Schwab Market Talk - February
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MARK RIEPE: Welcome, everyone, to Schwab Market Talk, and thanks for your time today. The date is February 7th, 2023. The information provided here is for informational purposes only, and all expressions of opinion are subject to change without notice in reaction to shifting market conditions. My name is Mark Riepe, and I head up the Schwab Center for Financial Research, and I’ll be your moderator today. For those who are new to these webcasts, we do them monthly. Some of you took the opportunity to submit questions when you registered for the webcast, and we’re going to be spending the first half hour or so trying to answer as many of those as we can. After that, we’ll start answering questions that were submitted live during the webcast itself. If you want to ask a question at any moment, you can just type it into the Q&A box and click Submit, and like I said, in the second half of the hour, we’ll be getting to those. Live attendance and only live attendance at today’s webcast qualifies for one hour of continuing education credit from either the CFP Board or the CIMA organization. If you watch the replay, you aren’t eligible for credit, though. When you registered for the webcast, you were given the opportunity to type in your ID for either one of those organizations. If you did that, Schwab will go ahead and submit to the respective… submit that number to the respective boards on your behalf so that you can get credit. If you didn’t enter a number at registration you can do so with a window that will be popping up at the end of the webcast. And please make sure… when you type in your ID number, please make sure that you specify whether that’s for CFP or CIMA. If you submitted your number at registration, again, there’s no need to resubmit that. Finally, you may also download a CFP or CIMA credit certificate for your own records at the end of the webcast when we’ll put up a little widget that will take care of that for you.
Our panelists today are Liz Ann Sonders, our Chief Investment Strategist; Kathy Jones, our Chief Fixed Income Strategist; Jeffrey Kleintop, our Chief Global Investment Strategist; and our special guest today, Mike Townsend, our Managing Director of Legislative and Regulatory Affairs.
We’re going to start off with a bunch of questions we got about the economy. Liz Ann, kind of the most popular one is recession versus soft landing. Clearly, we’ve got a lot of sectors that are kind of already in that recession area. Others are doing quite well, you know, as we see so from the strong labor jobs number last Friday. Where do you stand on this debate, which side are you on?
LIZ ANN SONDERS: So I guess if I had to just pick a word, it would be ‘recession.’ But as you know, Mark, we’ve been calling this a rolling recession because, to your point, different segments of the economy have gotten hit at different times. And for now, anyway, the strength in services is offsetting what is unquestionably recession conditions in certain parts of the goods side of the economy, a lot of the consumer-oriented goods, call it the, you know, the stay-at-home era beneficiaries, and then, of course, housing and just about anything housing-related is very much in recession-type territory. But we’ve had the pent-up demand that got unleashed on the services side, and that, in turn, helps to explain the strength in the labor market, because services is a much larger employer of Americans than on the goods or manufacturing side. So that helps to explain the strength.
So, to me, best case scenario is some version of a continuation of this, either with services not faltering, or if it does, maybe some offsetting, either just stabilization or improvement in some of the areas that have been hit, so that at the end of the day, week, quarter, whatever you want to call it, you don’t officially get a recession declaration by the NBER, you just see the weakness come over an extended period of time in various pockets. But if somebody said, ‘All right, do you think that, ultimately, it will be a declared recession, I think the risk is higher than the possibility that that’s not the case. But for now, it’s sort of just rolling through the economy.
MARK: You know, we’ve had this inverted yield curve, Liz Ann, for some time. One of the questions we got, ‘Any statistics on how many months a yield curve needs to be inverted before an official recession begins?’
LIZ ANN: Well, there’s not any number of months that it has to. The average is about 12 months. But it’s also a function of which spread you’re looking at. The inversion between the 10-year and the two-year occurred earlier than was the case between the 10-year and the three-month. And that’s not abnormal, it’s just the nature of how you kind of work through the economic cycle and the impact it has on the yield curve. But given the level of inversion right now, if we were to avoid a recession, it would be the first time in history that the economy had managed to do that. But there have been, you know, times that it’s sooner. I think… and Kathy may know the answer to this more precisely, I think the minimum was six or seven months. But, again, the average is about 12 months. Sometimes it’s taken longer, but it’s never failed.
MARK: One more question for you, Liz Ann. Strength of the labor market, arguably that’s the thing that’s been kind of keeping us out of recession. What accounts for the strength? And you’ve talked in the past about, you know, maybe there’s some cracks under the surface that are less apparent.
LIZ ANN: And by the way, I think there are still some cracks under the surface, even inclusive of the data that we got last Friday, including seasonal adjustments and birth-death model, the fact that full-time employment is actually lower now than it was last May, which means on a net basis more than all the jobs created have been part-time in nature, multiple job holders going up. But, in general, what accounts for the strength, in light of so many other pockets in the economy being quite weak, I already mentioned one, just services is the larger employer. We’ve got demographics, which tie into why labor force participation has not moved up to the degree that many would have expected or to pre-pandemic highs. So there is still to some degree a labor shortage. And I think companies, many of them have expressed this directly, if not, you can imply from some of what you’re seeing happening that companies are more desirous to hang on to the hard-fought labor. We know there was a huge skills gap prior to this part of the cycle, and it looks like companies are just maybe a little less willing to let go of employees. That’s why until this most recent jobs report, you had seen a compression in hours worked. It’s also unique what’s happening under the surface, in that it’s a lot of higher income, higher wage jobs that are coming out of the mix, all the high profile announcements, not just among tech companies, but moving into professional services and finance. And most of the job creation is down the wage and income spectrum in those services areas like leisure and hospitality. So there’s a mix shift that’s happening right now that also has broader economic implications, not least being just the aggregate income coming down, even though there’s still support down the wage spectrum because of those services jobs that are being created.
