Anatomy of a Recession: Anatomy of a Recession: Not All Hiking Cycles Are Created Equal

Jeff Schulze · ClearBridge Investments (Franklin Templeton)

Fed likely to skip October and deliver one final hike in December, with patience justified by tepid wage growth.

Fed funds futures moved from a 70% chance of an October hike to about 22% after the weak jobs report, and Schulze thinks that is about right. Several FOMC members have talked about being patient, so the bar for an October hike is high. Because wage growth is tepid and there is no sign of a wage-price spiral, the Fed can remain flexible. He still expects one more hike, in December, which he thinks may be the last of this cycle. Upcoming CPI and PPI readings could still move these odds.

“Now I do think we are gonna get another rate hike. I think it's gonna be December. And at that point, that may be the last one of this cycle.”at 4:27

Jeff Schulze · ClearBridge Investments (Franklin Templeton)

Futures-implied hikes of about 115bp would make this the most modest hiking cycle in history, limiting economic damage.

Schulze argues the size of a hiking cycle drives how much economic and market pain follows. The 2004 to 2006 cycle was 425bp and the 2022 to 2023 cycle was 525bp, the fastest pace in 40 years. Both brought equity bear markets, and the 2004 to 2006 cycle was followed by the 2007 to 2008 recession. Fed funds futures currently price only about 115bp of cumulative hikes. If that holds, even a bit higher, it would be the most modest hiking cycle in history. He expects that to limit economic damage and keep the typical post-first-hike pattern intact: some early volatility and multiple compression, but still earnings-driven gains. He does not see a modest cycle materially changing today's resilient economic backdrop, and he notes the classic late-cycle warning signs (real rates deep in restrictive territory, inverted curve, widening spreads, rolling leading indicators, red dashboards) are absent.

“if that's accurate, it's gonna be the most modest hiking cycle in history, which I think is going to limit economic damage and it's going to keep that typical pattern after the initial rate hike intact”at 6:27

Jeff Schulze · ClearBridge Investments (Franklin Templeton)

The 130bp rise in the 10-year is mostly real yields, not inflation fears or fiscal stress.

Since the late-February low, the 10-year Treasury yield has risen about 130bp. Of that, about 90bp came from higher real yields, inflation expectations rose about 20bp and the term premium rose about 26bp. Schulze argues that fiscal-sustainability fears would show up as a much higher term premium and much higher inflation expectations, and neither has happened. He attributes the real-yield move to a major repricing of Fed policy: in February markets priced about 2.5 cuts, and now they price more than four hikes, with expectations for July 2027 up 165bp. The term premium is about 70bp, which is modest against history and only elevated from a deeply negative base in the 2010s. Stable long-term breakevens and a modest term premium suggest the bond market is not pricing persistent inflation or a credibility shock.

“Of that 130 basis points, 90 basis points has been an increase in real yields. Inflation expectations have moved up by about 20 basis points, and the term premium has increased by 26 basis points.”at 12:17

Jeff Schulze · ClearBridge Investments (Franklin Templeton)

A 5.3% long Treasury yield is not concerning, since it tracks nominal GDP growing near 6%, as in 2003 to 2007.

Long-term Treasury yields have historically tracked nominal GDP (real growth plus inflation) rather closely. Nominal GDP is now running at about 6%, the strongest persistent growth in years and the last comparable run was 2001 to 2007. In 2003 to 2007, nominal GDP was near 6%, the 10-year averaged 4.5% and traded in a 4 to 5% range. Schulze says today's 5.3% yield is in a similar position. He also sees the global rise in long yields as a normalization after the post-financial-crisis era of deleveraging, deflation risk and unconventional policy, driven by stronger growth, strong consumer spending and robust business investment across the US, Japan, the UK and the Eurozone.

“they've historically tracked nominal GDP rather closely. And when you look at it through this lens, today's level at 5.3% really isn't all that concerning.”at 15:16

Jeff Schulze · ClearBridge Investments (Franklin Templeton)

Recession dashboard shows 11 of 12 indicators green, implying only about 15% recession odds over 12 months.

The Recession Risk Dashboard has held its colours through summer into fall. Of its 12 indicators, 11 are green (expansion), none are yellow (caution), and only one is red (recession). Schulze says this configuration typically corresponds to roughly 15% recession odds over the next twelve months, so the economy is on a solid foundation at the moment.

“I'm really excited to say that the recession risk dashboard continues to have a very strong overall green signal.”at 1:27

Jeff Schulze · ClearBridge Investments (Franklin Templeton)

Weak September payrolls reflect a labor market settling at a lower equilibrium, not a deteriorating one; job gains stay near zero to 100k.

September payrolls came in at 29,000 versus 90,000 expected, with a big private payroll miss, negative revisions totalling 60,000 for July and August, barely positive monthly wage growth and a higher unemployment rate. Schulze still does not think the labor market is deteriorating enough to worry him. He argues it is settling into a new equilibrium because immigration flows have dried up and many baby boomers are retiring early with capital markets at record highs. He expects monthly job releases in the zero to 100,000 range for the rest of 2026 and into the first half of 2027. He also sees the prime-age labor force participation rebound (up 0.3% after falling 0.6% in July) as eroding one of the labor-market bear cases.

“So, yes, the labor market is not boiling. It's simmering, but it wasn't bad enough that makes me really concerned about the labor market overall.”at 2:29

Jeff Schulze · ClearBridge Investments (Franklin Templeton)

No evidence of a wage-price spiral: wage growth is tepid after the weak September jobs report.

