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JACK McMANMON: Hello, everyone, and welcome to the second quarter 2022 Chartbook Educational presentation. My name is Jack McManmon and I’m joined by Rob Fleming, Senior Market Analyst 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 market landscape, and Rob will show you key charts in the chartbook and also provide some talking points that may be helpful in your client interactions.
But before we jump in, let me quickly remind you of a couple of details. First of all, the Charles Schwab Quarterly Chartbook is for one-on-one use with clients only and is not for further distribution. And, second, this presentation is for institutional use only. Please do not share this presentation with others.
The global markets have seen increased volatility with drawdowns to the S&P 500 and several other global markets surrounding the path of interest rates, economic growth, inflation, and currencies.
US bonds saw pressure as markets grappled with increased expectations of tighter monetary policies, geopolitical turmoil, and uncertainty regarding economic growth.
TIPS continued to rise amid elevated inflation expectations, while high-yield corporates were down as financial conditions tightened.
International bonds fell on the tightening of global monetary policy and currency weakness, which has led to slightly higher yields, but partially offset by the geopolitical turmoil.
Commodities experienced a bit of a wild ride, as energy, grain, and metals surged with the war in Ukraine beginning. Meanwhile, REITS continued to be buoyed by gains in warehouse, industrials, and residential.
Rob, let’s start with the biggest economic point of contention right now, inflation. In the first quarter, we saw inflation persist and foster a focused change from the Fed from the labor markets to price stability. How is the inflation picture developing now?
ROB FLEMING: Well, great, Jack. Thanks for having me. Yeah, given the overall inflation picture has broadened and become more widespread, as you can see in the chart on the left, with still elevated food and energy being accompanied by gaining momentum out of services inflation, while housing prices continue to soar, it explains why the Fed has made a decisive shift from supporting its full employment side of its dual mandate—as they’ve made clear that that goal has definitely been reached—to fighting inflation, the other side of its mandate. The Fed is in a tricky spot right now in trying to engineer a soft landing and not letting longer term inflation expectations become unanchored. And their track record has not been very good. They’ve succeeded only three times out of the last 12 cycles, since 1960. But the good news is so far inflation, although continuing to rise with the Fed’s actions, we may see a little softening of the goods consumption, which may offer a reprieve to the supply chain challenges, and as we get away from the base effects in Q2 and later on, we may see, you know, a peak later this year in inflation. But as you look at the charts on the right, you can see that it shows longer term inflation expectations remain relatively calm and suggest a slowing to pre-crisis levels over the longer term.
However, there are some areas of concern there, chief among them are uncertainty regarding the ultimate impact of the geopolitical crisis, not just in terms of, you know, energy, but in terms of ingredients in a lot of the global food supply, such as wheat and other grains. Moreover, we have seen some signs of momentum in wage gains, which are one of the more stickier components of inflation, as the strong housing prices are flowing through to rents and shelter costs are some of the heaviest burdens on household finances. So you can see why the Fed has turned so hawkish as of late and is signaling a very aggressive monetary policy tightening campaign. Pricing power by businesses, meaning passing on higher costs to consumers, is leading to an inflationary feedback loop.
So, Jack, there a few things to keep in mind as we look forward.
JACK: All right, Rob. Thank you. Let’s turn to the economy. What are some things we saw in Q1 that you would like to note?
ROB: Yeah, as you can see in the chart on the left there, we’re looking at the rollover in the year-over-year of Leading Economic Index—I’ll refer to it as the LEI from here on out. This is one of the most reliable gauges of turning points in business cycles. It has continued to rollover, and given its nature of its 10 subcomponents, such as the average workweek, jobless claims, new orders for capital goods, ISM, and consumer goods, also, with building permits, stocks prices, credit activity, yield curve, and consumer expectations, this index, you can see how the moves in it generally signal when economic activity has reached a peak, trough, or a slowdown. As you can see here, the year-over-year pace remains strong relative to history, as economic growth, although peaking, remains solid. As you can see on the right-hand side of the chart, the ISM, manufacturing, and services PMIs, which are still solidly above the horizontal yellow line there that’s a demarcation point between expansion and contraction there.
So growth has held up due to strength in spending on goods and services, a strong jobs market, and some modest easing of supply chains. But as both charts show, there’s slowing activity, and although, you know, an imminent recession, it’s not our base case right now, but we’ve been saying for some time that we might need to dust off our recession playbook. And both the ISMs and the LEI, notably the manufacturing ISMs, these are great gauges of turning points in the economy. So we’re looking at, you know, the rate of change in the data as it is often where look for seeing if we can find a ‘tell’ as to whether we’re entering a new phase of the cycle.