MARK: Thanks, Liz Ann. Jeff, got a couple of questions for you related to China. We’ve got the China sudden reopening. Obviously, that’s going to have some big… big impacts on the global economy. What are your thoughts about that and how should investors be thinking about it?
JEFF KLEINTOP: Well, you know, Liz Ann mentioned this rolling recession within the US and different industries. Well, we’re seeing that across countries, too. You know, right now, Germany experienced negative GDP in the fourth quarter, probably going to see negative GDP in Q1, as well, with that back-to-back two quarters pointing to a recession. Yet at the same time, some countries are emerging in a very rapid way from any kind of downturn last year, like China. The suddenness and speed of the rebound in China may be the biggest upside risk to growth in inflation here in the first half of the year. Last week, we learned that China’s manufacturing and services sectors expanded for the first time in four months in January, as that reopening continued and a Lunar New Year spurred some holiday travel and spending. The Manufacturing Purchasing Managers Index rose to 50.1 from 47 in December. So that was nice, still kind of stalled. But the non-manufacturing gauge, which measures activity in services, where were really looking to see a pickup in, and construction, as well, right, tied to the housing downturn that has been going on in China for quite some time, that jumped to 54 from 41. We know numbers above 50 represent an expansion and anything else is below contraction. So that 13-point leap from 41, deep recession level, to solid growth really is impressive.
And we’re seeing retail spending in China, which has been down on a year-over-year basis for much of 2022… I’ve never seen that before, other than a few months during the pandemic in 2020. We haven’t seen that in decades. China’s government produced economic data isn’t always trustworthy, certainly admit that, but I’m seeing a steep rise in things I watch that are measured independently from the government, like air travel air pollution, box office results, and the like. We heard from retailers this earning season, that demand has returned rapidly, as well. Inventories have been brought down quickly, I think it was Thursday, I think, was Apple’s earnings call that I was listening to. And Tim Cook noted there was a marked change in traffic in Apple stores, foot traffic in their stores in China. So really starting to see that comeback in a big way.
So January’s improvement is welcome news for the world economy, which is cooling and will rely, in part, on China’s recovery this year to offset weaker growth elsewhere. In fact, the IMF on Tuesday raised… last Tuesday… yeah, it was just last Tuesday. They raised their global outlook to 2.9% for GDP for the world. That’s pretty close to the 3% long-term average pace. And that was the first increase in a year, and primarily the result of an upgrade to China’s outlook.
Now, policymakers have been holding back on any new stimulus or rate cuts… yeah, cuts… until reopening so it could be effective. China doesn’t have an inflation problem. Core inflation in China is 0.7%. So China’s policymakers have an opportunity here to announce more stimulus to support growth when it unveils a new annual economic plan at the National People’s Congress in March. So we could see even more fuel driving further upward revisions to China’s growth outlook.
China’s stock market is up about 55% since the start of November when signs of reopening began. And that’s really driven a new bull market in emerging market stocks market, Mark.
MARK: Jeff, one more China question for you. The question here is, ‘Is China walking away from being a world’s manufacturing center on purpose?’
JEFF: Well, you know, China’s manufacturing output is actually at an all-time high, as are US imports from China on a 12-month moving average basis. Since they vary every month, I like to look at it that way. But China is changing what they make. They, for years now, have been focusing on higher value manufacturing. So you don’t look to labor-intensive low-end products like t-shirts or shoes coming from China anymore, as they leave those to cheaper labor in neighboring countries, like Vietnam or Cambodia. China is making more value-added items that require more capital, and that should support productivity growth in China helping offset the shrinking labor force.
More broadly, on the demographics in China, most developed nations, along with the likes of China are aging, and it’s a real significant part of why China is changing what it’s making and why. In fact, the US is aging less quickly than Japan, China, and most other European countries. So you might assume that the US would seem to be the least dirty shirt out of a bad bunch, but what sets the US apart is its healthcare cost being multiples of anywhere else, especially China. And as one gets older, the more one spends on healthcare. So the US will end up spending multiples of what a more rapidly aging China spends on healthcare. So the question is, where will that money come from? And that will likely mean, you know, more capital is directed towards the elderly in a number of these countries.
But I think China is not stepping away from manufacturing but stepping into different areas of manufacturing as they move up the value-added curve.
MARK: Thanks, Jeff. Let’s talk about the Fed for a little bit. Liz Ann, there was a Fed press conference last Wednesday. Certainly, you know, Powell reiterated his commitment to getting inflation down. Do you think it’s going to get all the way back down to that pre-pandemic target of 2%?
LIZ ANN: Well, if it continues on the trajectory that it is, if you look at a three-month rolling basis or a six-month rolling basis, we’re heading in that direction. I mean, there are possibilities that you see a spark back up in the up upside. Jeff, obviously, talked a bit about China and the ongoing reopening, all the vagaries of the war and the impact that that might have on energy prices. But I think, you know, inflation will get there, at least to maybe a two-handle on some of the metrics, if not all the way down to 2%.
