Schwab Market Talk - May 2023
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MARK RIEPE: Welcome, everyone, to Schwab Market Talk. Thanks for your time today. The date is May 2nd, 2023. My name is Mark Riepe, and I head up the Schwab Center for Financial Research, and I’ll be your moderator today.
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Our speakers today are Liz Ann Sonders. She’s a managing director with us and our Chief Investments Strategist; Jeffrey Kleintop, he’s also a managing director and our Chief Global Strategist; Collin Martin is a director and our Fixed Income Strategist; and we’ve got a special guest today, Mike Townsend, he’s a managing director in our Office of Legislative and Regulatory Affairs. Obviously, a lot going on in Washington. So thank you, Mike, for being able to drop by.
We’ve got a lot of topics today. We’re going to start out talking about the banking system. Then we’ll move to central banks, the debt ceiling, the economy, various bond market strategies, equity strategies. And then we’ll… like I said, then we’ll be taking live questions.
So, Liz Ann, why don’t we start with you. It looks like the First Republic chapter of the current banking saga is more or less wrapped up. Has the risk of a, you know, 2008-type crisis, do you think that’s been fully abated?
LIZ ANN SONDERS: I think the conditions surrounding not just First Republic, but, obviously, Silicon Valley Bank and Signature are different relative to what was going on in 2008. 2008 was sort of literally and figuratively a house of cards that took down the entire global financial system, a system that was nowhere near as well capitalized as is the case today, as well as there being just trillions of dollars […audio dropout…] of massively of today. But when you look at on a day like today, with halts in a couple of other West Coast-based banks like PacWest and Alliance, you know, I think it’s a bit of a stretch at this point to say the problems are done. You talked about them in chapter terms, and each chapter now sort of is represented by a company, not a systemic situation. It is the case that the regional banks, KBW Regional Bank Index has suffered mightily, and it has really had no lift. You’re seeing better performance up the capitalization spectrum.
I do think from a broader market perspective, we probably need to see more stability in the banks. When we hit the six-month point from the October 12th low in the S&P 500, the S&P financials were still pretty deep in negative territory. And if you go back over the history of major market lows and then go to the six-month point following them, there was never an experience in history where financials weren’t up, in most cases, double-digit territory. So not that we’re repeating the past, but we probably from a broader market perspective, do need to see a bit more stability. But this is just sort of a slog and we’re going company by company, but I think it’s a stretch to say it’s over.
MARK: Thanks, Liz Ann. Mike, what are your thoughts on this particular situation in terms of the regulatory response, the legislative response? What’s going to be the end game here as regulators and legislators continue to digest the news?
MIKE TOWNSEND: Yeah, sure, Mark. And hi, everybody. You know, there’s really been a flurry of regulatory activity. Just in the last few days, we’ve had four separate reports come out: one from the Fed that examined the Silicon Valley Bank collapse, one from the FDIC that examined the Signature Bank failure, one from the Government Accountability Office that took sort of a broader look at the regulatory environment, and another yesterday from the FDIC that had some recommendations around potential changes to the deposit insurance system. I think there are two big takeaways to watch.
One, there’s going to be tougher regulation coming from mid-sized banks. You know, we’re talking banks in the 100 million to 250-, maybe a little higher than that in assets range. And the Fed said it’s going to propose rules in the near future that enhance stress testing, probably raise capital and liquidity standards, take some other steps to tighten regulation for these banks. Both the Fed and the FDIC also acknowledge some of their own supervision failures here. I expect you’re going to see some changes in their processes, too. All of this is going to take a while. You know, regulatory change takes a long time. You’ve got to propose it, you’ve got to have a public comment period, all that process. So you’re talking, you know, next year, probably, before this gets finalized.
And the other area I would watch is deposit insurance. In the report that they put out yesterday, the FDIC looked at some of the ideas that have been floating around, like taking the cap on deposit insurance up above that 250,000 level. There’s been some talk on the Hill and even in the report about maybe just getting rid of the cap entirely. But what they ended up recommending to Congress is that Congress look at raising the deposit insurance amount for business accounts that are used for payroll. Today, of course, the deposit insurance amount is the same for a business account as it is for a personal account. So looking at changes on the business account side, I think probably has some legs on Capitol Hill. We’ll have to see, you know, how quickly Congress takes that up.
But those are the two big things that I would watch for over the next several weeks.
MARK: Thanks, Mike. Liz Ann, let’s talk a little bit about the Fed. We’ve got, you know, a couple days of meetings for the Fed right now. What are you expecting to hear from them, given that on the one hand, inflation is still an issue, but also as you were just talking about, we’ve got to make sure that the financial system remains stable?
LIZ ANN: So market expectations have been pretty firmly in the 25 basis points camp. I think with what’s going on with the debt ceiling and the June 1st date, it is arguably the case that it makes it a bit more difficult for Powell to do much precise telegraphing… maybe that’s a bit of an oxymoron… in the press conference with regard to the June FOMC meeting because of the murkiness associated with the debt ceiling, but I wouldn’t be surprised if he gets asked a lot of those questions. But prior to the date shifted to early June, the expectation was 25 and hint that that’s probably it. So that could still be generally what gets communicated during the press conference.
But I think from an inflation standpoint, Powell may want to leave the door open a little bit, particularly if we don’t start to see some weakness in the labor market. We did get a little bit weaker than expected JOLTS report today, a little bit weaker than expected quits rate, which both of those, arguably, are good from a Fed’s perspective, but that may not move the needle enough for Powell to be firm in suggesting that it’s… you know, the May hike and done.
MARK: Collin, what are your thoughts on the Fed? What are you looking for?
