MARK RIEPE: Hello, everyone. Welcome to Schwab Market Talk, and thanks for your time today. It is August 8^th, 2023, and the information provided here is for general information purposes only, and all expressions of opinion are subject to change without notice in reaction to shifting market conditions. My name is Mark Riepe. I head up the Schwab Center for Financial Research, and I’ll be your moderator today. If you’re new to these webcasts, we do them monthly. We’re going to start out for the first 30 minutes or so answering some of the more popular questions that we received, and the last 30 minutes, we’ll focus on the questions that you submit during the during the webcast. If you want to ask a question, you can just type it into the Q&A box at any time and click Submit, and then, like I said, we’ll try to get to those at the at the latter half of the show.

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Our speakers today are Jeffrey Kleintop, our Chief Global Investing Strategist; Liz Ann Sonders, our Chief Investment Strategist; and Kathy Jones, our Chief Fixed Income Strategist.

Kathy, why don’t we start with you talking a little bit about the Fed. The Fed likes to use the word ‘data dependent’ to describe their actions. What’s some of the impact of them adopting that approach on the future direction of interest rates?

KATHY JONES: Yeah. Hi, Mark. And hi, everybody. So I think data dependence leaves us with a Fed that is reacting to coincident indicators rather than leading or lagging indicators, particularly leading indicators. So presumably what you want the Federal Reserve to do is have a forecast and set policy for that forecast going forward. By being data dependent, it means they’re just looking at coincident or maybe lagging indicators. And that probably raises the risk that they over tighten in this cycle, because inflation is a lagging indicator. So if they’re watching current inflation or current indicators, they’re probably missing the signals for the future.

I think the second thing it does is just raise volatility. You know, volatility in the bond market is related to uncertainty about the path of interest rates. When you have a Fed that’s in data dependence mode, reacting to the incoming data, it really doesn’t give you a clear path for the future of interest rates, and that raises the volatility. So I think it’s one reason we’ve seen a lot of elevated volatility in this cycle.

MARK: Kathy another question about a different central bank, the Bank of Japan. What do you think about their decision to exit their yield curve control policies? What do you think that’s going to do to interest rates and the currency over time?

KATHY: Well, we have seen a… we did see a quick reaction when the Bank of Japan announced that it was expanding the ban for its 10-year yields by 50 basis points from 50 to a… a ceiling of 50 to 100 basis points, or half to 1%. It was partly that it was a surprise to the market. We had been getting mixed signals from the Bank of Japan. The new governor had initially said, oh, no reason to change policy, and then all of a sudden announced to change the policy. And I think the big concern is, of course, that Japan is a big net creditor nation. They buy bonds for all over the world, and that has been an anchor having a zero interest rate policy and having Japan buying other bonds.

So, initially we saw yields move up, the yen move up, as the idea is that Japan would be sending less money abroad and bringing it home. And the attractiveness of domestic interest rates could subtract from the appetite for foreign interest rates, or foreign bonds. That’s kind of backed off now. We’ve seen the Bank of Japan intervene a couple of times to kind of keep that ceiling a bit lower. So we’ve seen yields come back down a bit, and the yen has corrected to some extent as well.

You know, when you look at over the long term, I suppose, on the margin, it’s a concern that Japan may be exporting less money, less of its excess savings to the rest of the world. Maybe on the margin that lifts interest rates and bond yields all over the world, but keep in mind that it’s just one pretty small factor. So it’s not like Japan is going to start dumping all of its foreign bonds. And there are… you know, global bond markets in Europe are soft. We’re looking at some weak economic data. We’re seeing declining inflation in the US. And those are in the long run bigger drivers than what’s happening in Japan.

So I’d say it was a bit of a jolt to the market, but I don’t think in the long run it’s anything more than a marginal difference, rather than a major structural difference.

MARK: Thanks, Kathy. Jeff, I wanted to go to you. There are, of course, other central banks besides the Fed and the BOJ. Which ones are you paying attention to and who is doing something interesting that investors need to care about?

JEFF KLEINTOP: Yeah, great question, Mark. I’ll just quickly add on the BOJ move. We wrote about this coming back in April, and that commentary entitled, ‘Are You Watching the Wrong Central Bank’ is still on schwab.com and encourage you to check it out. I’d also add that Japan’s stock market has been the best performing developed market this year, with a gain of 24%, but the drop in the yen versus the dollar has reduced this year’s total return to about 14% for US-based investors. So a stronger yen supported by higher rates in Japan could benefit investments in Japanese stocks here.

Watching ECB. President Lagarde provided guidance on the next meeting in September. She said, ‘We might hike or hold, but we won’t cut.’ That was as much as we got. Again, data dependence, just as Kathy talked about, watching the coincident data. I believe the incoming data over the next five weeks will likely persuade the markets to further back out the probability of a September rate hike. Our favorite leading indicator for Europe’s economy and the Composite PMI fell by one point to 48.9 in July on the back of a broad-based decline across sectors and countries in Europe when it was reported a week or so ago. The reading was below consensus expectations, and importantly below 50 that marks that threshold between growth and recession. And, of course, inflation is cooling fast in Europe. I’d point out that Spain has already seen inflation retreat to under 2% after being above 10% last fall. Spain has consistently led Europe’s overall inflation by about three months. It’s a pretty good indicator. It’s like right on top just with a three-month lead. And, you know, that’s because Spain moved more quickly to apply and then phase out government aid during the pandemic. And that suggests that Eurozone inflation may be at the Eurozone’s 2% target by the end of the third quarter, possibly pointing to no rate hike in September. That would be great news for European stocks, which are trading at a PE of 12. That’s well below their 10-year average of 14. So signs that rate hikes have come to an end could support valuation gains for European stocks.

