AOR Update (Podcast): Tariffs still in play

Podcast 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 me today. Let's start today's conversation with the ClearBridge Recession Risk Dashboard. Were there any indicator changes at the end of May?

Jeff Schulze: Well, thanks for having me. And I'm happy to say that we have our first upgrades for the dashboard than we’ve had in four months since January at the beginning of the year. So we had two positive signal changes. The yield curve has uninverted, which has improved that signal from red to yellow. And truck shipments have improved from yellow to green. And when you look at the 12 signals in totality, again, it's a stoplight analogy where a green is expansion, yellow is caution and red is recession. We have eight green, two yellow and two red signals as of the end of May, but more importantly, strong overall green expansion color and our odds of recession still remain at 35% over the course of the next 12 months. So a really positive development, and we're hoping that there's going to be some follow-through as we look towards the back half of the year. 

Host: Jeff, tell us a little bit more about those two indicators. What exactly are they and how important are they to the overall dashboard signal?

Jeff Schulze: Well, the first indicator I'll talk about is truck shipments. Now if there was one signal that is not as important that goes green than others, it's probably truck shipments because it is the lowest-weighted variable in the dashboard. It has about a 3% weighting overall. And what we're looking at here is a survey by the American Trucking Association, the ATA. And their membership includes about 3.5 million truck drivers. They haul 11 billion tons of freight annually. And about 73% of the freight tonnage moved each year in the US goes on trucks. So when you're looking at truck tonnage, it provides a really good read on the domestic activity. For example, if the economy slows, there's going to be fewer products that are shipped and freight shipments will drop.

And for this particular sample, you have an array of trucking companies that are surveyed. So you have the mom-and-pop fleets, which have 1 or 2 trucks all the way up to the largest carriers. Now, this metric was introduced in 1973. So we only incorporated in the dashboard to the mid-1970s. So it doesn't capture all of the last eight recessions like a lot of our other indicators do, which is one of the reasons why it's lower ranked than the other 11.

But nonetheless, the fact that this is moving green is a signal that you still have some robust economic activity that's going on when it comes to moving goods through the economy’s ecosystem.

The yield curve is much higher-weighted. It's about a 10% weighting in the dashboard. So it's one of the higher-ranked variables. And this is one of the most commonly utilized recessionary indicators out there.

The yield curve has inverted prior to every recession going back to 1965. And some people like to use the two-year part of the yield curve. But the two-year bill is a little bit limited from a history standpoint. We can't get those last two recessions. So what we like to use is the three-month T-bill minus the 10-year Treasury, because it gives you, again, more historical analysis and a similar read overall.

And the yield curve is uninverted. And for it to move to a green signal we're going to have to see that part of the yield curve move to over 50 basis points, which is not where we are right now, but we could potentially see that moving forward. So again, these are two variables that are important to the dashboard.

But we're hoping that we'll see some follow through at least on the yield curve. So that moving green as we look to the third quarter.

Host: We're going to get the May payrolls report in a couple of days. This morning, the ADP payroll report was disappointing to the market. I think it came in around 37,000. Is this consistent with what you are seeing in the labor market, and is that report a harbinger of disappointment for what we will see on Friday?

Jeff Schulze: It's not a harbinger of disappointment. A great example of this is if you look to April's ADP report. That had said that job creation was 62,000. When you got the actual payrolls report a couple of days later, actual job creation was 177,000. So there's not a real strong correlation between ADP and what you actually get on non-farm payrolls.

So I wouldn’t read too much into today's reading reflecting what we're going to see later this week. But ultimately, when you look at other areas of the labor market, things continue to hold up pretty well, all things consider[ed], with this tariff uncertainty. So we got JOLTS [Job Openings and Labor Turnover Survey] earlier this week. Job openings came in at 7.4 million. That actually rose by about 3%. That's a really good dynamic. JOLTS have been moving lower and lower, and you started to see it move higher here with this latest release. And I think that this is a stark reminder that the labor market isn't rolling over at the moment. We also have initial jobless claims, which is our economic canary in the coal mine, top-ranked variable in the dashboard overall.

And it did rise in the latest release that we've seen to 240,000. But if you look back to the late second quarter, early third quarter in 2023 and 2024 claims tend to rise as you move into the summer and then peak and then move lower as you move into the fall, and ultimately the winter. So we think that this is a seasonality issue, and it's not really something that's signaling that more layoffs are on the horizon.

But if there is one fly in the ointment when it comes to the labor market, it is continuing claims, people who are on unemployment insurance for a longer period than their first eligibility. This has risen for three consecutive weeks, which suggests that if you do lose your job, it's becoming a little bit more difficult for those that are unemployed to find new jobs.

