MARK RIEPE:  Welcome, everyone, to Schwab Market Talk. Thanks for your time today. The date is October 4^th, 2022. The information provided here is for general information purposes only, and all expressions of opinion are subject to change without notice in reaction to shifting market conditions. My name is Mark Riepe. I head up the Schwab Center for Financial Research, and I’ll be your moderator today. For those of you who are new to these webcasts, we do them once a month. Many of you took the opportunity to submit questions during the registration process. So we’ll focus the first part of the call on answering as many of those questions as we can, and then we’ll shift to answering questions that you submit during the event itself.

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Our speakers today are Kathy Jones, our Chief Fixed Income Strategist; Liz Ann Sonders, our Chief Investment Strategist; Jeffrey Kleintop, our Chief Global Strategist; and Cooper Howard, our Municipal Bond Strategist. We’re going to start by answering a few questions about the economy, then we’ll shift to talking a little bit about bond strategies, international markets. We’ll finish up with equity strategies, and then, as I mentioned, we’ll start answering some live questions.

So, Liz Ann, why don’t we start with you, got a couple of big picture questions about the economy. The economy is clearly weak, but the labor market is strong. What do you think about whether the labor market can continue maintaining that strength in light of the Fed’s actions?

LIZ ANN SONDERS:  Good morning, everybody. Thanks, Mark. I think there are already cracks appearing in the labor market that suggests some of the weakening, quite frankly, that the Fed has to some degree been trying to engineer here as a tool to get inflation down more sustainably. We’re already starting to see those. We just got the JOLTS data out this morning, and job openings dropped down to just a little over 10 million, which was one of the largest single-month drops in history. Now, the JOLTS data does lag a lot of other labor market data. It’s August data. That said, I wouldn’t expect the situation to have improved in the month since that data. So maybe we don’t have a subsequent additional drop to that same degree.

But we’ve also seen some cracks even before this JOLTS data came out. You had the ISM Manufacturing Index out yesterday, and that showed the employment component move back down into contraction territory. Even though the payroll gains have remained decent, you’ve seen some weakness under the surface in the Household Survey, the fact that multiple job holders are up, part-time jobs are up versus full-time jobs that are down, and hours worked have been coming down. So as is may be obvious, one of the early things that companies can do in advance of actually laying folks off is to shrink the number of hours that are worked. We’ve also seen layoff announcements up for the past three months.

So I think the answer is, no, I don’t think the labor market can remain as strong, and I think we’re already seeing signs of that weakness. But, again, the Fed has very pointedly said that some weakening in the labor market is, in their view, a necessary condition to bring inflation down sustainably.

MARK:  So, Liz Ann, given all that, what do you think is the most likely outcome of this cycle, a recession or some sort of a soft landing?

LIZ ANN:  I think recession is the more likely outcome. If you simply look at the 110-year or so history of the Fed and hiking cycles, we’ve had 13 of them, and we’ve had 10 recessions and three soft landings. And of those three soft landings, which were 1967, 1985, and 1995, 1967 was sort of a failed soft landing, in that we ended up just pushing off a recession, but we got one in 1969, so it just held it off for a little bit, where we had five or six years ahead after the ‘85 and ‘95 soft landings before we had the next recession. So really only two successful soft landings. And you add into the mix the fact that they’re combating a 40-plus-year high in inflation, simultaneously shrinking a $9 trillion balance sheet, while a war goes on between Russia and Ukraine, and the ongoing effects of the pandemic, not to mention the fact that growth was already in negative territory in the first half of the year, plus the Fed using the word ‘pain’ maybe as a euphemism for recession, again, as maybe a necessary condition, I’m not sure how that points the needle more towards soft landing. So I think recession is more likely. And, frankly, if it’s sooner rather than later, that might not be a bad thing from the perspective of either the economy—the sooner we get through it, the sooner we’re on the other side—but also from the perspective of the stock market.

MARK:  Oh, thanks, Liz Ann. Kathy, I wanted to bring you into the discussion, talk a little bit about bond strategies, and we’ve got some questions for Cooper about munis. With the Fed still hiking short-term rates, doesn’t it make sense to stay in short duration bonds or floating rate debt until they’re done with the rate hiking cycle?

KATHY JONES:  Hi, everybody. Yeah, this is probably one of the most commonly asked questions I get, especially from our retail clients, and, you know, obviously, there’s a risk with that. The first is that nobody rings a bell at the top. You don’t know it’s the last rate hike until usually well after that, and you start to see the economic effects, and the Fed either reverses course or goes on hold and gives us that signal. By then, chances are, you know, intermediate- and long-term yields have declined pretty substantially. We already have an inverted yield curve, pretty steeply inverted. So I think if you wait, you know, imploding rate, you’re going to ride the wave up, but you’re going to ride the wave right back down and miss that opportunity to lock in a income stream for clients that right now, frankly, is pretty attractive compared to where we’ve been over the last 10 to 15 years. So intermediate-term durations, high quality bonds, you can find, you know, yields in the 5%-plus area that can be, you know, very attractive for a long-term plan, and that may not be the case six months or a year from now, or even within, you know, a month of the Fed hitting the peak in rates.

And then, lastly, you know, I would just suggest that the Fed’s aggressive pace in this cycle suggests that we may be nearer the top than people might realize. You know, with only seven months into this rate-hiking cycle, we’ve already got the fastest pace of change in modern history. And with added QT onto that, we’ve got, you know, a steeply inverted yield curve, an elevated move index, you know, volatility, slowing economic growth indicators, and stress in global markets. I mean, all that seems to spell the likelihood of rising yields from here is probably less of a risk than the likelihood of falling yields if you’re trying to lock in some income for clients.

