- Good morning, everybody, and welcome to Schwab Market Talk, and thanks for your time today. The date is July 11th, 2023. My name is Mark Riepe, and I head up the Schwab Center for Financial Research, and I’ll be your moderator today. 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. For those who are new to these webcast, we do them monthly, and we’ll be starting out by spending the first 30 minutes or so answering some of the more popular questions that we’ve been receiving. If you want to ask a question, just click on… just type the question into the Q&A box on your screen, and you can just click Submit. And we’ll be taking live questions in the latter half of the program, nd you can submit a question at any time during the webcast.
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Our speakers today are Kathy Jones, our Chief Fixed Income Strategist; Liz Ann Sonders, our Chief Investment Strategist; and Jeffrey Kleintop, our Chief Global Strategist. 
We’re going to start out with a couple questions about the Fed. Kathy, what are the expectations for Fed policy going forward? 
-  Well, you know, I think a foregone conclusion is that we’ll get a 25 basis point rate hike at the next meeting, July 25th and 26th, and probably a signal from the Fed that they will continue to either hold rates high or leave the door open to another 25 basis points later in the year. And that will be the forward guidance, likely, that we’ll get from the statement. Now, there may be some folks that dissent this time around, it’s not a unanimous any longer kind of conversation that we’re hearing in the public. But, in general, the Fed continues to send the message that they want to continue to hike rates and keep them high for a while. And they will also probably indicate they’re keeping quantitative tightening going. That has started to really kick in after the effects of the debt ceiling standoff. So we are starting to see that balance sheet come down. So, you know, onto the higher for longer conversation at the Fed, I think, is what we’re going to see. We do think they’re close to a peak in the rate cycle, but not quite there yet. 
- So given that, that the Fed has pretty been pretty clear they want to be bringing inflation down, do you think the actions taken to-date and what you just described, do you think that’s going to be enough to kind of bring that inflation rate down to their 2% target? 
- Yeah, we do. Obviously, there’s the lag times and the question of those long and variable lags kicks in. But, you know, if you consider where we are today versus where we were when this cycle started, you know, nominal yields are at 5% for the first time since 2008. Real yields across the treasury curve are the highest they’ve been since 2008. We’re starting to see, you know, banks tighten up on lending, and we’re starting to see some deceleration in growth, and inflation is starting to trend lower, maybe some hints of softness in the labor market. So that, combined with quantitative tightening, and the fact it’s a global tightening cycle, I do think inflation will come down. It will probably hit the target sometime in 2024. It’s hard to estimate at this stage of the game, but I don’t think the Fed wants to give it too much leeway. 
- Let’s start with the broader economy. Liz Ann, one of the things that you’ve been talking about for some time has been this concept of the rolling recession. Maybe take a minute to kind of describe what you mean by that and whether you think that will be continuing. I’ve been noticing kind of increased chatter about, well, maybe there won’t be a declared recession at all, given last Friday’s Jobs Report. 
- So, yeah, Mark, you’re right, we’ve been using the terminology ‘rolling recession’ for one more than a year at this point. It references the unique nature of this cycle. And not that anybody wants to rehash the last three years, if you do go back to 2020, the point at which the massive stimulus kicked in, of course, double-barreled, the nature on the monetary and fiscal side, that pulled the economy out of what was a very, very brief but painful COVID recession. But all of that stimulus and the demand associated with it was forced into the goods side of the economy because of the shutdown in services. And that bred not only strong growth on the upside and commensurate inflation, but then on the other side, we went into recessions in many of those segments—housing, housing-related, manufacturing, a lot of consumer-oriented goods that were big beneficiaries of the worst kind of lockdown phase of the pandemic. But we’ve had then the subsequent offsetting strength on the services side. Services is a larger employer, which helps to explain the resilience in the labor market. Things like the Leading Economic Index, the LEI, not inappropriately in terms of how cycles normally unfold, has more weight on the manufacturing side of the economy, in addition to financial components like the yield curve, like the stock market. So the crunch we’ve seen in the LEI is at least not yet reflected in the broad economy because of that offsetting and more recent strength in services. 
And it’s also, by the way, rolled through in terms of the inflation data. The pop started on the goods side, we’re now in disinflation for many of those categories, and we’re only now starting to see the light at the end of the tunnel on the stickier services side components of inflation. So the roll through has not just been associated with the economy, but also how it’s had implications for inflation data. 
- Liz Ann, you touched on the source of the strength of the labor market. Do you think that can be maintained in the face of, you know, these continuing rate hikes? 
- There’s more than just a few cracks now appearing in the labor market, and it’s not just things like the pickup in unemployment claims, which is a key leading indicator. And perhaps on the surface the job’s data last Friday looked good, although the payroll number out of the Establishment Survey was lower than expected. It actually broke what was a 14-month string of better-than-expected numbers. It’s also the case that government jobs were a big part of that, meaning there’s been more of a compression in private sector jobs. 
There was also a lot of less-than-appetizing meat on the bone. Where you look in more detail, you’ve seen a rolling over in temporary employment. That tends to be a leading indicator. There’s a big jump in multiple job holders, a big jump in people working part-time for economic reasons. And those are the cracks that you tend to see initially.
In addition, although household employment, which is the separate survey from which the unemployment rate is calculated, was up, that came after a big decline in the prior month. And in the last 15 months, we’ve had five months where household employment has gone down versus an ongoing string of positive payroll employment. Household employment now shows 2 million less jobs in the past 15 months relative to the establishment survey, that non-farm payroll number. And for what it’s worth, the household data tends to lead when you’re seeing a bit of a rolling over. So I think we’re starting to see more cracks. 