COLLIN MARTIN: You know, I’ll echo a lot of Liz Ann’s points there, but one thing I think is important that I’ll agree with is, you know, Powell will likely stop short of saying this is it if they hike tomorrow, because they do want to leave the door open a little bit. We won’t get too much because this meeting isn’t accompanied by updated economic projections or rate hike projections. So a lot of it will come down to the statement, and then, of course, the Q&A and press conference from Powell. And I think what we’re going to be looking for is how much they discuss, you know, tighter bank lending conditions and tighter bank lending standards, because that’s been a key theme right now. Next week, we get the updated Senior Loan Officer Survey. In February, we got the one that mostly went through the fourth quarter of last year. It already showed that banks were significantly tightening lending standards, and that can do a lot of the work for the Fed already. It’s expected that those conditions are likely to continue to tighten. And if that’s the case, it certainly leaves room for the Fed to hike tomorrow and pause. But, again, as Liz Ann mentioned, if the labor market doesn’t show as many cracks in the near future as we’re expecting or inflation remains stubbornly high and doesn’t continue to come down, then the Fed would maybe need to do more.
In terms of what the outlook is going forward, the markets are still pricing in rate cuts by the end of the year. We still think that’s a bit premature because inflation is still really high, and we think the Fed will only cut rates if they absolutely need to since that’s a form of stimulus. They’ve told us they want to hike and then hold for as long as they can. We agree with them. So unless things really begin to crack, we don’t anticipate a rate cut until early 2024.
MARK: Thanks, Collin. Jeff, there have been some other central banks meeting this week, as well, in addition to the Fed. So which ones and what have they been talking about, and what do you think the outcome is going to be?
JEFF KLEINTOP: Well, the concern, obviously, is inflation. Most major central banks just aren’t done yet. The Reserve Bank of Australia, in fact, just did a surprise 25 basis point hike this morning after they had paused in April, and they aren’t the only one to stop and start again. We saw Norway do that earlier in the year.
Looking ahead, of course, we get the Fed tomorrow and the Bank of England next week, and they’re both likely to do 25. And we get the ECB on Thursday of this week. Now, we got Core CPI in Europe today, and that remained stubborn, at 5.6%. And we also got the Bank Lending Survey for Q1 today in Europe. When we talk about banks tightening lending standards, this is the survey we’re talking about. It’s done quarterly in the US and the UK and in Europe. The percentage of banks tightening lending standards in Europe held steady at 27% in Q1, same as Q4. And lending didn’t shrink in Q1, but it was flat instead.
So with Core CPI and lending standards pretty much unchanged, today’s data suggests the ECB has more work to do. So even if they hike by 25 basis points on Thursday, and there’s a chance they do a surprise 50 and not step down to 25, there’s still probably more rate hikes to come. Inflation is coming down in Europe, but so far, only in energy, and all the other categories inflation remains at peaks. Core inflation is probably going to be sticky. The weights used to construct the index are going to prevent, I think, a material falling core inflation for months.
Rate hikes aren’t over despite the bank stress. And that might seem like a negative for Europe stocks, Mark, versus the one-and-done maybe from the Fed. But the stronger than expected growth that’s supporting inflation in Europe is also driving the MSCI Euro Index, so the index of European stocks, to post a 19% total return this year for yesterday’s close in US dollars. And that more than doubles the return on the S&P 500, as international stocks continue their outperformance from last year.
MARK: Thanks, Jeff. One of our questions here is, ‘I hope there will be comments regarding the debt ceiling, the June deadline for the debt ceiling.’ So, Mike, I’ll throw this one to you. Well, I guess two questions. First of all, what do you think about this June 1st deadline that Janet Yellen has thrown out there? You know, I assume there’s some reality there, but do you think there’s an awful lot of cushion built into that, or does is that, you know, going to be the date? And then, secondly what’s going to be the negotiating strategy as administration officials and congressional officials get together and maybe not negotiating, but at least start talking?
MIKE: Yeah, Mark, you know, obviously, big, big news yesterday when Secretary Yellen came out with that letter that said that the country could default as early as June 1st. I would say that the next line of that letter gives a lot of caveats, you know, saying that this is, you know, inherently hard to peg and that it could be as many as weeks after that deadline. So there is a lot of wiggle room there. But I certainly think that jumpstarted the effort to negotiate. Within about an hour of that letter coming out the President had reached out to House Speaker Kevin McCarthy to set up a meeting that looks like it’s going to take place a week from today at the White House. I think that’s likely to include the other congressional leaders from both chambers and both parties. And I think that’s a significant development. Obviously, Speaker McCarthy and the President haven’t met since February 1st.
And, you know, from the sort of state of play standpoint, obviously, the House last week passed their bill, and that bill would raise the debt ceiling by a trillion-and-a-half dollars, or through the end of March of 2024, whichever comes first. Of course, it has a whole bunch of other stuff on it. It would cut spending by nearly $5 trillion over the next decade, although it does not outline exactly how that would happen. It would repeal most of that IRS funding increase that was passed last year. It would repeal a bunch of the green tax credits that were part of the Inflation Reduction Act. It would streamline permitting process for energy projects. It would increase work requirements for recipients of food stamps and Medicaid. And it’s all that other stuff, of course, that makes this a non-starter in the Democrat-controlled Senate. And so that’s why we have this kind of impasse. Democrats continue to insist they want to raise the debt ceiling without strings attached, and then move that spending and other issues discussion to a separate discussion. Republicans are saying, ‘Hey, we passed a bill. Let’s negotiate on that. We’re the only ones who have done that.’
