Schwab Market Talk - September
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MARK RIEPE: Welcome, everyone, to Schwab Market Talk, and thanks for your time. Today, is September 13th, 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 who are new to these webcasts, we do them once a month. We’re going to start by answering a lot of the questions that registrants have submitted as part of the registration process. And after we get done with those, then we’ll start taking live questions that you submit during the event itself. If you want to ask a question at any time, on the lower part of your screen, you should see a Q&A box. Just go ahead and type your question in and click Submit. And like I said at the end, we’ll try to answer as many of those as we can.
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Our speakers today are Jeffrey Kleintop, our Chief Global Investment Strategist; Liz Ann Sonders, our Chief Investment Strategist; and Kathy Jones, our Chief Fixed Income Strategist. We’re going to start out by talking about the Fed for a little bit, the economy, inflation. Then we’ll pivot towards some bond strategies, equity strategies. I think we’ve got a couple of questions about China in there, as well. And then, as I mentioned, then we’ll start taking the live questions that you submit.
Let’s start with the start with Fed, Liz Ann. I’ll go with you… go to you for the first one here. Chairman Powell’s short speech in Jackson Hole led to some weakness in stocks. Of course, we’re seeing a little bit more this morning. Were his comments a surprise?
LIZ ANN SONDERS: Not to me, frankly. And good morning, everybody. I think part of the reason why he decided to be short and sweet was to make a point. The narrative that had gelled around the bottom of the market in mid-June, which came in conjunction with, at the time, the peak in the 10-year yield, was this notion of a Fed pivot. And at least at that point, the meaning of pivot was the Fed going from aggressive rate hikes to rate cuts, with the market pricing in possibly as soon as the beginning of next year, first half of next year. That didn’t seem to make a lot of sense, given that that was a narrative that was often wrapped around the bullish case, because in our view, anyway, a situation in which the Fed gets a green light to go from what are clearly very aggressive rate hikes to not just a pause or lowering the pace of rate heights but an actual pivot to rate cuts suggests either significant deterioration in the labor market relative to where we are now and/or deterioration in the economy. And we haven’t seen that deterioration in most metrics within the labor market. And I think the Fed and Powell’s speech, in particular, was very firm about not just pushing back against the notion of a pivot, but really emphasizing that once the Fed gets where they want to be and they start to see that impact on inflation, they’re going to maintain rates at that higher level for an extended period of time. And I think that is what the market has been digesting, and, certainly, is having another day of indigestion, given the hotter than expected CPI report.
MARK: So, Kathy, what are your thoughts on, what are you expecting from the Fed for the rest of this year, and then, you know, looking more forward into next year?
KATHY JONES: Well, I’ll start with just noting what the market is pricing in. So at this stage of the game after this morning’s rate hike… I’m sorry, CPI report, the market is, you know, definitely 100% convinced, we’ll get a 75 basis point hike at the next meeting next week. And we’re starting to see the market start to price in the potential for even 100 basis points. I think that’s unlikely at this meeting, it’s too close. But I think they’re moving up the peak of the cycle for Fed funds to around 4-1/4%.
What we do know… and all of this is guesswork because it’s going to depend on the data. What we do know, though, is that, as Liz Ann said, they tend to be aggressive in terms of hiking rates until they start to see the inflation numbers come down. I think the key, rather than just CPI or PPI or PCE or any of those indicators, will be wages. So something that has been mentioned by several Fed officials, including Powell, is that they’re looking for wage gains to level off. And they are currently, average hourly earnings, running about a 5.2% year-over-year pace. It’s leveled off, but it hasn’t come down. I think the last expansion, the average was around 2-1/2% in terms of average hourly earnings. And when the Fed did pivot to hiking rates in the last cycle, it was when wages moved up through that 3% annualized rate.
So I think that’s really what we have to watch. Unfortunately, that’s probably going to involve higher unemployment, but I think it’s the labor market data more, perhaps, than even just the straight inflation data that the Fed is going to be watching.
MARK: Kathy, at least my impression is that at least in terms of the media coverage of the Fed, most of the coverage seems to be about interest rates and a lot less on quantitative tightening. So how does that work, and how do you think that’s going to be affecting the markets and interest rates?
