AOR Update (Podcast): Robust earnings good for labor market

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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. 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 United States economy. Jeff, welcome to the show.

Jeff Schulze: Happy to be here, John.

John Przygocki: Jeff, let's start with an update on the US economy and your measuring stick. Jeff, were there any changes to the ClearBridge Recession Risk Dashboard with the October 31st update?

Jeff Schulze: Well, there weren't any changes in October, but it's important to note that the US federal government shutdown has halted most economic data releases over the course of the past month. So, when you look at the 12 individual indicators of the ClearBridge Recession Risk Dashboard, seven of them are from sources not impacted by the shutdown. So they continue to be updated. But five of them weren't. Housing permits, jobless claims, retail sales, wage growth and profit margins can't be updated. But at this point, given the trajectory that we saw coming out of September, we think that there were no indicator changes for those five indicators.

So if we pull forward the September reading, right now we have seven green, four yellow and one red signal. And we continue to have a firm overall green expansion color for the dashboard.

John Przygocki: Okay. Firm green expansionary overall signal. Five indicators you said are currently unavailable for the update. I think I can clearly state that that is certainly a first for our monthly conversation. Are you concerned that you're currently flying blind a bit here?

Jeff Schulze: I'm not concerned. Yes, it is certainly a first. But the silver lining here is that there is an abundance of additional alternative data sources that can be utilized to gauge the health of these individual indicators. And when you look at these alternative data sets, they indicate that you've had a continuation of the trend for each of them. So for example, when you look at labor stress, you can look at alternative indicators from Revelio Labs, the Challenger dataset, LinkUp, MacroEdge, ADP, Paychex, Indeed, NFIB. There is a lot of things out there. And we generally look at all of these alternative data sets to confirm what the dashboard is saying. But when you look at these in totality for the labor market, it shows no signs of a rise of the unemployment rate. And the labor market is doing fine. So, while there is a little bit of concern that we are kind of quote unquote flying blind, all of the other data suggests that nothing has deteriorated over the course of October.

John Przygocki: Very interesting. So, let's dive into some of the ways that you're looking at the different indicators. You mentioned the labor market. Jobless claims typically have been a very important indicator for you and in some instances that economic canary in the coal mine over the years. Is there a good substitute for this most important indicator on the dashboard?

Jeff Schulze: There is a good substitute and probably the best substitute that we have, because when you look at jobless claims, they're normally reported by the individual states and then aggregated and adjusted by the Department of Labor, and because the states themselves are not impacted by the federal government shutdown, the underlying jobless claims data still exists. It just needs to be compiled and aggregated.

Now, fortunately, there are a lot of Wall Street banks, research boutiques, economic think tanks, that have aggregated and compiled this data. And, based on their work, clearly shows that the trend in jobless claims has remained steady over the past month. So this means that jobless claims likely remain green. And that's a really important dynamic because as you mentioned, it's a top-rated variable in the dashboard. It's our economic canary in the coal mine with having no false positives over the course of the last eight recessions going back to the 1960s.

John Przygocki: Housing continues to be in the headlines, Jeff. I mean, do you have something that you're using to gauge building permits?

Jeff Schulze: We have a number of different things that we're looking at. One of the things that's important to understand is the future trajectory of housing is the NAHB Home Builders Sentiment Index. It popped by five points in the latest release in October. That was on better-than-expected, lower mortgage rates. Has homebuilders more optimistic about sales in 2026. There's less inventory that's expected. So that's a really positive dynamic. Another thing that we look at is the Dodge Construction Network's Residential Building Starts. It rose by 3.6% in the latest release. And while the dashboard focuses on housing permits as opposed to housing starts, the concepts are pretty closely related.

So those are some positives, but there are some negatives. When you look at weekly mortgage purchase applications from the Mortgage Bankers Association, it fell in October. And when you kind of put this together, it does paint a near-term picture of a housing market that's mixed, which is actually pretty consistent with the yellow caution signal that we have for housing permits. So, this is another indicator where the data is corroborating what we thought was happening with housing permits before the shutdown occurred.

John Przygocki: All right. It looks like retail sales is missing as well. Is there an alternative data source for that measure?

