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JACK McMANMON: Hello, everyone, and welcome to the Q4 2021 Chartbook Educational Presentation. My name is Jack McManmon, and I’m joined today by David Kastner, Investment Strategist with the Schwab Center for Financial Research.
Today, we’ll be talking about a few topics and themes that are particularly top of mind, primarily, the state of the economy. It’s dramatically changed the economic and market landscapes, and David will show you some key charts and provide some talking points that hopefully may be helpful in your client interactions.
But before we jump in, let me mention a few items quickly. First, the Charles Schwab Quarterly Chartbook is for one-on-one use with clients only and is not for further distribution. And then, secondly, this presentation is for institutional only. Please do not share this presentation with clients.
David, it’s good to have you back and talk about the Q4 Chartbook, and how it can help clients understand some of the developments in the economy and the markets and provide some helpful investment principles in the asset allocation charts, especially in the chartbook. In terms of the markets last quarter, there’s plenty to talk about. Here on page 3 of the Chartbook, you show performance for many of the asset classes. We saw the S&P 500 claw back into a meager gain for the quarter after the volatility in September, amid debt ceiling concerns, the Federal Reserve, potentially peaking economic growth, and events in China. Yet interest rates were flat and the US dollar rallied with the Fed talking about tapering, and inflation not looking quite as transitory as previously expected, particularly with commodities continuing to climb. On page 4 of the Chartbook, you provide a great summary of what’s been driving the markets, as well as the latest developments in the economy.
Speaking of the economy, I think that’s a great place to start. As the title page suggests, these charts provide a view of what’s happening in the US. What are these charts telling us?
DAVID KASTNER: Hi, Jack. Well, they’re painting this picture of a transitionary phase in the economic and monetary policy cycle. So much as you said in the intro there on the market summary, we’re starting to see the growth rate peaking. Now, growth is continuing, but at a slower pace.
Now, the right chart here is what’s called the Weekly Economic Index. It’s provided by the Federal Reserve. And it shows somewhat real-time, on a weekly basis, at least, a picture of what’s happening in the GDP, gross domestic product, which is a quarterly report. So we get an update throughout the quarter, which is helpful. But as you can see here, it’s clearly dropping. Now, there’s a base effect going on, a higher base last year, a year ago, so we’re going to see a drop, but even on a quarter-over-quarter basis, we’re starting to see some slowing happening in the economy. And this is consistent with some of the other indicators that I highlight in the Chartbook on a regular basis. You know, the Purchasing Manager Indexes, or PMI, they’re showing the same kind of choppiness. After a strong recovery, they flattened out, and now starting to show a little bit slower growth.
Now, the left chart there, that’s the Citi Economic Surprise Index. And that’s a good barometer as to whether economic indicators, the data that comes out, is meeting, beating, or missing economic expectations, or consensus expectations. You can see at the heart of the crisis, when things started to improve, the reports were beating expectations, the fiscal policy, the monetary policy. There were enough to lift the economy much faster than anybody expected.
Now, conversely, if we look now, they’re consistently missing expectations. Now, this is in general. We’ve had some good reports here and there, the labor reports recently were good. But, in general, we’re seeing the slowing that economists and analysts are trying to catch up with on the downside, coming in a little below expectations on a more consistent basis.
Now, what’s happening? Well, you know, we talked about some of the reasons what’s causing the volatility in the market, but we’ve got a peaking in the fiscal policy tailwind. We’re not adding much there anymore. That’s being spent and moved through the economy. There’s still some there, but it’s starting to fade a bit. We’ve got this ongoing supply chain problem, and, of course, labor shortages, and all these things together are starting to hold back production and sales. And it’s also stoking inflation. So while growth is underpinned by a few items still out there, as I mentioned that the fiscal policy still has some momentum to it, slowing, but household balance sheets are quite strong, so there’s some consumption that can still go through the pipeline. The Delta variant, those cases after peaking in August are on the decline, so people are getting back out again. Infrastructure spending, that’s going through Congress right now. If that passes, there will be a nice fiscal tailwind from that.
But in the meantime, economist are downgrading their growth expectations and raising their inflation expectations, and the Fed is included with that. And we’ll talk about that in more detail in a moment. But, of course, as you mentioned, this is impacting stocks and bonds. We’re seeing higher volatility. The Fed tapering, along with all the other recent events—the debt ceiling, the events in China, and so forth—are causing some of this concern in the marketplace. On top of that, now we have to look forward to a potential peak in earnings growth, as well. So in the context of high valuations, a peak in earnings growth could portend some volatility in the market coming forward.