But let me talk about some of the fun stuff here that’s going on with EM Central Banks, Brazil, Latin America’s largest economy, cut rates for the first time last week, just a few days after Chile cut its benchmark interest rate by a larger-than-expected full 1%. Inflation has eased as has growth in Latin America. And those countries that have been hiking rates that led major developed markets’ central banks by six to 12 months on the upside, are now maybe leading on the downside as they’re implementing rate cuts. Brazil, for example, began hiking rates in March of 2021. That was one year before the Fed. And they ended hikes in August of 2022, maybe one year before the Fed. If that pattern continues, Mark, it would suggest the Fed and other central banks might begin to cut rates around, let’s say, August of 2024.

MARK: Thanks, Jeff. And you mentioned sort of recession risk, and we got a lot of questions related to that.

Liz Ann, let’s bring into the conversation. The Jobs Report came out last week. That’s been a source of strength for the economy. What was your take from last Friday’s report?

LIZ ANN SONDERS: Well, so the payroll number, which is always the first release, was light relative to expectations. It was 187,000. I think expectations were around 200. There was some whisper numbers higher than that. It was the second month in a row where you had a worse-than-expected payroll reading. You did see a dip in the unemployment rate to 3-1/2%, but that was because you didn’t have any increase in labor force participation rates. So that’s sometimes seen as, you know, a bad reason why you saw the dip in the unemployment rate. And if you dig under the surface even more, that 187 was actually flattered by seasonal adjustments, for one. You also have something called the Birth-Death Model, which is the Bureau of Labor Statistics estimates business births and business deaths. And notoriously, they tend to overestimate business births when you’re getting to a weaker phase in the cycle. And that appears to have been a factor in the boost to 187. You also saw yet another dip in the average work week. That’s seen as a leading indicator. And even though there’s legitimacy to this notion of labor hoarding, when you see companies cutting hours, it does suggest that demand is having a factor. It’s, again, the second consecutive month with payrolls weaker than expectations. Also embedded in some of the details of the data that comes out is the fact that temporary help is going down and multiple job holders are moving up. In addition, full-time payrolls actually dropped by close to 600,000, which was the worst since April of 2020. And I think we all know what was going on in April of 2020. And then there was also a CEO Confidence Survey that was out, put out by the Conference Board. That’s separate from the Jobs Report. But that showed that 60% of companies either plan to layoff workers or they’re going to keep payrolls flat. So that’s another indication that in an environment where margins are under pressure, revenues have moved down to flat in nominal terms, negative in real terms, that in order to maintain profit margins, increasingly companies are either already looking at or might have to look at headcount reductions. So we’re starting to see it in even the headline-type numbers like payroll. So I think some of those cracks are widening a bit.

MARK: Another key aspect of economic health, Kathy, is the supply of credit. You’ve been paying a lot of attention to bank lending surveys. What are you seeing with those, and does it jive with what you’re seeing when you look at credit spreads on the part of corporate bonds?

KATHY: Yeah, we’ve been seeing this actually a major disconnect between the bank lending surveys, which indicate a tightening in credit standards, and a reluctance to lend particularly to small- and mid-sized businesses and consumers. And then when we look at credit spreads, they’ve been low and, actually, you know, trending lower. There’s a little bit of dispersion within the credit market, where lower-rated, say, triple-B bonds are starting to see their credit spreads widen a little bit versus, you know, double-B, versus, you know, double-A and single-A.

But, you know, in general, what we’re seeing is still very low credit spreads. And I think part of that is that a lot of companies were able to term out their debt to longer durations. So we’re not hitting a big jump in maturities and probably until later this year or next year and beyond. So there’s not a need to refinance for some of these companies. So that’s partly keeping credit spreads low.

And then we’ve had private sector lenders step in and seem to be pretty willing to loan money to businesses. But it doesn’t really change the dynamic here. We’ve never seen this kind of tightening and credit standards not lead to some deterioration credit spreads over time. So I think that relationship still holds, and I think we need to keep watching it.

And it’s one reason we’re still reluctant to go overweight or to be too aggressive in the high-yield market or the bank loan market because, you know, those increases in the cost of funding are going to hit at some stage of the game, and then we’re in this slowing economy at the same time. So we’d be neutral at best in terms of high-yield or lower credit quality bonds.

MARK: Thanks, Kathy. Liz Ann, given what you were talking about in terms of the labor market, what Kathy was just talking about in terms of credit, as well as other factors you’re paying attention to, how would you summarize your overall attitude in terms of the risk of a recession going forward?

LIZ ANN: Yeah, Mark, so as you know, and probably most people viewing this webcast know that we’ve been taking a little bit more of a nuanced approach to describing this cycle, having used the term ‘rolling recession’ or ‘rolling sectoral recessions’ for quite some time right now. And that is somewhat unique to the pandemic cycle. If you think about the worst part of the pandemic at a time when we also saw record setting stimulus, both on the monetary and the fiscal side, that gave a huge boost to the economy, but concentrated on the goods side of the economy, including things like, you know, personal goods and computer, a lot of things tech-related, housing, housing-related. Then as we saw the stimulus fade and we hit that point of, you know, pent-down demand on the goods side of the economy, those areas, those segments of the economy went into their own recessions. Again, housing, housing-related, a decent part of the tech sector, especially the consumer-orientation, manufacturing. But we then had the offsetting and later to come strength on the services side of the economy… service is a larger employer… helping to explain why the labor market until recently hasn’t shown many cracks. But now we’ve actually got some of those segments that had been hurt, like housing, showing some signs of life, although I would say that’s more on the new home side, not the existing home side.