Although the September jobs report was weak across the board, Schulze sees no sign of a wage-price spiral because wage growth is barely positive month over month. That lets the Fed remain flexible and take a more patient approach to the next rate hike rather than respond to inflation pressure from wages.

“but you don't really see any evidence of a wage price spiral because wage growth is really tepid.”at 4:16

Jeff Schulze · ClearBridge Investments (Franklin Templeton)

Positive on US equities: pre-hike digestion is done, strong Q4 seasonality and post-midterm strength support further gains.

Historically, the S&P 500 gained 5.5% in the three months before a hiking cycle begins and then fell 0.7% in the first hike and the three months after, so some digestion is normal. This time the S&P 500 rose only about 0.5% in the three months before September's hike, so that digestion has already happened. Schulze expects this to help as third-quarter earnings season arrives and the historically strong fourth quarter follows. He adds that the 12 months following midterm elections have averaged a 15.1% S&P 500 return since the 1950s, with all 19 observations positive. He also argues equities have shrugged off the rise in yields: the 10-year has repeatedly hit the high 4% range after past hikes and markets kept rising, so higher yields have been a test the market has passed.

“what has me encouraged about US equities is that the S and P 500 was only up a half a percentage point in that three months leading up to September's hike. So we've already had that digestion”at 7:14

Jeff Schulze · ClearBridge Investments (Franklin Templeton)

Non-US equities have historically done well after modest Fed hiking cycles, with developed and EM equities up strongly in the following year.

Schulze's team split nine hiking cycles since 1980 into aggressive cycles (above 250bp cumulative) and modest ones (below 250bp). Today's cycle falls in the modest bucket. In the year after modest cycles, developed non-US equities (EFA) returned 13.2% on average and emerging markets returned 8.7%. He says US equities may not get a digestion period this time, but when the Fed is fine-tuning, non-US equities have historically joined the party and done quite well on a relative basis.

“when the Fed just is kinda fine tuning, if you will, non U. S. Equities have joined the party and have done quite well on a relative basis.”at 8:27

Jeff Schulze · ClearBridge Investments (Franklin Templeton)

Embrace credit risk early in the hiking cycle: high yield and emerging market bonds have historically performed well.

In modest hiking cycles, short-duration bonds did reasonably well. Schulze also points to high yield bonds, which returned 6.1% on average in the year after the first hike, and emerging market bonds, which returned 15.2% in the same period. Because the cycle is early and the Fed is not expected to kill it yet, he thinks investors should take on some credit risk, and he sees emerging market bonds as tending to do well in this setting.

“So you wanna be embracing some credit risk because we're earlier in the cycle. The Fed is not gonna kill the cycle yet.”at 9:09

Jeff Schulze · ClearBridge Investments (Franklin Templeton)

Earnings-peak fears are overstated; next-year earnings growth above 10% should drive markets higher, not multiple expansion.

Since 1980, the S&P 500 returned 19.6% on average in the year after an earnings peak when the following year's earnings growth topped 10%, versus 6.1% when growth stayed below 10%. Consensus says the peak is near or already here, but expects earnings growth over the next twelve months well above the 10% threshold. Schulze therefore expects returns to come from earnings growth rather than P/E expansion, which he notes has been the pattern in 2026.

“we're optimistic that the markets will continue to melt higher driven by earnings growth rather than PE expansion, which has exactly been the story here in 2026.”at 10:14

Jeff Schulze · ClearBridge Investments (Franklin Templeton)

Hyperscaler bond issuance causes only modest investment-grade indigestion and does not explain the Treasury yield rise.

Hyperscalers are tapping debt markets to fund AI build-outs, which raises the question of whether they are crowding out Treasuries. Schulze says investment-grade spreads are close to the near-record levels seen in late May, so supply may create a modest headwind or indigestion in IG credit. But that does not explain the large move higher in 10-year Treasury yields, so there is more to the story than hyperscaler supply.

“supply may be creating a modest headwind or indigestion in the IG space or investment grade space, but it doesn't explain why you had this massive move higher of ten year treasury yields.”at 11:07

Jeff Schulze · ClearBridge Investments (Franklin Templeton)

Fiscal sustainability fears are not driving Treasury yields; long-term Treasury CDS is nearly unchanged since February.

Many investors argue that debt sustainability fears or currency debasement are pushing yields up. Schulze says the data does not support that. Long-term credit default swaps on US Treasury debt are nearly unchanged from the late-February lows, when the 10-year was below 4%, which suggests no panic. Decomposing the yield rise also shows little inflation premium or term premium of the kind fiscal stress would produce.

“When you look at long term credit default swaps on US treasury debt, it's nearly unchanged from the late February lows when the ten year treasury was below 4%.”at 11:46

Jeff Schulze · ClearBridge Investments (Franklin Templeton)

Equity markets point to a productivity wave from AI investment and a new, stronger growth regime over three to five years.

Schulze reads the equity market's resilience despite a 130bp rise in the 10-year yield, a Fed that moved from expected cuts to hikes, and an oil spike as a strong signal. He thinks it points to stronger GDP growth ahead, strong earnings, and a likely productivity wave from current AI investment. That is why he is optimistic for a three- to five-year horizon, because the economy could be entering a new regime that differs from the 2010s after the global financial crisis.

“we're probably on the cusp of a productivity wave from all of this AI investments.”at 18:02