JACK: Thanks, David. You know, you mentioned supply chain issues. Can we dig into that a little bit more? What’s going on there, exactly? And how is that feeding through the economy in terms of affecting growth and inflation?
DAVID: Sure. And these charts, I think, here encapsulate what’s going on with the supply chain issue. On the left chart, that’s reflecting the World Trade Volume Index. And that’s an important indicator, in that global trade is a huge portion of world economic activity. That’s increasing over the years with globalization. Consistent with what we’re seeing in some of the more contemporaneous economic reports, we’re seeing a peaking in this world trade volume. That’s an indicator that goods are not getting through, and there are two components to that. One is, of course, the shipping backlog component, but the other is the production or supply shortfalls, constraints there.
So let’s start with the shipping backlog side. August, we saw a resurgence of the shipping backlog. The number of ships anchored outside the ports of Los Angeles and San Diego spiked again after coming down earlier in the year. Now what’s going on here is it’s not just the ports. You know, we’ve heard calls for the ports to operate 24/7. They don’t right now. They’re off on Saturdays and Sundays. But the issue there is that’s not going to fix the problem. We’ve got a labor problem, and that’s in the trucking and rail transportation. And they can’t fix all of them at the same time. They can’t fix any of it. So we’ve got a worker shortages. And we also have truck shortages, the chassis to carry those containers, we don’t have enough of them. So these containers are stacking up in the warehouses. Therefore, they can’t pull them off the ships yet. There’s nowhere to put them.
So the right chart illustrates what’s happening price-wise, the shipping costs. That’s the Baltic Exchange Dry Index. And as you can see, it’s gone up about five-fold since the crisis last year. But if we looked at another data point, which I don’t show here, it’s the West Coast ports, so, again, Los Angeles and San Diego. The 40-foot container shipping price from East Asia to the West Coast used to cost about $1,000. That’s up to $20,000 now.
So, clearly, shipping costs are part of this problem and part of this inflationary spiral that we’re starting to see that may result in continued inflation, because we don’t know when the shipping backlog is going to end. We are starting to see companies do workarounds, like Walmart and Costco. They’re chartering their own ships and bringing them to different ports, and have their own trucks and workers to pull those off the ships and transport them. But those are the big players. Our economy is built off a lot of small businesses, as well, and they’re still not able to get their supplies.
So in terms of the supply shortfall, not the shipping, but actual supplies being there to put on these containers, there’s multiple factors. Of course, demand has been skyrocketing more so than the current capacity could even... the old capacity could satisfy. The fiscal stimulus was a big part of that. People wanted to buy cars, computers, games. COVID also changed the type of products that businesses are looking for, particularly in technology, the work from home, the business resumption infrastructure, the cloud computing required for that, as well. These are new demand for new products that just weren’t available in appropriate quantity.
Now, demand is likely to stay high. We’re not going to see this falling out by any means. There are other factors that I mentioned earlier that are going to be tailwinds for this. One of those factors is inventory. Now, if you look at the PMI indexes, and, again, I don’t show those here, but in the Chartbook, there’s the order backlogs. It’s a measure by the survey of who is facing… what companies are facing backlogs in their orders, meaning the product is not there, and it’s at a record high. At the same time, inventories are at record lows. So to build up their inventories, even if consumption, consumer consumption, backs off a bit, businesses are going to want to build those inventories back up to sustainable levels, but there’s an additional factor to that. You’ve heard of the just-in-time inventory strategy. That’s likely to decline significantly. Manufacturers and retail businesses, they’re not going to get caught flat-footed again with what happened.
Now, on the supply side, I think we’re all familiar with what happened. The COVID shutdowns, the supply is still not catching up with those backlogs from the closures. In terms of manufacturer input shortages, semiconductors are kind of the top line. We hear about… in the news about the auto industry having to cut production. There’s machinery and electronics that can’t be completed—appliances, PCs, phones, tablets, you name it. So the input components to semiconductors are even a problem. The lead casings that are required to build the semiconductors are in short supply. So it’s this whole supply chain from product availability, input availability, all the way through the shipping.
Now, there’s going to be a continued flows of this. We’ve got the retail… and that was the manufacturing. We’ve got the retail and wholesale component of this, with apparel, sporting equipment, and furniture. There’s just a lack of availability. So on top of the new shutdowns that we’re hearing about now, China has had rolling power outages recently, having to cut electricity to some of the semiconductor plants because of their shortage in energy. The Delta variant, still out there, periodically shutting down some areas like in Southeast Asia. Some factories that make appliances and apparel had to be shut down.