But all in all, when you take this mosaic of the labor market, I'm expecting some softening as we move through the next couple of months, but nothing suggests that we're going to be close to a potential economic downturn. So it's a really good development because labor income is the number one source of spending power in the US. So if people have jobs, the consumer should continue to be able to spend in a durable fashion.

Host: Jeff, you mentioned the word tariffs in your previous answer. So let's transition and address the 1,000-pound gorilla in the room. Tariffs, tariffs, tariffs. Are the tariffs in the United States going to go substantially lower or lower at all with this recent revoking of the IEEPA [International Emergency Economic Powers Act] tariffs?

Jeff Schulze: Well I'd love to say that they are going to go substantially lower because of that. But I think that tariffs will remain relatively the same. But the composition of them may ultimately be different. So the IEEPA tariffs were ruled that Trump is not able to use them at the Court of International Trade. They're still in effect because that is being appealed to higher courts.

And this is really important because if you look at all of the tariffs that were announced in the second Trump administration, the tariffs from the IEEPA, 80% of those goods are through this measure. So that would be all of the “Liberation Day” tariffs that were announced in early April. That's the 10% universal baseline tariff. It's the 20% China fentanyl tariff. And it's the 25% Canada and Mexico tariffs. So even if this isn't able to be used by Trump (and it's unclear whether or not that's the case. We're going to have to see that with the Supreme Court decision eventually over the next couple of months), there's a number of different avenues where Trump can replicate those tariffs. First and foremost, he could use section 301, which suggests that a country is using unfair trade practices.

That may sound familiar, because that's what Trump used with the original China tariffs in 2018 and 2019. So he can increase the tariffs on China using that. But he can also launch new investigations into our major trading partners. And that may take about six months to ultimately come to fruition. But it's a route that Trump can go that probably has more legal authority.

You also have section 232 tariffs. These are those sectorial tariffs and those are already outstanding on steel, aluminum, auto, auto parts. There's open investigations into copper, pharmaceuticals, lumber, semis. Trump could look at other products in order to increase tariffs on our trading partners. But he also can do things like the section 122 tariff, which could impose a 15% across the board tariff for 150 days. Now, that could be a way that Trump can replace that 10% universal baseline in order to bridge the gap between what was necessary for those other investigations that I talked about to come to fruition.

And then lastly, there's a section 338 tariff where Trump can put up a 50% tariff on any country that discriminates against US products. So I know that's a lot of information, but the core essence of it is that the tariff situation is not necessarily going away. If the Supreme Court ultimately decides that Trump is not able to use the IEEPA tariffs, tariffs will come back. It's just going to be in a little bit of a different shape or form.

Host: Why do you think that President Trump is demanding that trading partners put forward their best trade offer by today?

Jeff Schulze: Yeah, I mean, today is the deadline for our trading partners to put in their best offers, with the administration likely to have a counter offer next week.

But I think there's a rush to have countries get commitments in that are irreversible ahead of a potential Supreme Court decision as we look out for a couple of weeks or even a couple of months from now. So if you do have some tariff deals that are announced and ultimately signed prior to that Supreme Court verdict, that takes a little bit of the uncertainty off of the table from the administration.

So I think there's a desire for the administration to get some of these trade deals signed before they might have to pivot going to some of those other statutes that I talked about a little bit earlier.

Host: All right, Jeff, one more question on this topic. What do you think will happen when we get to the July 8th reciprocal tariff deadline?

Jeff Schulze: A glass half-full perspective of it is that we have a lot of trade deals that are struck. And even though it's going to take time to iron out the details, Trump will continue to push out that pause until those trade deals can be finalized.

Pessimistic view or glass half-empty view is that there won't be a lot of deals that are reached, and you could see a ratcheting up of tariffs because some of the concessions may not be as aggressive as the administration would like. For example, you have a pretty short deadline to get a trade deal inked by July 8th. Usually trade deals take years, not three months. But also there may be a reluctance of some of our trade partners to do a large concession because of the court decision that potentially takes that IEEPA  tariff off the table. So you certainly have the possibility that tariffs are going to be moving higher. And I think given market price action, the fact that the S&P 500 is close to all-time highs right now, I think you're probably going to see this one way flow of tariff news that has been positive for two months, probably take a little bit of a reversal over the next couple of months and see some higher tariff news and some potentially disrupting news for the markets. But ultimately, there's a lot of uncertainty between now and then. And we're going to get visibility as we move through the next couple of months.

Host: All right. Let's switch gears and address the capital markets. We've had a huge rally in US equities coming off of the early April 2025 lows. Where do you see US equities going over the next 2- 3 months?