KATHY: Yeah, it’s a good point. QT has picked up as of this month. The Fed has increased or doubled the pace at which it’s allowing bonds to roll off its balance sheet. It’s down 95 billion a month, comprised of 60 billion in treasuries and 35 billion in mortgage-backed securities. Now, it’s an uneven pattern, partly because of some of the flows in and out based on TIPS, payments, etc., but we have started to see the rate of change, the rate of decline in the balance sheet come down.
You know, QT, in theory, is supposed to work through a couple of different channels to tighten financial conditions. Primarily, what it does is reduces reserves in the banking system. So when the Fed allows funds to roll off of their assets, they offset that by reducing reserves, which are the offsetting liability. That shrinks the amount of money available to the banking system to make loans. And that’s supposed to cool off the economy, taking, you know, less… having less liquidity in the financial system.
It also means that when the treasury issues new bonds, one of the big buyers that’s been priced in different or yield in different, the Fed is stepping back, which means other buyers have to take their place, and that’s supposed to lift the term premium, the risk premium in longer term bonds. So it’s supposed to shift the duration in the market.
And then, finally, it works through signaling. In other words, in conjunction with quantitative tightening, the Fed is raising rates. That’s signaling the message that they want to tighten policy and slow the economy, and get inflation down. How it’s worked in the past, and we really only have one true quantitative tightening period to look at, you know, the way it worked was not necessarily according to what the textbooks would say. Ten-year yields actually started to drop during that period because the economy slowed down and inflation cooled off.
So I think the one thing that we can say, the one important takeaway of the Fed policy is they’re just going to keep tightening until either something breaks and they feel the need that they have to slow down, or until they see the inflation and wage data come down to where they would like to see it.
MARK: Thank you, Kathy. Liz Ann, why don’t I go to you here for a couple questions about the economy. The labor market has been a source of strength that’s been offsetting some of the other weaknesses in the economy. So why don’t I kind of combine two questions here? Do you think the labor market will continue to be strong enough to offset that weakness, and, especially, can it really… the strength that we’re seeing today, is that really going to last, given the pace of Fed rate hikes, and as Kathy just mentioned, the shrinking of the balance sheet?
LIZ ANN: Sure. So the labor market, at least as measured by payroll growth, does continue to be strong. Part of the reason why economists’ estimates, especially for the Jobs Report two months ago that was much, much, much hotter than expectations, that the payroll print was 528… that’s, obviously, come down with the most recent report… but part of the reason why even the highest economist estimate was in the 300-and-change range, is because most leading indicators have been suggesting a move down in payrolls, a weakening in the labor market, and it just hasn’t shown up in measures like payrolls. But there’s a lot of… I’ll use a technical term here… there’s a lot of funky things that go on, not just at this point in the cycle, but also really unique things that have impacted the labor market tied to the pandemic that really don’t have a lot of historic precedents, some of which is maybe the idea that companies are going to be a bit more hoarders of labor, given the skills gap that still exists, given the difficulty in finding talent leading into this period. That could mean that we don’t see the same kind of hit to the labor side of the economy, even if we are in or go into a recession.
But under the surface, there’s a bit more weakness, and is picked up by the traditional data. The Household Survey, which is how unemployment is measured… because payrolls just measures the number of jobs. It doesn’t say anything about unemployment. The Household Survey is the survey from which the unemployment rate is calculated. And in that survey you pick up things like multiple job holders, which have been on the rise for quite a few months now. Also, part-time jobs have come down… I mean, full-time jobs have been coming down, part-time jobs for economic reasons, have been coming up. So under the surface, there’s a bit more weakness. Hours worked has also come down quite significantly. That, somewhat obviously, is what employers tend to do initially, they cut hours first before it then feeds into layoffs. Layoff announcements are up year-over-year for three or four months in a row right now.
So I do think we’re likely to see more weakness in the labor market, but, clearly, there’s been enough strength, still enough tightness, still enough wage growth that we’re at that point where the Fed, not that they are turning a blind eye to the labor market, but, clearly, in this role of a dual mandate, they are much more focused on inflation. And unless you see commensurate deterioration in the labor market, which may give them a little more of a reason to pause at some point, I think they’re going to be full steam ahead with aggressive rate hikes, to Kathy’s point, about November very much being in play for yet another aggressive rate hike. But I wouldn’t be surprised to see at some point, a start of more weakness in those traditional labor market metrics like payroll growth.
