AOR Update (Podcast): What is the labor market signaling?

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. 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. I'm excited to be here.

John Przygocki: Jeff, as we typically do on this podcast, let's start off talking about the US economy. I'd like to focus on the ClearBridge Recession Risk Dashboard from last month and see if there have been any changes.

Jeff Schulze: Well, there were not. The output that we saw in July was the same as June. So it's a pretty healthy overall dashboard. Out of those 12 individual indicators, eight are still green, two are yellow and two are red. And we have a strong overall green expansion color. And our odds of a recession didn't move last month. It's still 30% over the course of the next 12 months.

John Przygocki: No changes. Has your view on the economy and how it will play out over the course of the next year changed?

Jeff Schulze: It hasn't. We have been expecting a second half tariff-induced soft patch before reaccelerating in 2026 on the back of three key catalysts: a Fed [Federal Reserve] cutting cycle, peak fiscal impulse from the “One Big Beautiful Bill” that was passed and an unleashing of corporate animal spirits as we get visibility on the trade front and the One Big Beautiful Bill’s tax provisions really incentivize capex (capital expenditure) from a corporate perspective.

So we're expecting a slowdown. You're starting to see it in the numbers. For example, consumer spending came in at 1.4% annualized in the second quarter. I'm expecting that to drop below 1% when we get to Q3’s GDP number. But ultimately, I think that those catalysts will create a reacceleration of momentum as we turn the page to 2026.

John Przygocki: Jeff, if I remember correctly, in our conversation last month, your expectations for a slowdown in job creation were pretty strong. I think you might have actually highlighted the possibility of payrolls starting to come in under 100,000. July's release came in at 73,000. So it looks like you were on target. What are your thoughts? Is this a one off or are we starting a trend?

Jeff Schulze: Well, it was on target. If you look at July, the payroll number came in at 73,000, but it actually slowed more dramatically than even I was anticipating. So when you look at the July jobs report, in totality, you had 73,000 jobs that were created, which was below consensus expectations. But it's not a terrible print. But what was really shocking was that you had negative payroll revisions of a negative 258,000 to the prior two months.

So that means that the jobs that were created in May were shaved down by 125,000, and now the number in May is 19,000. In June, that was shaved down to 14,000. So May only creating 19,000, June 14,000 and 73,000. Those are pretty low numbers. And it completely alters what the labor market is signaling to us. Because before we got that jobs report, a three-month average job creation we had thought was 135,000, which is a really healthy number.

Today, that number is at 35,000. So with job creation at stall speed and tariff headwinds lying ahead, there's a strong possibility of a negative payroll print in the coming months, which could conjure up some fears of a recession. So I'm not thinking too much about this. When you get payroll prints, they can be pretty quirky. But you know, this does show that, the Fed may need to move a little bit more aggressively and the labor market is not as solid of a foundation as what we had initially thought.

John Przygocki: Wow. Those revisions are quite strong. Are revisions of that magnitude normal, typical?

Jeff Schulze: Yeah. Over the last couple of years, you've seen negative payroll revisions pretty consistently. But this was a bit of an aberration. So maybe to put a time stamp on it, 258,000 in the prior two months, that was the largest two-month revision since 1968 outside of NBER defined recessions.

And that's assuming that we're not in a recession right now, which given the dashboard, I don't think that's a high likelihood. So, yeah, this is a pretty big revision. And when you look even further, it was evenly split between public and private sector jobs. So this is potentially problematic if this is the level of job creation that the economy's creating.

But there is a silver lining in my opinion. Yes, you saw those numbers in May and June, both of them less than 20,000. In July that number popped back up to 73,000. So I think a lot of the weakness was fears when the Liberation Day tariffs were being announced and we were working through what type of trade policy was out there and how it was going to affect the economy. And now that we have a lot more visibility and we've seen a pickup of payrolls in July compared to the prior two months, maybe the worst has passed. But this is obviously something that we're going to be watching really closely.

John Przygocki: Fantastic. You mentioned the word visibility. I guess what I want to follow up with here is, are there any other areas of the labor market that are showing cracks?