Jeff Schulze: There is. There's a pretty straightforward proxy in the Chicago Fed Advanced Retail Trade Summary reading. That's a very long acronym. I like CARTS better. It's a nowcasting tool basically that's similar to what you see with the Atlanta Fed's GDP now tracker. It basically looks at all the data that's been released for retail sales. And it's the best guess of what retail sales would be if it was actually released. And the latest estimate shows that retail sales is pretty firm right now.

Also, we're looking at consumer spending trends in the Johnson Redbook’s Same Store Sales Metric. We're also looking at credit card spending data from a lot of the large banks, all telling us the same story. Consumer spending is very consistent. So, while we may see a temporary hiccup in consumer spending because of the government shutdown and the fact that 40 million people are no longer getting their food stamps, we think as we move forward to December and January, and those food stamps are mailed out to all of those constituents, you're going to see a bounce back of spending in the next couple of months. But, ultimately, there really aren't any signs of broad-based consumer weakness. And we think the retail sales indicator will remain green once we get that formal data.

John Przygocki: Jeff, how about wage growth? Do you have anything to monitor there?

Jeff Schulze: There are again a number of different data sets. ADP, Indeed.com both point to wage gains continuing at the recent pace. Wage gains have moderated. And as a reminder to the listeners, with our wage-gain indicator, when wage gains are moving down, that's actually a positive development. That means that the Fed is likely to be more dovish, going to be cutting rates. Inflation isn't going to be a concern. And the moderation in wage growth continues ever since peaking out about three years ago. So, yeah, similar to what we've seen with all of the other consumer metrics, this is one that will likely continue to be green when we get the next release.

John Przygocki: All right, Jeff, let's move away from the consumer section of the ClearBridge Recession Risk Dashboard and talk about the last indicator that doesn't have an October 31st update. Profit margins. What are you seeing here?

Jeff Schulze: Well, as I mentioned in the last podcast, corporate profits don't look recessionary with the latest release that we have. We're looking at the National Income and Product Account data, better known as the NIPA data. It's a subcomponent of the quarterly GDP release. And when you look at NIPA data going back to the 1960s, typically as you enter into a recession, profits plateau about two quarters prior and then move down in a very dramatic fashion and NIPA profits have been on the uptrend over the last 15 months.

So, this is consistent with what we've seen from the earnings season here in Q3. Earnings delivery has been quite robust. You've seen strong guidance. And even though we don't have the NIPA profit margins data that we use for the indicator, the earnings season is confirmation that profits remain in an uptrend. And let's not forget, if companies are making more money, it's very rare to see a recessionary labor market cycle. So this is a really positive dynamic, and it bodes well for the labor market looking out to 2026.

John Przygocki: All right Jeff, you just mentioned earnings were strong for Q3 S&P 500 [Index] companies. Are there any key takeaways that you could share with us from this earnings season, at least to date.

Jeff Schulze: Yeah, so we're not through Q3 earnings season. So, you know, just want to say that the final numbers may be a little bit different. But directionally these are going to be pretty close. Right now, earnings are beating by 6%, which is the strongest beat that you've seen in four years. Sales or revenues are beating by 2.2%, which is double the long-term average. So this is a really good earnings season. When you look at the number of companies that are beating on both earnings and revenues, again, some of this best breadth that we've seen in a long time.

So this is a really positive development. It's a key reason why the markets have moved up. I think the markets anticipated a lot of this strength. But I think more importantly, with revenue growth firming into next year, that, in my opinion, creates more upside potential for earnings delivery. And I think this is one of the more underappreciated trends that you're seeing in the markets.

Lastly, on the earnings season, you saw guidance. Guidance has been very strong if you're thinking about companies that are upgrading their guidance versus downgrading it. So if you put this together, even though we're seeing a little bit of volatility in the markets today, ultimately, I think this earnings season bodes well for the next couple of earnings seasons.

And the last statistic I want to share with you is that when you think about fourth-quarter earnings estimates, so earnings estimates for next quarter, typically at this point in the earnings season, those estimates have moved down by close to 3%. Today they're flat. So this is again historically a harbinger of positive earnings delivery as you look forward.

John Przygocki: Jeff, the hyperscalers Amazon, Google, Meta and Microsoft all reported Q3 earnings last week, and the investor reaction seemed mixed. What's your view? And is this enormous AI capital expense sustainable?