MARK: Thanks, Liz Ann. Jeff, let’s turn to you to get kind of the global economic perspective. What are your thoughts about the possibility of a global recession?
JEFFREY KLEINTOP: Well, Mark, GDP has been growing better than expected outside of the US in the first half of the year, but it slowed in Q3. And obviously, many countries are now seeing high inflation, rate hikes, and slowing demand, just as the US has seen this year.
One of my favorite indicators of global economic activity is the Global Composite PMI. It adds manufacturing and services together, and just looks at 37 countries around the world. That fell by, I think, it was one and a half points in August, and just below 50. It got to 49.3 when it was reported on September 6th. And that marked the first reading below 50, which as we know, is a threshold between growth and recession. So this could be the data that marks the start of a global recession.
The PMI for the manufacturing sector fell in August to 50.3. So that’s still just above 50, but it implies that the global pace of industrial activity has stalled and the further decline in the leading measures of that index, like new orders and new export orders, suggests that the September manufacturing reading could dip below 50, as well as the service sector has. So that kind of rounds out to saying we’re at least on the threshold of a global recession.
And this matters for investors, since the Global Manufacturing PMI tends to lead the trend in earnings growth for global companies, usually by three months or so. So this points to the risk of an earnings recession beginning in a few months. Maybe we get guidance here in the third quarter earning season that’s a little bit more pessimistic than investors had hoped for. Earnings have proven pretty resilient so far into the slowdown, but with increasing signs of slower growth, this third quarter earning season could be characterized by downward financial guidance by business leaders.
So the question of an economic recession may be more a matter for economists. But for investors, this third quarter earning season is going to be really one for us to focus on to see if earnings finally break down, and enter a recession that we’ve already seen, maybe, begin with the global economy.
MARK: Thanks, Jeff. Liz Ann, let’s go to you. We’ve got a couple of questions about inflation. Obviously, that’s a lot of the big news this morning affecting the market. So what’s your take on this latest reading? Is this an indicator that maybe, you know, ‘70s style inflation is going to rear its head, or is this part of a declining, a receding process that’s just going to take longer than maybe some have anticipated?
LIZ ANN: Well, there are a lot of similarities relative to the 1970s, not least just being the level of inflation, but there are also big differences, which may not matter to people who are living in this environment that feels very much like the ‘70s, but could have implications for how this whole process unwinds relative to what was the case back then. And very, very different demographics profile. We didn’t have the same kind of globalization. You had much higher unionization in the 1970s. A recent study done by I think one of the regional Feds was around how much of ‘70s style inflation was demand- versus supply-driven. And it was supply-driven by about 2X relative to demand-driven. And it’s a bit the opposite in the current period of time. There was also more fits and starts in terms of monetary policy reaction to it in the 1970s where I think that’s one of the things Powell wants to avoid by kind of having a steady hand, at least, in this phase of raising interest rate and pushing back on this notion that they’re going to pivot to a more dovish stance sooner rather than later.
I think, really, what we’re experiencing right now is a shift from what was the onset of inflation driven by a huge surge in demand. And it was funneled largely into the goods side of the economy because it occurred during the worst part of the pandemic, the lockdown phase. Massive amount of stimulus, and that stimulus as it related to demand, could only be funneled onto the goods side of the economy because there was the absence of services availability, and that’s what ignited the inflation problem. Now, of course, we see this shift from the goods side of the economy to the services side of the economy. You see it in economic metrics, you see it in behavior in the stock market, and you’re seeing it in the inflation numbers. Whereas the services components, some of which are stickier in nature, you certainly saw that today, the continued strength there, especially at the core level, is an offset to what has been a little bit of a better trajectory at the headline level because, in particular, the recent weakness in energy, and that could be an important issue for the Fed. They have focused a lot more on headline inflation because that’s what impacts consumers. That’s what consumers’ experience is tied to, is headline inflation, energy and food, but it’s core inflation that tends to be a better sort of predictor of future inflation trends.
So the Fed has to focus on headline inflation because of the impact on consumer, the impact on inflation expectations. But I wouldn’t be surprised if they shift maybe some of their sort of language in discussions to what it might take to get those stickier core components of inflation to come down, not least being the shelter components, rent of primary residents, owners equivalent rent, which make up almost 40% of core CPI. And that’s where we really saw the hit on a reading like today.