MARK:  I think given that in the taxable bond sector, where are you seeing the best opportunities right now?

KATHY:  Yeah, so we like investment-grade. We think that, you know, most of the larger companies that are investment-grade-rated have a pretty good leverage ratio still, have cash flow, and can weather the storm here. And in IG you get 5-1/2% right now. Now, that’s with a 7.2 duration on the index. You could go a little bit shorter and still get 4.8-, 5% in terms of investment-grade corporate. So we like that. That compares pretty well to the ag. The ag has yield about 5.7 and a duration of 4.7. So both of those look attractive. We tend to lean towards the investment-grade to get a little bit more bang for the buck.

And then, you know, if you’re willing to take a little bit more risk, we think preferreds are okay. Again, you’re getting yields north of 6-1/2- to 7%. Now, the duration is long, but if you’re looking to add a little bit more aggressive income, we think that most of the issuers, which are bank and finance companies, are in good shape to pay that. So if you can ride some of the ups and downs of the waves of the cycle, you can lock in a pretty good yield with preferreds here.

MARK:  Great, thanks. Thanks, Kathy. Cooper, let’s bring you into the conversation. Given what Liz Ann was just talking about in terms of the economy, where do you think just overall the credit quality stands for municipal bonds?

COOPER HOWARD:  Yeah, good morning everyone, and thanks, Mark. Overall we think that the credit quality of municipal bonds is relatively high. There are some weak spots out there, but we do think that we’re in a very good starting position. If you look at just kind of the overall makeup of the market, about two-thirds of the muni market is either double-A- or triple-A-rated. So it’s a very high credit quality market to begin with. We can also look at what would happen if a recession does occur. Tends to be that the way that municipalities are set up, it’s not an immediate concern. So for states and local governments, the two primary sources of revenue are either property taxes or income taxes. We’ve seen both of those surge quite a bit. They also operate with a lag. So income taxes, they tend to be based off of the prior years’ tax revenues. We also see that sale… or excuse me, property taxes are based off of an assessed value which lags the market value. So both of those, even though we may hit a recession, for municipalities you should actually start to see those slow after the recession occurs. And that coincides with what we’ve seen historically. So if you look at the 2007-2008 recession, not until about 2010 did tax revenues for state and local governments start to slow. So our view is that even if we do see a recession, it doesn’t pose an immediate concern to state and local government credit quality.

We can also look historically, ratings had also tended to hold up quite well when a recession does occur. For example, looking, again, at the 2007-2008 credit crisis for municipalities, the average downgrade was fairly nil, it was not that much. Whereas if you look at the average downgrade for a corporate bond, it was about .7 notches. Now, one notch, Mark, is the difference between something like double-A and double-A-minus. That would be considered one notch.

So, historically, we haven’t seen municipal credit quality falter in a recession, and given the strong starting point and the lag that revenues operate with, I still think that we’re in a strong case going forward.

MARK:  So where would you focus then, Cooper, in terms of, you know, the credit spectrum, the duration spectrum, where is that sweet spot?

COOPER:  Yeah, so Kathy spoke to some of the opportunities in the taxable bond market. I also think one of the opportunities is in the municipal bond market. If we look at yields in the muni market, the broad index is yielding about 4%, and that’s on a pre-tax basis. So after you adjust it for taxes, you can gross it up for those who are in the top tax bracket, and that can be over 7%, and that’s with a duration of about 5.6. So you’re getting higher yields with shorter duration in the broad municipal bond index.

Looking at credit quality, I think that even though we have a strong view of credit quality, it does make sense to move up in credit quality, focus on higher-rated issuers. And the reason for that is that spreads have risen. So we think that even though we have a positive view, given the rise in spreads, no longer do you have to plum the depths of the credit market or the lower rated portions of the muni market to find any yield. There are attractive yields with higher rated issuers and you just don’t have to take that risk. So in terms of a duration, we’ve seen relative values start to increase and we would suggest, like Kathy had mentioned, consider extending duration, we think that we may be at or near the peak in the cycle. So it does make sense to not stay short-term, but target a little bit of an intermediate-term duration and take advantage of that rise in yields, Mark.

MARK:  Thanks, Cooper. I’ve got some international questions here for you, Jeff, but first I wanted to go to Kathy. Kathy, the dollar has been a beneficiary of the Fed’s actions. Do you think that trade is basically played out at this point?

KATHY:  Well, I think we’re getting close to the top because the dollar will probably peak as we see the peak in the Fed Funds Rate. And as I said before, I think we’re getting to a point, at least in the near-term, where the Fed is at least reconsider the pace of rate increases, if not the actual rate increases. You know, dollar strength is beginning to be a real problem for the rest of the world. We’ve heard more and more of our trading partners and other institutions coming out and asking the Fed to slow down. We tend to export inflation with a strong dollar. It works in our favor because it holds down import prices, the dollar buys more, and it slows down exports because our exports are less competitive. So, right now, it’s really working in the favor of the US and the Fed in its efforts to pull down inflation.

But, you know, the spillover effects of the strong dollar are now… and the tightening, are now being seen in the financial markets. So we’ve had Japan intervened to support the currency, the first time since the ‘90s. China has had to come in and request, you know, that the local bank is going to help out in supporting its currency within a band, even though it’s been falling. Emerging market countries under stress because of a strong dollar, because a lot of borrowing, both in companies and in governments, has been a function of borrowing in US dollars. And, of course, paying that back with an elevated dollar gets more stressful.