So the net result is end sale revenues have headwinds. There’s not enough product to sell. It’s showing that in the growth trajectory. The input costs are up. Profit margins are starting to suffer, and earnings may be rolling over soon.
So, Jack, there’s a lot to talk about there, a lot on that slide, but I think the slide helps encapsulate a lot of what’s going on in the shipping area.
JACK: It does. It was terrific, David. Thank you. So measures of inflation are certainly on the rise, but most of us are also feeling and seeing them at gas stations, and restaurants, and grocery stores, and the like. Airfares are higher today than they were before the crisis. In all of the narrative, we were all told that this inflation would be transitory. Now it seems like it’s more likely for it to be more persistent than we thought. Why is that?
DAVID: Well, first, you know, we’re hearing about the CPI. We hear those… we get those reports once a month. We’re seeing the skyrocketing prices, and so forth. But it’s also happening, as I mentioned, in manufacturing and non-manufacturing price indices, which on the upper left-hand side in that chart there, that’s what that represents. So the services side, that’s the retail, wholesale, even leisure services and the services they need. But we’re near 2008 highs in terms of pricing pressure in those industries, and that was just a spike in 2008. You actually have to go back to... or 1979 to see equivalent levels. So that’s not a very good sign if it does turn out to be persistent. We talked about the shipping cost, other input costs. The semiconductor prices are going up. Copper is just off of record highs. Oil is up 40%. We’ve been seeing that recently, the volatility there. Natural gas is even a story out there, up 50%.
You know, some of the positives that we’ve seen is that lumber prices have come down. That was a big headline earlier in the year. Steel prices have come back down, and some of these items, some of these products are going to be transitory, the inflation in those products are going to be transitory in nature. Automobiles, for example, there’s a lot of pent-up demand. So prices are probably going to stay high, but they’re not going to keep going higher to any great extent. That is when auto production comes back online.
Now, the PMI Prices Index is a good indicator to watch because it’s one of those monthly reports that’s got a little more to it than just the CPI. So keep an eye on that. That’s on page 10 of the Chartbook there.
But the areas that we need to watch that could cause this momentum and inflation to continue, it could cause some sticky inflation, if you look at the upper right-hand chart, that’s a wages, an hourly wages chart. And in the green section, prior to the crisis, that dotted line there, wages were going up at about a 3% annualized rate. Since the crisis, in that gold area on the right side of the dotted line, we’ve been seeing about 5%. And those wages are going up, they’re moving up the skill spectrum. A lot of this was in the retail area. When stores are just opening, they have to hire people, they are having to pay more to get it. But it’s going up into the blue-collar workers, in the hospital workers, and even on the Wall Street, we’ve been hearing stories about the junior analysts getting big raises. Unions, even though they’re a much smaller part of our economy than there were in the 1970s, there’s talk of strike. John Deere is dealing with that right now. So they’re asking for more wages, higher wages, more benefits, and so forth. So this momentum in wages can be a concern.
On slide 7 of the Chartbook, or page 7 of the Chartbook, I’ve got a bunch of charts just on labor. And one of those charts is for small businesses, the NFIB, and it’s the job openings that they can’t fill, and a record 50% of small businesses surveyed have open reqs, open positions that they can’t fill either because it’s skilled or they just can’t get people to apply.
Now, if you look at house prices, we can go to the lower left-hand corner. That’s the Zillow U.S. Rents Index, and that’s the year-over-year measure. And you can see how the housing price boom is now filtering through to rents. Whether it’s single-family rents or apartments, they’re skyrocketing up over 10% in the last year.
So, you know, we’re just going to start to see this in the CPI, as an example, because housing prices take a little while to filter through. It’s usually reflected in rents, equivalent rents, and so forth. So we’ll start to see that traction in the CPI soon from the housing.
Now, going to the lower right, again, looking at small businesses, they’re saying they’re planning to raise prices, and that’s at a record high, as well, almost 50% of businesses. What’s that is saying is they’ve got pricing power now. Businesses increasingly feel able they can pass those costs onto consumers. An example of this would be the staples industry, you know, Procter & Gamble, and so forth. It’s a very competitive field for the household products. And, usually, prices are very stable, and they increase their profits by building in efficiencies and lowering expenses. But now their expenses are up, but they’re also able to raise prices.
So we’ll see if that feedback cycle is able to continue. And that’s very important why we need to look at all of these things, because if you’ve got higher input costs, that raises the price of products, or the cost of products. You’ve got higher wages, that raises the cost of doing business. But if businesses can pass that price, that cost, along to consumers, then you can get that feedback cycle.
So, Jack, watching some of these more sticky items and inflation is going to be very important going forward.