And the last thing I’d say is what the story has been behind resilience of the labor market, in large part, is the labor hoarding on the part of companies that want to keep their sort of hard-fought talent. But the problem now is that revenue growth has rolled over and real revenue growth is actually in negative territory. So all the revenue growth in nominal terms has been because of inflation. Now inflation is running higher than nominal revenue growth, which means real revenues are in negative territory. That tends to be the precursor to additional layoffs. It’s also never been the case that you’ve had negative real revenues and not a recession, for what it’s worth. 
- Let’s turn then to the stock market. And Liz Ann, I’ll get back to you in a second, but a couple questions here for Jeff. 
Jeff, Treasury Secretary Janet Yellen, she’s been to China. What’s the takeaway for investors from those discussions? 
-  Well, yeah, it’s been a front and center issue. On Friday, Yellen said we seek to diversify, not to decouple. And Chinese officials seem to be receptive to that message. So this is maybe some progress on the tone, but it’s being offset by measures being taken. Economic conflict, of course, between the US and China is nothing new. President Biden has largely kept the Trump administration’s kind of trade war tariffs in place. But the US has taken a number of steps in recent months, even weeks, ratcheting up the tensions. In fact, days before Yellen’s arrival in China, China announced new export controls on metals used in semiconductors and solar panels, which was retaliation for the US’s limits on advanced chips and chip manufacturing sales to China. But none of this undoes the deep economic ties between Beijing and Washington, and that’s important to keep in mind. The Commerce Department reported just recently trade between the US and China climbed to a record-breaking 690 million last year. And firms like Moderna and Tesla are still laying plans for new investments in China. So the country’s economic relationship still remains close. China is still the US’s top trading partner. But heightened geopolitical tensions have had some American firms kind of reconsidering their investments in China lately. 
So I would say it didn’t really clear the air, but it may place boundaries on the actions to come. It didn’t suggest an end to more actions that may impact Chinese and US companies, but Chinese stocks are back near their lows of the year after a powerful 60% rally from the end of October to January 28th, when the Chinese balloon then heightened tensions and the selloff began, which is now a bear market for Chinese stocks. They’re down more than 20% from that peak in early January. 
But there is some hope that maybe these high-level meetings could stabilize the economic relationship. There are more to come. But it certainly hasn’t done a lot here in the very near term, given those other actual substantive measures that are being put in place. 
- Jeff, I wanted to stick in the region for a second and talk about a couple of countries that you’ve highlighted recently, one on the emerging market side and one on the developed side. Japan and India are a couple that you’ve highlighted. So what are your thoughts on those? What makes those interesting to you? 
- Yeah, well, I’ll start with India, just in contrast to China, since we just talked about China. It’s the best performing stock market in the world during the second quarter. Indian stocks make up about 14% of the MSCI Emerging Market Index. That’s the largest share of any country, other than China and Taiwan. And there are a number reasons why India is become increasingly important to the global economy and markets. 
A few stats on India’s rise here, because this is impressive. We get obsessed with China, but India’s economy is now the fifth biggest in the world. It just surpassed the UK. India’s GDP is expected to grow faster than 6% in each of the next three years. It’s a huge number compared to the US and other developed countries. In fact, the IMF forecasts India to become the third largest economy in the world by the end of the decade, by 2027, overtaking Japan and Germany in those next two spots. India’s population this year is surpassing China’s. And India has the world’s largest democracy, with a capitalist economy and the world’s most popular leader, Prime Minister Modi. As the world looks to de-risk supply chains in Asia, India is benefiting from some of that. 
But India isn’t just big, it’s got positive growth momentum. For years, foreign companies have been investing manufacturing operations in China, while India’s manufacturing, manufacturing sector has lagged […audio dropout…] in some of this Apple expected […audio dropout…] moves offered advantage to manufacturing. […audio dropout…] it’s less volatile through the purchase of Russian oil. India may be less prone to capital outflows, as Russia is receiving rupees in exchange for oil exports to the country. So that’s somewhat a more of a stable backdrop for China’s currency. 
And then, of course, China’s positive momentum does face some risks. One of these is that unlike China, India’s stocks are typically expensive, and they’re even more so right now. India does have a unique growth story, but it may be priced into the stocks at the moment. India stocks traded about 20 times earnings at a pretty large premium to the EM universe. So India stocks are expensive, perhaps already pricing at high expectations. 
Quickly shifting over to the largest country weighting in the developed market, Japan. Japan makes up 22% of the EAFE Index. So it matters a lot to international investing, not just from a country-specific perspective. And Japan’s stocks have been doing great this year. The NIKKEI 225 just hit a 33-year high last week. It’s up like 10 of the last 11 or 12 weeks. And the stock market is up over 20% this year. But the PE ratio is still a below average 14 on 12-month forward estimates, so there might be more room to run. We’ve got some pro-market reforms that are improving shareholder returns. The Tokyo Stock Exchange is forcing companies to improve the price-to-book ratio. Japan’s GDP growth is outpacing the rest of the G-7 this year, partly benefiting from some of that supply chain reallocation out of China. We’re also seeing some inflation in Japan for the first time in a generation. That’s in increasing consumption. And we’re also seeing investors reallocate towards Japan. In fact, we’re seeing a lot of inflows, including those from Warren Buffet. So all of that’s improved the attractiveness of Japan’s economy and markets at a time where it’s regaining decades of lost performance, Mark. 
- Thanks, Jeff. Liz Ann, let’s go back to the US and turn to you. We got a few different questions. I’ll just kind of bundle them all together. What’s your outlook on corporate earnings, profit margins, and valuations? 