Jeff Schulze: Well, you're right, it has been a mixed reaction. Meta and Microsoft saw lower stock prices after their earnings date. Google and Amazon saw pretty solid upside to their stock prices after their earnings release. But I think more importantly, these companies all guided to having more spending on AI [artificial intelligence] capex [capital expenditure]. I mean, as long as the markets are rewarding them for it, that has strong implications for both the US economy and the trajectory of the market going forward, because as long as that AI capex is moving higher (and AI capex expectations for the next 12 months were moved higher by four percentage points, up to 39%, versus last week after we got the hyperscaler earnings), that is going to create better earnings delivery, more resilient economic activity, and ultimately a continuation of this cycle.

And I know there's a lot of people that are concerned about how sustainable this spending is. Well, hyperscalers are funding a majority of the spending through operating cash flow. This is a very different dynamic than what you saw during the shale revolution and the telecom cycle in the 1990s where a lot more of that capex was funded in debt versus today, where AI capex is only funded by 7% with debt levels. So while there's a concern that this is overextended and this needs to come down, based on what we heard from the hyperscalers, they're actually ramping their capex even higher next year. And AI investment right now is only about 1% of GDP, right? It's a relatively small share of the contribution. When you go out to prior large technology cycles, that number is closer to 2 to 5%. So, while there is some concern here, I just don't see it over the next 12 to 18 months.

John Przygocki: How about any potential trouble that might be lurking in the private credit market after several high-profile bankruptcies were reported last month?

Jeff Schulze: Well, as Jamie Dimon said, the cockroaches are starting to come out, and, ultimately, I think there's going to be more cockroaches. I think that a lot of boards are asking bank management teams to look through their loan portfolios for similar issues of fraud. And given all of the lending that's taken place, you're probably going to have a couple of other cockroaches surface.

But ultimately, I don't think that this is indicative of something that's going to be systematic. These seem like more isolated instances with the charge-offs related to Tricolor, First Brands and Cantor Group. While there is some genuine concern here, and this has been an overhang for the regional banks—there's been an overhang to alternative asset managers’ stock performance over the course of this year—I  think as we get the results of those loan portfolio internal reviews, I think that these areas will start to move up in a more sustainable basis. But also, let's not forget when you look at the big banks and the results that they had, it was a really strong beat across the board. They’re highlighting consumer resilience, regulatory tailwinds and a strong deal pipeline. And I think that that is a reason to be optimistic on banks and the economy more broadly speaking.

John Przygocki: Jeff, last week we got our second US Federal Reserve Open Market Committee [interest-rate] cut when they cut the fed funds rate by 25 basis points. In Chairman Powell’s commentary and press conference after the meeting concluded, it did seem like he threw a bit of cold water on the argument or the case for a December rate cut. Is the Federal Reserve done at this point?

Jeff Schulze: I don't think so. I think one of the most important things that Powell said is that a December rate cut is far from a foregone conclusion. And I always expected Powell to say that December was not a lock. And while that was a more abrupt tone shift than what I was anticipating, I still think a December cut is a pretty solid base case.

Powell has mentioned that there's strongly differing views on the FOMC committee, but when you look at what would be a truly hawkish outcome, it would have been two hawkish dissents rather than just one. So, while there isn't a uniform view on the FOMC of what the path is going forward, given the lack of data, I think the Fed will likely cut in December and then wait to assess what's happening on the inflation front, on the economic front, before starting to cut again.

But ultimately, next year, with the Fed cutting, the peak fiscal impulse of the One Big Beautiful Bill and a strong acceleration of the labor market, I think that once we get that December rate cut, I think the Fed is done. But let's not forget, even if it's just 75 basis points’ worth of rate cuts, that was similar to what we saw in the 1995 soft landing cutting cycle and the 1998 soft landing cutting cycle. So I think that's going to be enough to propel the markets and the economy forward.

John Przygocki: Jeff, how about inflation? Isn't inflation still an issue?

Jeff Schulze: It isn't. If you look at the CPI release for September, core CPI came in at 0.23%, which is below consensus expectations. If you look at OER, which is Owners’ Equivalent Rent, part of shelter, it was the slowest pace since 2020. And shelter continues to move lower quarter after quarter. So that's a positive dynamic of why inflation is relatively benign.

But also, when you look at core goods inflation, which is going to be the area where you're looking for that tariff passthrough, it came in at 0.2%, which really is a lot less than what people were anticipating when the Liberation Day tariff announcements were made back in April.