So I think the recession versus soft landing simplistic debate sort of misses those nuances. And it’s the view that the best-case scenario is less about soft landing because we’ve already had hard landings in some of those areas, but maybe some additional stability and/or recovery in the areas that have already gone through their recession, offsetting any coming weakness in services in the labor market. So you know, continuation of the roll through, to me, is the best way to think about best case scenario.

That said, if somebody said you’ve just got to make a call on whether the NBER, the official arbiters of recessions, is ultimately going to declare some point in time around now a recession, I think that the needle points a little bit more in that direction. Leading indicators have plunged to a degree never before seen, other than not in the lead in to recessions other than already in recession.

All that said, we just have to look with a more nuanced eye at how to define this cycle because of the pandemic and the aftermath, and what has made that so unique relative to past sort of everything at once type recessions.

MARK: Thanks, Liz Ann. Jeff, I wanted to turn to you. We’ve got some questions here about China. By China’s standards, their growth outlook is not great at all. What is their plan to address that and how successful do you think it’ll be?

JEFF: Well, China is trying to stimulate demand, but they’re hesitant to do too much. With inflation in China to be reported tonight for July, likely to be negative on a year-over-year basis, something only seen around global recessions in the past, China has got room to stimulate more, and it’s expected to do so here in the third quarter. But China doesn’t want to fall into the trap other countries did emerging from the pandemic only to overstimulate their economy and have an inflation problem or just a bad debt problem. So they’re going slow but steady with the stimulus. In the past month, China sprinkled a little more stimulus on an almost daily basis, rolling out, you know, new provisions for lending to help property developers, to help consumers. There’s just an unending series of like these little moves, nothing massive. There’s been a rate cut or two, but nothing really shock and awe, nothing like massive infrastructure stimulus that China would have been known for in the past.

Now, China’s stocks have started to trend higher as the stimulus has been rolling out, but I’m not sure if it’s enough yet. I would note that China’s air pollution… it’s a measure of manufacturing… and transport activity that I like to use for a real-time read on China’s economy, had been plummeting during the second quarter, but now, over the last month or so, it appears to be rebounding a little bit, which is counter to the seasonal trend. So there are some small signs of a rebound.

I guess there’s a few companies with China’s sales exposure raved about the demand growth in Q2. I think Apple talked about 8% growth there. It was okay. But we can see from travel bookings and box office results that the Chinese are spending, but more on experiences than products, Mark.

MARK: Thanks, Jeff. On our last call, last month, you mentioned the risk of the cardboard box recession. How is that playing out so far?

JEFF: Yeah, so rather than a classic recession, as Liz Ann indicated, there’s more nuances to this one. I’ve been calling this a cardboard box recession since it’s concentrated in manufacturing and trade, things we make or ship that go in a box. But it may be coming out of the box and spreading to the formerly healthy services sector of the economy. Services PMI for July fell for either the second or third month in a row in all G7 economies, except Canada, which doesn’t have a services PMI. It’s still too early to call a recession in services, for sure, and I’m hoping we could avoid one, but, you know, clearly, we’ve started to see some weakening there in what had been the area of the economy that was strong.

Economists currently expect the third quarter to be the first with no contraction in any Group of Seven economy. It’s been a long time. It’s been six quarters since we saw that happen. It was a fourth quarter of 2021. So that may be good news, but it’s no V-shaped rebound in economic activity. The forecasts are really calling from a transition from, I guess, stagflation, no growth by inflation, to just stagnation, as the pace of economic growth and inflation is now slow enough to end the rate hiking cycle in most major economies. We’ll have to keep a close eye on services, where most of the optimism rests for growth in the economy and in earnings as we look out over the next several quarters.

MARK: Thanks, Jeff. Liz Ann, let’s turn to stock markets. And what are your thoughts about corporate earnings given that we pretty much wrapped up the second quarter?

LIZ ANN: Yeah, I think we’re right around 90% of companies have reported. Some of the consumer-oriented retail and tech companies, because they’re one month off a calendar year cycle tend to be later. But right now, what they call the blended estimate, which is all the companies that have already reported, we’re talking about the S&P 500 here, plus the consensus estimates for the companies that have yet to report, that’s at about minus 4% or so. And that is better than what was expected coming in. And, in fact, if you ex out the energy sector, which is the biggest drag in the second quarter in terms of earnings, you actually go into marginal positive territory to the tune of about 2%.

But I think what’s interesting, and maybe for lack of a better word, a tell about what’s really going on here is that companies that are missing estimates, so stocks have gotten pretty beaten up on the first full trading day following an earnings release… that’s not abnormal. Of course, you would expect stocks missing to get hit… but the stocks beating estimates are also down on the trading day. And the last time that happened, I think it was in 2011, in terms of, you know, a negative overall response to what would be deemed a positive season when just looking at the beat rate or percent by which companies are beating.

Speaking of which, the percent by which companies are beating is around 7-and-change. And both the beat rate and the percent by which companies are beating are better than average.