I think what’s maybe more interesting, or more important to think about is the disconnect that still exists in the market. Now, after Friday’s Jobs Report, you did see an additional rate hike built into expectations and one less cut toward the end of the year, but the market still expects a cut at the end of the year. And the disconnect in my view is that, yes, if inflation comes down to at or near the Fed’s target, that’s justification for a pause. But in my view, justification for an actual pivot to rate cuts would not be predicated just on inflation coming down, but would probably need weakness in the economy and/or the labor market to justify a pivot to rate cuts. So I think that’s the most interesting thing that happened, or maybe I should say didn’t happen in response to the jobs meeting, is that those cuts were not fully pulled out of expectations for the latter part of this year.
MARK: Thanks, Liz Ann. Kathy, what’s your take on where the Fed is heading? There seem to be… the bond market seems to be trying to find its footing in light of the Fed’s comments. Where are we and where you think they’re going?
KATHY JONES: Yeah, I think Liz Ann highlighted something we’ve been talking about a lot, is that this disconnect between what the market has been looking for and pricing in for Fed policy and what the Fed has been signaling through its Summary of Economic Projections and dot-plot have been apart. Now, that is a source of volatility that we’ve been highlighting, and, of course, that pretty much closed now after the labor report, or it certainly narrowed significantly.
I think the Fed has been clear on one thing, and that is the target Fed Funds Rate is at least 5- to 5-1/4%. They have been talking about a, you know, hike, hold and recalibrate policy or strategy in terms of tightening policy. And they’re pretty much sticking to that. I think where the question comes in is when and where is the recalibration and what will lead to that? And that will dictate what the market prices in. You know, at the press conference, I think Powell created a lot of confusion because he talked a lot about the progress that’s been made on inflation. He mentioned disinflation 10 or 11 times in his press conference. And so I think that that gave people a lot of optimism that maybe the Fed was getting ready to pivot. And then, of course, we had the strong labor market report, and a jump in the ISM Services Index, and that turned things around again in the bond market.
So, you know, it was a failure to communicate, and I think any muddled message increases the volatility in the bond market, but it’s still going to be, I think, a case of the bond market trying to read the tea leaves, not just from the Fed, but also from the economy. And I would expect this kind of disconnect to continue to widen, narrow, widen, narrow as we go through kind of a very uncertain outlook for the economy.
MARK: Kathy, we don’t spend… or nobody seems to spend a lot of time talking about quantitative tightening. So we’ve got a question here. ‘Will the… will QT put upward pressure on long-term rates given the huge supply of treasuries that need to be issued to fund the deficits?’
KATHY: Yeah, QT is one of those things where it… we’ve only had one previous example, and so it’s hard to draw a lot of conclusions about what to expect. You know, I would say… logically, you would say, ‘Well, the Fed is not going to be as big a buyer in the bond market, therefore, all else being equal, you would have to find another buyer or yields would go up.’ In practice, that hasn’t been the case, so other factors come into play.
I think that it’s doubtful that QT alone will change the dynamic of long-term rates unless, you know, the plan changes. But right now, the Fed is allowing bonds to mature without replacing them. That means, by definition, the ones that are rolling off as short-term. So it’s a question of how much do they replace at the long end. I think if the Fed were to actually sell long-term bonds, or certainly mortgage-backed securities would be the more likely bonds that they would sell, or swap them for short-term, yeah, that could create some upward pressure. But in practice, you know, the purchases and the withdrawals and the swaps really just haven’t had as big an impact on bond yields as I think a lot of people thought. QT is supposed to have the impact of 50 to 75 basis points in tightening over the long run, but so far haven’t really seen that play out either. So I think there’s just a lot more dynamics at work here than QT in terms of driving long-term bond yield.
MARK: Thanks, Kathy. Liz Ann, got a question here for you. ‘If interest rates are elevated over longer period, and credit card debt continues to rise, when will we see a decrease in consumer spending, and what will be the catalyst for it?’
LIZ ANN: Well, we have started to see some weakness in consumer spending, particularly down the income and wage spectrum. You’ve also seen a lot of substitution happening. You’ve heard that from the likes of the Walmarts and the Targets of the world saying even their regular customers have moved down kind of brand a little bit. And delinquency rates are starting to tick up. I think what has prevented more deterioration than what we have already seen is the strength in the jobs market, not only as that relates to the job stability or confidence in maintaining a job, or ability to get a new job, but through the confidence channels. And I think were we to start to see more meaningful, what I would call headline deterioration in the labor market, even initially through the confidence channels, I think that could start to come into play.
But, you know, one of the things that was sort of missing in the headlines associated with the fourth quarter GDP report, which was a little bit better than expected, inclusive of consumption, which is more than 70% of GDP, and that was… that grew by more than 2%. But of course, GDP is a quarterly number, and inside the quarter, the strength was concentrated at the beginning of the quarter and deteriorated pretty significantly toward the end of the quarter. And I think the increased use of revolving credit and the cost associated with that has been a factor in addition to the relatively low savings rate. But I think we only see a significant faltering in consumer spending if we start to see those more obvious cracks in the labor market than what we’ve seen so far.
MARK: Thanks, Liz Ann. Mike, I wanted to bring you into the conversation. Another risk we have is the is the debt ceiling. So given, you know, kind of all the back and forth and the negotiation, is that… how worried should people be about that?