So I think what we’re starting to see is kind of this breaking point where the dollar is more of a problem for the global economy. A long time ago, John Connolly was Treasury Secretary, and he told our trading partners, ‘It’s our currency, but it’s your problem.’ That was back in an era when we were not as financially interlinked as we are now in the markets and in the global economy.

And so I think we may be getting near a peak. It doesn’t mean it’s going to come down substantially. It may have to wait for the Fed to start, you know, signaling that the rate hiking cycle is over. But it wouldn’t surprise me if it happens, you know, end of this year or early next year.

MARK:  Thanks, Kathy. Jeff, I got a question for you. Another currency that’s been in the news has been the UK pound, and this question is a little bit snarky, but is the UK turning into another emerging market?

JEFF KLEINTOP:  Well, it may not seem as snarky as ... you know, there have been a lot of questions about this. I’ve gotten the question directly from customers. I’ve seen the question asked on social media. Look, the UK has seen four prime ministers in, what, six years. It’s had three general elections over the past seven. The Brexit referendum kind of cut off its trade relationships with its neighbors. And we’ve seen the collapse in trading volumes and stalled growth. Now, its currency has plunged. So I get the EM analogy and concerns about the economy going forward, but I don’t think it really fits under close scrutiny.

In an EM crisis, rising rates and falling currency reflect a devaluation and default risk, and that really isn’t plausible for the UK. An EM central bank, for example, couldn’t calm markets by monetizing government debt like the BOE did last week.  It said that would just add fuel to the fire. But the UK actually pushed yields lower by about half a percentage point with their action last week, and the pound has rebounded about 7% since then.

So, instead, the lens through which I see Britain’s experience today is that of a developed market, open economy, with a large current account deficit subject to capital outflows. And it reminds me of Canada in the early 1990s. You know, back then, Canadian deficits were high. They were aggravating inflation. The Canadian dollar was falling. And the Bank of Canada raised rates a lot to contain the inflationary consequences of that lower currency, and that worsened debt service and deficits. It took a change of government and a number of years of austerity, but by the late 1990s Canada’s debt-to-GDP ratio was falling, and the current account was in surplus.

So it looks to me like markets today are creating similar conditions to correct these British imbalances. Higher real rates will suppress inflation eventually and domestic demand will also come down along with that. The lower pound will boost net imports.

And that last part is really important. For investors, it’s important to remember that the UK businesses are largely exporters and historically benefit from a weaker pound. And to illustrate why, we can just look at the fact that the largest share of revenues for UK companies are in dollars. 27% of revenues for companies in the MSCI UK Index are in dollars. That’s bigger than the 19% of sales that are in pounds, but most of the costs are in pounds. So the currency that has the larger share of sales is up 20% this year, while the currency with the larger share of costs has plunged, and that’s resulted in some margin expansion. Earnings estimates for UK companies have continued to move higher in the second half of this year. They’re up 7% this year and trending higher. Now, you know, not what we’re seeing anywhere else. That isn’t something an EM country could claim. I’m not suggesting that things are fine in the UK, but the challenges are a symptom of tightening global financial conditions and not a driver of it.

MARK:  Jeff, I’ve got another question here about another European country, Italy. Is the new government something that investors should be worried about?

JEFF:  No, I don’t think so, at least not compared with all the other things to worry about right now. It’s a crowded list. I think that, at least initially, the new coalition government will stick to the fiscal targets that it agreed to with the EU and avoid a big clash. The likely new Prime Minister, Giorgia Meloni, has made pretty reassuring comments on both fiscal policy and on Italy’s role in the Eurozone throughout the campaign. There was no threatening to leave the euro. And she’s no doubt aware that missing EU fiscal targets would be very costly. It could cause Italy to miss out on some of that next generation EU funding, which is hundreds of billions of euros, a massive aid package, and green transition fund for Europe that Italy is going to get a nice chunk of. Doesn’t want to walk away from that. It could also result in Italy losing its eligibility to the TPI, the Transmission Protection Instrument, designed to keep Italian bond spreads from widening too far from German bond spreads. So all of that is really in Italy’s best interest to adhere to those fiscal targets.

That said, the new government will probably run slightly looser fiscal policy than the Draghi government did. It might try to negotiate the repurposing of some of that next generation EU funding to deal with the energy crisis. But this is something the EU might be open to, provided the changes aren’t too big.

So I don’t see this as something investors need to be overly worried about.

MARK:  Thanks, Jeff. We’ve been having a few questions here about the Fed. What about the ECB? I mean, the Fed seems to be going out of its way to demonstrate that it’s going to be tough on inflation whatever the consequences. What about the ECB? What is their mindset?

JEFF:  Well, they seem to be focused on a somewhat similar path. They are certainly putting in place much more aggressive rate hikes than many would have thought that they would have put forth. And there’s probably a few more to go.

But there are signs of slowing in Europe and elsewhere among developed market central banks. We’ve got the RBA, the Reserve Bank of Australia, surprising with a less than expected 25 basis point move yesterday, and the market pricing in only a 75% chance of another 25 basis point rate hike in November in Australia.  And even more significantly, two weeks ago, I think it was… yeah, it was on the 22^nd, I believe, Norway’s Central Bank signaled it might be close to its final rate hike after they made a 50 basis point move. Norway was the first among the group of 10 central banks to hike policy rates a year ago, and now it’s signaling it might be the first to halt. And Canada appears to be close to the peak in rates, maybe two more 25 basis point rate hikes to go. All of that begins to suggest that the potential for central bankers to slow or halt rates is a likelihood here as this global recession deepens.