So, you know, we’re going to have to see, obviously, how this plays out. I think there’s a lot of anxiety about exactly what the outcome is. Everyone sort of here in Washington says, ‘Look, Congress has always raised the debt ceiling. Even, you know, back in 2011, when we got as close as we’ve ever come to defaulting, you know, they got it done.’ And that’s kind of the fallback position, ‘They’ll figure out a way.’ But you ask anyone exactly how they’re going to get there, and nobody has a real clear idea.
So I think this is going to be a tense few weeks when these talks start next week, and we’ll see how it all plays out.
MARK: Thanks, Mike. Collin, what are you seeing in terms of the bond market, particularly in, you know, some of the bills that are maturing at some of these key dates?
COLLIN: Yeah, Mark, we are starting to see movement in the treasury bill market, especially following yesterday’s letter that kind of put that June 1st as that X date when extraordinary measures would be exhausted. So we’re seeing T-bills over the next month or so, specifically those maturing before June, with relatively depressed yields, as there’s a premium to hold treasury bills that investors are more certain will be repaid on time. And then beginning in June, you see yields jump about 100 basis points from late May to early June, about 100-basis-point jump, because investors are a little bit nervous, a little bit wary of holding a treasury bill that might not be repaid on time. This is similar to what we saw back in 2011. As Mike alluded to, that was the last time we really saw these prolonged discussions before we saw the debt ceiling raised. So we would expect that to continue, that gap, as long as there is no solution coming.
We get a question pretty often, Mark, and I think I saw a question come in along these lines of what should we do if our clients have some of these T-bills that are maturing around that X date? We don’t have a hard and fast rule or specific guidance there. Obviously, it depends on all of your clients’ needs. But there is a risk, we’re not sure how large or small, that there is a deferred or delayed payment. So if you need those funds or your clients need those funds in, say, early June and there’s a small risk that you won’t get paid immediately, then it might make sense to not hold those T-bills and either come a little bit shorter or maybe go in the weeks or months following that day when the funds would be exhausted.
Another way to look at it, Mark, is if you don’t need those funds immediately, you can earn relatively higher yields by taking that risk because we don’t see the risk as never receiving those funds. The risk is ‘When will I get that money once, you know, Congress comes up with some sort of solution?’ So there’s no hard and fast rule, but we would expect this kind of trend and theme to continue over the next handful of weeks, where we would see treasury bills maturing, you know, on that date, and then in the days and weeks follow to offer significantly higher yields because of the risk of some sort of deferred payment.
And then, Mark, one final point. We haven’t seen it yet, but what we would expect as we get closer to that date, we would expect long-term yields to fall a little bit. We saw this in 2011, but if we get closer to that date without a resolution, that, obviously, has negative ramifications and negative consequences. So we would expect some sort of flight to quality trade, where US treasuries, especially those maturing well beyond that date, would likely still be in high demand.
So we would expect long-term treasury yields to fall and see their prices rise a little bit.
MARK: Thanks, Collin. Liz Ann, let’s go to you. We’ll learn more about at least the labor market on Friday when we get the Jobs Report. But where are you where are you right now in terms of this debate over rolling recession versus hard landing versus soft landing? Where are you coming out on that?
LIZ ANN: So, so far, anyway, I think the rolling recession is probably the most apt description. I think a soft landing, as it’s traditionally defined, I think that ship already sailed because the nature of a rolling recession is that we’ve already had hard landings in many pretty important segments of the economy. And in order of sort of how they unfolded, you saw housing and many housing-related areas move into recession territory. You saw it in the factory sector with the ISM Manufacturing Index going into contraction mode. It’s certainly been picked up by things like a massive decline in the leading economic indicators, well into recession territory. You’ve seen it in CEO confidence, consumer confidence, which have bounced a little bit, but still fairly low. In consumer confidence, the spread between present situation and expectation is very deep in recession territory. You’ve just more recently had the offsetting strength on the services side of the economy. And that’s the nature of Covid, how weakness and strength has rolled through, depending on when there was stimulus, when the economy was shut down, when it opened back up, the reversal and demand on the services side, service is a larger employer, it helps to explain the resiliency in the labor market.
I think, ultimately, we will get an officially declared recession by the NBER, but I’m not sure if we don’t that that could be defined as a soft landing. And there are still shoes to fall. We are seeing consumption starting to wane by consumers in areas like leisure, hospitality, recreation. It’s new, it’s not extreme, but it’s certainly something to watch. And then, of course, commercial real estate. I know we’ve got some registration questions in, in advance, about commercial real estate. And maybe ‘next shoe a drop’ is not the right descriptor because it doesn’t look like something that’s going to implode all at once, like was the case with residential mortgages back in 2008. It’s more of a slog. And it’s also important to look at the various categories of commercial real estate because there’s five broad categories. You’ve got industrials, hotel, apartment, retail/malls, and then office. And, actually, with last year’s performance, there was record dispersion among those categories, with only office in negative territory. Unfortunately, still worsening from here because of everything that we’re seeing in terms of corporate America and hybrid work environments. That’s likely to get worse before it gets better. But you’ve seen a bit more resilience, particularly industrial, that actually had 15% positive performance last year and doesn’t look to be rolling over significantly. So I think for investors in commercial real estate, it’s very important to understand the different categories.
But back to, you know, where we started this call, Mark, in terms of the smaller and regional banks, that’s where exposure is greatest. If you look at banks that have between $100 million and $1 billion in assets, they own 25%... or 24% of commercial real estate loans. For the segment just above that, from 1 billion to 10 billion, that’s 27%. So the two of those added together is well more than 50%. To put that in context of the biggest banks, banks with more than $250 billion in assets, their exposure is only about 3%. So the troubles plaguing the smaller and regional banks tied in with what’s happened with the bank failures.