MIKE TOWNSEND: Well, I think there’s a lot of concern out there. I mean, obviously, there’s no question that this is the biggest policy issue that could potentially move the markets over the next six months. And I think, as everyone knows, you know, the United States hit the debt ceiling on January 19th, so Treasury has now taken its extraordinary measures to make sure we don’t default. Secretary Yellen has said that those measures will be effective until at least early June. Third parties have put the deadline more at a late June/early July timeframe. But, basically, it means the clock is ticking towards that.
On Capitol Hill, you know, the lines are pretty simple. Democrats, including the President, have been saying that they will only approve a debt ceiling increase that is clean, that doesn’t have strings attached. And Republicans, of course, are saying they will only approve a debt ceiling increase that has spending cuts attached to it. So that standoff is where we’re going to be, I think, for a while.
I do think there’s positive signs. The fact that President Biden and House Speaker Kevin McCarthy met face-to-face last week, had a positive conversation. Just the fact that they’re talking five… you know, about five months ahead of the deadline I think is significant. But whether, you know, at the end of the day, they can get together and sort of compromise on this spending question, I think is going to be a really tough one.
One possibility here is that the spending issue really needs and probably should move to the annual fiscal budget and appropriations discussion. And I would not be at all surprised if, ultimately, it gets moved off to that September timeframe. And, frankly, I’ve been saying that the chances of a government shutdown, which would happen if we don’t get the appropriations bills done by September 30th, is higher, probably much higher than the chances of a default in the summer.
So we’ll see, but I do think it’s a big issue that’s going to dominate talk here in Washington for the next few months.
MARK: Thanks, Mike. Kathy, from your standpoint, let’s assume there’s a lengthy squabble on this. What impact will that have on the bond market?
KATHY: Well, you know, it doesn’t look good to creditors to refuse to pay the bills. And so while, you know, most people… most people who buy treasury securities understand that this is a political squabble and not about the US ability to pay. So there hasn’t really been a big reaction, but it does send a negative signal to the market. Buyers of treasuries want to know they can get access to their capital when they want and not get caught up in this sort of political struggle. There’s also some risk to short-term funding markets that rely on liquidity in the T-bill market. So you need good T-bills, meaning those that, you know, are going to be paid off to use in the repo market. So it could create problems for someone trying to… financial institutions trying to access the repo market without good collateral to use. Now, I say that, but I don’t want people to get very panicked about it because the Treasury and the Fed are all over this, and I think that there are ways that they can work around it.
So far, the only impact that we’ve seen is a modest rise in T-bill yields for those maturing in the summer timeframe that Mike mentioned, when it feels like it might be crunch time. It’s just been five or six basis points so far. In 2011, when we had this showdown, it got to 25 basis points because investors, you know, don’t want to hold securities that may end up getting deferred payments on them. So that means the yield is got to be high to attract buyers to those. So far, so good. We’ll see what happens in the summer. It has potential to, you know, roil the market somewhat.
MARK: Thanks, Kathy. I’ve got an interest rate question for you, and then I’ll… why don’t we do a few different bond strategy questions and we’ll get to get to stock. So have we seen the peak of long-term interest rates in this cycle?
KATHY: You know, I think we have. Typically, the peak in, say, 10-year and 30-year yields happens well before the peak in the Fed Funds Rate and the tightening cycle. So even if the peak Fed Funds Rate continues to move up, the peak in longer term bond yields tends to lag behind. And we did get up to about 4.34 or so in late October last year as we were entering this aggressive Fed tightening cycle. I think that probably is the peak, barring some major, major surprise from here. So we think that the… you know, the idea is here that you see a still steeply inverted yield curve until you get something that actually changes the dynamic. It means we either need to see higher inflation developing, as opposed to the disinflation that we’ve seen in many sectors, or that you start to see, you know, something change in terms of the growth outlook, which could pick it up.
So, you know, I think that it’s… there’s still a lot of demand for long-term treasuries that will probably cap out this rallying bonds around the 4% level, but it’s going to tend to course on whether it’s perceived that the Fed has control of inflation or not. I think with an aggressive policy stance, the belief is that they will get inflation down.
MARK: Kathy, are any particular areas that investors… areas of the bond market that investors should look at with caution?
KATHY: Well, we’ve been highlighting a risk in lower credit quality bonds, particularly high-yield bonds and bank loans. So these are the sorts of… you know, the companies that issue these bonds tend to have the weaker balance sheets, they’re more leveraged, they tend to roll over their debt much more frequently, certainly in the bank loan area, they have to roll it over really frequently, so they’re really caught up in the rise in short-term interest rates. In the high-yield market, it hasn’t been as big a factor because a lot of the companies were able to extend the maturities on their debt when yields were low. Nonetheless, I would be cautious because the yield that you’re getting now, the yield spread versus treasuries and high-yield, is pretty low by historical standards, especially during a tightening cycle. So the market is not really giving you much extra premium to take that risk, so we’d be cautious about that.
A similar story, perhaps, in emerging market bonds. They’ve had a nice rally here off the lows, as the market prices in the Fed pivot, and, of course, a lot of those countries have raised rates very aggressively, but they’re still much more volatile, less liquid, more susceptible to changes… shifts in the interest rate market. So feel a little bit more cautious there, as well, because the yields, again, are not that much above the long-term average.
MARK: And, Kathy, what about all the people who are holding, you know, kind of big positions in shorter duration bonds? Does that make sense or do you think it makes sense to kind of move out on the yield curve a little bit?