The global central bank policy rate, though, is still pretty low. For global developed countries, it’s… you know, ex the US, it’s like 1.5%. Very low. It was 3% ahead of the great financial crisis. More significantly, they’re deeply negative on a real basis, on an inflation-adjusted basis, which is how central banks measure the effect of policy rates. I think if central banks respond to the weakening labor market in the coming months and stop hiking too soon or cut rates while the real rate is still firmly negative, there’s a chance inflation might rebound, and if it does, even higher rate hikes might ultimately be needed to quell inflation, which, you know, means we might get to a point here in the near term, the market gets excited that we’re going to pause, maybe even see some cuts potentially next year, but then it may turn out that they actually turn around and need to hike again. That, actually, played out in the 1970s and the early 80s among major developed market central banks. We saw it in Europe and the US and elsewhere—rate hikes, followed by cuts, followed by hikes again to even higher levels.  So that would be a recipe for more of 2022’s market swings next year, even if initially the market would get excited about a pause here by some of the world’s major central banks.

MARK:  Thanks, Jeff. Last question here for you, Kathy, and then I’ll switch to equity strategies with Liz Ann. I think you actually kind of implicitly answered this in your question about the dollar, but the question is what is your take on global markets? Do you see risks that these global markets, non-US markets, will be destabilizing the US market?

KATHY:  Yeah, I do see that risk. And I think that this is one of the issues that the Fed and other policymakers actually have to deal with, is the interconnectedness of the markets. It’s not so much that the Fed can’t go its own way, it’s just that it has repercussions throughout the global economy, and then spillover effects back to the US. So if we move too far too fast and things get unstable, it spills back onto the US economy and US markets. And we’ve had a little bit of a taste of that in the last week or two. And I think that is a potential, but my guess is that we’ll start to see central banks kind of dial down the rhetoric a little bit or slow the pace to try to manage this, and that will be kind of the next phase of this cycle.

MARK:  Thanks, Kathy. Liz Ann, let’s turn to you. We’ve been talking about the currencies and the dollar here. How has the dollar been affecting or will it affect US stocks?

LIZ ANN:  Sure. So there’s lots of ways you can look at that. If you look at just a rolling correlation between moves in the dollar and moves in the S&P, we move back into negative territory at the beginning of the pandemic after having been in positive territory prior to that, going back to the second half of 2013. And the correlation has dropped significantly into inverse territory, and it’s now an inverse 0.65, and that’s on a rolling one month basis, which is the largest inverse correlation since 2011. And so, clearly, you’re seeing opposing moves, for the most part, on a rolling one month basis. So stronger dollar, weaker equities helping to explain the weakness notwithstanding the last couple of days in the market, although, in part, that may be because of some of the retreat we’ve seen in the dollar.

There’s also earnings impact. Rough estimates are for every, you know, percent or so change in the dollar, it hits S&P earnings by about half of that. In other words, a half a percent. If you look at how within the market, within an index like the S&P, how stocks that are more or less exposed or behaving. So stocks that have more international revenue exposure tend to be hurt more by the strong dollar. And Goldman Sachs keeps a number of indexes that are very interesting to track that are somewhat thematic as it relates to some of these underlying trends. So they have an index that tracks the top 50 stocks with the most international revenue exposure versus the top 50 with the least international exposure. And just on a year-to-date basis, the international biased revenue names are down 28%, whereas the more domestically-oriented are only down about 12%. And if you go back to the trough, the recent trough and the dollar about a year and a half ago, the differential in performance is even more stark, with the international biased index down about 16% versus the domestic biased index up about 11%. So you can clearly see the behavior.

I think the tell maybe to a greater degree will be once we start getting third quarter reports, because even during the second quarter, you had a lot of big notable names that started to talk about how the dollar was impacting earnings. And it wasn’t just some of the big tech names. Yeah, big tech has 60% or so of revenues tied to oversea sources versus somewhere in the 40- to 45% range for the overall S&P 500. But it wasn’t just tech stocks that were warning about some of the hits associated with the dollar. You had companies like Medtronic and Philip Morris and Johnson & Johnson, in addition to companies like Microsoft and IBM, even Netflix warned about it. So I think there’s probably going to be more, if not proactive comments from companies about the impact of the dollar. I’m guessing on earnings calls, there will be a lot more questions from the analyst community on the forward-looking impact of dollar moves, which could both be on the upside and the downside, obviously.

MARK:  Thanks, Liz Ann. You mentioned that September was, you know, a pretty lousy month for US stocks. First couple of days here of October, much better. What’s your sense as to overall investor sentiment? What are you seeing in the different sentiment metrics that you track?

LIZ ANN:  I think we’re getting to the point of better news on this front. As you know and probably many of the viewers here know, I do keep a close eye on sentiment indicators. And I think it’s important to separate them into behavioral buckets and attitudinal buckets. And on the attitudinal side, we have hit what I would call sort of washout, puke phase, whatever term you want to use, capitulation, measures like AAII percentage of bulls at a very low level. The rub is that we haven’t fully seen that confirmed with behavioral measures. You haven’t seen the kind of spike in the Volatility Index. You haven’t seen fund flows go into a contraction territory. You have seen a move up in the put-call ratio. There’s a Panic/Euphoria Model that SentimenTrader tracks that’s akin to what my late great friend, Tobias Levkovich of Citi had created, that is mostly behavioral measures and that has moved into the panic zone. Not quite to the same kind of levels that you have seen in recent lows, whether it was the 2020 bear market low associated with COVID, or 2009, but we’re certainly getting there in those measures.