But what I think the focus has been on, and, you know, Mark, I always tend to focus more on rate of change and direction, as opposed to level, but I think there’s some level analysis happening here, too, given that we’re talking about a negative year-over-year quarter. First quarter was flat, but three quarters in a row without any earnings growth, I think that’s a focus, given that the rally since October was more than all accounted for by multiple expansion because there was no E in the PE during that period of time.

But I also think the revenue side of things is an increasing focus. As I touched on before, nominal revenue growth has moved down to only slightly positive territory, I think it’s 0.4%. Real revenues are deep in negative territory. So what you can infer from that, given stronger than average beat rate, stronger than average percent by which companies are beating yet virtually no revenue growth, is that the beats on the bottom line are, in many cases, if not most cases, coming from cost cutting. And increasingly, that cost cutting has been focused more in the labor market, which we already touched on. So that may help to explain why the reaction in this environment is not akin to what you might expect if you were solely looking at the beat rate and the percent by which companies are beating.

MARK: Thanks, Liz Ann. I’ve got a couple more questions to you related to stocks, and then we’ll go to Jeff.

So, Liz Ann, volatility seems to be back a little bit, a couple, you know, last week, week before, pretty strong movements in stocks. Yesterday, today, not so much. What’s your takeaway from that, or is it just, you know, normal market noise?

LIZ ANN: Well, you know, Mark, you mentioned volatility, so I’ll start there. And I never put all my eggs in any one basket in terms of indicators, especially things like seasonals. But for what it’s worth, the Volatility Index, the VIX, has been very closely following your typical seasonal pattern. And we’re right at the point, historically, where seasonals suggest you’re likely to get a lift in the VIX, and we’re seeing that. Yes, the market has been strong. I think the stories behind the strength until recently are around perception of a Goldilocks-type of environment, the possibility of a soft landing, even just the traditional wall of worry that the market likes to climb, but also this idea of a Fed pause. And if you look back in the past, the anticipation phase of a Fed pause has almost always been met with a market rally.

Now, the pivot rally that was occurring last summer that the Fed had to push back against… now pivot versus pause, different definitions. When I talk about pivot, it’s a pivot from rate hikes to rate cuts. Powell had to push back on that, and I think adjusted the market’s thinking to, okay, a pause. And it is normal for the market to rally when you’re approaching a pause. But keep in mind that most recessions have actually started after the Fed is done hiking rates.

In addition, as we’ve talked about on the past webcasts, be really careful about thinking about market behavior relative to some average path of the stock market around Fed pauses, meaning the Fed is done hiking rates. It’s a fairly small sample size, and the range of outcomes, historically, is incredibly wide.

So it just shows that just the Fed pausing by no means guarantees that the market will continue to be off to the races. We’ve got multiple pressure, which I already mentioned, some deterioration in breadth, and the recent high in breadth measured by things like 50-day moving average, the 200-day moving average across most major averages. That recent high was actually lower than the early January high. So I think we may be in the start of a bit of a consolidation phase, which from a sentiment perspective, actually, might be eventually healthy.

MARK: Well, that was actually my last question for you. What are you seeing in terms of the sentiment indicators that you’re tracking?

LIZ ANN: Yeah, so one of the charts I often show is the Ned Davis Crowd Sentiment Poll. And I like it because it’s actually an amalgamation of seven individual sentiment indicators, all of which I know many in the audience here look at on a regular basis—AAII, Investors Intelligence, put-call ratio, fund flows, etc. And so the aggregate sentiment data has moved into what would be considered excessive optimism territory, maybe not quite extreme froth, meaning, you know, near all-time highs in that measure, but definitely in that excessive optimism territory level, where you do tend to see at least short-term weaker performance.

So I think we were kind of pushing up, to some degree, on limits from a sentiment perspective, and you add to it the overbought technical condition of the market, and that may be one of the reasons why we’re seeing what may be the start of a consolidation phase. Because I think there was a bit of frothiness that crept in, if not, at best, complacency around the Goldilocks scenario and the continuation thereof.

MARK: Thanks, Liz Ann. Jeff, had a couple questions for you. One, what were your thoughts on what you are seeing overseas in terms of Q2 earnings? And then today’s announcement that Italy is going to be putting something like a 40% tax on windfall profits, or so-called windfall profits, on banks. What are your thoughts on that?

JEFF: Well, I’ll start with the earnings. Outside the US, the numbers really aren’t bad, especially ex energy. Remember, energy prices were sky high in the second quarter of last year, thanks to the invasion of Ukraine. So if we take that out, second quarter earnings are up 9.2% in Europe on a blended estimate. That compares to that 2% number Liz Ann mentioned, ex energy for the S&P 500. In fact, upward earnings revisions are now outpacing downward revisions. And it’s possible global companies might see a new 12-month high in the number of companies seeing profit upgrades over the next couple of weeks. So it’s better than expected this earning season.

But there’s another trend I’m watching this season. You know, Disney reports later today, amid rising scrutiny caused by labor disputes and the potential for more layoff announcements. And labor is what has really stood out to me this earnings reporting season, or maybe I should say layoffs. On Friday, Canada’s unemployment report overshadowed by the US Employment Report… I get that, but it did come out on Friday at the same time, and for the third straight month the unemployment rate rose, and for this two months now, two out of three, lost jobs in Canada. And that now joins a couple other G7 economies, including the UK and Germany, and really marking a turning point in the strength of their labor markets. And there may be more coming because the commentary from business leaders on earnings calls so far this reporting season reflect layoff discussions outnumbering those that talk about labor shortages, which had dominated calls all last year. It was all about shortage of labor. Very different environment now.