KATHY: Yeah, one of the things we’ve been suggesting for a while is starting to extend duration. We know a lot of people look at their short-term, you know, cash positions or very short-term bonds yielding 4-1/2%- plus and say, ‘Why should I move out the yield curve?’ But as I mentioned, typically, longer term yields do peak well before the Fed Funds Rate peaks. So if you want to capture some of that income stream for five, six years, which is close to, say, the benchmark of Bloomberg Barclays Aggregate Index, then you need to start adding some intermediate- and long-term bonds as we go along. And we think, you know, the attractiveness right now of high-quality bonds for a portfolio, if you’re building a portfolio for clients for income over the next five to 10 years, and you can lock in 4- to 5% in investment-grade bonds, treasuries, and high-quality munis, that’s an attractive proposition because that gives us that base for generating income, for capital preservation, for planning purposes, and for diversification of stocks. So that’s why we’ve been suggesting moving out in high credit quality bonds and duration to start locking in some of that yield.
MARK: Thanks, Kathy. And I want to go to Liz Ann, talk a little bit about US stocks. You know, the market has kind of come off it’s lows in mid-October. Where do you think it’s going to go from here? What do you think is going to be happening with earnings, profit margins, and valuations?
LIZ ANN: Yeah, so one thing I’ll say about the low in mid-October was even though it took out the prior low in June with indexes like the S&P and the NASDAQ, certainly in the case of the S&P, the internals were actually better. So that’s what’s often called a positive divergence, to use, you know, technical jargon, where you see a retest and a blow through, but under the surface you’re not seeing the same kind of carnage at the individual stock level. So that was one thing that, you know, somebody on the bullish side of the fence would sort of check that that box.
What’s been a little bit troubling, though, in the more recent era of the rally is that you’ve seen a lot of outperformance down the quality spectrum. You’ve also seen a tremendous amount of short covering, which helps to explain why, you know, factors that worked in January were the complete opposite of what worked in the latter part of last year. So it really was a mirror image, kind of a flip flop environment. And when you look at short interest across a lot of names, and you look at how heavily the short positions were, particularly by hedge funds and other shorter time horizon-oriented institutions, you did see that a lot of the buying was short covering in nature.
You know, we’re in earning season. That always takes on a higher level of importance than when you’re outside earning season. And so far, what we’ve gotten in terms of the beat rate, the percent by which companies have beaten is mildly better than expected, but worse than recent trends. So you’re in the high 60s in terms of the beat rate. That’s well down from where we were in the many quarters, six or seven quarters in a row, at coming out of the lockdown phase where we had record or near record beat rates of, you know, well into the 80% range and double-digit percent by which companies are beating. Now you’re in low single-digit percent by which companies are beating, which is also much lower than where we were in the past.
We have seen estimates consistently come down for calendar year 2022, as well as for calendar year 2023, but other than analysts that are on the low end of the range, the consensus for 2023 in dollar terms for S&P earnings is still north of the $218 or so that is expected for calendar year 2022. And I think the path of lease resistance is still lower. I think fourth quarter is expected to be a year-over-year decline for overall S&P earnings. I think that persists at least for the first two quarters of 2023, possibly even into the third quarter before just the base effects allow that number to move back up. But I think given the variety of leading indicators that tie into earnings, I think there’s probably still more to go on the downside in terms of resetting that bar lower.
MARK: Thanks, Liz Ann. Jeff, international stocks have been a strong performer for a few months. Do you think that’s going to continue?
JEFF: I do. You know, a year ago, we had predicted that 2022, last year would be the first year in a decade for international outperformance of US stocks and probably the start of a longer-term trend for diversified investors. International stocks, of course, did outperform US stocks last year by about 4%, and they’re still ahead so far this year, although that gap has narrowed in the last week or two, thanks to some of the renewed strength in the dollar.
Actually, if we measure in local currency, the outperformance last year was double-digit and the widest since 2005. So I think we have seen a regime shift. And the reason for the change in relative performance, I think, was the recession. And I know an official recession hasn’t been declared yet, really anywhere, but we believe a recession likely began during 2022. And I just… I guess I’d point to, you know, back to back quarters of negative GDP in the UK. We’re in our probably second negative quarter of GDP in Germany and Italy right now. Japan saw two negative quarters of GDP last year. So we’re certainly seeing global economic weakness. Each recession reverses the relative performance of US and international stocks.
We’ve been using a shark chart to talk about cycles in investing and the danger posed when the trend changes and the jaws begin to bite down. If you haven’t seen it, let me know. I’ll send it to you. It’s pretty popular. Historically, international stocks outperformed in the ‘80s and the 2000s, while US stocks outperformed in the ‘90s and the 2010s. It is reversed every cycle going back many, many decades. And the reasons are behavioral as much as they are fundamental. After a full cycle of outperformance trends revert. These cycles tend to last years and not months. So even after a year of outperformance, it’s not too late to rebalance from US to international stocks aligned with your long-term asset allocation.