- Three very big questions, but I’ll try to summarize it briefly. So we’re at the beginning of second quarter earning season, obviously. So far, slightly better than expected numbers, but it’s too early in the season to judge what they call the blended consensus, which is a combination of companies that have already reported. Plus the consensus for additional companies that have yet to report is somewhere in the negative five to six. Interestingly, this is the first quarter where energy is a drag on earnings, where last year anytime you ex’d energy out the expected earnings were much lower. This time it’s a bit the opposite. But first quarter was much better than expected. We’ve seen 2023 estimates go up, but only because of the better than expected first quarter. Second quarter, third quarter, fourth quarter estimates have been trending down. So I continue to think we’re in this sort of decelerating pace. 
The second half of the year shows a little bit of a lift in expectations. I just think analysts are not being given enough concrete information for two, three quarters out. I think they’re waiting for the current earning season to make adjustments to the third and fourth quarter. So I think that’s just as important. 
I already touched on revenue growth being in negative territory when looking in real terms. In terms of profit margins, depending on whether you just look at the S&P, if you’re looking at a broader mix of companies, you can also just look at domestic profit margins. No matter what, the level is different, but you’ve seen somewhere between a two and three percentage point move down in profit margins relative to the peak, which for the most part, was in 2022. And given that labor costs for most companies is the highest input cost, and the fact that wage growth has not come down commensurate with the move down in revenues, I think we’re at that critical point where companies have to make a decision as to whether they’re going to consider headcount reductions or take the hit in terms of profit margin. And it’s one of the reasons why we’ve been suggesting looking for companies that have that pricing power, they’ve been able to maintain profit margins. They’ll be able to come through this, I think, critical point in time a little bit cleaner. 
- Thanks, Liz Ann. You’ve written a couple pieces recently about the concentration of the market so far this year in a handful of tech companies. What’s your thoughts on what’s driving that concentration and to what extent do you think it’s a risk? 
- So I think there’s multiple forces driving it. But if you look at the point where you really saw a dramatic acceleration in the performance bias up the cap spectrum into the magnificent seven, the grade eight, whatever category within the top 10 and fun descriptor you want to use, it corresponded directly with the fall of Silicon Valley Bank. So March 8th is really when you saw that acceleration. But you’ve had that call it fundamental kicker of AI on top of that. And then, as we all know, you know, FOMO kicks in, as well, and I think has been an important driver and some froth associated with that. 
Now, the risk associated with heavy concentration varies looking at history. It’s not so much any time there’s a bias in terms of a smaller handful of names that that’s an imminent risk for cap-weighted indexes like the S&P or the NASDAQ. It becomes a bigger problem when the remaining stocks are significantly underperforming the index. And that was the case heading into the beginning of June. We’ve started to see some convergence in both directions, some improving breadth, better performance down the cap spectrum, while you’ve seen some profit-taking in most of those stocks. Really important is what’s happening in the next couple of weeks. Just yesterday, the NASDAQ announced that they would be rebalancing to a special rebalancing. They do it annually in December, but a special rebalancing of the NASDAQ 100. And they only cited specifically the top five stocks, which are now, I think, 47-, 48% of the index. And the target is to go to 38… I think 38-1/2. And that takes effect on July 24th. But at the top seven stocks, those magnificent seven, they’re more than 50%. I think they’re 55% of the index. So that has implications for investors that have either been indirectly trying to track indexes like that by chasing some of those names, but also the index-related funds, ETFs, that benchmark relative to the index will have to do some of their own rebalancing. So that’s coming up. We’ll get an announcement of the details next Friday, or this coming Friday, I mean, and then 10 days later the actual rebalance occurs. 
- So, Liz Ann, let’s kind of, you know, bring this full circle back to prices. What kind of signals are you looking for or signs that the worst of the bear market is over? Maybe. Maybe the worst has already happened and that the move up that we’ve seen this year in prices isn’t just a bear market rally, it’s really part of a sustained recovery. 
- So the conditions that existed in mid-October when we saw both the S&P and the NASDAQ bottom were sort of pretty good in the sense that you had the trifecta that you tend to want to see, where even though the indexes were taking out their prior June lows, the breadth under the surface was actually improving. You had a bit of a washout in sentiment from a contrarian perspective. That was a positive. And, of course, the market was dramatically oversold. 
Now, unfortunately, even though we’re starting to see a little bit of breadth improvement, it’s come in conjunction with sentiment that at least until recently had gotten a bit frothy, and the market technically was overbought. So I think we need to work off that overbought condition, which we may be in the process of doing. And I think a bit more of a corrective phase, especially up the cap spectrum, might ease some of those frothy sentiment conditions. And then I think in conjunction with improving breadth, I think you set the stage for a healthier market environment. 
I also think you need to get a firm sense of a bottoming in those forward earnings estimates because the rally since October has been all multiple expansion, there’s been no help from the denominator in the PE equation. You don’t need to see a turn back up to strongly positive earnings, just a stabilization in those downward estimates. That’s usually a positive kicker for the market. 
So those are some of the things that I’m keeping an eye on. 
- Thanks, Liz Ann. Kathy, we’ve got a few bond-related and interest-related questions here for you. Can 10-year yields get back to the highs of last October? 
- Well, I think it’s a possibility, but it’s not our base case. So we probably could test those levels if the Fed hikes even more than they’re signaling now. You know, they have the possibility of two more rate hikes for another 50 basis points. And all else being equal, you know, the yield curve would reflect, should shift up to reflect the higher for longer signal from the Fed. That is, you’ve already seen the shorter-term yields move up to adjust to the expectation where the Fed is going to be next year or later this year or next year. It could, if they were really, really aggressive, pull up long rates that way. Or the other way it would happen is if inflation was just much stronger than it currently is and would reverse and go higher, and that would give us higher inflation expectations. But seems unlikely. But I do think the downside is more limited than we thought because of the Fed’s rate hike. 