The recent layoff announcements aren’t just from tech. I know we heard them just out of a few tech companies initially, but they’re coming from a wide range of industries. Now, in the last week or so, we’ve heard from drugstore chain CVS, we’ve heard from InBev, which is the parent of Anheuser-Busch, biotech company Biogen, we’ve had Salesforce laying off people in Ireland, Qualcomm, money manager T. Rowe Price. So it’s not just concentrated in tech, and we could be starting to see a turn in the global labor market with ramifications for investors.

What else has ramifications for investors this potentially… yeah, this potential change in Italy’s right wing populous government and looking at creating a windfall profits tax for bank profits. It’s a bit of a surprise, stemming from the gains on the ECB rate hikes. But Italy isn’t alone in this. Spain first outlined plans for a temporary tax on bank and energy company revenues last year. The UK opposition politicians are raising the idea of more windfall taxes in the UK. Lithuanian lawmakers, in May, passed a temporary windfall tax on banks. Estonia is planning on doing the same thing. I mean, it’s a little disappointing to see this in Italy because Italian banks have been the sick man of Europe for a decade now, and just when they start making some money to shore up their capital, it possibly gets taken away again. But it’s not a done deal, and there’s certainly opposition to that as it moves through the Italian parliament.

But Eurozone budget rules, Mark, are likely to get tighter next year. They’re reimposing that limit of 3% of GDP on budget deficits after all that was suspended in the wake of the pandemic and the war, and so money to fund spending has to come from somewhere. Italy’s budget deficit last year was 9%, and Fitch estimates it’s going to be about 3.9% this year, and maybe 3.3 in 2024. So this tax may actually help get that down to 3% or lower, so we don’t have to see maybe more dramatic cuts there in terms of Italy’s fiscal balance.

So I’d just follow up and wrap it all up by saying despite this negative surprise this morning, Italian stocks are still outperforming US stocks this year, even after today’s sizable drop in the Italian banks.

MARK: Thanks, Jeff. Kathy, let’s go to you and talk a little bit about bonds. We get a version of this question virtually every call, but we haven’t addressed it recently. The federal budget deficit is rising at a fast pace, and the cost of borrowing is going up. When will that have an impact on the bond market or the dollar?

KATHY: Yeah, so, you know, unfortunately, it’s one of those things that’s talked about a lot, but you don’t actually know it’s happening until it happens, right? You know, people anticipate it, but we really haven’t seen much impact over time. We have a little taste of it. Now, we have big Treasury auction this week. The Treasury has announced a big borrowing program for this year, this fiscal year, partly because of the rising deficit and the cost of financing that deficit at higher interest rates, but also because we had the shutdown of borrowing during the debt ceiling standoff that delayed some of the issuance of bonds, so we’re kind of playing catch up right now. And we did see bond yields start to move up when that announcement came out, but it also coincided with the Bank of Japan’s announcement about widening the band on its 10-year treasury. So it’s hard to parse out just how much is worry about the rising deficit and financing that and how much has to do with other global factors. But I will point out a few things.

We’ve had a… a lot of people are pointing to the fact that long-term rates have risen in this move. And we’ve seen a bear steepening of the yield curve, that is long-term rates kind of leading rates up over the past six weeks or so. But it doesn’t look like that’s due to embedded fears of longer-term inflation or a rise in the term premium. So what’s happening is real rates are rising, that is nominal rates have risen faster than inflation, so we’re getting some reaction, I think, in the market to this seesaw in terms of what economic prospects are. But the term premium, which is that premium that investors require to invest in longer term bonds, has actually stayed negative. And it hasn’t really… it’s moved up just a tiny bit, but it hasn’t really moved a lot.

So that tells me it’s probably not reacting as much to what’s happening with the deficit as it is with what’s happening with other factors out there—you know, the possibility of the Fed will tighten, the shrinking of the Fed balance sheet, and Japan’s decision to loosen its ban on its 10-year yields. So a lot of uncertainty, but I don’t think the impact so far is there.

So, you know, again, we come back to this issue where on the margin you would think that yields would have to move up and/or dollar down in order to attract more buyers to fund rising deficits, and I think there’s probably, you know, good evidence that we’ll see that at some stage of the game. But the offsetting factor is it’s just not a lot of alternatives for long-term buyers of government debt. They’re not looking at attractive yields. In much of the world at this stage of the game, dollar dominance still continues to be a driving force. And it’s certainly the case that the US has the ability to pay the bills and ability to make changes if it wants to. You know, the recent downgrade had to do with our unwillingness to address a political dysfunction. So, you know, there just aren’t a lot of substitutes for US treasuries in the global bond market, or the global economy for that matter, and so the idea that our rising deficits will trigger, you know, a major abandonment of the US treasury market anytime soon doesn’t seem very likely.

So the impact is probably more marginal, rather than, you know, widespread or large. And kind of mixed evidence, we’re even seeing a tiny bit of that right now.

MARK: Kathy, you mentioned inflation. It’s come up, you know, a few times in our discussion today. So are TIPS still attractive right now for bond investors concerned about inflation, you know, especially given how much it has come down?

KATHY: Yeah, I think TIPS can make sense in a portfolio. So, right now, it looks like TIPS could outperform nominal treasuries in the two- to five-year area. I think the break-evens are about… for two-year TIPS about 2.3; 2.4 for five-year TIPS. So if you think average CPI over the next two to five years will be above that level, then nominal treasuries should outperform TIPS.