So it was a pretty dovish print when it comes to the CPI. Also, what I thought was positive is you saw a jump in airfares and hotels, which from a demand perspective is a positive, because these travel components are firming after seeing weakness earlier this year. So, while I think inflation may move a little bit higher as we move through the next couple of quarters, it doesn't seem like it's going to run away. And it really feels more like a one-time price increase rather than something that's sustained, which ultimately the Fed would be more concerned with.

John Przygocki: All right, Jeff, let's end with two really important questions on the policy front. US President Donald Trump and Chinese President Xi were able to iron out a temporary trade deal last month. What are the implications here?

Jeff Schulze: Well, this is obviously a positive development. The markets were unsure on how this trade deal, quote unquote, would come together. And the outcome was pretty optimistic. Both parties are going to postpone for a year their reciprocal tariffs. There's going to be a one-year postponement of the export controls on rare earths for China and the 50% rule for the US, and then a one-year postponement of shipping fees.

The Chinese are going to purchase more US agriculture and energy products, and the US reduced the fentanyl tariffs by 10 percentage points, which a lot of people didn't think that would happen for a period of six to nine months to make sure that the fentanyl problem was actually being addressed. But ultimately, this is a really positive development. It's a key reason why markets have moved higher. But the one thing that I want to caution is that, although this is going to be a longer détente than what you've seen, likely going to be a year, there's the potential for flare-ups as we move forward, because this is not a lasting trade agreement. It's more of a truce than anything else. But ultimately, this was a positive, and it removes one level of uncertainty from financial markets.

John Przygocki: All right, Jeff, second policy topic: the US government shutdown. Do you foresee a deal being made soon, and will there be any lasting implications on the US economy?

Jeff Schulze: Well, the current shutdown looks likely to be the longest shutdown on record, surpassing 2018 and 2019, and have the greatest economic impact of any shutdown because today it's much broader than what we saw seven years ago.

But assuming that the shutdown ends in the middle part of November, it's likely going to reduce fourth quarter GDP by about 1%. But you're going to get that likely back in Q1 of 2026, as some federal purchases and investment spills over to the new year. Now, I think that will likely get some sort of agreement over the next couple of weeks, because things are getting amplified here in November. For example, about 40 million people are losing access to their SNAP benefits, better known as food stamps. And although the government is using contingency funds to pay out around $4.5 billion in SNAP benefits, that is only about half of the $8 billion per month outlay they normally have. So that's one reason for the sides to come together.

Also, air traffic controllers and TSA agents are likely going to start to call out sick because they missed their paycheck on October 28th, and they're likely going to miss their second paycheck on November 10th. And when you go back to that longest previous shutdown in 2018 into 2019, again, a big reason for the end of that shutdown was because of staffing shortages at airports.

Also, the military is likely going to potentially miss a paycheck sometime over the next couple weeks. So the cost is exceeding the benefit right now for both sides, politically speaking. And I think given the news flow that we've heard today, that both sides are starting to think about how we're going to end the shutdown rather than if we're going to end the shutdown. So I see this ending sometime over the next couple of weeks.

John Przygocki: All right, Jeff, as we look to close out today's update, do you have a final thought for our listeners?

Jeff Schulze: Yeah, I think a key takeaway here is that although they're not getting a lot of the official data from the government, when it comes to the economy, there's a lot of alternative data that we can look at that corroborate the fact that the economy remains on a firm and positive trajectory.

Right now, we have a policy mix that you don't see outside of recessions. You have the Fed that's cutting. You have the peak fiscal impulse of the One Big Beautiful Bill hitting next year. And we're likely going to get more visibility on the trade front. We think that creates not only resilient economic activity but better earnings delivery. And from what we've seen so far with the earnings season, we think earnings delivery probably is going to surprise to the upside next year.

So, while we're expecting a much more volatile 2026, we think it's going to be similar to the late 1990s where volatility is high. You had some very vicious corrections. But, ultimately, we think that those dips are meant to be bought by investors because of this strong policy mix that we have and the fact that earnings have been great, and I think they're going to be pretty strong going forward.

John Przygocki: Jeff, thank you for spending your time today to provide an update for us on Talking Markets. To all of our listeners, thank you for spending your valuable time with us for today's update. If you would 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 just about any other major podcast provider.