So assuming that, you know, the yield curve between two-year and 10-year doesn’t get much more inverted than 100 to 110 basis points, which it was recently and where it was in the early 1980s, then, you know, you’re going to see the yield structure kind of move up to adjust to the higher terminal rate. So bottom end of the range for 10-year treasuries is probably closer to 3-1/2 than the 3- to 3-1/4 that we thought earlier this year. 
But, again, to retest the highs, possible, but we don’t think that it’s that likely. We think the yields peaked last October. 
- So given that, Kathy, in prior calls, you suggested that investors, or bond investors, extend the duration of their fixed income portfolio. Does that still make sense? 
- Yeah, we think it does. You know, it’s very difficult to time the market, as everybody knows, whether it’s the bond market or the stock market or any other market. But these are yields that we haven’t seen in decades, in some cases, and we really think it makes sense. With the Fed on the job of fighting inflation, that signals that we’re likely to see lower growth, lower yields down the road. And with the Fed on the job with high real rates, high nominal rates now, higher than we’ve seen in a very long time, we think it makes sense for investors to extend duration to at least a benchmark level. You know, what does that mean? Everybody has a different benchmark. The Ag, the US Aggregate Index, is roughly around 6-1/2-ish or so in terms of average duration. So we think at least be at the benchmark level at this stage of the game, because, typically, longer term yields tend to peak somewhere within a four- to six-month timeframe from the peak of the Fed Funds Rate. So assuming we’re getting close to the peak, those yields will tend to fall over the next 12 months or so. 
- Thanks, Kathy. Why don’t we turn to the credit market, specifically high-yield. That’s been doing pretty well so far this year. Do you think that’s going to continue? And I guess a follow up question, then, what do you think about investment-grade corporate bonds? 
- Sure. So high-yield has hung in there really much better than I think we had anticipated this year, given the fact the Fed has been so aggressive in tightening, but we’re still cautious. The average spread over treasuries, comparable maturities, they’re right around 400 basis points or so. That’s actually kind of at the low end of the long-term average. And I think some of that is the fact that the economy has been more resilient than expected, but also a lot of those high-yield issuers have locked in lower yields into, you know, next year or the year after. So they don’t have to refinance that quickly. 
But the problem with the high-yield market is it’s really priced for kind of a perfect scenario here. So if we get any deterioration in economic growth, if we see feed-through from the private credit markets, which have been weakening, to the public credit markets, which have been holding in, then I think that you could see those spreads widen a bit. So we’ve been neutral, we like earning the coupon, but we do look for those spreads to widen and we’d be more cautious. 
We do like investment-grade, as you mentioned in the question. We do prefer investment-grade corporate bonds. Again, yields are very attractive, 5%-ish or more. We think the larger companies with more solid balance sheets should be able to handle that, and handle rising rates and still, you know, pay their bondholders. So we would prefer, given the tradeoff risk-reward, to be in investment-grade rather than high-yield. 
- Thanks, Kathy. I’ll take one more question for you and then we’ll start taking live questions. Are international bonds looking attractive with the dollar falling? 
- Yeah, the dollar is down, you know, 9- or 10% from its peak on a broad trade-weighted basis. And that has spurred a lot of people to say, ‘Well, maybe I can get some diversification and maybe get some benefit from going into international bonds.’ And, unfortunately, when you do the analysis, it just doesn’t look that good for developed market bonds. And the reason is that the yield on, say, the US Ag is about 90 basis points higher than the Global Ag excluding the US. So you’re giving up a lot of yield and taking some currency risk in an effort to diversify. And that’s usually kind of an uphill battle to try to do that. You would have to anticipate that the shift in aggressiveness by central banks would happen in the near-term. 
The second problem is that you’re just not seeing the diversification benefits in developed market bonds that a lot of times we anticipate in various economic scenarios. And that’s because this has been kind of a synchronized tightening cycle with the exception of Japan. And so correlations in those bond markets with the US have been pretty high. 
So from a yield point of view, it’s kind of an uphill battle. And from a diversification point of view, it’s kind of an uphill battle or a disappointing situation. So developed markets are not looking that great in terms of increasing allocation unless you think the dollar is really going to come down pretty hard. 
EM bonds, you know, much more attractive yields they’ve been doing well if you’re in local currency. But that’s a whole different set of risks. And about, you know, a third of that market is in China. And US dollar-denominated EM, the yield, again, not that high relative to the US to justify some of the risk-taking there. 
- Thanks, Kathy. Jeff, I want to go back to you. We’ve got a question here. How should investors handle the potential China versus Taiwan conflict? 
- Well, I’m not a geopolitical strategist, markets are hard enough, but, you know, I think as it relates to the likelihood of a conflict that investors should be considering, China has been really clear, that if China were to declare independence, China would take military action. To me, that seems highly unlikely because the Taiwanese don’t seem to want it. The latest survey published in January… the next six-month update should be out very soon, in a few days from Taiwan’s National Chengchi University, their election office. It provides details on Taiwan’s sentiment on independence versus unification versus status quo. And it goes back decades. Currently, only 5% of the population, specifically 4.6, is in favor of independence right now. The top response, 29% of the population was status quo indefinitely. And that was tied with a similar response, status quo for now and decide at another time what maybe we want to do with regard to independence. Together, they sum to 57% of the population, a majority for the status quo, which is also fine with China. Only if we combine those who want to move immediately towards independence, which is about 5% of the population, with those who… excuse me… want to maintain the status quo for now, but eventually move it to independence over time, at about 25%, we can get to about 30% of the population. That’s a significant amount, Mark, but nowhere near the overwhelming majority it would take for Taiwan’s democratically elected leaders to openly declare independence.
