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Schwab Chartbook Q3 2021 Update
Hello everyone and welcome to the Q3 2021 Chartbook Educational presentation. My name is Jack McManmon and I’m joined by David Kastner, Investment Strategist with 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 has dramatically changed the economic and market landscape, and David will show you some key charts in the chartbook and provide some talking points that may be helpful in your client interactions.
Before we jump in, let me quickly remind you of a few details:
- First of all, the Charles Schwab Quarterly Chartbook is for one-on-one use with clients and not for any further distribution.
- And second, additionally, this presentation is for institutional use only. Please do not share this presentation with others.
David, it’s great to have you back to talk about some of the featured slides in this quarter’s Chartbook. As reflected in the market summary on page three, we continue to see significant developments in the economic and market landscapes. Stocks continued to push to new highs on the coattails of fresh stimulus and optimism on the progress of the vaccine distribution; but interest pulled back after strong Q1 gains as inflation expectations and non-energy commodities rolled over, supporting bond returns; However, the price of Oil continued to surge as recovering demand outpaced supply. I see that you’ve added some new slides to the chartbook again this quarter—a number of them are on the hot topic of inflation risk, and Fed appears to be making a shift in its view. Can you walk us through the key issues that our advisors and financial consultants can talk to clients about?
Hi Jack, I’d be happy to. Let’s start with the Fed. It appears that it is time, the time has come for it to at least start talking about the next steps for monetary policy. You know, after cutting rates to zero and adding trillions of dollars to its balance sheet, it is now saying that the economy is facing less of a headwind from the COVID crisis and that’s as the distribution of the vaccine allows the economies to reopen. Yet, it still notes the considerable risk to the economy and that it has not yet achieved its mandates—that’s steady inflation and full employment—despite the really strong labor reports recently. Now, while the Fed has stuck with the belief that inflation will be transitory, the recent spike is keeping the topic front and center. Fortunately, investors interpreted the latest Federal Open Market Committee statement, comments by Fed officials, and their fed funds forecast as being less dovish and it advanced the timeline for rate hikes slightly. This is easing concerns that the Fed will wait too long to act to the recent surge in inflation and that it doesn’t turn out to be transitory in nature. Yet, if they raise rates too soon, it could dowse economic growth. So, Fed members have been very deliberate with their commentary, threading the needle between keeping inflation concerns in check and signaling that rates will stay low for quite some time.
Now this chart here shows the historical fed funds rate in blue, and the forecasted rate according to the fed funds futures in the orange diamonds. These shifted higher in the last couple of months, with late 2022 being the soonest that the fed is expected to raise rates. But before it does, however, it will need to taper its quantitative easing—which we’ll hear more about in the coming months. The 10-year Treasury yield rose sharply higher on good growth, on inflation expectations. It did that in Q1, but stalled in the latest quarter as inflation expectations pulled back, despite these hot inflation reports and continued strength in the economy, of course. In fact, they have continued to fall in the last quarter, and into this quarter in fact. If you are interested, you can see the breakdown of the nominal interest rates and inflation expectations and real rates on page 39 of the chartbook.
David, these charts on page 15 of the chart book provide a high-level snapshot of economic growth. Can you explain these indicators, and talk about how some of these underlying components continue to point to strong growth?
Sure, yeah these charts show some of the leading economic indicators that reflect the momentum in the economy. On the left is the OECD composite LEI. The composite shows that we’ve essentially made a full recovery, and indeed have entered an expansion phase. On the right are the purchasing manager indexes or PMIs. They show where the rubber meets the road, so to speak. Above that red line reflects growth in several areas within the businesses surveyed—so we’re talking about new orders, employment, backlog of orders, export orders, et cetera. Now, both charts reflect strong momentum and you can see that the U.S. is actually currently has the strongest momentum of the major economies—despite the slight pullback we’ve seen in the latest PMI reports.
And despite the marginal change in its outlook, the Fed is not going to get in the way of this momentum. As I mentioned, the labor market has yet to fully recover, with non-farm payrolls, which is a coincidental indicator, still well below pre-crisis levels, and that’s not for lack of demand; on page 7 of the chartbook I’ve added a chart showing that small businesses are struggling to fill their open positions. However, high household savings, improving consumer and business confidence, strong global trade, and the recovering services all point to continued spending and recovery in the labor market.
And of course, it’s the strong economic growth, spurred by these factors—including the stimulus, that have contributed to the recent spike in inflation. Can you walk us through the charts on page nine of the chartbook that help illustrate the rationale to support the notion that inflation will be transitory?