You know, interestingly, back to AAII, the most common part of their survey that gets the most attention is their Sentiment Survey, the weekly question they ask of their members, ‘Are you bullish or are you bearish?’ But they also ask about equity exposure. And that’s come down, but not what you would typically expect to see. So earlier, in the spring this year, exposure to equities was around 71%. Now it’s down to about 63%. But at the recent major market lows—2020, 2009, 2002—that had dropped to below 50%. So maybe there’s still a little bit more room to go on the downside in the behavioral measures, but I think the sentiment environment is shaping up to be more of a positive backdrop for the market. And as you know, we haven’t been able to say that for a while.

MARK:  That’s right. One more question for you, Liz Ann, then I’ll switch to Jeff. So, you know, kind of what do you think, what are the best opportunities in US stocks right now?

LIZ ANN:  I continue to think that taking more of a factor approach versus, you know, a sector-based overweight/underweight approach, or even a traditional style approach, if you’re talking about just buying or not, the growth and value indexes, I think focusing more on factors, which has been an emphasis, with still a quality bias, we think quality-oriented factors, but also factors tied to where fundamentals suggest things are dear. You know, positive earnings revisions, positive earnings surprises are harder to come by, so companies that are displaying those. Aggressively higher interest rate environment that put strains on companies that have higher debt and less ability to pay interest on that debt. So stronger balance sheet, companies with stronger cash flows. So that’s the approach we’ve been telling investors, especially stock-oriented investors to take, is sort of that quality wrapper where you look where there’s a shortage of some of these fundamentals and then screen for the companies that display some of those characteristics that are more dear in the broad economy.

MARK:  Thanks, Liz Ann. One more question for you, Jeff, and then we’ll start going through the live questions. Jeff, what opportunities are you seeing in the international equity market area?

JEFF:  Well, they are just an extension of what Liz Ann just talked about. Really, the focusing on how to implement that quality theme across portfolios. One way we’ve been defining high quality this year is short duration. Shorter duration stocks have helped manage the risk of rising rates. Put simply, stocks with more immediate cash flows, rather than cash flows out in the distant future have outperformed since rates bottomed in 2020. They’ve outperformed quite powerfully this year, as well. The way we find short duration stocks is using the price-to-free cash flow ratio. The lower the price to free cash flow, the shorter the duration. And those low price-to-cash flow stocks have been doing very well. I wrote an article about this back in the first quarter of this year on schwab.com. It’s still very relevant. There are more short duration stocks found outside the US. In fact, the non-US indices are made up about 70% of short duration stocks, the reverse of the US market, and that’s one reason why international stocks are outperforming the S&P 500 by 800 basis points measured in local currency, even though they’re lagging by 400 basis points measured in dollars, thanks to this year’s dollar strength.

Mark, another way we’ve been defining high quality stocks this year is dividend payers. Generally speaking, a sizeable dividend is a sign of financial strength and good cash flow. High dividend-paying stocks that outperformed during past recessionary bear markets, and are outperforming by a wide margin again this year in the US and Europe and Japan. There certainly can’t be any guarantees, but these stocks may continue to reward investors as company cash flow appears adequate to pay dividends even as the overall economy struggles.

MARK:  Thanks, Jeff. Liz Ann, I’m going to give you the first question here. ‘What impact do you see the upcoming mid-terms having?’

LIZ ANN:  So there’s a lot more commentary out these days as we approach, in terms of everything from what the four-year election cycle tends to look like, the fact that the mid-term year has historically been the weakest year of the four, but you have a decent consistency in a rally once the mid-term election has passed. I’m always pretty cautious about expressing views tied to calendar or election cycles as some gospel for what the market is going to do. Quite frankly, what has happened this year already bucks what the market typically does in mid-term election years. Yes, it’s been a weak market, but it tends to… mid-term election years tends to be more choppy in the past, and then you get the lift after November. Clearly, this has not really been a choppy market, but a very weak market.

I also think that what often can cause a bit of that boomerang is if leading into a mid-term, if there’s a prospect of a change in leadership, there’s often, in turn, a prospect of a significant change in policy proposals, whether it’s on the spending side, whether it’s on the tax side. And I think the nature of the environment, the fact that we’ve already had massive stimulus that came through the early stages of the pandemic, less likelihood that that’s going to be unleashed looking ahead; we had significant tax cuts back in 2017, that’s not really top on the list of what Republicans are suggesting they want to do. So I think implications may be more, not so much on the margin, but maybe more at the sector level if you think about where the policy biases are, be it on the energy front, on the regulatory front, on defense spending. But even there you tend to see a lot of action at the sector level that is front running in nature, trying to game what’s going to happen. They don’t tend to turn into true long term leadership trends in one direction or another, and we often sort of reiterate that force when we get around elections, whether it’s mid-term election or a presidential election. So I’d be cautious about trading around or trying to anticipate some of those changes, thinking that they’re going to turn into longer term kind of appropriate bets to make in the market.

So I think you’ll see some sector movement, but I don’t anticipate any significant major policy shifts that are going to move the needle beyond what are all the other factors that are moving the economic and market needle right now, aside from the mid-terms.