So I think the threat of military action is actually really low. 
In fact, there’s a national election in January 2024, coming up, in Taiwan, and China’s nationalist candidates of the nationalist party have been faring really well in recent elections in Taiwan, leaving China to kind of relax and see what happens. Notably the great-grandson of Chiang Kai-shek recently won the election as the mayor of Taiwan’s capital city, and as a member of the Chinese Nationalist Party, whose charter still calls for reunification with China. So I think the pressure on China to take any military action against Taiwan that would disrupt economic activity that would impact investors, like semiconductor production, is unlikely, at least for the next year or so, despite how the media kind of makes it seem like Taiwan’s on the brink of declaring independence any moment now.
Let me say this, though. There is a related risk of a Chinese consumer boycott of American-branded products, just given the US-China tension, setting aside Taiwan, Taiwan contributes to that, but there’s still some tension there. You could look at, for example, cars. For example, GM could lose market share to Tesla. If there was a sort of a voluntary boycott of US brands, Tesla might have to increase share exports from its Shanghai plant to make up for lower Chinese demand. China contributed about half of GM’s vehicle sales and about a third of Tesla. So it’s potentially a big risk, and it’s happened before. So that might be a more relevant risk for investors to consider tied to a further escalation of US-China tensions over Taiwan than war breaking out between China and Taiwan. 
- Thanks, Jeff. Liz Ann, I’ve got a question for you. Small cap has underperformed this move up. Typically, they lead. What are your thoughts on that? 
- Well, there really isn’t typically. If you have a big acceleration in economic growth, especially with a domestic orientation, you tend to see small caps broadly do well. But that is such a broad descriptor that I think you have to go a little bit more granular to actually see what’s going on. The Russell 2000, and somewhat unique in this cycle, has a very high percentage of zombie companies, and that has been exacerbated, of course, by the surge in interest rates. And there is no profitability filter in an index like the Russell 2000. But if you look at an index like the S&P 600, which has a profitability filter, it has a much more reasonable valuation. Performance has been much stronger there than you’ve seen in Russell 2000. So you are seeing pockets of pretty significant strength. It just depends on what segment of small caps you’re looking at. 
And in conjunction with what we have been focused on at the factor level of making sure you are moving up and staying up in quality, looking at the combination of growth and value factors and particular as it relates to profitability, positive earnings surprises, positive earnings revisions, and you apply that kind of screening down the cap spectrum, that’s where you’ve actually found opportunities that have done well. 
So I’d be really careful about thinking about the market, what’s done well and what hasn’t, in really monolithic, with a monolithic lens. That doesn’t give you the true picture of what’s going on and it’s certainly not the way to go about proactively making investment decisions. 
- Thanks, Liz Ann. Kathy, I’m going to take a couple questions here and kind of combine them. The first part here, are you concerned about the growth of private credit and potential for defaults in a worse-than-expected slowdown? And then the second part of that, what does a full credit crunch look like for the economy and the market? 
- Well, we are concerned about the growth in private credit, and so something we’ve talked about quite a bit, because it’s going a little bit under the radar now. As I mentioned, high-yield has been doing fine, even bank loans have been doing okay, but in private credit, you don’t have to mark to market. And we know that some of the private credit lenders have had to write down some of the assets already, and a lot of money is poured into there, which is yield chasing when you couldn’t get a decent yield in the public markets, you couldn’t get a risk-free rate that was positive. And when you get that kind of explosion, and then you go into an economic downturn, which is clearly a risk, as the Fed tightens up on policy, then that’s where the cracks emerge. And we just don’t have probably as good a measure there as we’d like. But yes, bankruptcies are rising, smaller companies are starting to default or have to restructure their debt. Again, because it’s not mark to market and it’s not easily seen in the public, you know, we don’t have a great view into that. But it can have a spillover effect, and this is where kind of it blends into the credit crunch question. 
So and credit crunch is simply when, you know, credit availability dries up, right? So, right now, we’re starting to see banks pull back on lending. We’re starting to see that will ripple through, so people can’t get loans to extend their businesses, so they will lay people off or, or have to default on maybe some debt that they’ve issued. And that ripples through the economy and grinds it to a halt or certainly causes a write-down in the asset values that are underpinning some of the some of the loans. So that’s kind of how a credit crunch works. And until you get that kind of debt equity ratio back in balance, so that it’s manageable for companies, for individuals, for households, then you recover from it. 
So I don’t think we’re on the edge of credit crunch, per se, but the risk increases the more the Fed hikes, the more aggressive the Fed is, particularly since in the shadow banking area on this private credit area, we’ve had so much debt issuance and we don’t have a good lens into what that actually looks like now or how much stress there is. So it is something we worry about. 
- Thanks, Kathy. Jeff, this one is directed towards you. It’s actually not so much a question as a request. It reads here, ‘Jeff, growth versus recession and tightening monetary policy in Europe. An update.’ I guess that’s a request for you to update on those things. So what do you think?
I am not hearing Jeff, so we may have lost a connection there. So… 
- Sorry, Mark, you think I’d have figured out this muting thing by now? How many years into this? Sorry about that. 