MARK: Thanks, Liz Ann. Jeff, let’s go to you since inflation is not just a US thing, it’s a global phenomena. A lot of that is driven by supply chain. So a couple of questions on supply chains for you. How are global supply chains looking as we enter the holiday shopping seasons? And other than supply chains, what else are you looking for when it comes to signs that maybe global inflation may be either persisting or starting to recede?
JEFF: Well, there’s, obviously, not much good news to talk about when it comes to inflation, but this is sort of a bright spot. The supply chain situation is actually pretty good, despite this being the peak week each year for container ship bookings. The volume of containers coming into the ports of Southern California on the world’s most popular route, the Shanghai to Los Angeles route, is way down. In fact, I haven’t seen the numbers consistently this low in a long time. I tweeted this data this morning on my Twitter account, so I’m going to do this by memory, but I think there’s 87,000 containers coming in this week to the ports of Long Beach and Los Angeles compared to 130,000 for this week last year. And I think for the last week of September it was 65,000 coming in, roughly, compared with 156,000 for that same week a year ago. So you can see the numbers are down a lot. And the price to ship a container is down about 50% from the start of the year, despite the higher fuel costs. Obviously, there’s a lot of excess inventory that’s keeping a lid on new shipments and demand is weaker so those aren’t good reasons, but it is nice to see that come down and supply chains moving a little bit more efficiently. In fact, in the PMI, the share of firms reporting a lengthening of delivery times, it’s now the lowest in about 22 months. So retailers and manufacturers have the opposite problem than last year, too much inventory and not too little.
You know, as I think about the overall inflation picture, it’s really what Liz Ann left off with there. It’s so much of it is about housing. For most countries, the excess inflation is currently concentrated in housing and food. Now, we know agricultural commodity prices have shown recent signs of easing around the world and that may eventually feed into food prices, but housing has continue to climb, and it’s the largest component of overall inflation in many countries, most countries. Following the rapid deterioration of housing affordability driven by higher rates, home sales are falling quickly, and home prices are coming down, as well.
But the flow through to housing inflation in the CPI isn’t that straightforward. Only in four countries, Canada, New Zealand, Sweden, and Australia, do they include home price data in housing inflation. In contrast, inflation measures for Europe include only data on rental rates. And those in the US, and the UK, and Japan, and a few other countries, really, primarily, depend on what we call owner’s equivalent rent, or what the owner would get if they rented out their house, and, you know, it’s high. In fact, in the latest reading we just got today, it’s rising at a 10% annualized pace, and it’s very sticky.
So I think the takeaway for investors is that the CPI will likely ease significantly where housing inflation is based on home prices, like Australia, Canada, New Zealand, and Sweden. But in contrast, countries where shelter inflation is based on rental rates, as it is just about everywhere else, inflation may remain fairly sticky, and that might mean continued rate hikes by those central banks. You might increasingly see this division between central banks and some of the countries I mentioned, like Australia, versus those in maybe the US and Europe forced to continue to hike rates as rental prices continue to rise as housing affordability deteriorates, Mark. It’s like this thing where it gets harder to buy a house so there’s more renters, and that pushes up rental rate. That exacerbates the inflation situation where rate hikes ... it’s almost like a loop here in terms of the spiral. So I’m a little bit worried about that in many of these countries. Again, Europe, the UK, the US measure inflation that way in housing, and that is the stickiest component for one to focus on right now.
MARK: Thanks, Jeff. Kathy, let’s go to bond strategies. We got a bunch of TIPS-related questions. What’s your thought on TIPS? Are they still in position to provide good inflation protection? Are they too rich, too cheap? What are your thoughts?
KATHY: Yeah, we think that they’ve gotten a lot more attractive. You know, they were not that attractive earlier in the year and a lot of people are disappointed by the performance because they didn’t do what people thought they might do with high inflation. But you have to remember what the starting point was, and the fact that they’re still bonds and they’re still going to react to a rise in yields. But now we’re looking at positive yields pretty much across the curve in TIPS, which means when you buy a TIP security, you’ll get that positive yield plus the inflation rate over the life of that bond. And it’s pretty much close to 1% if you go out in the three- to five- to 10-year area in TIPS.