Jeff Schulze: Well if you look at all 20% declines going back to 1950—and we didn't quite hit 20% with the S&P 500. It hit 19%. But I think that's a good barometer of where we want to look at. I mean, it's been pretty common for a consolidation between month two and month three from the trough levels. So that's where we are right now.

And again, I think a consolidation, some choppiness is probably a good way to look at this. But also when you look at historical patterns of new bull markets going back to 1966, usually in years one and two, the markets are up substantially. They're up around 60% on average, which, you know, this time around we're up about 60%. And then in year three, you have a one-year digestion period where the markets are essentially flat.

And, you know, we entered into year three of this bull market on October 12th of 2024. And the S&P 500 is only up about 1.7% since then. So we're following this pattern of seasonality pretty closely. And should this history repeat, which it appears like it is, you're likely going to see some sideways price action over the next few months until you can get to a resumption of the uptrend.

So in my view, I'm thinking that we're going to have some choppiness over the next couple of months, which could be amplified by some of the tariff-related news that we're likely going to get as we approach that Liberation Day tariff deadline.

Host: So what would a potential catalyst be for that short-term pullback in US equities? Is it tariff uncertainty?

Jeff Schulze: Well that's certainly one of them. There's a number of different catalysts potentially. You could have a rebound in long yields because of some concerns that you have of the fiscal package and of debt sustainability that would weigh on equity market valuations. You can have, again, the court ruling against the Liberation Day tariffs be deemed unconstitutional and Trump really goes a little bit more aggressive on the tariff front. You could have an economic soft patch, which can result in some concerns about earnings expectations being able to be achieved. You also have the potential for CPI to start moving higher, which fully incorporates tariffs overall. And then lastly, I mean this is, you know, not extensive. There's probably more. But maybe payrolls start to move down a little bit and get people concerned about a recession. So I think the key here is there's a number of different catalysts that are out there for some volatility. But all of them in my opinion, are temporary. None of them really are going to inflict real lasting damage on the markets. And ultimately, even though we're expecting some volatility, I see higher markets as you look forward.

Host: So why are you so optimistic about the equity markets moving durably higher here for the remainder of 2025 after some near-term choppiness or volatility?

Jeff Schulze: Well, when I talk about year three having a digestion period, when you get to year four the market tends to move higher. And that's going to be coming in early October. So you know, from just a seasonality perspective, that's one reason to be optimistic. Another reason to be optimistic is you’ve had a weaker dollar. And a weaker dollar tends to boost earnings as you look out 2-3 quarters, which will start to really be reflected in Q3 and Q4 earnings.

You also have potential for tax policy to help not only the corporate and earnings environment, but also the overall economy. You also have higher productivity coming from AI [artificial intelligence], which can come in in a little bit more of an aggressive fashion than what we saw with the latest release. So there's a lot of different variables, but ultimately, I think you're going to see a push-pull of policy where we're going to get a better view of the tax package that's coming into Congress right now. And ultimately, I think that could surprise people to the upside.

Host: Okay, so you just mentioned it, Jeff, the “One Big Beautiful Bill” [OBBB]. How much growth do you think that package will stimulate in the US economy?

Jeff Schulze: Well, a lot of people were not optimistic about the size of this bill. A lot of people thought this would just be a pure extension of the TCJA, the Tax Cuts and Jobs Act, the Trump tax cuts from 2018, but it's actually proving to be much more stimulative and front-loaded than people had anticipated.

So there's really two avenues to really think of this through. You have business incentives and breaks, and you also have breaks for the consumer. And a lot of the tax breaks for the consumer are going to be on the low end, which is really good, because those are the consumers that are going to be impacted the most by higher tariffs.

So there's a number of things to look at. So you have a child tax credit which is potentially going to be increased over the next four years. No tax on overtime. No tax on tips. The SALT deductions being raised and the threshold for that being raised up to potentially a half a million dollars of earnings. You also have a senior tax deduction and auto loan interest deduction as well.

So there's a lot of things that are being discussed that ultimately should boost consumption, especially in the lower end in the fourth quarter of this year as paycheck withholding tables are adjusted for these new taxes on tips and overtime, but as in the first half of 2026, when people file for their taxes. So this is going to be a boost that's going to start to be felt in the next four quarters, which the markets will start to sniff out. And then also for businesses, they're going to have lower estimated cash tax payments in December. And they also have bonus depreciation and R&D expensing retroactive to January of 2025. So if you put this all together you're looking at net stimulus in 2026 of probably close to $250 billion, which is more than enough to offset some of the headwinds that we're going to see from the tariff increases from the administration. So I think that this is something that the market will start to sniff out once we move through this period of choppiness over the next few months to the next quarter.

Host: But Jeff, it does seem like there are quite a few investors out there who are concerned about what this package, this tax package will do to the US deficit. Is the US deficit situation sustainable? And then a follow up there would be, where do you see the US 10-year Treasury going for the remainder of 2025?