JACK: David, a few moments ago, you talked about the Fed starting to unwind its easy monetary policy. What do we know about the timing of this? And is inflation the only thing they’re looking at, the only consideration?
DAVID: No, there are a lot of considerations, clearly, but inflation is a primary one right now. And one of the reasons I say that is because we are seeing some slowdown in growth, and they’re noticing that, and they’ve downgraded their expectations, but at the same time, increasing their expectations for inflation. So the Fed has two mandates. One of them is steady inflation, moderately above 2%, as well as full employment. On the labor side, the Fed is saying they need more progress in that. There are some indicators, like the Kansas City Fed Labor Market Conditions Index, which you can find on page 40 of the Chartbook, that is well above that threshold where historically the Fed has raised rates, but they’re wanting to see some more progress there. Fine.
On the inflation side, however, the Core CPI Price Index, which is their main measure they look at, is that 3.6% in the latest month. That’s the highest since 1991, and it certainly isn’t stable. The Fed says it’s transitory, but their forecast is up. They’re making hedge statements about when they expect inflation to come back down. So were seeing broader inflation out there, and, clearly, this inflation indicator is giving them a green light. In fact, they’re seeing a need to get ahead of the curve by raising interest rates and starting to unwind.
So let me explain first… or, lastly, I should say, this chart here, what I’m showing. The bright blue line is the Fed Funds Rate. So that’s one of the main monetary policy tools they have to deal with. The dark line is the balance sheet for the Federal Reserve. So that includes all the bonds they’ve been purchasing over the last couple of years now in order to support liquidity, provide liquidity into the marketplace. So they’re buying treasuries and mortgage-backed securities, and putting them on their balance sheet. Others now have cash on their balance sheet in order to add liquidity.
If we go back to 2014, and take a look of the timing that we could expect in terms of a rate hike, we only really have that one example. So looking at that, when they finished tapering, meaning that they slowed down those purchases, they didn’t shrink their balance sheet, but they didn’t continue to grow it. It took about a year for them to start to hike interest rates. This time, there is risk, as I said, that they’re behind the curve. The tapering we’re expecting to start in December or January. We’re going to hear more about that at their November Federal Open Market Committee meeting. They expect, or at least Jay Powell has said, Fed chairman Jay Powell has said that’s going to be about six months from the wind down their purchases. So their tapering period. It could take as long as nine months, depending on when they start from now.
Rate hikes last time took a year. They’re not going to wait that long. According to the Fed’s dot plot, the start of the rate hikes is likely to happen in 2022, by late 2022, with multiple hikes in 2023.
So there’s a little taste of the timing to look for. Obviously, there’s a lot of influx there, Jack, but this is kind of the blueprint we’ve got right now.
JACK: David, as we talked about earlier, we’ve seen a little bit of volatility in the market recently. How much of that is due to the Fed tapering versus other headlines we’ve seen?
DAVID: Well, it’s hard to ferret out exactly what’s causing the volatility. Certainly, the Fed tapering is part of that, but in the meantime, we’ve got this spike in oil we talked about, the issues in China with the tech sector, and their real estate problems. The debt ceiling has been the most prevalent, unclear motive for volatility more recently. So even though every period, every time there’s an issue like this when the Fed starts to pivot on their monetary policy, there are issues going on, but there seems to be more issues going on this time.
In 2014, as I showed earlier, when they finished up their tapering and started to gear the market towards rate hikes, there was a little bit of volatility. But as you can see over on the left side now, on this chart, the red arrow, when they actually started raising rates, there was higher volatility. Now, there were other things going on at the same time. But now we’ve got an inflation… inflation is a much bigger issue. Growth is peaking. There’s stagflation worries.
So even though there’s going to be these other news items here and there, we’ll start to see more volatility pick up as we close in on that time when they make the full pivot, and they actually start executing that new monetary policy.
Now ,this chart here can provide some heads up and some indication that it’s not just the Fed. They’ve been very deliberate with their communication. But this chart is the S&P 500 in that dark line. That bright blue line is the 50-day moving average of the S&P 500. That light blue histogram below it is the percentage of stocks within the S&P 500 that are above or below their 50-day moving average. And as you can see more recently, that came down. Even before we really started to get a concern that inflation was going to be transitory, the stagflationary issue the leadership of the rally was much narrower than it had been. So there’s some technical issues going on, but also other issues going on at the same time.
But this is a good way to get an idea whether we’re going to… you know, we’re going to see this leadership in the market, where we’re currently seeing leadership in the market that’s broad, which is generally positive, or if it’s very narrow, which can lead to some volatility and some choppiness in the markets.
