the small-cap index, is outperforming the Russell 1000, which is the large-cap index by about 4%. That's really small. I think that there's more upside to come. And I think rate cuts are obviously going to be needed in order to really help out small caps and some of those lower quality stocks that are out there. Now, small caps are much more interest rate sensitive. They tend to have more floating rate debt. So this is something that can really kind of supercharge their earnings potential and have them exit the earnings recession that they've been in over the last couple of years.

Let's also not forget small caps are going to benefit as well from immediate capex and R&D [research and development] expensing, because they are more focused domestically speaking than a lot of companies that are out there. They're also going to benefit from deregulation. You're going to have more M&A [merger and acquisition] activity, lower compliance barriers. And I think, even though it's been a frustrating trade for a lot of people with small caps over the last couple of years, because you've had these periods where small caps outperform and then they promptly give back that outperformance versus large caps, I think we're probably at the point where this will be a more durable trade over the next call it 18 to 24 months, until we probably get to the other side of 2026 going into 2027. So I do see more upside for small-cap stocks. And I think the cutting cycle probably being a little bit larger and a little bit longer than what I was anticipating a couple months ago, is going to be a key driver of that.

John Przygocki: How about the mega caps? Will the Magnificent Seven[1] stocks continue to lead?

Jeff Schulze: I think in the near term it's difficult to fade the Mag Seven stocks, right? They just have such a superior earnings profile versus the rest of the index. The Mag Seven, if you look at R&D and capex, they're going to spend about $700 billion this year. And if they get immediate expensing, a big boost to their cash tax rates, their free cash flow generation.

But ultimately, when you look out on the horizon, you look at the second half of 2026, I think there's going to be a turning point for the rest of the index. In the second quarter of next year, the S&P 493, so the rest of the index, is expected to be at the same earnings growth of the Mag Seven. And then in the back half of the year, the rest of the index is expected to outgrow their earnings versus the Mag Seven. So I think the Mag Seven will probably be in a good position over the next quarter or two.

But looking at it on a longer-term basis, the broadening out of earnings growth, a stronger economic environment, all that stimulus that we talked about before, I think the average stock is going to start to do better on a relative basis. And it's not to say that some of these Magnificent Seven stocks aren't great stocks, but I think it's going to be a stock picker’s market where, you know, you're really going to have to understand what's embedded into these stocks and whether or not those expectations are attainable and able to be beat going forward. And I think active managers obviously have a really good competitive advantage versus passive indices in this regard.

John Przygocki: Jeff, as a historian of our economic past, you've always done a terrific job giving us relative time periods to compare to current times, to give us a view through the looking glass. Given the landscape today, is there any time period that seems similar that can provide additional perspective for us?

Jeff Schulze: Well, it's hard to ever match up a period directly, but you can have some parallels. And I think today really feels like the late 1990s, I would say 1998. In October of ‘98, the Fed started its cutting cycle again. And that was due to the long-term capital management crisis.

And that really set the stage for the tail end of the dot.com bubble. And back then there was an emerging technology that everybody was excited about. There was a lot of capital that was being deployed into that technology, similar to AI today, which I think could result in a nice productivity wave. The one thing that we have today that we didn't have back in the late 90s is we just passed a large fiscal package.

So I think when you kind of put this mosaic together, yes, US equities look expensive, but I think the returns that we could get over the next couple of years really could surprise people to the upside. So, in just thinking about, you know, some parallels, it does seem to rhyme a lot with what we saw in the late 1990s.

John Przygocki: Jeff, as we look to conclude today's terrific conversation, do you have any closing thoughts for our listeners?

Jeff Schulze: Well, I think we may see a period of volatility. I mean, it's been a long time since we've had some real volatility. Could get a growth scare. But we are looking at this as a potential buying opportunity if you have cash on the sidelines. Because when you look out to 2026, I think it's going to be a pretty big year for US equity investors. Right? You have a policy mix that you rarely see outside of a recession. You’ve got a big fiscal stimulus coming, and a lot of that's going to hit the consumers when they get their tax refunds in 2026. You've got Fed easing that's likely on the way. You’ve got regulatory relief that's coming. You potentially have tariffs that are going to be refunded back to corporations, which would be another big boost, not dissimilar to a lot of the stimulus that went out in the aftermath of the pandemic. And when you put all that together, that creates just a more resilient economic backdrop but also broadening earnings backdrop as well.

And I think some of these laggards are going to do a little bit better than what we've seen. Small caps, value. Some of the more rate sensitive areas of the markets like homebuilders and transportation. I think diversification is going to be much more additive than it has been over the last couple of years. So I think the key takeaway here is that, yes, we may see some choppiness, but I think any dip that we see is likely a good opportunity for longer term buyers to buy.

John Przygocki: Jeff, thank you for your terrific insight here today on the economic and capital market landscape. To all of our listeners, thank you once again 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 any other major podcast provider.