Sure, sure, and as most of you are aware, we had a high print in the year-over-year change in the consumer price index for May of 5%—that was the latest available that we had for the chartbook when this went to print. Now, while the high year-over-year numbers were large in part due to the base effect after the CPI fell in May of last year, the annualized rate of the recent month-over-month prints—those are not shown here—they were even higher, and that surprised even the Fed, and raised questions as to about how persistent inflation could be.
Now when we look under the hood of the May CPI report, we can get a better understanding of what exactly has been driving inflation recently, and what things could persist—at least in the short-term. To start with, let me explain the components of the inflation data in the left chart. The first dark blue line is the All Items CPI; it’s the headline number that came out at 5% year-over-year. The next column–reflected in the bright blue bar—that’s food costs—they were up a modest 2.2%, even with the spike in agriculture and livestock prices, though we’ve seen them roll-over recently, so that’s good news in terms of food prices.
But Energy—the orange bar—rose 28%. And this was the biggest driver of the most recent inflation prints, it accounted for 1.6 percentage points of the rise in the overall CPI in May. And we’ve seen oil shoot from below $20 a barrel earlier last year to more than $70 a barrel today. Will it continue to play a big part going forward? Of course, it will depend on the trajectory of oil prices, but it’s unlikely for oil to see another $50 rise from here. However, higher costs from oil at $70 per barrel even can still be passed through to food costs, manufacturing, and goods shipments cost and that can happen over the next several months, so there is some momentum to higher costs associated with the rise that we’ve already seen. And demand for oil is still rising amid constrained supply, and that’s drawing down inventories, so we could see prices continue to rise. Take a look page 52 in the chartbook for more on this topic.
Move to another column to the right and this is the less volatile Core rate in the blue bar, which excludes the volatile food and energy components. It was up a whopping 3.8%—and that’s the sharpest rise we’ve seen since 1992. This was the standout number that got people’s attention.
To break the Core rate down, we can look at the two charts to the right, that together make up the core measure.
- On top is the Commodities less food and energy. It was the major driver of the core rate, rising nearly 6%. The components of this category include among other things, apparel, household furnishings and used cars, which rose an astonishing 30% from a year ago! On the demand side of this it’s pretty clear. Consumers had and still have money from stimulus checks to spend, on top of the money that they didn’t spend going out to dinner, the movies, or on vacations.
- And on the supply side, new car inventory was low. With auto plants shut down, new cars weren’t being made, and when they did re-open they couldn’t get parts—especially semiconductors— because those plants were closed, too.
Buyers went for the next best thing—which was used cars and trucks. Automobiles alone added nearly a percentage point to the overall CPI. And that’s simply unlikely to repeat itself.
Now the lower chart includes the services component of the CPI. There, transportation services—includes among other things, auto insurance and air fares—they added more than a half percentage point—both of those were quite depressed a year ago so what we’re seeing there is, we’re seeing a rebound as those are recovering, as insurance companies have cut premiums, air fares of course plummeted. Now those prices are coming back up, so on the year-over-year basis, we’re seeing those big increases.
These are likely to be one-time price increases for the most part and are behind the Fed’s contention that inflation will be transitory.
However, there are some stickier increases. House prices as you know have shot higher. On page 13 of the chartbook, you can see that the Case-Shiller house price index rose over 13% year-over-year. Now, the pass-through to the CPI component—that’s owners equivalent rents, as well as apartment rents—they’ll follow in the coming months. This accounts for 32% of the total CPI, so it’s an important component to watch. Although, remember that the Fed uses the PCE Price index to target inflation, and shelter is a smaller proportion in that index. The good news is that there are already signs that the housing market is cooling. Existing home sales have fallen dramatically in recent months. Now, that’s in part because of the lack of inventory of available houses for sale. But surveys also show that people are being priced out of the market, with potential home buyers saying this is not a good time to buy a house. So, the advantages of lower interest rates have been more than offset by that, the rise in home prices.
So, David, while there could be some stickiness in a few components of inflation, it’s just a handful of them that really drove the recent spike, I suppose. What about the long-term? There are concerns that rising labor costs and money supply growth could bring back 1970s-style inflation, and we know what impact that historically had on the markets and economy. In this slide, page eight of the chartbook, you provide a long-term illustration of inflation that financial consultants and advisors can use to help talk about inflation and put the current inflation surge into perspective for clients.