Jeff Schulze: Nothing to this degree. As everybody who listens to this knows, we love initial jobless claims. Our economic canary in the coal mine, top three variable in the dashboard drops down to 218,000. That's a great number. Continuing claims still hanging out at about 1.9 million people. If you look at the job openings survey that we got last week as well, it was a no hire, no fire type of environment.

This has been the case over the last couple of years. People aren't quitting their jobs. So yes, there's some softening and some of that JOLTS report (the private openings were softening a little bit), but nothing that suggests that we're, you know, at a recessionary junction at this point. But it's not all doom and gloom. I just want to be very clear about that.

But when you look at that July jobs report, when you saw the steady wage gains and a pickup of weekly hours, that's going to support spending, and when you combine those two, it's called aggregate weekly payrolls. It's a great proxy on how much labor income individuals are getting. That rose by 5.3% on a year over year basis, which is the best reading since late 2024.

So the labor market is slowing. This is a normal dynamic, but the consumer should still be able to spend and again, given these other dynamics, it's not looking recessionary at this juncture.

John Przygocki: Okay. So it's not all doom and gloom. It appears like there definitely is a bit of a silver lining there. Let's transition to monetary policy. When do you see the Federal Reserve's first rate cut coming?

Jeff Schulze: I was in the “no cut in 2025” camp because of the labor market that was holding up. The economy was doing well. But this latest jobs release kind of changes my view on that.

And with the labor market at stall speed, the Fed needs to cut in September. Fed fund futures are pricing in a 93% chance of the Fed cuts in September. The Fed fund futures are also pricing another one and a half cuts by December. So I think we get three in a row at the next three FOMC meetings September, October, December.

And even though inflation is going to be a concern for the Fed, full employment is going to be a bigger concern given the change in the labor markets that we saw with the latest release.

John Przygocki: Okay, Jeff, how about another hot topic? Tariffs and inflation. Will inflation increase in the second half of 2025?

Jeff Schulze: Absolutely. We're already starting to see it pick up in the goods data. Core goods saw its first increase since February. And the, you know, increase in core goods were broad based. You saw it in appliances, apparel, recreation, commodities. And these are all areas that are imported from countries with high tariff rates. But it's not all bad news. Your shelter has moderated throughout the course of this year. You're starting to see some cooling in core services. So you're starting to see some weakness in lodging away from home. Airfares, declines in these areas, are indicative of slowing demand. So inflation is going to move higher. It took about 3 to 5 months during the first Trump administration for those price hikes to move into inflation, which means we're going to start to see that follow through now. But there are other areas of inflation that are offsetting this. But ultimately I could see core CPI getting up to 3.1%, 3.2% on a year over year basis by the end of the year before ultimately moving down in a more durable fashion.

But I want to be very clear. There are a lot of people or actors, if you will, that can absorb these tariffs, right? It could be the exporters themselves. So someone exporting from China or Taiwan. It could be the retailers. And it also can be consumers. And when looking at the data, it appears at least early on that about 20% is being absorbed by the exporters, 40% to 50% by the retailers or companies in the US, and then 30% to 40% by the consumer.

So I think that this is a very different than a value-add tax, where it's completely borne by the consumer and it picks up inflation. But we are going to start to see inflation pick up. But I really don't think that it's going to be problematic from the Fed. Because when you see a pickup of inflation like this this is a tax on the consumer and that creates lower demand and lower inflation as we look forward.

John Przygocki: Okay. How about the August 1st Liberation Day tariff pause coming and going? We've had some trade deals and some additional escalation. What are your high-level thoughts here on this topic?

Jeff Schulze: Well, I thought I was going to have to be up all night of that entire week and waiting for Friday, August 1st, the Liberation Day pause. And we got a lot of deals prior. It was not that big of a deal. So when you look at the deals that were made, deals with major trading partners like the European Union, Japan, the UK, Vietnam. Truces are in place for China and Mexico and Canada. And the average effective tariff rate has moved from about 2% coming into this year, up to 17%.

So it's a pretty big move, all things considered. When you look at the actual tariffs, they range anywhere from 10% to 25% depending on which country you are. If the administration thinks that you're shipping something from a different country, so if you're shipping something from China through Vietnam, those goods are going to be tariffed at 40%.