And by the way, speaking of bank failures, First Republic kind of leapfrogged Silicon Valley Bank to be the second largest. And now the aggregate total from an asset size of the failed banks is greater than was the case in 2008. I forgot to mention this in the first question. However, back in 2008, when it was, I think, $525 billion of assets represented by bank failures, it was across 25 banks. In this case, it’s 532 billion across three banks. So there’s also that bias toward a much smaller grouping of banks in this environment.
But, certainly, the commercial real estate exposure is hitting and will continue to hit that smaller to regional bank size.
MARK: Thanks, Liz Ann. Jeff, what are your thoughts on the global economy?
JEFF: Well, just following up on where Liz Ann left off, commercial real estate, fortunately, is less of a risk in Europe than it is in the US, and in Japan, pretty small as well. Relatively small portion of lending by banks, single-digit percentage, and vacancy rates are very low. So even though the carrying cost of that real estate has gone up, it hasn’t moved up quite as much as it has in the US, and, again, a much smaller portion. It’s still something to keep an eye on, but maybe less onerous than what we’re seeing in the US, and one of the reasons why we’re seeing a difference in the banking sector there.
But purely looking at the bigger picture economics, the GDP, looking beyond the US, GDP for Q1 actually came in generally better than expected around the world. And Q2 is broadly reflecting an outlook for growth. But really, it’s flat. It’s really around zero, or zero-point-something pretty much everywhere. Let me just give you the comp.
So in the US, for Q1, on a non-annualized basis, GDP was 0.3%. For comparison, 0.4 in Canada. It was 0.2 in France, zero in Germany, 0.5 in Italy, and 0.3 in Japan. That’s a lot of zeros. And that was kind of similar to Q4, a lot of zeros. What’s expected for Q2 looking forward is a lot of zeros. And the key reason, Mark, why growth is flat, around zero, is that services are booming while manufacturing and trade are in recession. This rolling recession that Liz Ann talked about is evident around the world.
We can see this downturn in manufacturing and trade in one of my favorite indicators, cardboard boxes. Pretty much everything we make and ship goes in a box, right? So demand for corrugated liner board, which is what boxes are made out of, is seeing demand in line with past recessions. I’ve got a tweet out on that. It’s down where it was in 2008-2009, back in the 2001 recession. We’re seeing that much weakness in global demand for cardboard boxes. And that means we’re at the widest gap between services and manufacturing PMIs we’ve ever seen. So it’s easy to say something’s got to give, and it may be services if the lagged impact of tightening in the credit markets begins to have more of an impact on jobs.
Now, I’m tracking labor shortage versus labor glut indicators. In Q1, we crossed from labor shortages being more popular in corporate communications and on earnings calls, talking about ‘we can’t hire workers,’ ‘difficulty in finding workers,’ to gluts, essentially talking about reductions in headcount and layoffs. That has flipped over. I talked a year ago about how we were going from shortages to gluts in materials and products. Now we seem to be hitting that for labor. So I think we could start to see this begin to show up in terms of headcount reductions as companies start to undertake them in the coming months that they’ve already been announcing.
But so far, it’s really a tale of two economies, manufacturing and services going in different directions. We’ll have to keep an eye to see if service demand begins to soften up along with the labor market.
MARK: Thanks, Jeff. Let’s switch now to some bond strategies. Collin, with the yield curve being inverted, should investors emphasize the shorter end of the yield curve and shorten their duration?
COLLIN: No, we don’t think so, Mark. I mean, it might look attractive, and you can have some of your clients’ holdings in short-term investments, but we don’t want to have a bulk of the holdings there. Our view for a while has been that we think investors should gradually extend duration and take advantage of what are some of the highest yields we’ve seen with intermediate- and long-term yields in years. Now, we know it’s a difficult pill to swallow these days with the inverted yield curve when you can get, say, close to 5% with a lot of short-term alternatives when the 10-year US treasury is only offering yield about 3-1/2%. Why would we give up, you know, 1.5 percentage points in yield when we can get a much higher yield with a lot less interest rate risk?
The big risk we see, Mark, is reinvestment risk. And even though we don’t think the Fed will be cutting rates this year, we think at some point they’ll be cutting rates. We do think it’s likely in 2024. So while a 4-1/2-, 5% yield with short-term alternatives might look attractive now, what happens when those maturities come due in the next six, 12, 18 months and you’re potentially reinvesting the maturing proceeds in lower-yielding investments?
So we would rather take some of those funds and just move a little bit further out in the curve where you can get, say, 3-1/2%, 3-3/4%, depending on the maturity, and just lock in those yields with certainty rather than really being at the mercy of Federal Reserve policy and the risk that they cut rates down the road. There’s a few strategies that you can employ for your clients.
You know, one we talk about is a barbell, where I view that as a compromise. It’s holding some of your investments short term, one, because they are… you know, the yields, there are attractive, but also gives you a lot of flexibility, and then taking some of those proceeds into the intermediate-or longer-term parts of the curve to lock in those yields with certainty. Like I said, I think that’s more of a… it’s a compromise, but also gives you a lot of flexibility. And then the second strategy is just a bond ladder. It’s one of the most simple investing strategies out there, but we think it takes the guesswork out of investing. We think it’s a nice way to just spread out those maturities, and you’re taking what the market is giving you rather than trying to time the market, which is what we think of a lot of investors are doing if you are very short. We view that as a, as a form of timing the market, Mark.
MARK: Thanks, Collin. Let’s move to Jeff. I’ve got a question here for you. Developed markets are outperforming the US, but emerging markets are, in fact, lagging. What’s driving that?
