Fed policy, tech stocks and small caps: A discussion with Jeffrey Schulze

Jeffrey Schulze, Managing Director of ClearBridge Investments, shares insights on the US markets, discussing interest rates, catalysts for the rotation out of tech and the Magnificent Seven and the durability of the move into small caps.

Paul Sanger: Hello. I'm Paul Sanger with the Finance News Network, and today I'm joined by Jeffrey Schulze from ClearBridge Investments. Jeffrey serves as the Managing Director and Head of Economic and Market Strategy, where he oversees capital market and economic research, providing thought leadership to institutional investors and financial advisors. He is the creator of the ClearBridge Anatomy of a Recession program, which utilises a dashboard of 12 indicators to monitor shifts in the US economy that could indicate a rising risk of recession. Jeffrey is a well-known figure in the financial media, frequently quoted in publications like The Wall Street Journal, Bloomberg, CNBC and Reuters. He is also a regular guest on numerous financial broadcasts and as an editorial contributor to Forbes. Welcome to the network, Jeffrey.

Jeffrey Schulze: Thanks for having me, Paul.

Paul Sanger: Now, Jeffrey, let's start with US interest rates and the Fed policy. The outlook for the US rates has significantly influenced the recent movements in the US equity markets. Traders are now factoring a 9 per cent chance that the Fed will cut rates in September. The Fed are obviously meeting tomorrow as well. What are your thoughts on this and what do you think happens tomorrow?

Jeffrey Schulze: Well, I think tomorrow is going to be a pretty calm meeting. There's not really a catalyst for the Fed to act tomorrow. You're seeing a cooling of the labour market, but nothing that suggests that it's going to see a step-down in momentum that will require a rate cut. So, I think the Fed is going to talk about the fact that they're still data-dependent. They want to see continued disinflation over the next two inflation releases. But I think they're going to open the door to September being that first rate cut. And I think that that will materialise. And the markets are pricing in another two rate cuts in December and January of 2025. And this is a really positive development because, when you look back to 1995's soft landing, the 1998 soft landing, both of those soft landings saw three rate cuts from the Fed to create economic re-acceleration. And we're anticipating that next year as well, which we think will prolong this expansion in the US and propel further gains in US equities.

Paul Sanger: And moving on to what we've seen in the US equity markets in the last month, we witnessed a big sell-off in tech and the Magnificent Seven alongside what appears to be rotation into cyclical and small-cap names. Can you talk a little bit about this sector rotation and the Magnificent Seven?

Jeffrey Schulze: Well, it's been pretty violent and pretty swift, but there's been a lot of catalysts kind of driving this move. First off, you had really extreme positioning after mega-cap tech outperformed by such a wide margin at the end of the second quarter. So, you've seen an unwind of that position, some short covering on the small-cap space. And that's been a pretty key driver, at least in the beginning of this rotation. A second driver was after the CPI release that we got on 11 July. It was clear that the Fed would be able to finally embark on that rate-cutting cycle and create that re-acceleration of economic momentum next year, which will lead to a broader earnings delivery, which should help a lot of these companies that are smaller or on the value side that really have had some pretty tough earnings releases over the last 12 months.

Another reason for this was last week's release from an earnings perspective for Tesla and Alphabet. Alphabet's CEO mentioned the fact that the risk of underinvesting right now is dramatically greater than the risk of overinvesting in AI. And I think that's spooked investors that there's going to be a lot more upfront costs with an uncertain payoff period as we look out on the horizon. But, obviously, we have a pretty big week of earnings with Amazon, Meta, Microsoft and Apple all releasing this week, which really could change that momentum. So, again, there's been a lot of drivers that have created this very sharp rotation here in July.

Paul Sanger: Yeah. And with regards to some of the stocks you mentioned, they're kind of priced for perfection. And any hiccoughs in any results that come out, the market punishes them for that, yeah?

Jeffrey Schulze: Certainly. Again, the frothiness has come out of a lot of these stocks over the last three weeks, but they still trade at very elevated multiples. So, any disappointment would probably result in a further continuation of this trend. But, again, we have four of the Magnificent Seven stocks releasing this week. What I'm really looking for, if there's any commentary or guidance on how much more AI spending is going to be necessary or expected by these larger companies.

Paul Sanger: And turning to the Russell 2000 and small caps specifically, how durable do you think this recent move into the companies is? And how sustainable is this rotation in your view?

Jeffrey Schulze: Well, I think there is some durability to this trade. One of the bigger drivers, and I didn't mention this on your previous question, for this rotation has really been a broader earnings delivery. Now, this is the last quarter where the magnificent seven is going to have a large earnings advantage versus the S&P 493 and the Russell 2000. When you look out to Q3, that earnings advantage is neutralised, so their growth rates are basically in line with one another. But when you look out to Q4 and Q1 of 2025, the S&P 493 and the Russell 2000 in particular is expected to outgrow the Magnificent Seven by a pretty wide margin. So, you had a pretty strong earnings season in Q2, even though expectations are moving down slightly for Q3 and Q4. Should these earnings expectations come to fruition, I think that there is some durability to this trade. But I want to be very clear. We've had a really strong move in a short period of time. We could get a counter-trend rally back into the mega-cap tech names. But, ultimately, on a 12-month basis, I think that this rotation will ultimately prove resilient, at least much more resilient than what we've seen throughout this bull market.

Paul Sanger: And what do you see as the key risks to the view that this rotation into small caps and cyclical gains has staying power?

Jeffrey Schulze: The key risk has to be growth. If you see a step down in economic activity in the back half of the year, investors are going to flock back to the perceived bulletproof leaders that can grow their earnings in any type of environment. There was a lot of recession fears last year, and that was a key driver of the outperformance of these larger mega-cap growth names. If you have a recession, again, small-caps are more economically sensitive. They don't have that earnings buffer that you have in the large-cap space. That is something that could derail this trade. But with the Fed likely embarking on a cutting cycle in September and likely to see some follow-through on cuts later this year and into 2025, we think that the odds of a soft landing and a continuation of this expansion are improving.

Paul Sanger: Jeffrey, many thanks for taking the time to share those insights with us today. It's been an absolute pleasure.

Jeffrey Schulze: Thanks, Paul.