I think the thing… and we’re starting with positive yields. You know, one reason TIPS did so poorly even though inflation ramped up, is you’re starting with negative yields to begin with. So they still respond to interest rate changes, real interest rate changes, so that’s been a weight on TIPS performance.

But I think, you know, going forward, this can make sense. You know, a lot of clients get very nervous about inflation with a fixed income portfolio. This is one way to keep pace with inflation in a fixed income portfolio. So, you know, they’re still bonds and they’ll still react to changes in interest rates, but I think at these levels, particularly out to, you know, two to five years, they can make sense for a lot of clients.

MARK: Final question for you, Kathy, and that’s duration. So what’s the sweet spot when it comes to duration?

KATHY: So, you know, we use the Ag, the Bloomberg Barclays, you know, Aggregate Bond Index, both the domestic and the global, as sort of our benchmarks for duration because they’re so commonly used in portfolios, and because they reflect kind of in the grand scheme of things, what the market is. Both are around 6, 6.2 or so. We think that having a benchmark duration makes sense. So if you’re building a portfolio in terms of maturities right now, and you use bond ladders, which is kind of a go-to strategy for a lot of investors, that means you can have maturities out to 10 years, maybe even munis out to 12 years, and still have an average duration that’s closer to six or seven. We think being at benchmark or even a little bit longer makes sense right now, even though the yield curve is still inverted. We still think we’re near peak tightening by the Fed. We still think that inflation will continue to drift lower from here. We think the risk of recession is greater than… or the risk that the Fed over does it versus under does it is greater. So in our look, yeah, we’d stick with the benchmark duration and continue to, you know, probably stay with that, maybe go a little bit longer, particularly in the muni market.

MARK: Thanks, Kathy. Let’s start taking some of the some of the questions that people have submitted.

Liz Ann, I’m going to send this one your way. ‘With revolving credit balances, reaching new heights and student loan repayments beginning in October, how do you think that will affect consumer spending and the economy going forward?’

LIZ ANN: Well, there’s lots of influences on consumer spending. Those would be some of them, though not all of them. Although if you look at a collection of those, particularly related to the cost of servicing debt, student loans coming back into the mix, you are starting to see some of those pressures. You’re starting to see, particularly down into the subprime area, default rates pick up across the spectrum of various types of loans. You know, in the aggregate, the data is not terribly ugly. If you look at sort of nominal changes in debt, there, in many cases, up at a record high, but as a share of income, they’re not at a record high. So you have to take that income into consideration.

But, clearly, there is more pressure down the income spectrum. And down the income spectrum, that’s where wage growth had been strongest, but now that has started to come in, and that’s where you’re starting to see some pressure. There’s also been some recent surveys on consumer spending, not to mention the anecdotes we’re hearing from companies, from retailers, saying that there’s been more of a concentrated focus in terms of spending on the basics—on groceries, on household goods—and starting to move well away from prior strong areas like consumer electronics, but even leisure hospitality spending is starting to weaken a bit.

So I think we’re going to start to see, maybe not in all of a sudden and at once, but we’re starting to see, again, to use the ‘cracks’ term that we used for the labor market, some cracks in terms of the consumer and their relative health. And we’re seeing it in more than just the unit side of things. And I think it’s probably going to be something that gets increasing attention, given that consumer spending is about 70% of GDP.

MARK: Thanks, Liz Ann. Kathy, we have many muni bond questions. So we’ll start with this one. ‘What are Schwab’s feelings and outlook on muni bonds?’ And then a follow up to that is, ‘Do you think the Fitch downgraded US is going to affect munis?’ And there’s another one in here. ‘What are the sweet spots on the yield group for munis?’

KATHY: Okay. One of these days you’ll have to get Cooper Howard, our muni expert, on to talk munis at length.

So in terms of munis, our outlook on credit is still positive. The reasoning is that, you know, revenue flows into municipalities, state and local governments, tend to be lagging. So as the economy does better, those revenues flow in at a deferred rate, so you pay your property taxes one year based on the year before valuation. And that has been true all along. And so we still see those revenues climbing at a very rapid rate. There’s still quite a few state and local governments that have pandemic funding on hand. On the spending side, you haven’t seen the big spending that you might have anticipated even with that pandemic funding because there has been a very slow pace of hiring in terms of government jobs, education. Very much have lagged in this cycle, which means spending hasn’t really, in general, on a broad base, kept up with revenue growth. So budgets look to be in good condition. We think that that will carry credit quality through. We’re not seeing increase in, you know, defaults or warnings. We would be careful, as always, in the high-yield muni space, just because those are smaller issues, less liquid. Things like hospital systems, maybe some property development, they’re much more speculative, so be more careful there, as always. But, in general, muni market from a credit quality point of view looks pretty good, or it looks very good.

We don’t think Fitch’s rating will probably have much impact. You know, that is on the federal budget deficit, and that is really about the political dysfunction. That means that we’re not addressing the longer-term issues that we need to address. That is not the case with state and local governments. They do need to balance their budgets on a regular basis. So I don’t think that that’s going to be a big impact on the muni market.

In terms of the sweet spot, you know, we think you can go a little bit longer duration in the muni space than perhaps the benchmark, 6, 6-.1/2 on the Ag, we think you can go out a little bit further in terms of that. It’s more of a flat curve than an inverted curve. So you can probably go out to an average duration around 7 or 8, and maturities there on an after-tax basis, particularly for high income earners, are really quite attractive and competitive with what you would get in a comparable, you know, very highly rated, you know, bond in the taxable market. So generally positive, the outlook for munis, and we think that, you know, a little bit longer duration than the benchmark can make sense.