Jeff Schulze: Well it's not sustainable. You know, running 6-7% deficits in perpetuity, especially when you're not having a recession or a financial crisis is not sustainable over the long haul. But one thing actually that's interesting to note is that just today, the Congressional Budget Office released scoring (mind you, it’s as of mid-May. So it's a little bit dated because things are moving very fast) that tariffs, their estimate for tariff revenue is going to be $2.8 trillion over the 10-year budget window.

Now that's a number that's going to come down. Tariffs may not be as high as what we were talking about three weeks ago. You're also going to have some substitution effect that's go in. But if you look at the OBBB, the fiscal package that's being talked about, the scoring is expected to increase the deficit by 2.4 trillion.

So that goes a long way to negating some of the deficit concerns of investors. And I think a smoking gun on to what investor psychology is regarding this tax bill is that when the House bill was passed and it moved over to the Senate on that day, the 10-year Treasury dropped seven basis points and the 10-year Treasury has continued to drop over the course of the last couple of weeks.

So, I mean, that's a really good indication that the bond vigilantes are not running into town because of the tax package. And although the deficit will have to be addressed and you're going to need to bring that down, I don't see any real reason why that's going to be disruptive over the next 2-5 years. More likely the longer end of that trend before you're going to see maybe some sustainable upside on 10-year Treasuries.

Now, now, talking about where Treasuries go this year, you kind of have a push-pull dynamic that's going on right now. You have things that are working to push up 10-year Treasury yields. And you have things that are pushing down 10-year Treasury yields. What's pushing them down is that inflation has been declining. You may see a small pop of inflation because of tariffs.

But if you're looking at super core, that has fallen pretty aggressively, which the Fed [Federal Reserve] puts a lot of stock into because of its relationship with trend inflation. Wage growth is inconsistent with 2% inflation. Unit labor costs have all dropped. Those are all reasons for the 10-year Treasury to be moving lower. And then also everybody's short that US Treasuries right now.

So from a pure contrarian perspective, this is probably a bullish dynamic. On the other side of the equation, you obviously do have risks that the Fed is going to stay on hold longer because of the big fiscal package that's being talked about in Congress. The Fed does stay on hold because the Fed is concerned about inflation expectations unanchoring to the upside.

And then also, although I don't think that the market is too concerned about the tax package, maybe you do see another increase of the 10-year Treasury as we get a better view of ultimately what that package will look at. So you take these things into consideration, I don't really see the 10-year Treasury moving much from here. It's going to be in a range between, I'd say 4% and maybe 4.75% as we make our way through the back half of this year.

Host: So, Jeff, as we look to conclude this afternoon's conversation, do you have any final thoughts for our listeners?

Jeff Schulze: The economy is on solid footing as we moved into this heightened period of trade uncertainty. And there's going to be potential air pockets as we look forward. We got that last week, advanced trade data that showed the largest decline on goods imports on record in the month of April, which means that you could have had a pull forward of demand for both individuals and businesses that creates some lumpy economic activity as you look forward, when you get that payback period and fewer purchases occur.

So that has the potential to spook investors, especially if you start to see some slower payroll momentum, you start to see an increase of initial jobless claims. But ultimately, you know, we think that the budget reconciliation package, the tax package that’s being talked about right now is going to be something that will boost economic growth and ultimately continue to make that market momentum move further.

So if we do have an air pocket, and we have some downward pressure in equities, you know, I would suggest buying the dip for long-term investors. And I'm going to just do a quick trivia question, I think that this really frames things in a perspective that people should consider. So since 1928, you've had 97 years of market annual returns. 97 years. Out of those 97 years, how many times do you think that the market returned 20% or greater? So 97 years, 20% or greater returns in that calendar year? What's your thought? Throw out a guess.

Host: I'm going to say 30.

Jeff Schulze: Okay. You're on the high end. All right. Same 97-year period going back to 1928. How many times have the markets returned negative 20% or greater in a given year? And mind you, this includes the Great Depression.

Host: I’ll say 15.

Jeff Schulze: Okay. That's a great guess. That's consistent with what I usually hear in seminars when I do this. But if you actually look at the numbers since 1928, the market’s returned 20% or greater 36 times. So in any given year, you have roughly a 40% chance of getting a 20% or greater return of your money.

Those years that everyone's always deathly afraid about, so scared about, negative 20% returns? Only six. So when you look at the market from that vantage point, if you're a long-term investor, as all of us are, and again, there's no recession on the horizon, the market very much is your friend rather than your foe.

Host: Jeff, thank you for your time today. And I love the twist with the trivia question there in the closing comments. To all of our listeners, thank you 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.