Another indicator that we’ve got in the Chartbook that I don’t show here is investor sentiment, and that’s more on the technical side, as well. It’s off its highs. Extreme levels of sentiment is usually bearish. So it’s off those highs, but we’re still at levels that’s consistent with low returns, continued volatility, again.
So, Jack, you know, there’s some technical slides in there on the individual sectors to give you an idea of the price action we’ve had on those in the last couple of months, but bottom line, volatility seems to be the word of the day.
JACK: David, you mentioned earlier the peak in the rate of economic growth, as well as a peak in earnings growth. And as most people know, valuations are at extreme levels. Will you walk us through some of these charts on valuation?
DAVID: Yeah, sure. This chart on the right is actually a new one. I borrowed this chart from Liz Ann Sonders and Kevin Gordon with Schwab Center for Financial Research. I think it’s a good illustration of the extremes that we’re talking about in valuations. And you can go down the list there, most metrics are at extreme levels. The first one, the PE ratio, the forward PE ratio. Now, you can see over on the left side, the chart on the left, that compares to the tech bubble in the late 90s. And we’re not as high as that, but we’re still at very elevated levels. But if you go down the list—price-to-book, price-to-cash flow, price-to-dividend yield—all at extreme levels—market cap-to-GDP. The only ones that are in the green are those that are related to interest rates. That’s the risk premiums relative to treasury rates, relative to corporate rates. The Federal Reserve valuation model includes interest rates in that.
So that poses a problem. In some ways, it rationalizes why stocks will be so high in valuations, but it also poses some risk, as interest rates may rise, and, in fact, we’ve started to see that, and it’s caused some choppiness in the leadership of the market. Generally, growth stocks do not do well when interest rates are going higher. Some cyclical value do, but at the same time, why are those rates moving? That’s where defensive comes in. So we’ve seen that choppy leadership between sectors. We’ve seen that between style. We’ve got some charts in there on factor, the factor performance, like momentum versus dividend yield versus growth, and so forth. It’s also got some global valuation pictures there. But the trading rotation strategy is that, typically, you don’t have to look at valuations much. We may be at this inflection point where it’s hard to have conviction. So the advice to clients may be make your bets small and appropriate to the level of risk in your portfolio, and perhaps focus more on rebalancing diversification to a greater extent than usual.
JACK: Great. Thanks, David. We have time for one more slide, and I see this quarter, you added a new ESG chart in the asset allocation section. This is certainly a very popular topic these days. How can these charts give clients some perspective for investing in ESG?
DAVID: Sure. Well, there’s been this long thought theory that ESG stocks will underperform. When investors invest on principles and not as much on the fundamentals of individual stocks, you’re just not going to have those great returns. But this chart on the left argues against that point. It’s the MSCI World Index in that bright blue, and behind that, which you can barely see, is the MSCI ESG Index. So there’s just short periods of time where that has actually underperformed. And one of the reasons for this is that investors are incenting companies to pivot, as well as benefits that they see by pivoting, and now they’re included in those ESG criteria. Less regulatory risk. Clean energy costs are actually coming down. Better governance is always good for businesses. And then from a social perspective, it’s been long known, but we’re seeing more diversity, and the more diversity you have in your workforce, we’ve seen it over and over, with a higher caliber workforce. And that’s being rewarded by the market. And that creates opportunities for investors to invest on the fundamentals and in the principles, and we created this competitive performance.
Now, on the right, however, you have to be careful. Just like any area of the market, there can be excessive optimism, and that’s still the case with ESG. That bright blue line there is the ESG Alternative Energy Index. And you can see after the election last year, that went through the roof, really priced in some optimistic view on what’s going to happen with alternative energy. And that’s since come quite down quite a bit. That dark line there is that same ESG Index, that benchmark, as I show on the left one, just a different timeframe.
The point here is remain diversified. If we’re going to make thematic bets within ESG, make them modest and control for risk.
JACK: Perfect. Thanks, David. And thanks for all your work on the Chartbook. Terrific slides this quarter.
Thank you to all of you joining us today. If you have any questions at all on what we’ve covered, please reach out to your SAMS sales representative, or you can find your regional representative’s contact information, as well as lots of phone numbers for general inquiries, at schwabassetmanagement.com, or you can call directly to our sales desk, which is 877-824-5615. And we look forward to speaking to you next quarter. Thanks, again.
David Kastner, CFA, Senior Investment Strategist, Charles Schwab & Co., Inc. and Jack McManmon, Client Portfolio Strategist, Charles Schwab Investment Advisory, walk you through how to share with clients the Chartbook’s ~60 pages of economic information.