So at this stage of the game, if you’re concerned about inflation and think it might be stickier or has the potential to continue high, then I think TIPS could… or should outperform nominal yields here in terms of treasuries. And, you know, that would be combined with the idea that perhaps nominal yields are a lot closer to the peak than to the trough, and so you could have the opposite of what we experienced this year.
So I think TIPS can make sense. I wouldn’t buy the real short-term TIPS. There’s some sort of odd things that go on with liquidity at the short end of the curve, but really if you go one year out, you can lock-in at least a positive real yield now using TIPS and some inflation protection.
MARK: Thanks, Kathy. Softball question here. Where are interest rates going the rest of the year?
KATHY: Oh, I think we pretty well know up. But I do think that… and, obviously, until inflation starts to show some progress that they’re going to continue higher, particularly at the short end of the curve. But I do think that the overall dominant trend is going to be a further inversion of the yield curve. So, right now, we’ve, you know, got 2-year/10-year inverted by about 30 basis points or so. 3-month/10-year after the Fed hikes rates will likely be inverted next week. And I think that you could argue levels in terms of bonds, but I think the one trend that’s kind of seems inevitable is that we’re going to have further inversion to the yield curve.
MARK: So given that, Kathy, and the large losses we’ve seen in the first half of the year to bond holders, just a portfolio construction question, where do you see bonds fitting into the overall portfolio, you know, given what we were just talking about?
KATHY: Yeah, you know, it’s been a big debate this year because, obviously, we’ve had touch on brutal year in the fixed income markets and it hasn’t been fantastic in the stock market either. So we’re not getting that benefit of diversification, largely because we started at such low rates and we’ve moved up very, very rapidly. But I still think bonds, actually, as we go forward, will perform better in terms of providing, you know, the sort of traditional values—the diversification from stocks, the income generation, and capital preservation if you’re in higher credit quality bonds.
And then I think, too, remember now that we have higher real and nominal yields, is the opportunity for clients who are income investors just to, you know, lock in some of those yields. So you can build an investment-grade bond portfolio right now with, you know, fairly diversified, some treasuries, some investment-grade corporates and munis, that the yields are 4-1/2- to 5% at this stage of the game. And that’s a pretty attractive proposition for investors who are focused on earning yield. So we think next year is going to look a lot better from a diversification benefit for fixed income.
MARK: Thanks, Kathy. Jeff, I got some questions about China for you in a second. But, Kathy, before you go, on past calls you’ve been fairly positive when it comes to municipal bonds. Do they still look attractive?
KATHY: Yeah, we still like munis. You know, again, rates are moving up all over the place, but we think valuations on intermediate- to longer-term munis are attractive for high income investors. The short end of the muni curve is still a little bit rich. The average duration is around 6.2 years on the index. We would be at the benchmark maybe a little bit longer. So if you look out at the 10-year muni market, you’re seeing MOB spreads around in the mid-80s, which is a pretty attractive valuation. We’re seeing still continued upgrades versus downgrades. We’re still seeing the lagged impact of the rebound in the economy, boosting revenues from, you know, property taxes to sales taxes to income taxes, and that all helps state and local governments. So we still think on a relative basis, munis are pretty attractive, and it seems doubtful that, you know, tax rates are going to go down for high income earners anytime soon.
MARK: Thanks, Kathy. Jeff, got a question to you about China. Everybody’s… central banks around the world, everybody seems to be raising rates, but China is actually cutting their rates. Why is that and what do you think the impact is going to be?
JEFF: Yeah, China is so different here. China is battling deflation while most of the rest of the world battles inflation. Deflation and the continuation of weaker than expected economic growth in China are the country’s main economic risks. Both core and services CPI in China are below 1% and property prices are also in decline. Housing is a big store of personal wealth in China, so it’s kind of a negative wealth effect going on at the same time, too. China needs lower interest rates and weaker currency to battle these deflationary pressures because deflation can depress spending and weaken the economy while worsening repayment burdens for borrowers, and China has really grown its debt in recent years.