Of course, Europe was in a recession in Q4 and Q1, and looks like... negative GDP in both quarters, minor declines, negative 0.1% in both quarters. Now appears to be maybe in Q2 slightly emerged, but still on the cusp of it. A lot depends on the service sector. That’s where the strength has been. Of course, we know the weakness has been in the cardboard box recession, manufacturing and trade. But, you know, the service PMI in June fell after advancing for much of this year. It had been really strong, much stronger than expected in the first half, but now showing some signs of weakening up. In Europe, there are four times as many services jobs as manufacturing jobs. And so were we to see more weakness in services, we would begin to see that job situation deteriorate. And I think that will be part of the key for the European Central Bank to declare an end to those rate hikes. But we’re not quite there yet. And so we continue to see tighter policy and constraints on growth. So, yeah, the growth backdrop is still very soft for the economy. 
Fortunately, earnings have been faring a bit better. If you ex out the energy sector… Liz Ann talked about earnings here in the US earlier and the impact of energy… we’re looking at about a 4% gain for earnings on a year-over-year basis because, you know, energy was such a big comp last year with the war in Ukraine. So we’re still seeing kind of slightly positive ex energy earnings growth in Europe, despite the weak economic backdrop, but of course that could deteriorate here as we look to the second half of the year. So we’ll keep a close eye on it. 
I think the service sector is one I want to watch most closely. I think the ECB is talking tougher than they’re actually going to be with regard to the rate hikes. But Q3 will be very important as it relates to the additional monetary policy tightening and then the delayed impact of that on the economy. 
- Thanks, Jeff. Liz Ann, this one is for you. How will the US national debt impact the economy over the next decade? 
- So I get that question or some version of that question at pretty much every event. And there’s no simple answer to that because I think in conjunction with looking at the level of debt, you also have to look at the deficit and the interest payments associated with that. 
In addition, when you talk… I’m going to assume that by debt, the person asking the question is talking about government debt, and, particularly, federal government debt, which has now jumped over 100% of GDP. But if it’s a broader debt question, if you include state and local debt, non-financial corporate debt, financial sector debt, and all consumer-oriented debt, instead of it being 100% of GDP, it’s like 340% of GDP. I think the interest cost is crucial now as we look forward. And that really has not been a factor that many, certainly not politicians have worried about in the past, I don’t know, I’ll call it 20 years or so. If you think about the great moderation era from the late ‘90s up until the pandemic, that was an era where interest rates were coming down, inflation was generally coming down, you were in a disinflationary environment, so you had quite easy monetary policy. So even though debt levels were growing as a share of GDP, the cost of servicing that debt was not onerous. Now we’re picking up off of that. And I think the ratio that’s most important, more near-term, maybe not a 10-year look, is the interest payments as a share of tax revenues coming in. And the latest data I saw, they were at about 13%-and-change of tax revenues coming in. Historically, once you’ve hit 14%-plus, that’s when things like austerity, broadly defined, start to kick in. 
But I do think what’s going to happen, and maybe already has as it relates to things like the debt ceiling fight that we just got through, is that the burden of debt, the interest cost associated with our debt, the fact that debt has been growing faster than economic growth, I think is becoming a larger part of the macro conversation, which may force some more honest conversations to be had about it in places like Washington.
The one consistent implication of a high and rising burden of debt has been on overall economic growth. It tends to put downward pressure on economic growth and its component parts, like productivity, like job growth. And I think if we continue to operate in an environment where debt growth is faster than economic growth, that in and of itself, I think, acts as a suppressant on economic growth. 
- Thank you, Liz Ann. Let’s see, Kathy, I’m going to combine a few questions here for you, as well. Could the CPI announcement tomorrow affect the Fed’s decision for an increase in July? And then that’s sort of part one. And part two, what conditions would need to be present for the Fed to cut rates? 
- Yeah, I doubt tomorrow's CPI will be a game changer for this meeting. Again, we’ve heard the vast majority of Fed speakers who have been out over the last couple of days indicate that they’re inclined to raise rates again, and we did see that implied in the dot plot at the last meeting. So even if we get a really, really good CPI reading, and we’re not expecting CPI to drop, and to be a good reading, I don’t think the Fed will forego that. I think they’ll look at that as, ‘Okay, good progress, but we have a ways to go.’ And they do focus more on that core PCE number which has been more sticky or, you know, has been stubbornly persistent, as they like to call it. So I think the Fed would probably not pivot just on one report. They want the sum of a bunch of reports before they change their minds. 
But, you know, in terms of what we’re watching, what will it take? I think it will take softness in the labor market, getting that wage growth down, closer to 3%. Historically… well, during the period after the great financial crisis, we saw wage growth roughly in the 2-1/2- to 3% area. And I think the Fed would like to see us get back to that because that would give them more confidence about demand-driven inflation, that consumer demand-driven inflation. And the unemployment rate rising, the Fed has a forecast for a mild recession. I think they’re kind of parsing words as to whether it’s a slowdown or recession, but when you look at least the staff numbers, they are looking for a recession, they’re looking for unemployment to go up. 
And then I think that the difference in this cycle from many other cycles that we’ve had for a while is the Fed doesn’t feel confident that it can just start cutting rates as it sees inflation and growth come down. They want to have that lag time to make sure it happens over time and that they get to 2% because there’s all this worry about persistence of inflation. So long story short, it’s probably going to take a prolonged period of falling inflation and rising unemployment before the Fed actually tips back towards easing. 
- Thanks, Kathy. Liz Ann, this one’s for you. Could unexpectedly strong corporate profit growth overcome the headwinds of higher rates allowing for more gains in the US stock market? 