MARK:  Thanks, Liz Ann. Kathy, I’ve got a couple of questions for you. I’m going to try to merge these into one. Kind of the first part, ‘Do you see the US reversing course from QT back to QE at some point, like the UK?’ And I guess the second part of that, ‘Given the lag in monetary tightening and sizeable consecutive increases the Fed has reasonably made, what is the risk of a pause? Do you think that’s still possible?’

KATHY:  Okay, on the first one, I would just point out that the Bank of England’s move was to stabilize their bond market. They’re not calling it QE, so it’s not a program where they’re trying to stimulate economic growth, so much as to stabilize their bond market after a big fallout in the pension fund area. And their pension funding is very different than ours, it’s a whole light years away. But that was a crisis moment. They said they’re going to unload the bonds at some stage of the game, we don’t know when, but this is not a program to continue buying bonds as QE would imply.

I don’t think the Fed will reverse its QT until it is ready to start actually cutting rates. So QT is running in the background, and it is having a significant impact in terms of adding to the tightening through rate hikes. So I think the Fed would like to continue it as long as they’re in not easing mode. Once… I’m sorry, should have put that on silent. Once they’re in easing mode at the end of the cycle or start of the next easing cycle, then it doesn’t make any sense to continue rolling off the balance sheet. But for the moment, I don’t think they will stop it. I think this is one of the big drivers here behind the scenes. It’s helping to tighten policy. They might actually ease up on the interest rate increases and keep QT running in the background.

So sort of the second question is how close are we to the Fed pausing or stopping? You know, I would say that there’s a good case to be made that they could follow what the Central Bank of Australia did last night, and instead of increasing as rapidly as they have been, start to slow the pace of increases. That is not unusual for the Fed, or for any central bank. And after the jumbo rate increases we’ve seen, and all the volatility in the markets, and the lagged impact that monetary policy has, it wouldn’t surprise me if we start to move more towards 50 basis points away from the 75. And probably getting closer and closer to the top of the cycle.

MARK:  Great, thanks, Kathy. Cooper, I’ve got a question for you about municipal pensions. So given the losses that pension funds have suffered, are they in a position to continue to make good on their pension obligations?

COOPER:  Yeah, so, right now, I don’t see an immediate concern in terms of pension funds affecting municipal credit quality. Obviously, this year has been a pretty difficult year from an equity perspective, and that tends to be that municipal pension assets would decline in value. Now, that’s really just wiping out a lot of the gains that we’ve seen prior to. So prior to coming into this year, municipal pensions were at all-time record level highs. So they were in a very good shape and it wasn’t posing an immediate concern.

The thing about pensions, also, is that we can look at the aggregate numbers, but really what’s more important is how much municipality tends to be paying towards their pension. And for most municipalities, they are making good on their regular pension payments. They’re keeping the issue at bay. And you can also look at it as, is it crowding out debt service? And for debt service, the median amount that municipality pays towards debt service is about 3% of their own source revenues, so it tends to be a very low portion. So there’s a lot of flexibility that state and local governments have to make good on their debt service, which is, obviously, the important thing from a bondholder perspective.

So immediately, it doesn’t appear to be a concern. There are, obviously, some issuers that do have outsized pension plans, I’d point to Illinois, for example, but they’ve actually been receiving credit rating upgrades, so their credit quality is pointing in the right direction. New Jersey is a similar one, they’ve received credit rating upgrades.

So immediate concern? Probably not. Longer term down the road, it’s an issue that bears watching.

MARK:  Thanks, Cooper. Jeff, this one is addressed to you. ‘Is there more to poor international and EM performance than a strong dollar? Is there more needed for international to outperform relative to the US, other than a weakening dollar?’

JEFF:  Well, they are outperforming if you take away the dollar situation. So I’d say no. You know, what we’re seeing here is, you know, even the UK, I mean the FTSE Index is down, what, 5% this year, versus, you know, 20%-plus for the S&P 500. The Nikkei 225 is down something similar, 2-, 3-, 4-, 5% this year, you know, versus a much deeper decline.

So, no, I mean, I think, that we’ve already seen compressed valuations in those markets. More durable earnings growth. I mean, not to say that they’re immune to declines. I think we will see some declines there, but they’ve held up a bit better, and prospects were a little bit more sober going into the year. So, no, I don’t think there’s a lot of things that need to have to come together to turn around international performance. I think, more importantly, it’s this break in the dollar. Again, EAFE would be outperforming by 800 basis points if it weren’t for the dollar strength this year. And I think as you think longer term, you know, maybe that begins to work itself out.

Over the long term it doesn’t make sense to use hedge products, currency hedge products to invest in international markets, simply because the currency provides you with (a) some diversification, and (b) over time tends to wash out. But in the near term, from time to time, hedging can make some sense as it has this year. But I think as we look out, this is an environment that suggests that international stocks have already started outperforming. In part, because they’re shorter duration equities, they pay higher dividend yields. There are a lot of characteristics that have been rewarding in the markets, even in the US here, that show more prevalent in international benchmarks. So that’s one of the reasons why fundamentally they are outperforming this year, and it’s really just a currency issue so far.

MARK:  Thanks, Jeff. Kathy, this one is for you. ‘What should be the rate for 10-year treasuries if the long run inflation rate is 3.5%?’

KATHY:  So I think most models, and the ones used by the Fed, would suggest that, you know, the real interest rate above the treasury rate would be, you know, 25 to 50 basis points. We get into a question that has a lot of academic back and forth about what our real rate should be, and what R-starred should be, which is the underlying rate at which we can grow, etc.

But I would say, you know, historically, that yield… the difference between inflation rate and the yield premium in 10 years has fallen as economic growth has fallen, as inflation has been more stable over time.