JEFF: Well, you know, overall what we’re seeing is emerging markets are really driven by what’s going on in China. International markets are generally doing well. The developed markets are showing stronger growth. We’re seeing much better growth than expected. I just talked about how it was basically around zero, but there was expectation for a recession in Q1 on energy problems in Europe tied to the war in Ukraine. That has not happened. But what we’ve seen is, you know, they’ve actually performed pretty well. And emerging markets have suffered despite really much stronger growth coming out of China. China, of course, accounting for about 30% of the EM Index directly. And more of that indirectly through countries that are really driven by China’s growth.
What seems to have happened is geopolitical tensions have seemed to have weighed on China’s stock. Haven’t weighed on the economy, but they did appear to weigh on the stock. So despite the strong growth and better than expected economic performance, China’s stock market peaked on January 27th of this year after a 60% surge on the reopening optimism, and they fell 14%. So what happened on January 28th? The spy balloon. China’s stock market momentum was burst by a balloon. So what happens next matters a lot to EM stocks. The next potential flareup in US China tensions could come this month. The Biden Administration may announce its executive order tracking and restricting outbound investments in China in critical technologies like semiconductors and quantum computing and AI. And those restrictions are probably not going to have much impact on most businesses, but tech stocks in the US and other countries could suffer if China retaliates in-kind in some way. And there are several ways in which they might do this.
For example, we just heard about the Activision-Microsoft merger that was just killed by UK regulators. Those are two US companies, but foreign regulators get to opine on these things because it can affect concentration in the global industry. China could kill or drag out the merger of other US tech companies. For example, Intel’s plan to take over Israel’s Tower Semiconductor is just one deal currently being reviewed by Chinese regulators. Those deals could see regulatory delays in China. Another potential risk is any restriction placed on exports of rare earth processing and magnet technologies, where China is a dominant position.
So these US-China tensions could actually increase in May and hold risks for tech stocks not just in China, that’s been weighing on Chinese stocks, but perhaps outside of China, as well.
But, Mark, if we look out past the potential flare up in May, tensions might begin to cool. Maybe there will be a call between Presidents Biden and Xi. There’s a lot of talk about that. Maybe the delayed trip to China by Secretary of State Blinken and Treasury Secretary Yellen and commerce secretary, others. They want to forge relationships with this largely new economic team in China after that had a lot of turnover at the two sessions meetings back in February. So if that happens, if tensions cooled, maybe in the second half of the year, perhaps, hard to predict, but that could lift the heavy weight that seems to be weighing on Chinese and overall EM stocks, and keeping them falling over the last couple of months here, despite some incredible economic performance and a brighter earnings outlook.
MARK: Thanks Jeff. Liz Ann, I’ll give you the last question and then we’ll start taking the live questions. It’s kind of a big broad question. What’s your take on corporate earnings, profit margins, and valuations?
LIZ ANN: So we’re, obviously, in the middle of earnings season, so there’s a lot more to come, but so far, the results have been better than what was a lowered bar in terms of expectations. At the start of the quarter, the estimate was for about a 5% year-over-year drop, which would be the second quarter in a row with negative year-over-year change in… and this is for overall S&P 500. Excluding energy, this will be the fourth quarter in a row in negative territory. So the beat rate has been a little bit better, but, again, there’s a lot more to go.
Valuations, that’s been a little bit tougher because if you go back to the… call it the first half of last year, the first half of the bear market, you actually were seeing continued earnings growth, but obviously a massive move down in the market, which compressed valuations to a much more reasonable level, kind of low teens area. More recently, you’ve seen a bit of stabilization in the market, but in an environment where earnings and out earnings, at least for the first half of the year, are declining, which means the multiple is now up to on a forward earnings 19, and the denominator, the E component, is still a bit of a moving target, not to mention the fact that inflation, although down from the peaks of a year ago, is still at a level that is not supportive of a 19 multiple. So there is still that push and pull in terms of, you know, pressures down on multiples from a macro inflation perspective, upward pressure on multiples because of the decline in the E.
The last thing I’ll say that has improved a little bit relative to the worst part of the pandemic is that analysts are flying a bit more blind than they often do, not quite as much as was the case a couple of years ago when you had a record percentage of companies that didn’t just guide down, they just withdrew guidance altogether. They threw their hands up and said, ‘You know, this unique uncertainty associated with the pandemic, we’re not even going to try to telegraph earnings for the benefit of analysts having some precision.’ That’s improved a little bit, but there’s clearly ongoing uncertainty. And what the impact has been is that analysts are less willing to adjust their estimates two or three quarters or a year out. They’re really only adjusting […audio dropout…] quarter conference calls. Profit margin estimates have moved down from about 17-1/2 to 15-and-change. And there’s probably more room to go on the downside, especially if inflation continues to come down, because that then eliminates some of that just inflation tied pricing power. And now with labor costs maintaining at a still fairly high level and demand coming down, that suggests the path of least resistance still is down for profit margins.
MARK: Thanks, Liz Ann.
Let’s take some live questions here. Mike, I’ll send the first one to you. Banks are getting hit in a big way today. What do you think the regulators will do to stop the whack-a-mole strategy? Do you think this gets out of control?
MIKE: Yeah, I mean, the confidence being projected here continues to be very high. And, you know, the regulators have consistently said that the banks, the three banks that have failed have all had pretty unique circumstances to their… you know, you look at Silicon Valley bank, for example. Extraordinary amount of uninsured deposits, very kind of an unusual client base, and that sort of thing. So they continue to project that, you know, these are pretty unique circumstances for these banks.