- To some degree, yes. And it ties back to the point I made in response to the question about what conditions are we looking for to get a sense of the worst is over in terms of the bear market. And it is a stabilization in earnings and a firm belief that the worst of the earnings decline is in the rear-view mirror. I think that would be a positive for all else equal, which you can never say that about anything, really. But all else equal, I think that that would be a positive force. Of course, it comes with the multiple expansion that has not had any earnings associated with it, given this rally. So there are valuation excesses that still need to be worked off. A rising denominator in the PE equation would certainly be a benefit, but if we’re in this higher for longer rate environment, again, all else equal, that still puts downward pressure on multiples. So I think it would probably have to be a combination of some improvement in the denominator, but also background inflation and rate conditions supportive of valuations that have gotten a bit rich in this rally.  
- Thank you, Liz Ann. Jeff, this one is for you. What do you think about small cap emerging markets? 
- Well, you know, emerging market stocks, obviously, have a lot of volatility associated with them, partly because of the concentration in China. And China has a bear market almost every year, in fact, it’s in one again this year. Usually, they recover, but, you know, there’s a lot of volatility. Small caps magnify that volatility. So if you’re a big fan of volatility, then emerging market small caps may be the place for you. 
In general, what you’re looking at are smaller companies that are more dependent upon financing conditions. And what we know about financing conditions in emerging markets is they’re a bit tight at the moment. Ex China, we’ve seen most central banks raise interest rates, some very substantially, and banks have tightened up standards. Though we don’t have the same type of lending standards data we get in the US and Europe and UK, we can see that it’s much more difficult for banks to extend the borrowing in those very borrowing-dependent companies. So we’ve seen some strains there.  That said, they’re in different countries, some of the small caps are more concentrated in the commodity space, and they’re big and they’re small, but generally, you get a pretty hefty weighting in commodities among emerging market small caps. And we’ve seen a lot of weakness in commodities so far this year. That streak has been now five quarters in a row. That’s the longest so far this century that we’ve seen commodities decline back-to-back to back-to-back to back. So that could begin to turn around on tighter supplies. We know the Saudi OPEC-Plus cuts kick in this month. We’ve got El Nino, which could disrupt production, particularly of agricultural commodities. We’ve got the war in Ukraine that can push up wheat prices. So there are a number of factors there that could, on the supply side, tighten things up and help some of these smaller cap emerging market companies. But I’d say that the volatility picture is very high and the backdrop of credit availability that they’re very dependent upon just doesn’t look particularly bright at the moment. 
- Thanks, Jeff. Kathy, this one is for you. ‘Kathy Jones, how do you identify opportunities in the fixed income market and what indicators or signals do you look for in today’s market?’ 
- Yeah, so, you know, the way we look at fixed income is basically on a risk-reward basis. So we divide up the fixed income world, the sub-asset classes into core bonds, which, you know, tend to be your higher credit quality bonds, least risk of default, treasuries, other government-backed bonds, investment-grade corporate and municipal bonds. And we look at those yields relative to, say, you know, what you might get in the risk-free rate, what you might get in dividend-paying stocks, and then we look at, you know, kind of the prospects for the direction. So we also look at not just the valuations, but we’ll also look at the yield curve, which provides a tremendous number of signals for us and tells us kind of what the market is expecting from the Fed and from the economy. And then we, you know, kind of look at the riskier, the more aggressive income side. And we basically look at that as, you know, these are things that preferred securities, high-yield bonds, emerging market bonds, as Jeff just mentioned, you know, much more volatile asset classes, much more highly correlated with equity. So we have to look at those in a risk-reward basis differently than the core bonds. 
But, in general, what we’re looking at right now is the slope of the yield curve, not just here, but everywhere else, and then credit conditions. Because right now, as we get through this tightening cycle by the Fed, it’s really important to gauge how much credit is tightening. And that’s one reason we’re leaning pretty heavily towards higher credit quality bonds because the magnitude of the tightening in the pipeline, and the shrinkage of the balance sheet, and all the other things that are going on make us pretty cautious. But we are looking at real yields that are very positive, the highest they’ve been in a long time, nominal yields pretty attractive, and that’s why we’re saying, yeah, go ahead and extend duration and lock some of this in, because the direction of travel in the next year or two is probably going to be lower core rates, not higher. 
- Thanks, Kathy. Liz Ann, this one is for you. What are your thoughts on growth versus value in US equities? 
- Mark, you know, I love this question. You know, if this was a one-on-one conversation, the first thing I would do is go back to the person asking the question and say, ‘Well, what do you mean by growth versus value?’ So I think there’s three ways that everyone should think about growth and value, and maybe not everybody does. There’s the actual characteristics of growth and value, lowercase, g and v. Then there are maybe preconceived notions of what certain stocks, whether they are typically growth, typically value, you know, tech stocks or growth stocks, or utility stocks or value stocks. But then there’s also the indexes that are called growth and value. And here, in particular, is where it gets interesting because the two big index providers of the growth and value subset indexes are S&P and Russell. Russell tends to be used as benchmarks a bit more, but S&P is obviously a big index provider. And Russell has their four growth and value indexes—Large Growth, Large Value, Small Growth, Small Value. And S&P does it a little bit different, but they have four as well—S&P Pure Growth, S&P Growth, S&P Pure Value, S&P Value. And, again, here’s where it gets interesting. So S&P does a rebalancing in December. On December 18th, the day before they rebalance their indexes, just as an example, S&P Pure Growth, which are stocks that don’t overlap into value… because stocks can overlap, they can be both growth and value stocks, but Pure Growth are those stocks that do overlap into value… while all eight of the MegaCap 8 were in Pure Growth, and partly as a result of that, tech was 37% of Pure Growth. They did the rebalancing on December 19th, and that day tech went from being 37% of Pure Growth to only 13% of Pure Growth. And guess what became the number one sector? It was energy because that’s where all the earnings growth was last year. It was the only sector with positive earnings growth last year. 