So 50 basis points, 25 basis points, if that’s where we end up, and it looks like that’s going to be the forward-looking inflation rate, that would imply 10-year yields probably around 4%. But right now when you look at where the market is pricing inflation five and 10 years down the road, it’s closer to 2-  to 2-1/4%. So I know people say we’re going to get to 3-1/2 and stop. I’m not really sure why they’re saying that, but that being the case, I would pencil in 25 to 50 basis points.

MARK:  Thanks, Kathy. Liz Ann, are analysts still too optimistic about 2023 earnings?

LIZ ANN:  Well, if we were running out of time, I’d say yes, but I’m assuming the person asking the question probably wants a little longer an answer to that. Both 2022 and 2023 have started to come down, but I think there’s more to go on the downside. I think it was around early June when you had the highest consensus estimate for 2022, at around $230. That’s the dollar amount of S&P earnings. That’s now down to about 223. I’m not sure where the 2023 number is, but it’s a percentage increase up off of 2022. I think both this year and next year’s calendar year earnings still have to come down.

Keep in mind that even as of the second quarter, ex energy earnings were down 2% year-over-year, and they’re expected ex energy to be down again in the third quarter. But then the consensus is that we see a lift in the fourth quarter, and a continued lift through the first half of next year. I think that that’s too optimistic, and I think those have to come down. And even inclusive of energy, I think within the next few quarters we will go to a negative year-over-year percent change, which is not embedded in the consensus right now.

So the net is that the path of least resistance is down. The strength in the dollar, high labor costs, and an environment of waning demand, pressure on productivity, and, in turn, pressure on profit margins. So I don’t anticipate a significant collapse in earnings, but more to go on the downside in terms of forward estimates.

MARK:  Thanks Liz Ann. Jeff, I’ll send this one your way. ‘If Russia uses tactical nuclear weapons against Ukraine, what impact will this have on the markets and the global economy?’

JEFF:  They will probably go down. That will be my short answer, if we were short on time. Look, there’s certainly a risk that Russia chooses to expand the conflict either beyond the borders of Ukraine, attacking convoys of weapons coming in, or, yeah, escalating nuclear threats, using some sort of other weapon of mass destruction. It seems unlikely. A bit more saber-rattling, you know, in an attempt to sort of placate domestic critics and continue this ongoing conflict that, you know, he expects to resolve with at least some sort of territorial increase for Russia.

So I don’t know. Obviously, that would be negative news. I’m no expert on geopolitics or defense strategy. Certainly, I don’t know what’s going on in Putin’s head. But I think what we’ve seen so far is, you know, fairly limited developments in terms of expanding the war beyond the borders. In fact, it’s remained almost calcified to certain areas of Ukraine. And, you know, if you look back to prior to the start of the breakout of the war, those eastern portions of Ukraine were already constantly fighting with Ukrainian forces. There was a ceasefire line that had ceasefire violations on it every single day, with Russian forces fighting Ukrainian forces, and we’re almost back to that very same scenario.

So I don’t see an environment here that would prompt any type of tactical nuclear weapon, whatever we want to call that. But certainly that will be a terrible risk, not only for Eastern Europe, but for the world as a whole, and would certainly pull down markets pretty dramatically. Obviously, markets have been priced in that scenario.

MARK:  Thanks, Jeff. Let’s see, Kathy, ‘Are countries throughout the world moving away from the US dollar? It seems some Asian countries are using a different currency for trade, especially with sanctions happening on oil and gas. What risk is that to the dollar?’

KATHY:  Well, you know, in actual fact, most transactions still globally, or a rising level of transactions globally are still taking place in the US dollar, and that’s actually increased over the years. There’s always talk about moving away from the dollar for different kinds of trade. I would say, right now, at the moment, there’s not a clear alternative to the US dollar, and so its influence has actually gained over the last five or six years. And, you know, most financial transactions still take place in US dollars, most global trade still takes place in US dollars. It doesn’t seem likely that that is going to be something that happens very quickly. Typically, when currencies shift, it takes a very long time because you’ve sort of institutionalized the factors that go into global trade and global transactions. So I would not say it’s a near-term threat or a threat over the next couple of years.

MARK:  Thank you. Kathy. Liz Ann, this one is for you. ‘How long do you think it will take for inflation… or for inflation rates to return to the Fed’s target?’

LIZ ANN:  Well, I, actually, just yesterday put a chart on Twitter that was a bit of a scenario analysis. It looked at the track of core CPI up to the most recent data point, and then different scenarios in terms of the month-over-month change in CPI. And it doesn’t cover every scenario, because it assumes… let’s say, we have no change month-over-month, and it assumed a consistent no-change. That’s not going to happen, but just for illustration purposes. You would have to start to see month-over-month declines to get not back to the 2%, but to call it… have a 2 handle on it by, you know, February or March. Obviously, if we saw some acceleration and we continue to see increasing month-over-month, then it’s going to take longer, even considering base effects that start to work to the benefit of lower readings. So I would say, you know, go on the Twitter feed and you can see the various month-over-month change scenarios, and how quickly it would bring inflation back down to something sub-3%.

MARK:  Thanks. Thanks, Liz Ann. Kathy, this one is for you. Actually, it’s kind of related to what Liz Ann was just talking about. ‘The Fed’s target inflation rate is 2%. Is that core inflation or something else?’