So back to the chart on the left there, the year-over-year rate of change remains comfortably above the average, negative 1.4% year-over-year pace that we’ve see historically in the months prior to past recessions dating back to 1960. But I do want to point out that the level, by no means, is a definitive threshold to guarantee the end of the cycle, as there has been a wide historical range, but it tells us, at least for now, there may be some still good portion of runway left. These LEI levels have remained mostly strong, but at this point in the cycle, we’re looking at the trends. And most of them are yellow, meaning they’re stable right now, and there’s one that’s in the green, which means improving, and counterintuitively that’s the yield curve, and a couple are in the red, which are stock prices and consumer expectations. So the key there will be to watch the emergence of additional worsening trends in those categories.
But, yeah, I wanted to just emphasize, we’re looking at not just the levels there, but, most importantly, where we’re at here trying to decipher where we’re at the business cycles is the trends.
So what could cause these trends to worsen? Spiking inflation. It’s been exacerbated by the war in Eastern Europe; it’s weighing on sentiment of the all-important US consumer; it’s offsetting rising wages, which have been positive for some time now, while it’s being cited by small businesses, as well, as one of the top concerns. And, finally, one of the other major concerns is the Fed overcorrecting and delivering a policy mistake and slamming too hard down on the brakes of the economy.
JACK: Rob, speaking of a policy mistake or over-correction, are credit conditions and the yield curve part of the recession playbook or checklist?
ROB: Absolutely, Jack. That’s why I wanted to bring this slide to everyone’s attention. As you can see on the right, is showing a rollover in the Bloomberg’s Financial Conditions Index. Now, this is an index that tracks the overall level of financial stress in the US money markets, bond and equity markets. It’s used to help assess the availability and the cost of credit, and a positive reading indicates accommodative financial conditions and a negative reading indicates tighter financial conditions relative to pre-crisis norms. So we are seeing some tightening conditions as the markets grapple with the expectations of an aggressive Fed, which has signaled a series of rate hikes, possibly above the standard 25 basis points, and maybe 50 basis points for the first time in over 20 years. And the beginning of its balance sheet reduction is being signaled, as well, which can be a powerful tightening tool, while given the size of the balance sheet.
Also, the markets, you know, have been unnerved somewhat by the geopolitical front. This, actually, if you look back at Wednesday’s, yesterday’s Fed meeting minutes, they had mentioned and cited this as being a reason they didn’t go 50 basis points at that meeting, and decided for their traditional 25 basis points. So we’re looking at that.
The action in the treasury markets, that’s been a fascinating area of the markets to watch. As you can see on that chart on the left, the short-term treasury yields have jumped at a much faster pace than the longer end, as the markets wrestle with the Fed’s actions and the economic implications of those, because, if you remember, the shorter-term rates track Fed expectations, while longer rates key off of the economic expectations. So, typically, when we’re looking at, you know, recessions and all that, we want to see, you know, where they’re at in terms of inversions or tightening financial conditions, because significantly tightening invert prior to recessions, historically.
JACK: Staying with the Fed for a moment, can you walk us through a couple charts to show how the rate increase expectations and the stock markets tend to intereact?
ROB: Yeah, most definitely, Jack. Yeah, this is one of my favorite slides here in the deck here. You know, history shows us that stocks do have a different reaction to the pace at which the Fed hikes rates. Stocks, typically, continue to rise when the Fed takes its time raising rates, but then struggle when they raise rates at nearly every consecutive meeting. And, unfortunately, if you look at the chart on the right-hand side, you can see that they’re forecasting rate increases at every meeting this year and next. But it’s, you know, important to remember, you know, at any pace of Fed rate hikes, the markets tend to be much more volatile than prior to the rate hikes.
JACK: Rob, we have time for one more slide before we wrap up. Amid the expected increase in volatility and the volatility we’ve seen already, is there any way that investors can potentially take advantage of volatility?
ROB: Absolutely. Well, Jack, I brought this slide. This reminds me of my time as a financial consultant in the Tyson’s Corner, Virginia branch, when I was hustling around in my broken-down loafers trying to help clients through times like this, volatility. These charts lay out a nice picture illustrating a potential silver lining to volatile markets. You know, volatility can provide opportunities for clients to use losses to their advantage with tax-loss harvesting. You can offset capital gains by realizing capital losses, while using additional losses to offset some ordinary income. And then, also, you can, you know, reinvest proceeds in a similar but different security, or wait 30-days to buy back the same security, taking advantage of the wash rule.
JACK: That’s great, Rob, thank you. I realty appreciate you joining us today. And thanks to everybody listening. We really appreciate your support and for joining us today.
If you have any questions on anything we covered, please feel free to reach out to your Schwab Asset Management Sales Representative. And if you don’t know that contact information, feel free to find it on the web address shown right here on the screen, or call our sales desk at 877-824-5615. Again, thanks very much for joining us, and we look forward to seeing you next quarter
Rob Fleming, Senior Market Analyst, 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.