But there’s, obviously, a lot of concern about contagion. And the problem is the regulatory response is very slow. And, you know, as we saw in some of these reports, even some of the supervision wasn’t kind of followed through. You know, and with the Silicon Valley Bank, regulators identified problems months ago and really didn’t put pressure or keep pressure on the banks to address those problems.
And so, you know, it’s hard for regulators to turn on a dime, and I think it’s going to be tricky to see, you know, dramatic changes right away, just given the pace of regulatory change.
MARK: Thanks, Mike. Collin, this one is for you. ‘Would you please opine on all of the treasury securities that are maturing over the next three years, and that the rates, the interest rates that the Treasury will have to pay, you know, to roll that over will be much larger than it was prior to those rates, those bonds being issued?’
COLLIN: Yeah, that’s right, Mark. It will be a lot higher. If you look at just the T-bill market right now, yields of 4- to 5%, versus, you know, near zero for a year, a little bit higher than that for a year, and then in the, you know, say, you know, up to 4% last year. There is a lot of short-term debt that the US Treasury has outstanding. The average maturity of all treasury holdings, I believe, is around six years, but there is a good chunk that is treasury bills or short-term maturing notes that will be refinanced at higher yields.
So, clearly, that’s an increase in the interest expense US government needs to pay. It is coming from very low levels. Also, there’s a possibility that in the next year or so that actually comes down. So it might be more of a short-term risk relative to a long-term risk, but it absolutely is something to be aware of, something to be cognizant of.
We don’t think that it’s necessarily… it can’t be sustained in the near term. I mean, the path of debt may be over a long period of time, but right now, the ability to service the debt, even with the rise in short-term interest rates, the government still has the ability to do that right now.
MARK: Thank you, Collin. Let’s see, Jeff, I’ll send this one to you. ‘Liz Ann talked about the earnings for US companies. What is your assessment of the earnings for non-US companies, and what does that tell you, if anything, about the future direction of markets?’
JEFF: The earnings recession we’re in seems pretty mild, and companies are beating expectations by, you know, better than expected margin in Q1. But still, we’re looking at earnings declines this quarter, probably next quarter, probably the quarter after that. Again, mild, low single-digits, but generally, when we’ve seen even this degree of earnings declines in the past, as you hinted, Mark, it does tend to lead to a job downturn.
Now, certain industries are more effected than others. I talked about manufacturing versus services. We’re definitely seeing that. Industrials and materials, two manufacturing-driven sectors, are seeing the worst year-over-year earnings declines. Whereas services sectors, believe it or not, financials in Europe are actually posting some of the strongest numbers, again, in the services sector.
So, generally, there are more jobs in services than manufacturing, right? They use more capital to produce output in manufacturing, more people in services. So to the extent that earnings are coming down and they’re coming down in manufacturing, there may be less layoffs tied to that than there would be services in the weaker spot, as we saw back during the pandemic when there were tremendous number of layoffs around the world or furloughs in Europe.
So a little bit more of a muted impact in terms of the earnings downturn seems fairly mild, at least so far, and it’s not concentrated in services. Nevertheless, we are seeing a weakening up of the labor picture. And as that translates, hopefully, into… I only say ‘hopefully’… hopefully, into weaker inflation because that’s what we need it to do. If it doesn’t do that, then weakening of jobs really doesn’t do much for us at all.
But that’s the outlook, again, might take some time to get that much weakness in the labor market in order to really bring down core inflation in Europe, given, again, the earnings backdrop and where those job losses are coming from.
MARK: Thanks, Jeff. Liz Ann, this one is for you. ‘What does Liz Ann think of the current level of M2 and money velocity, and the Fed’s efforts to reign in inflation?’
LIZ ANN: Well, you know, M2 has had both extreme moves on the upside and extreme moves on the downside. At the peak of the influx of stimulus, of course, provided both on the monetary side and the fiscal side, you saw money supply growth jump to more than 30% year-over-year. And based on, you know, traditional economic theory that was a big contributor to the surge in inflation we saw. Now that has gone straight down into negative territory, and the theorists that believe it was a major driver would point to that as continuing this path of disinflation that we’ve been on. But there are other forces that have been driving inflation, and there’s those sticky components that aren’t as much impacted by things like money supply. But I’m still an adherent to the view that it does matter and that we will continue to be in this disinflationary environment. It’s just maybe not going to happen as quickly as a lot of people want or expect inclusive of the Fed.
You know, speaking of the Fed, I did see one question pop in. I know that’s your job, Mark, to monitor that, but since I caught it, I figured we were on this subject. You know, I think what the Fed is trying to do here is tackle inflation on the rate side from a tools perspective using their so-called macro credential tools inclusive of things like not just the balance sheet, but funding facilities like the new funding facility that was created in the aftermath of Silicon Valley Bank, as well as their traditional discount window to tackle the banking crisis side of things. And I think they’re also trying to avoid the errors that occurred with monetary policy in the 1970s, which were the fits and starts of policy: Raising rates. Money supply comes down. The Fed viewed inflation as being tackled. They eased policy and inflation was let out of the bag again. So you saw this sort of volatility, the inflation volatility, in money supply and fits and starts in terms of monetary policy. I think that’s what the Fed is trying to avoid.
MARK: Thanks, Liz Ann. Mike, I’ll send this one your way. ‘Can McCarthy cut a deal, or is he hostage to elements in the Republican caucus?’