MARK: Thanks, Kathy. Jeff, this is for you. ‘Given China’s recent difficulties, has that changed your view of the emerging markets asset class in general?’

JEFF: You know, I have been cautious on emerging markets this year. I’ve been enthusiastic about developed markets, expecting that the average international developed markets stock would outperform. But I just don’t have great visibility on what’s going on in emerging markets. So much of it is tied to China. I do like India. India has been doing well. I wrote a commentary on that. Take a look into it. India is the third largest country within the EM Index, but China and Taiwan is number one and number two.

So what really matters is what is the momentum in China’s economy and where are we going on geopolitics? And I talked a little bit about the stimulus measures, China’s, being put into place. So it’s really a guess on will US-China relations improve? That’s really what’s weighed on China’s stock market and overall EM, this year, starting with January 27^th when Chinese stocks and the EM Index peaked out. That was the day before the balloon started to, you know, move across the US here.

So I think tensions appear to be cooling. You know, we had Secretary Blinken’s invitation to China’s foreign minister to come to Washington for a meeting. That continues a summer of more constructive US-China official interaction than, I would say, in nearly half a decade. Secretary Yellen’s recent trip to Beijing was followed by Climate Envoy Kerry’s visit. And that pre-staged a likely trip this month to China by Secretary of Commerce Raimondo. And it appears even that Presidents Biden and Xi might meet in November in San Francisco, when the US hosts the APEC Leader Summit. So on the surface that re-engagement is lifting Chinese stock valuations. We’ve seen them come off their lows here in the last four weeks or so, as these re-engagement have taken place. But it doesn’t clear the air. There’s still a number of issues, and even more coming up here in the coming weeks and months that could cause those relationships to deteriorate once again.

So very difficult for me to forecast what’s going on with US-China relations. I think they’re improving slightly, as we talked about. They might this summer, but it’s still hard to say. I think, economically, China still needs to do a bit more to really get their economy back on track again.

So those two things, not a lot of clarity. I don’t know what Chinese policy makers are planning to do next, either on geopolitics or their economy. Therefore, I put a much higher range of probability and risk around that than I would developed markets, where I think the policy and economic backdrop is a little bit more grounded.

MARK: Thanks, Jeff. Let’s see. Liz Ann, this one is for you. ‘What are your thoughts on the small cap space?’

LIZ ANN: That’s a big space. So, you know, shame on anyone that answers that question somewhat monolithically. You know, I think they’re generally seen, rightly so, as a bit more domestically-oriented. So sometimes that ties into movements in the dollar and either the hit or the benefit to multinationals versus small caps. Small caps have been huge, huge under performers. So I think there’s some bottom fishing starting to happen. But I think you have to stay up in quality. That’s been our mantra across the spectrum of the equity market and certainly applicable in the small cap space. Don’t look with a monolithic lens.

And then, you know, Mark, I don’t believe in giving tips, but I’m going to give a tip here, and it’s not a stock tip. But if you’re either an index-oriented investor or you look at indexes as maybe a source for ideas, one thing to be mindful of is the Russell 2000, although it’s the most common small cap benchmark that is used, it does not use a profitability filter. And as a result, I think it’s right now more than a third of companies in the Russell don’t have any profits, and there’s still a decent share within those that would be considered zombie companies, just don’t even have the cash flow to cover interest on their debt. Conversely, the S&P 600, which is not as widely used as a benchmark, but it has a profitability filter, so you don’t get that drag from non-profitable companies. And as a result, from a valuation perspective, and I don’t know the exact numbers to-date, the last time I looked it was a week or two ago, but using round numbers, the Russell was trading at call it mid-20s in terms of forward PE. And you have about a 10 multiple point discount kind of in the mid-teens for the S&P 600. So if you want to get at that quality angle, you may want to focus more on an index like the S&P 600 than the Russell.

MARK: Thanks, Liz Ann. Kathy, I’ll give you two questions here. First one, ‘Any thoughts on floating rate bonds?’ And the next one here, there it is. ‘What is Schwab’s outlook for mortgage-backed securities?’

KATHY: All right, on floaters it depends. You know, the floating rate bond universe is relatively large. So if you’re talking about investment-grade floating rate bonds, there’s not a lot of them out there to choose from, but we think that those are fine. Although we do think we’re sort of at the peak of rate hikes, so you’re not going to get as much adjustment upward as we’ve seen over the last year or so. But nonetheless, they’re priced reasonably well.

When we talk about bank loans, however, which are floating rate, which is usually how people access that market, then we’re more cautious because you have a… they’re very short duration, which has helped, and they do adjust upward with Fed rate hikes. So if we get more Fed rate hikes, they’ll still do okay. But if we are at the peak in terms of Fed rate hikes, not only do you not get that upward adjustment, but that probably means we’re going into a downturn in the economy. And these are junk-rated companies, and so they tend to be the ones that are most susceptible to defaults, bankruptcies, etc. So I’d be careful in the junk-rated space, even in the bank loan space, or in the floating rate space.