Well, yeah, that’s the intent. While these numbers are high—certainly higher than we’ve been accustomed to in recent years—we actually last saw inflation numbers like this as recently as the late 2000s. But if it were to persist, history shows us that it has had a rather dramatic impact on economic growth, as well as market performance. And I’ve added a box here, and in that box, you can see that when inflation is low, the economy and markets tend to perform better than when inflation is high. For example, look at the Real GDP column. When inflation is between one and four percent, Real GDP growth on average has been 3.2 percent, but that drops to 2.5 percent when inflation is between four and nine percent and just 1.1 percent when inflation is over 9 percent. At the same time, annualized market returns dropped from 9.5 percent on average to 1.2 percent and 0.7 percent, respectively.
However, as I mentioned, the Fed maintains that we don’t have an inflation problem, and as we’ve already seen in the recent surge and inflation expectations, they may be transitory. And we agree. If fact, Kathy Jones, with Charles Schwab, has written several articles on this, which you can find on Schwab.com. In fact, on slide 10 of the chartbook, I’ve added some charts from those articles that provide some statistical studies on why the return of inflation from those past eras is unlikely to repeat—primarily because the traditional drivers of inflation have had a more muted impact in the past few decades compared to prior decades. For example:
- Rising unit labor cost is still associated with a higher inflation, but that relationship is much weaker than it has been in previous decades. One reason, labor unions—they’ve declined dramatically.
- The impact of money supply growth, now that is virtually non-existent now, and we began to see that in the mid-80s when Milton Freidman predicted that the earlier surge in money supply would reignite inflation—and he was wrong and inflation, as you know, continued drop for nearly four decades.
- Now, public debt has never had an inflationary link going back to the 70s; on the contrary, it’s been deflationary, particularly as the dollar has never been destabilized by the debt. Now, each of the time periods had their own unique characteristics and market reactions, which are unlikely to repeat themselves.
- But there are actually still some structural headwinds to inflation in place: we’ve got globalization, demographics, and the impact of technology, and they’re all likely to continue to be deflationary forces. And one more major consideration is the activist role of the Fed; it’s much different now than prior to 1980, they’ve got the tools and the willingness to stop an inflationary spiral.
Great, thanks David. Shifting gears a bit, on page 25, you provide some charts on valuations. With the rally in equities, it’s obviously a concern that most measures of valuations are flashing, you know, red flags. What can you tell us here?
Well, that’s right. Nearly all measures show that stock valuations are high. That table on the upper right has a number of valuation metrics—price earnings ratio, price to book, price to sales, et cetera, and I've provided for each of those the current reading, along with the 30-year mean. And a common way to categorize the metrics as favorable, neutral and unfavorable is using what is called the z-score. It gives you sense of how far off that mean the readings are based on the historical variability of those indicators. Now here, the z-score is plus or minus one—that’s the demarcation line and currently, all those measures are unfavorable, showing unfavorable valuations, except for the earnings yield minus the Baa corporate yield. Now, high P/E ratios can sometimes be rationalized by lower interest rates, because they’re the discount rate of future earning flows. The earnings yield minus the Baa corporate yield is one way to take that into account for these low rates we’re seeing right now, and currently it’s in the neutral zone—although, it’s up from favorable before interest rates when they rose earlier of the last year. Of course, a rebound from the recent decline in rates would erode this measure more.
Now, there is some other good news reflected in these charts. With the strong economic growth, earnings expectations have surged and you can see that in the lower left-hand chart, and in fact have they’ve outpaced the rise in stocks—which has resulted in the forward P/E ratios declining recently, and you can see that in top-left chart.
Thanks, David. We have time for one final slide. Do you have a favorite slide this quarter that you’d like to share?
I’ve got a number of slides and I’ve spent a lot of time on what’s happening in the markets and the economy, but the chartbook is also a great resource for sharing investment principles with your clients, important concepts on asset allocation and diversification, and ways to navigate low interest rates in this low interest rate environment. Now, the Income section has some great charts that illustrate the impact that dividends have on total return. And there are also some new charts on munis, which clients may be interested in if taxes end up rising. The asset allocation section, there’s some pages with Schwab’s capital market expectations, and this can help give clients some context in their investment planning process. And this chart here reflects the level of diversification within bonds, and just going for higher-yield, that can add a lot of risk. However, by managing considerations of risk in the context of the overall portfolio, this can help in that respect. But if you ask what my favorite slide is, I actually don’t have it here, I’ve shown it before—it’s, Time in the market is more important than timing the market, and it shows the dramatic decline in returns if you just miss a handful of the best days.
Absolutely, that’s right. Well David, thank you very much for joining us today and thanks to everybody else for joining us today; we really appreciate it. If you have any questions on anything we covered, please feel free to reach out to your SAMS Sales Representative or find your representative’s contact information at the web address shown right here on the screen. Or call our sales desk at 877-824-5615. Again, thanks very much and we’ll see you again next quarter.
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.