MIKE: The question in Washington right now is exactly that. I think it’s going to be very, very challenging for him to cut a deal that can then get enough support in his caucus. There’s lots of speculation about whether they’ll end up having to, you know, pass something that has mostly Democrats in the House in order to get it through the House, but, you know, we’re going to have to see what the deal is. I don’t think he can put, you know, just a clean debt ceiling on the House floor and pass it with Republican support. I think it’s going to have to have some kind of plan to address the spending questions and other things. And I think the thought is among some Democrats that, you know, you set up some sort of commission or some sort of, you know, other mechanism for working through spending cuts, and I don’t know that that’s going to fly in the House.
I do think that the fallback here is potentially a short-term extension. It’s often said in Washington that Congress has one great skill, and that is kicking the can down the road if they can. And so, you know, if nothing is coming together, don’t be surprised if you see, you know, a relatively short-term extension or suspension of the debt ceiling that pushes us out, you know, into the September-type timeframe and buys them more time to negotiate. So I do think that’s a possibility.
MARK: Thanks, Mike. Jeff, this one is for you. ‘Will a more aggressive… if the ECB is more aggressive than the Fed, will that encourage overweighting European developed market stocks?’
JEFF: Well, there’s two ways to look at it. One, you can say increasingly tight monetary policy could be a negative for economic and profit growth even if it does support the Euro. You know, the other idea is, well, it’s because economic momentum is maybe a little bit stronger there and a little bit more durable, and the rates haven’t moved as far as they have in the US that maybe there’s more optimism there.
I think the reality is, is that the ECB is on the path to tighten a little bit further, but they are relatively close to being finished. There’s probably, including Thursday, maybe 75 basis points more to go before they find that they are in a more comfortable position with regard to the trajectory of core inflation. And what’s going on with the rate level.
I think, you know, the markets are really focusing on the fact that we didn’t see the deep economic downturn. So we’ve seen a pretty good rally this year, just, you know, again, European stocks up 19% this year. Don’t expect that momentum to continue. But I do think that we can continue to see relative outperformance versus the US. Again, looking at the differences in the banking system, looking at the relative differences in economic momentum, and, importantly, looking at the difference in valuations. Europe has been priced for a mild recession going into the start of this year, with a PE around 12 times earnings, below the 10- or even 20-year average, pretty attractive. So, actually, already braced for a downturn. So I think that gives us a backdrop where there’s more resilience to the markets, perhaps, in Europe here, should we see a further weakness in equity markets tied to some of these concerns, even including further rate hikes than maybe what we might see in the US.
MARK: Thanks, Jeff. Collin, this one is for you. ‘I’ve heard that move up in quality has been a suggested bond strategy. Do you agree and what does quality mean to you?’
COLLIN: We do agree. It’s been one of our key themes for most of the year. Often, we throw out that term ‘quality,’ and sometimes we might not explain it as clear as maybe we should. When we talk about quality fixed income investments, we’re talking about investment-grade-rated, highly rated bonds, so, generally, the things that are in the US Aggregate Index, US treasuries, agency and mortgage backed securities, investment-grade corporate and municipal bonds, or even certificates of deposit, obviously, within those FDIC limits. And CDs are certainly an opportunity lately with those yields, because of kind of the funkiness on the short end of the yield curve CDs are starting to look pretty attractive.
But we do like high quality investments and continue to suggest any investor move up in quality because you don’t need to take too much risk right now to earn what we think are still pretty attractive yields. I mean, investment-grade corporate bonds are a great example. It’s an area I cover pretty closely. On average, you can get yields of 5% or more in the investment-grade corporate bond market, with intermediate-term maturity, so moderate interest rate risk, low to moderate credit risk, but still yields at 5% or more. We think that’s attractive and probably what a lot of your clients have been looking for and waiting for years.
Now, one of the reasons why we’re suggesting you focus on quality is because we see a lot of risks in the riskier parts of the market, whether that’s, you know, junk bonds, bank loans, emerging market debt, things like that. As the Fed hikes rates, as the economy slows, you start to see volatility down there, and you tend to see price decline. When we look at things like high-yield bonds, we’ve been cautious there for the past, you know, six to 12 months, mainly because of the compensation that we as investors are receiving. The average spread that you get by considering high-yield bonds, the extra yield you get above treasuries, it’s only around 4-1/2%. Historically, during periods of Fed tightening, during periods of potential economic slowdowns, you see those spreads rise pretty sharply.
So with the inverted yield curve right now, with banks tightening credit standards, we don’t want to take those risks right now because we do see the risk of price declines going forward. There could be opportunities later in the year, maybe, but for now, we still suggest you focus on quality, again because of those attractive yields that are still out there.
MARK: Thanks, Collin. Liz Ann, this one is for you. ‘If we do end up in a recession, how much of that was already priced in during the October lows?’
LIZ ANN: I suppose the short and honest answer is I don’t know. Probably not appealing to listeners, but that is the honest answer. There’s, obviously, a wide range in terms of history and how bear markets that have had some overlap with recessions have performed. I don’t love to talk in averages, especially related to things like bear markets that overlap with recessions, because there’s just not a huge sample size. But for what it’s worth, the impact on a bear market, when you also have a recession with some overlap… they don’t line up timing-wise perfectly by any means… there’s not as big a difference in the performance of bear markets with recessions and bear markets without recessions. The average and median is only a few percentage points different in terms of how deep the bear market ends up going.
The bigger difference is duration of the bear market. You tend to have about 50% longer, on average, bear markets when you’re dealing with a recession. And, in part, that has to do with the monetary policy reaction function, the fact that the stock market tends to lead the economy. You don’t always see deterioration sufficient in the coincident indicators to make a judgment on whether the NBER is going to declare a recession. That tends to come way after the fact.