There are, also, Mark, some near-term drivers that may help to sustain international outperformance this year. First, the mildest winter on record in Europe has limited the drawdown of natural gas in Europe to such an extent that Europe will probably exit winter with 50% of its natural gas stockpiles intact. And as a result, gas prices are down 80% from their August peak, and the worst case scenarios of energy shortages stemming from the war in Ukraine can be excluded now in Europe. And those cheaper than expected energy prices have supported economic activity and employment. I’d also say China’s sudden reopening promises an economic rebound that will boost demands for Europe’s exports. China is a huge customer of European exports of industrial goods, and that has helped earnings growth be stronger outside the US. The year-over-year earnings growth for the S&P 500 companies here in Q4 down about 3% or so compared to up about 9-1/2% for companies in Europe’s STOXX 600 Index.
And, Mark, I’d sum it up with some of the… echoing some of the comments Liz Ann made about characteristics that have been helping stocks outperform, like high quality, high dividend yields, lower price-to-cash flow ratios. They’ve contributed outperformance within and across sectors and countries over the past year. And you combine that with much lower valuations, international compared to US, is trading at about a 6 PE point discount. And that’s pretty substantial. That’s helped international stocks outperform. And that might become even more pronounced if we could get a pause or reversal in the sharp rise in the dollar that’s characterized much of the past year.
MARK: Thanks, Jeff. Mike, I’m going to ask you a couple of questions and we’ll start taking live questions. Mike, at the very end of 2022, Congress passed the Secure Act 2.0. It makes a lot of changes to retirement savings. What is the timing and process for making all those provisions effective? And are there any particular issues that you think advisors should be aware of?
MIKE: Yeah, Mark, I think as everyone is aware, the biggest immediate change is that the required minimum distribution age increased from 72 to 73 on January 1st of this year. So, basically, anyone who turned 72 on January 1 or after has another year before hitting the RMD age. Most of the rest of the Secure Act 2.0 is going to come online in 2024 and in subsequent years. So some of the big things that are in it, like, you know, retirement plans, having the option to match student loans with a contribution, or the additional catch up contributions, those actually come online in 2025 for folks age 60 to 63. So this is going to kind of be a rolling process where different elements come online over the next couple of years.
One interesting thing that advisors should be aware of, there’s actually been reporting about how there is a glitch in the new law, a technical glitch that has to do with expanding catch up contributions that apparently inadvertently eliminates catch up contributions for everybody if it’s not fixed. Key members of the House and the Senate are aware of this. And this would potentially take effect next year. They need to do a technical fix. It’s not unusual when you have a complicated bill that’s part of the Tax Code that this sort of thing happens, but they’ve got to find a mechanism to actually get it done. So it’s one thing for everyone to say, ‘Oh, yeah, we’re aware of it, we’re going to make sure that gets fixed.’ And as we know in a divided Congress, it’s another thing to get something across the finish line.
So, you know, they’ve got 10 months to figure this out. I have pretty high confidence that they will, but it’s definitely something that we’re going to be keeping an eye on because it could affect planning for 2024.
MARK: Mike, we got a number of RIAs on the on the call. Any other particular action in the regulatory space that RIAs should be aware of?
MIKE: Yeah, there’s a lot going on at the SEC that’s sort of RIA-focused. And a lot of it has to do with sort of prescribing ways that RIAs have to do things. That’s new requirements for disclosure around ESG strategies, new cybersecurity rules are in the queue, and, also, new rules about how you do your due diligence and monitoring of third party service providers. And so there’s some pushback, I think, coming from RIAs, who are worried that the SEC has taken an overly prescriptive role in trying to kind of tell RIAs how to do their jobs. So that’s something to watch.
One other thing I’d flagged that’s getting a ton of attention right now at the SEC, and this goes for big, giant banks, all the way down to small RIA firms, there’s a real focus at the SEC in looking at the use of personal mobile devices, personal phones for business communications. The SEC is making this a big a exam priority, and they’re doing a lot of cracking down on this when they find problems. So RIAs really need to be aware that they need to have strong policies and procedures in place to make sure that employees are not conducting business interactions with clients on personal phones that don’t have the ability to be archived and monitored. So this is a big priority for the SEC, definitely something RIAs should be on a lookout for.
MARK: All right. Thank you, Mike. Jeff, I’m going to send… if I can scroll down here and get it. Where is it? Here we go. There we go. ;The tensions with China are rising—Taiwan, trade, technology, spying incident. How should investors evaluate this risk? And, additionally, how do we measure the inflationary impact of China’s end to the lockdowns?’
JEFF: Well, I guess I’ll take the first part of that first. I think we’ve got the Chinese spy balloon issue, right? These rising US-China tensions, I guess probably doesn’t change things too much, but there are some potential US-China flashpoints that could be of greater consequence for financial markets in the coming weeks and months. We’ve seen this incredible rally in Chinese equities. I think that’s still probably still rooted in what’s going on with their economic reopening. But there are some questions about whether China is providing more material military support to Russia. There’s, of course, an executive order limiting certain exports to China that can be broader or narrower. We’ll have to see where that goes. Is it just AI and certain types of chips, or is it something much broader? And we’ve got a potential visit in April by House Speaker Kevin McCarthy, and we know what happened when Pelosi went to visit last fall, and that could further fuel some tensions there. You know, there’s a number of these issues going on.
I think the real issue is just the extent of China’s economic recovery, which is driven domestically and not really dependent upon export markets. That’s been what’s most important to China’s and EM stocks, certainly over the past few months.
The other…what was the other part of the question, Mark?
MARK: The inflationary impact or the risk of inflationary impact coming from the reopening?