Mortgage-backed securities, the spread has widened on MBS to the highest level since the financial crisis. And I think part of that has to do with, you know, duration extension, but also part of it has to do with, you know, some concerns about what’s going on in the underlying market. But I think if you look at just the straight pass-throughs, with very low or little credit risk, that they can be an attractive way to add some income, to add some interest. The spread is pretty wide versus treasuries. It’s just that you’re going to get probably a fair amount of volatility because of that duration, of that extension that we’re seeing in the market.

MARK: Thanks, Kathy. Liz Ann, this one is for you. ‘It seems that we’ve been seeing more breadth recently. Do you agree?’

LIZ ANN: Well, we had until very recently. We started to see a rolling over again in breadth. And that had been really the good part of the story coming up off the October lows. Even at the lows last October, where the indexes had taken out their prior June lows, under the surface breath had started to improve, and that carried pretty strongly to the early part of 2023. Then we had some deterioration in breadth, and particularly during the period from the Silicon Valley Bank failure until call it the beginning of June, where you actually saw the market become incredibly concentrated, really the MegaCap 8 representing virtually all the performance. And it was our view at that time that you needed to start to see a broadening out in breadth, which we did start to see. Unfortunately, that rolled over, and as I think I mentioned earlier, the peak in breadth, whether it’s, you know, indexes trading above 50-day moving averages or 200-day moving averages, that peak came at a lower peak than what you saw at the beginning of the year.

So we have started to see some deterioration in breadth. Nothing significant yet, but were it to continue, it would further support this necessity of consolidation view that I think, again, would be beneficial in terms of helping to correct the valuation access, as well as the sentiment excess. So some deterioration here. We need to keep an eye on that.

MARK: Thanks, Liz Ann. Kathy, ‘Does Kathy have an opinion on preferreds right now?’

KATHY: Yeah, we’re still… we lean positive on preferreds for people who are willing to ride out the ups and downs of the market. So, you know, again, the two key risks in preferreds. They’re very long duration. Some have no maturity date, so they’re perpetuals, and so they’re going to fluctuate a lot with long-term rates. And, secondly, most are issued by bank and finance companies, which have been sort of in the crosshairs. So our view is that the preferreds issued by the larger institutions we’re not worried about the credit risk there.

In terms of duration, you know, that’s well discounted by a very high yield right now. So we think that that makes an opportunity. The dollar price on preferreds is near the lowest it’s been historically in most cycles.

So we think that preferreds can make sense. Again, it’s, we put it in the aggressive income category, so it’s not like part of your core bond allocation, but if you’re willing to ride out the ups and downs of the income interest rate cycle, we think preferreds in this cycle can be one area of the aggressive income part of the market that can make sense.

MARK: Alright. Thank you, Kathy. Last question for each of you. ‘What are the handful of things, you know, one or two things that you want viewers to take away from today’s call?’ So, Jeff, why don’t you start? Then we’ll go to Liz Ann and then we’ll go to Kathy. So, Jeff, take it away.

JEFF: Yeah, I’ll start off. So earning season looks a little bit better than expected, but we are starting to see some signs of increasing layoff announcements, which could undermine some of the consumer confidence that has, you know, supported overall corporate earnings. So keep a close eye on that. Service sector also showing some signs of deterioration, so I’m going to watch that. And, finally, China, you know, a big part of EM. Obviously, the US-China relations are starting to improve, but very difficult to forecast. So watch out if we see a whipsaw rally in Chinese equities there. That could reverse on further deterioration in that very volatile relationship, particularly heading into next year’s election.

MARK: Liz Ann, take it away.

LIZ ANN: Sure. So, you know, as it relates to the economy, particularly the labor market, because that’s been such a strong underpinning to the economy, you need to focus on rate of change. And it makes me think probably the line about the economy and markets that I like more than any, which is better or worse, can often matter more than good or bad. So that trend, the rate of change, the direction, focus on that more than level.

And then with regard to the market, as I touched on, you want to stay up in quality. Be careful about monolithic decision making, like buy small caps. Be careful about it as it relates to style areas, like growth versus value. Be careful as it relates to sectors. Stay up in quality, focus on factors like strong free cash flow, positive earnings revisions, and surprises, lower volatility-type names. And you can apply that across the spectrum. Stay disciplined, though, that’s really important. Diversification across and within asset classes. Periodic rebalancing. And much like we always say about panic not being an investment strategy, neither is FOMO.

MARK: Kathy, bring us home.

KATHY: Okay. Couple of things. So expect volatility to stay high because it really reflects the uncertainty about the direction of interest rates. We have a Fed that is looking at coincident indicators instead of leading indicators, and that means we’re likely to have a lot of uncertainty about that path and direction of interest rates. So expect volatility to stay pretty high in the bond market relative to what we’ve experienced over the last decade or so. We still believe the peak in bond yields is behind us, longer term yields is behind us. Again, a lot of volatility there. We also think the Fed is at or near the peak in the tightening cycle.

So we do still favor extending duration, locking in some of these cash flows for the future, for end investors. But as Liz Ann said in stock market, same thing in the bond market. We want to stay up in credit quality. We don’t want to start mining for higher yields in the junk bond market or in the more aggressive parts of the market right now.

MARK: Thanks, Kathy. And we are out of time. So Jeffrey Kleintop, Kathy Jones, Liz Ann Sonders, thanks for your time today.

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The next call will be September 12^th at 8:00 AM Pacific Time. Kathy, Jeff, and Liz Ann will be back for that. Until then, if you would like to learn more information about Schwab, Schwab insights, or anything else about Schwab, please reach out to your Schwab representative. Thanks again, and have a nice day.