And there's also going to be some finance agreements and investment for US products by our trade partners. But ultimately, this is a really good dynamic in the sense that it gives businesses the ability to know what type of terms they're operating on. Right? The goalposts are no longer being moved. And when that's the case, that really creates the incentive for businesses to do larger capex projects, to hire those people that they've been waiting to hire because there hasn't been visibility.

And with One Big Beautiful Bill really incentivizing capex on structures and equipment and R&D, getting full expensing of those, I'm expecting a pretty strong capex cycle as we look forward.

John Przygocki: Jeff, the legality of the IEEPA tariffs are currently being debated in the US courts. Is there a chance that these tariffs will be terminated and deemed illegal and therefore tariff revenue that's already been collected returned?

Jeff Schulze: Yeah. So for those of you that aren't familiar with that acronym, it’s the International Emergency Economic Powers Act. The IEEPA. Trump has used this for fentanyl, for example, the border crossings, things like that. And about 70% of the tariffs that are outstanding are under this statute. It's being challenged legally. And there's a very strong possibility that it will be deemed illegal and Trump won't be able to use that to impose tariff policy. But the key is that this final day of resolution probably won't be until the fall of 2025. It's got to go up to the Supreme Court. And by that time, Trump would likely have carried out his trade and tariff strategy. And, again, most of these deals would be wrapped up.

Now, some people say that if that tariff revenue is returned to individuals, that would be a big boon to the economy. Maybe momentarily so. But I think more importantly, even if this is deemed illegal, Trump can stitch together and replicate those IEEPA tariffs with other tariffs that are out there. Section 232, which are those sectorial tariffs on pharma, semiconductors, lumber, things like that. Section 301, which was used against China during the first Trump administration. Section 122, which allows Trump to put 15% tariffs across the board for 150 days. The key message here is yes, it may be deemed illegal, but most of these trade deals will have already been inked. And even if it is illegal, Trump will be able to stitch this back together. So, tariffs are here to stay. It's just what type of form are they going to be in?

John Przygocki: Jeff one final question connected to tariffs. Tariffs we know have the potential to damage corporate profitability if companies aren't able to pass those higher costs on to the buyer of their products. Are we seeing any of this in our Q2 earnings season and how has that been going?

Jeff Schulze: It's been a blockbuster season. But I think it's important to note that the bar was lowered exceptionally low for Q2 because of the fears around the Liberation Day tariffs. But I think it's going to get a lot harder as you get to Q3. And you have a much higher bar to beat.

But what makes me optimistic is that when you look at corporate commentary, there's a lot of confidence that corporations are going to be able to mitigate the impacts of tariffs on profits. There's been strategies that were cited, like managing supply chains. Increasing pricing is cutting other costs. And when you look at profit margins, they continue to increase in this type of environment.

So again, we're going to get the full hit of tariffs once we move into the third quarter and into the fourth quarter, when all of that inventory that was lower priced has now been worked through. But I have a saying that you never want to underestimate corporate America. You know, they just need to know what type of environment they're operating in. And they can be extremely nimble in being able to manage their costs.

John Przygocki: Okay. Optimistic. How about just last week we had some selling in the US equity market for the first time in a long time. What do you see there going forward?

Jeff Schulze: Well we've been advocating for a market pullback for about a month or two. We've come a long way in a short period of time that you do need some sort of digestion period. I wouldn't be surprised if we do see some choppiness over the next couple of weeks to months. With the labor market at a standstill, you know, a lot of people are waiting for that Fed cutting cycle. They thought it would be bullish for risk assets. But when it came with a very weak labor market, guess what. The market sold off because that bad news was actually bad news. So I think in the near term, I think we're going to have some choppy price action until we can get a real handle of where labor is and what's the trend on the economy as we go through this soft patch.

But going forward, a lot of reasons to be optimistic and to expect that markets are going to be moving higher. And I shared this on the last podcast, but I want to share it again because it is so powerful. When you had the selloff during the Liberation Day tariffs, it took 55 trading days for the markets to get back to the highs.