KATHY:  Yeah, that’s what they call their core PCE, the deflator for personal consumption expenditures. That’s kind of the benchmark that the Fed uses. They look at all kinds of inflation rates. So that’s not exclusively the one that they look at, but it tends to be the one that they highlight in their projections, and their summary of economic projections, and that’s sort of target that they use. So, you know, still above that, around 4-1/2-. I think 4.7% at this stage of the game, but it’s considerably lower than where CPI has been.

MARK:  All right. Thank you. Thank you, Kathy. Why don’t we maybe go for one last question for each of you, and that’s our what are the three things you’d like the viewers to take away from what we’ve been talking today? Liz Ann, why don’t you go first? I think we’ve lost Liz Ann’s connection. So, Jeff?

LIZ ANN:  There, I’m back. I wasn’t unmuting for some reason. So, you know, we’ve talked a lot about the Fed, and policy and impact on the markets, and still get questions about why hasn’t the weakness in the market volatility caused the Fed to step back in. The whole notion of a Fed put, which we’ve been arguing for a while, that’s sort of been put to bed. And, in fact, I think market weakness is not really a bug of what the Fed is doing. It’s a feature of what the Fed is doing, in that it helps tighten financial conditions. Now if we ended up with financial system instability then maybe that would be an impetus for the Fed to pause or pivot, whatever you want to call it.

I touched on staying up in quality, especially if you’re stock-picking oriented and I touched on some of the factors we’ve been emphasizing.

And then the third is, I get questions all the time, you know what types of things from a macro perspective would you look for as a sign that we’re sort of getting to the end or closer to a bottom, and I would say stabilization in forward earnings estimates which we touched on. I think you need to see stabilization in housing, maybe something like the NEHB Housing Market Index, and a stabilization in PMIs. Not just US PMIs like ISM but global PMIs. And from a more macro perspective those would be the things I would be keeping an eye on to get a sense of, okay, the worst looks to be over.

MARK:  All right. Thank you, Liz Ann. Jeff, what are your summary comments? What are your two or three key points?

JEFF:  Yeah, so three things I talked about. Europe’s financial conditions continue to tighten and that’s pressuring the economy and exacerbating the balances, but the UK and Italy are not likely to blow up or be major sources of market risk amidst what is already a recessionary bear market.

Another point, encouragingly some developed market central banks that led the rate hikes a year ago are now signaling they’re slowing or ending their series of hikes. The downside is that it is likely already too late to avoid a mild global recession but that seems priced into most markets already.

Finally, consider short duration of high dividend stocks is a way to stay invested. So far this year, those strategies have only seen about half the downside of the overall market, Mark.

MARK:  Thanks, Jeff. And, Kathy, what are your three key points?

KATHY:  The first is that we believe you should extend duration and not sit around trying to, you know, guess the peak in the Fed Funds Rate. We do think it’s closer than perhaps the dot plot implied or that many believe, but this is an opportunity… since we’ve had accumulative rate hikes, quantitative tightening, all that’s ongoing, this is an opportunity, we think, to lock-in some attractive income streams for clients. We like barbells, ladders, always a classic way to do that.

Secondly, just keep in mind volatility is likely to stay elevated as long as the Fed is in tightening mode. I don’t think the pace of tightening is sustainable. The implied and realized volatility in the credit market now is the highest it’s been since 2009. That equates to about a nine or 10 basis point change in yields on a daily basis. That’s way too high. So we do think that there’s a strong case here that volatility, although it’s going to stay elevated, will start to come down as the Fed signals it’s plateauing, or at least reconsidering the pace of rate hikes.

And then,  finally, you know, stay in  high credit quality, downside risks to the economy is still significant as Liz Ann has talked about. Stay up in credit quality and start to extend duration.

MARK:  Thank you, Kathy. And, Cooper, we’ll give you the cleanup spot. What are the key points for municipal bonds?

COOPER:  Yeah, the big thing that I would say is that municipal bonds are an area of opportunity in this market. There’s two reasons for that. The first is that the rise in yields, you can actually now earn income on your fixed income portfolio. Again, the yield for the broad index is a little over 4%. On a tax-adjusted basis it’s even greater than that. Like Kathy had said, we do believe that it makes sense to extend duration and move up in credit quality. Muni market, again, tends to be a very high credit quality market and on an adjusted to forward duration basis, it does provide those attractive yields. We don’t think that a recession poses an immediate concern to state and local government credit quality. Again, the starting point is already very strong. The amount of money that was afforded state and local governments through the different fiscal aid packages after the COVID crisis was quite high. So the point I would make is, again, we do think that the municipal bond market can be an area of opportunity going forward.

MARK:  Thank you, Cooper. And we are out of time. Cooper Howard, Jeffrey Kleintop, Liz Ann Sonders, Kathy Jones, thanks for your time today. If you would like to revisit this webcast, we’ll be sending out a follow-up email with a link to the replay. If you’re interested in continuing education credit, live attendance and only live attendance is eligible for one hour of CFP and CIMA CE credit, but if you watch the replay you aren’t eligible for that credit. When you registered for the webcast there was a field where you could enter your registration number, and if you did that we will submit those numbers on your behalf to the respective agencies. If you didn’t enter your number at registration you can do so now, there’s a window that should be in the lower left-hand corner of your screen. You can type in your number right there and click submit. And make sure you specify whether it’s for CFP or CIMA.

The next installment of this series will be on November 15^th at 8 AM. Liz Ann, Jeff, and Kathy will be back, along with Mike Townsend, our Washington analyst. Until then if you’ve got more questions about Schwab’s insights just please contact your Schwab representative. And that’s it. Thanks, again, for your time, and have a nice day.