JEFF: Yeah. Yeah. So I think that’s being underestimated. I’ve talked about this for a while. You know, I think as we take a look at the incredible rebound in some of the data I’m getting from China, I mentioned earlier, you know, the box office receipts and travel, air travel and the like, really seems like quite a, quite a rebound in activity. And I do think that could lead to some inflationary pressures. Remember, where we’ve seen inflation come down in Western part of the world, it’s really been in commodities and in goods prices. Services prices have remained relatively sticky. And what we’re seeing now is potential that China’s reopening could be lifting some of these. We’ve already seen copper prices up 25% on expected Chinese demand. Oil has been trending higher. If we see a stability or a reversal in the price declines that have been helping to bring inflation down, it could mean central banks have to hike more than currently expected, or may not be able to cut later this year or early next year, as the market has been increasingly counting on, given the rally and the shift towards liquidity beneficiaries in the stock market.
Just focusing on Brent crude oil prices, which are down about $82 from a peak of 127 last year, if Chinese oil demand rebounds from the 1.6 million barrels per day below trend that we saw sort of pre-reopening, that could boost Brent oil prices, based on just my simple regression, by about 15 bucks. In a more aggressive reopening scenario, which seems to be unfolding, that can be $20 or more.
So I think the optimism that inflation has been beaten and we’re headed towards rate cuts as the global economy has a soft landing, might be ignoring the inflation risks, and the everything everywhere, all at once, rally we’ve seen over the past three months could be at risk of a pullback as this risk of inflation is reassessed.
MARK: All right. Thanks, Jeff. Liz Ann, this one is for you. How does the market perform in recessions?
LIZ ANN: Well, there’s no… there’s no one average answer to that. In fact, I always harken back to the line who I don’t know who it can be attributed it to, but I love it, which is, you know, ‘analysis of an average leads to average analysis.’ So we can look at something on average, but what’s important to note is that the timing of bear markets and the timing of recessions do not align when you’re in a cycle where you have both, where you have some overlap between the bear market and the recession. And there are exceptions, there are times where we’ve had a recession where we don’t have a bear market and vice versa. One perfect example of that would be the crash of ‘87, which was clearly a bear market, but it didn’t really have anything to do with it being a recession. But when you look at those cycles that have both, with very, very, very few exceptions, the peak in the bull market comes first, then the peak in the economy. Conversely, when you’re troughing with both the trough in the market tends to predate the trough in the economy. So it really depends on what timeframe you’re looking at.
If you’re looking at the magnitude of bear markets that have had a recession associated with them, bear markets with associated recessions, on average, are down in the mid-30s, whereas it’s only in the low 30s if you have a bear market that doesn’t have an overlap. You can also simply look at the span of time from beginning of recession to end of recession and look at how the market has performed. There, the market performance tends to be better, but there’s such variability in terms of the timing of a bear market bottom or start and recession start, that you can slice it and dice it a lot of different ways. But, in general, bear markets are more severe when they overlap with the recession less severe when they don’t overlap with the recession. Maybe just as important is where the even bigger variability comes, is duration of the bear market. Bear markets that have a recession, again, associated with them, not overlapping perfectly, tend to be longer, about 50% longer, historically, than bear markets that have occurred absent any economic recession in a reasonably similar period of time.
I know that was sort of a non-answer, but I can slice and dice it a million ways, and could provide all the data depending on what timeframe you’re looking at. That’s why I had to answer it generally.
MARK: Yeah, makes sense. Kathy, this one is for you. ‘If the market is anticipating a recession, why do you think high-yield spreads seem so tight?’
KATHY: Great question. I don’t have the answer to that. I think there have been a… I could posit a few explanations, but I don’t think it really makes sense.
So, first of all, there’s a lot of talk now about a soft landing, not a recession. I think, as Liz Ann said, that’s still sort of up in the air. Secondly, a lot of companies did use this opportunity of low rates to term out their debt over longer time periods. So we haven’t really seen a significant pickup in defaults yet. It has ticked up a little bit but they haven’t picked up as significantly. A lot of companies have been able to roll over debt, raise new capital, etc.
And there’s been, you know, a chase for yield. In every cycle, particularly with optimism about the economy and maybe yields starting to edge down, people will chase that yield. But I think that that’s what makes it a little bit concerning at this stage of the game, because you don’t have that wide spread that you usually get when there’s a recession.
And I will say that typically going through a recession, those spreads widen right at the end of the cycle. High-yield is one of those markets, though, that just jump really quickly, a couple of hundred basis points, and that’s why we’re cautious.
MARK: Thanks, Kathy. Mike, this one is for you. ‘With the split parties in Congress, what do you think, if anything, will get done?’
MIKE: It’s going to be tricky. There are a few things that have some bipartisan support. I would point to cryptocurrency regulation as one of the real potential bipartisan issues. I think both sides, particularly in the wake of the collapse of FTX, the cryptocurrency exchange, in November, and some other bankruptcies in the field, I think both sides realize that they need to put a better regulatory structure around cryptocurrency. There are a number of bipartisan bills to do so, and it’s really about just, you know, finding the right combination to get something done. There’s going to be a hearing next week in the Senate Banking Committee on cryptocurrency. I think that’s a signal that this is one of the priority issues for the two relevant committees in the Senate and the House side. So that’s definitely something that I think has a chance to move forward.
There’s also some talk about some data privacy legislation. There’s talk about, you know, bipartisan support toughening our stance on China, particularly, obviously, in the wake of the great balloon gate incident of this past week.