Russell just did their rebalancing two weeks ago. They do it at the end of June. Now, because energy has lost all those growth characteristics this year, those didn’t move much. They still have more of this tech bias. But as a result, you’ve got Russell 1000 Growth up year-to-date, about 28%. S&P pure growth is flat year-to-date. 
So my comment back is really if you’re an index-oriented investor, understand what you own because not every growth or value index is created equally. We have been factor-focused, and we think you want to focus on factors that are a blend of both growth and value factors, so positive earnings revision, positive earnings surprise, the ability to maintain and protect profit margins, but also more value-oriented factors like strong free cash flow, strength of balance sheet. And don’t put blinders on in terms of where you look for those opportunities by screening for both. And if you just want to screen for growth factors, you can find them in areas that might generically or even at the index level be in the value categories and vice versa. So I think the answer to a question like that is more complicated and its simplified way too much by people who just say one or the other. 
- Thank you, Liz Ann. Let’s see, final audience question here. I’ll send it to you, Kathy. What are your views on municipal markets? 
- Yeah, so we’ve been pretty positive on the municipal bond market from a credit point of view. Most state and local governments still have pandemic funding they haven’t used. They’ve had good revenue flows from sales taxes, income taxes, property taxes, you know, you name it because the economy coming out of the pandemic was so robust and a lot of that comes in arrears. So, you know, you pay your property tax for last year. So a lot of that is keeping the budgets pretty flushed. Now, obviously, there’s some situations that aren’t so great and those are things that you need to parse through. But, in general, the credit quality is high. It should stay pretty firm. We’ve seen more upgrades than downgrades. 
And the valuations are fairly attractive now. It’s been a moving target in terms of valuation. You know, we look at the munis over bond spread, the MOB spread. Earlier in the year, short-term muni valuations were not that attractive. Now, if you’re in a higher tax bracket they are more attractive again. And certainly, as you go out the yield curve, because that yield curve is either flat or more positively sloped, you do get more for investing in long-term munis than you do, say... you know, relative to short-term than you do in, say, treasuries. 
So all in all, you know, we’re pretty positive on this space. Obviously, economic downturn is a risk to some of the weaker credits. But if you stay in investment-grade munis, we still think for high tax bracket investors they make a lot of sense. 
- Thanks, Liz Ann… or excuse me, sorry. Sorry, Kathy. Liz Ann, I was going to ask you and Jeff and Kathy last question here. Just what’s the one or two things… we covered a lot of ground here today. What’s the one or two things you want viewers to walk away from? Liz Ann, why don’t you start out first? 
- Sure. So I’ll bring up a phrase I say quite often as it relates to things like how to look at economic data when you’re at this point like we are now of trying to gauge risk of recession and where we are in the cycle. And just remember that better or worse tends to matter more than good or bad, that it’s rate of change, it’s direction that maybe matters more than level. And I think it’s particularly important now to look at economic data in that context. 
And then the other one I’d say, Mark, is what I already touched on, is be really careful about monolithic decision-making, whether it’s at the sector level or at the cap level to say, you know, like or don’t like small caps. Well, small caps is not one thing. In the case of the Russell 2000, there’s 2000 stocks in there. 
So I think especially in an environment where I expect to see continued fairly high dispersion, fairly low correlations, you want to focus more on factors and characteristics and be really mindful of not making these monolithic calls. 
- Thanks, Liz Ann. Jeff, one or two thoughts from you as we close out.
- Yeah, all that is echoed for international markets, as well. I’d say geopolitical developments may be key to the direction of Chinese and emerging market stocks in the second half of the year. I talked a little bit about the Yellen situation. EM stocks are benefiting from India’s growth momentum this year. And I should mention that EM small caps have a huge weight in India at 25% which has helped them this year. I should have said that in response to the earlier question. And Japan is doing a lot to help the average developed international market stock outperform the average US stock this year as they did last year, just looking at the equal-weighted MSCI EAFE and S&P 500 indexes. So when you’re thinking about fundamentals and characteristics you want to focus on what the average stock is doing, and we continue to see that international out performance this year. 
- Thanks, Jeff. Kathy, take us home here. 
- Okay, I’ll be quick. We like extending duration and staying up in credit quality because we think we’re near the peak of the cycle. And, you know, that bodes well for locking in some longer-term yields here, but it doesn’t bode as well for taking a lot of credit risk at this stage of the game. 
I’d also say expect volatility. We haven’t had this kind of bond market volatility in a very long time. Expect that to continue because volatility in bonds just reflects uncertainty about the direction of interest rates. And we’re going to see quite a bit of that. 
And then, finally, I’ll just say, know what you own. Fixed income is not one thing. Just as Liz Ann mentioned in the equity market. It’s a large market, it’s varied, lots of different asset classes. Really important to kind of dig in and understand what you own. 
- All right. Thank you, Liz Ann, Jeff, and Kathy. We are out of time. If you would like to revisit this webcast, we will be sending out an email with a replay link. To get CFP credit, please make sure that you enter your CFP ID number in the window that will be popping up on your screen right now. In order to get credit, you need to have watched at least 50 minutes of the webcast, and then Schwab will submit your credit request to the CFP Board on your behalf. For CIMA credit, you’ve got to submit that on your own. Directions for submitting it can be found in the CIMA widget that’s at the bottom of your screen. 
The next installment of this series will be on August 8th at 8:00 PM… excuse me, 8:00 AM Pacific. Liz Ann, Kathy and Jeff will all be back for that call. Until then, if you would like to learn more about Schwab’s insights or for other information about Schwab, please reach out to your Schwab representative. And thanks for your time, and have a nice day.