So the one maybe punchline to this story is, and only because I’ve gotten questions and comments from our clients, is why wouldn’t I just… let me paraphrase… you know, stay out of the market until we’re through the recession and we know it’s over? The average span of when a recession has ended and when you find out when it ended officially is 15 months. And the leading nature of the stock market is such that the launch off the trough has typically already been well underway. So waiting until that official announcement, for the most part, you’ve missed a lot of that leading indicator recovery that you get in the stock market. So just a commensurate word of caution around the whole nature of timing of recessions relative to bear markets.
MARK: Thanks, Liz Ann. Collin, I’ll give you the last question, and then we’ll summarize here. The question is pretty simple. ‘Do you like TIPS?’
COLLIN: That’s a simple one, Mark. We do like TIPS. They got hit really hard in 2022, mainly because their yields rose just like the yields of all treasuries, and the rise in yield and decline in price more than offset that principal adjustment. I think that caught a lot of investors off guard. You know, how could TIPS perform so poorly if inflation was so high?
Well, now because of that rise in yields, we think TIPS look relatively attractive. There’s two ways and two things you want to focus on if you’re considering TIPS. The first is how they compare to a traditional treasury. It’s known as the breakeven rate. It’s the difference in yields that a nominal treasury offers relative to a TIPS. And that’s, essentially, a hurdle rate, it’s what inflation would need to average over the life of that TIPS. So if you look at five- and 10-year TIPS right now, that break even rate is around 2-1/4%, and given that core inflation is still in the 4- to 5% area, that seems like a relatively low hurdle rate. Now, of course, those are for longer periods of time, five or 10 years. But given the current high level of inflation, that looks pretty attractive.
But more importantly, it’s just the absolute yield you’re getting. If you look at, say, intermediate-term TIPS, anywhere from three to 10 years or so, the yields are in the 1-1/4- to 1-1/2% range. But those are real yields, they already are adjusted for inflation. So regardless of what inflation does over the next five to 10 years, as long as you hold that TIPS, you would beat inflation by that amount. And then any inflation that comes in over that period of time would get added to that real yield for your nominal average annualized return. So I think that’s important.
So if you’re worried about inflation, if your clients are worried about inflation, we think those positive real yields right now make TIPS relatively attractive.
MARK: All right, thank you, Collins. So Liz Ann, let’s go kind of around the horn here. Liz Ann, what’s one thing you want to leave people with?
LIZ ANN: Neither get in or get out, our investing strategy. Those are just gambling on moments in time. I think that’s always an important message around things like diversification and rebalancing.
I also think from an equity selection standpoint, much as Collin touched on, on the bond market side, stay up in quality, focus more on factors, not monolithic sector calls, quality factors like high interest coverage, strong balance sheet, positive earnings revisions, reasonable valuations. I think that’s the best approach to take in what is still a very uncertain time.
MARK: Let me get unmuted here. Jeff, what is your summary?
JEFF: Similar thing. So those characteristics, higher quality characteristics, you’re going to find just more of those stocks in international benchmarks than in the US. It just has to do with the type of industries and the way the companies are managed. Generally, that’s one of the things that’s helping international stocks outperform again this year as they did last year. This is a longer-term trend I’ve been talking about for a couple of years now. But EM stocks are a tougher call. Coiled spring maybe, but could get more coiled in May, since I don’t see a trigger for the rebound in the near term.
And last, Mark, you got two weeks until Mother’s Day. Don’t forget.
MARK: Thank you. Collin, any final thoughts from you?
COLLIN: I’ll say it once again, focus on quality, so I can agree with Jeff and Liz Ann there. And then, more importantly, we still suggest investors and your clients gradually extend duration. It doesn’t mean to take all of your fixed income holdings and move them out further on the curve, but move some of those because we would rather lock in what we believe are attractive yields with certainty, because we do expect at some point down the road the Fed will be cutting rates. We don’t know how low they’ll cut, but whether they get to 3-, 2-1/2-, 2% we think a, say, 3-1/2% yield on a 10-year treasury will look attractive down the road, you know, when the Fed finally does begin to cut rates.
MARK: And, Mike, we’ll give you the final word,
MIKE: Debt ceiling is going to dominate the next several weeks here in Washington. Probably going to see some increase in market volatility as a result. Watch next week’s meeting between Biden and McCarthy. Remember, both sides want to get rid of this. They want to raise the debt ceiling. It’s about… now it’s about how do they save face and get the best deal possible. So watch that over the next several weeks.
MARK: Thank you, Mike. And we are out of time. So Mike Townsend, Collin Martin, Jeffrey Kleintop, Liz Ann Sonders, thanks for your time today. If you would like to revisit this webcast, we’ll be sending a follow up email with a replay link. Live attendance at today’s webcast is eligible for one hour of CFP and/or CIMA continuing education credit. If you watch the replay, you aren’t eligible to get credit. To get CFP credit, please make sure you enter your CFP ID number in the window that will be popping up on your screen, and Schwab will go ahead and submit that on your behalf to the CFP Board so you can get credit. For CIMA credit, you’re going to have to submit it on your own. Directions for submitting can be found in the CIMA widget at the bottom of your screen. And you can also download the CFA… CFP certificate, excuse me, for your records from the CFP widget below.
The next installment of this series will be on June 13th at 8:00 AM. Jeff, Liz Ann, and Mike will be back, along with Kathy Jones to cover the fixed income side of things. The theme of that event will be our Mid-Year 2023 Market Outlook. The format is going to be a little bit different. Instead of doing all Q&A, each speaker will have about 10 minutes to make a presentation with slides, and then we’ll open it up for questions.
Until then, if you would like to learn more about Schwab’s insights or for other information, please contact your Schwab representative. Thanks, again, for your time and have a nice day.