But these issues, frankly, are few and far between. I think we’re going to see a lot of partisanship, a lot of investigations that maybe don’t particularly lead to anything at the end. And a lot of squabbling, and probably not a lot of big legislative initiatives. The big tax and spending bills over the last couple years, not going to happen in this environment.
MARK: Thank you, Mike. Kathy, this one is for you. Let’s see, kind of a long question. I think the last part is the most interesting. ‘What role could municipal bonds play this year into 2025?’
KATHY: So in a portfolio, you know, I think they play a good solid role in terms of that ballast that any long term bonds, or any intermediate- to long-term bonds will provide. So the spreads on munis have come down a lot, and the MOB spreads come in a lot. There’s been tremendous demand for munis. And January, typically is a very seasonally strong year for the muni market, so you sort of expect that to happen. I think we’ll probably see the yields move out a little bit here, along with maybe yields moving up a bit in the treasury market.
But, overall, municipalities, as Powell mentioned at his last press conference, are flush with cash. They still have pretty decent budget balances, by and large. And they’re benefiting from the strength in the economy because that produces stronger tax revenues from income tax to property tax, to sales taxes. At the same time, you still haven’t seen the hiring in the public sector that we’ve seen in the private sector. So that’s still lagging behind pre-pandemic levels, which means you’ve got some good surpluses, or at least some good prospects in the muni markets. So I think credit quality is going to stay high. If you start to see the spreads widen out a bit, we think that’s a good opportunity to put some, you know, intermediate- to long-term munis into a portfolio for that tax-exempt income.
MARK: Thanks, Kathy. We got a few different questions about currencies. I think I’m just going to merge them all together into one big question. What’s our outlook on the dollar?
KATHY: Yeah, the dollar has come down about 7- or 8% from its peak level recently. That has been driven by the shift in expectations about how much Fed is going to tighten versus the pick up in the tightening cycle we’re seeing in Europe and England, say, Canada, etc. And then we had a boost to the Japanese yen when they had stronger economic data and some widening of the ban for yield curve control, which led to speculation that maybe Japan is going to allow yields to move up. And Japanese investors have been huge buyers of treasuries, and that’s helped support the dollar and hold down US interest rates. So all of that has brought the dollar down from that peak level, and that was a decade high. So the dollar has had a huge run.
So we do look for some correction to continue here. I don’t think we’re starting a major bear market in the dollar, unless dynamics change pretty substantially from here, but it certainly could move sideways to a little bit lower over the next, you know, balance of the year. I wouldn’t look for a huge move down unless the US economy really softens a lot relative to the rest of the world and the Fed cuts rates very aggressively relative to expectations.
MARK: Thank you, Kathy. Liz Ann, what do you think is the biggest risk to the stock market that isn’t priced in, and what is the likelihood of it occurring?
LIZ ANN: I would say a much more significant decline in earnings than what is built into expectations. Like I said, we’ve seen 2023 come down, but the median is still north of where it is in 2022. And not just a slight decline in year-over-year terms, but, you know, a significant decline. To the extent that what’s so far just a rolling recession turns into more of a across the board economic recession, you tend to see earnings declines from peak to trough of at least 20%, and that is not built into forecast right now. So I think the combination of a more severe hit to profit margins, and, in turn, profits. That, of course, is leaving aside anything black swan-related, which is always out there as a risk, but the more obvious one, I think, would be tied to earnings.
MARK: Thanks, Liz Ann. Mike, this is for you. ‘Do you expect the RMD age to get pushed out further again in a couple of years?’
MIKE: Well, actually, the new law increases the age to 75, but not until 2033, so it’s a decade out. Goes to 73 for this year. It will stay there until 2033 and then jump to 75. You know, will it will they accelerate that? I suppose that’s possible, but, right now, that’s what’s on the books.
MARK: Thanks. Thanks, Mike. Liz Ann, this one is for you. Let me scroll down, see if I can find it here. Number 25. Here we go. ‘Liz Ann said that the change in mix in job increases in the February report from high earners to low earners would have an effect. Could she elaborate on what effect that would be?’
LIZ ANN: So it would, obviously, have an effect on readings that are aggregate readings on… you know, generally on personal income because you’re taking a lot of those meaningful higher wage, higher numbers out of the of the mix, and consumption up the income spectrum has been maintained at a fairly strong level, and that would potentially get hit. The other impact that it would have and possibly is already having, is if you’re looking at average measures of wages… and the metric that comes out in conjunction with the monthly Jobs Report that we got just last week is average hourly earnings. Well, the nature of an average is if you take a lot of higher numbers out of the mix and add in lower numbers, that bias is the average down. That maybe is a bit of a kind of a false reading, suggesting that the wage pressure that the Fed is focusing on is coming down. It may be just coming down because of that mix shift of taking some of the larger numbers out of the mix and adding in some of the smaller numbers. That’s why we always suggest, if you’re looking at broad wage data, you want to look at median measures… Atlanta Fed has one called the Wage Tracker… and also look at more inclusive measures of wages, like the Employment Cost Index, the ECI for short, which, I think, is probably the gold standard of the most comprehensive way to look at what we generically think of as wages.
MARK: All right. Thank you. Thank you, Liz Ann. We’re going to awrap things up. Mike Townsend, Kathy Jones, Liz Ann Sonders, Jeffrey Kleintop, thanks for your time today.
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