That was the fastest rebound in 75 years following a 15% drawdown. So it left a lot of people on the sidelines and a lot of people feel like after you have these strong moves that you need to have mean reversion; you can't have more upside. But history actually paints a different picture. So again, going back to 1950, 10 largest 50 trading day S&P 500 rallies. After you go through that strong 50 trading days over the next three months, six months and 12 months, your forward returns are on average 6.4%, 10.9% and 16.4%. So I think with the Fed cuts here likely coming in September, deregulation, the One Big Beautiful Bill’s peak fiscal impulse, I think investors may be surprised on what the return environment looks like over the next 12 months, even with the move that we've seen off of the lows earlier this year.

John Przygocki: How about where equity valuations are today? Are you concerned with the current level?

Jeff Schulze: I would say they're stretched, but it's important to note that valuations are famously a poor timing tool. But there's a lot of structural reasons why current valuations look historically expensive. And one of those reasons is the composition of the market itself. So when you have higher P/E [price/earnings] sectors like information technology, like comm services that make a larger share of the benchmark, then you have also groups that trade at lower multiples, like energy that are at a much smaller weight, this tends to push up the overall benchmark multiple. So the benchmark is much more growthy, much more defensive than what we've seen 10, 15, 20, 25, 30 years ago. So the market should trade at a premium compared to its history.

Also, when you look at the fundamentals, the index has a higher operating margin. They have better revenue growth. They have stronger free cash flow generation, lower leverage. I mean, these are things that people pay a higher premium for. So while this can't fully explain why the market trading at 22.1 times earnings, this explains that the market should be trading at close to 20 times forward earnings. So the gap’s not as big as people think.

And when again you have rate cuts on the horizon and you have elevated earnings growth, that combination has historically seen multiple expansion, P/Es moving higher. I don't think that's the case today at 22 times forward earnings. But I don't see multiples contracting and moving lower with a loose Fed in an elevated earnings backdrop. So yes, the markets are a little expensive compared to where they have been historically. But given this backdrop I think the markets are going to stay expensive as we move through the next 12 to 24 months.

John Przygocki: Jeff, the US dollar has seen some strength recently. Do you expect that to continue?

Jeff Schulze: I do. The dollar was down by over 10% in the first half of the year. It was the worst first half since the mid-1970s, and the dollar has clawed back some of that relative underperformance. Part of that was obviously getting visibility on tariffs. If tariffs were creating dollar weakness, visibility on the tariff front would create dollar strength. And we've seen that. Another reason is that everybody was short the dollar. And now some people are pulling those shorts off and that's creating some dollar strength. What could pull the dollar down though going forward is the Fed cutting cycle. If the Fed does start to cut, that should weaken the dollar as we move through the back half of the year. But also if you think about the global economy, a lot of the global central banks have been cutting throughout the course of 2025. If there's less tariff concern now, that could be a reason for better economic growth overseas, which will ultimately push down the dollar on a relative basis.

So it wouldn't be surprised me if you see the dollar kind of hang out here for a month or two. But ultimately, I see the path of the dollar as moving down as we move closer to 2026.

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

Jeff Schulze: If we have some volatility, I just very much encourage you to take that volatility with a grain of salt. We think that there's reasons to be optimistic as you look forward. The peak impulse of the One Big Beautiful Bill is hitting. It’s hitting corporations right now. It's going to be hitting individuals when tax returns go out next year. You have a Fed cutting cycle that is very close to happening at the moment. Corporate animal spirits are going to be unleashed; there's going to be a large capex wave. And I do think that AI is becoming democratized. These models are becoming smaller, cheaper and more efficient and specialized. And as they get deployed across different industries, that ultimately helps productivity growth, profitability and economic momentum. And all of those things create lower inflation, which gives the Fed even more latitude to cut.

And it's always important to remember if you're nervous about a recession. There's an old saying that a bull market doesn't die of old age. It's always slaughtered by the central bank. And with the Fed cutting, not hiking right now, we probably got a couple more years to run for this equity bull. So, we're buyers of dips should a dip materialize over the course of the next couple of months.

John Przygocki: Jeff, thank you for your time and your terrific insight here this afternoon. To all of our listeners, thank you for spending your valuable time with us for today's update on the US economy and capital markets. 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 with any other major podcast provider.