Last month, in addition to rate cuts by the People’s Bank of China, Chinese officials announced a series of growth supportive fiscal measures, and they could help offset the sharp contraction in government revenue and support infrastructure investment growth in the coming months. That might also help to weaken the Chinese currency. You know, a look at the spread between the US and China’s 3-month interbank rates points to the potential for China’s currency to drop significantly further against the US dollar. It is already, but it could slide another 5- even 10%. And that may aid China’s efforts against deflation, but it could also reignite tensions with the US over currency moves in an environment of weakening export growth. That was a hot issue during the Trump administration, Mark.
MARK: Thank you, Jeff. Let’s go to the equity market here. Liz Ann, I’ve got a few questions for you. I think some version of this question has been asked, really, probably, the last three or four calls. Are we still in a bear market or are we in the midst of a bear market rally, or maybe has a new downturn started?
LIZ ANN: Well, if you want to use the very pure and somewhat simplistic definition of up 20% is a bull market, down 20% is a bear market, in the case of the S&P, during the rally that started mid-June to mid-August, we didn’t get to that plus 20%. The market sort of failed that the, you know, key moving average, and you didn’t reach above that. So, again, using that official textbook definition, we have not hit a new bull market, at least in the case of the S&P 500.
In terms of whether or not the market is likely to retest the lows, you know, Mark, the honest answer is I don’t know, and I don’t really know that it matters. I don’t mean to be flippant about that, I just think that there’s a lot of money, not just these days, in general, that I think often feels that the key to success is timing market bottoms and tops with some sort of timing precision, and I just don’t think that that’s the way that investors should approach the market. It wouldn’t surprise me at all to see a retest, especially given the aggressive stance that the Fed, especially after today, has to continue to take. You know, I started in this business in 1986, working for the late, great Marty Zweig, who coined the phrase, ‘Don’t fight the Fed.’
So I’m steeped in that understanding of an aggressive tightening policy, and the impact that that has on liquidity in financial markets, and a rising inflation and rising interest rate environment. The impact that has on multiples, because of that higher discount rate suggests that even at the recent lows, we probably didn’t have the market already pricing in all of the bad news. Maybe some of the monetary tightening, maybe even some, if not most of, the economic weakness, but I think what is yet to be fully priced in is the potential weakening in the labor market and what I think is the coming further downturn in earnings. So maybe the bottom line is I don’t think we’re out of the woods yet.
MARK: Thanks, Liz Ann. And just as you were saying that a question popped up here. ‘Do you see an outright earnings recession coming?’
LIZ ANN: So those are not defined as somewhat cleanly as economic recessions are in terms of the metrics. But right now, the expectation in dollar terms is after a 2021 that had $208 of S&P earnings, the consensus is $225. That’s high single-digit percent increase for 2022. I think it’s 243 or 244 for 2023. Now, those have come down a little bit, but I think those are still definitively too high. I think that’s the message that companies are sending with the combination of downward guidance pre-announcements. Again, we have started that trajectory down in terms of 3Q, 4Q 2022 estimates and into 2023. But I think there’s more to go on the downside. I wouldn’t be surprised to see if at the end of this year, we end up with a dollar amount of S&P earnings relative to the 208 from last year, something less than that this year, which would mean that the percentage change is in negative territory.
Maybe not to a significant degree, but I think this coming quarter will probably clarify a bit more for the analyst community because top-down estimates have been coming down more significantly than bottom-up estimates. I think because analysts were somewhat flat-footed over the past couple of years in being behind the eight ball as it related to improving earnings coming out of the pandemic low, I think they’ve been hesitant to cut estimates to a more significant degree, but I think the color that’s likely to come out of third quarter earnings probably pushes analysts from a bottom-up perspective to take down these forward numbers second half of this year into the first half of next year, more significantly, such that it wouldn’t surprise me to see a negative year-over-year change in earnings by the time we get to year end.
MARK: So, Liz Ann, given that earnings forecast and given the price action we’ve seen, what are your thoughts on valuation? And then we’ve got a question here. Multiples have contracted to around 12 to 13 times earnings when looking at prior recessions. Do you see multiples getting back down to those levels?
LIZ ANN: So recession versus no recession is actually not typically the key determinant of where multiples end up sort of bottoming out. It tends to be more driven by inflation and interest rates. And that tends to be key because as interest rates go up in response to an inflation problem, that, obviously, raises the discount rate using… that we use to discount forward-looking cash flows and earnings. And for what it’s worth, and I saw a question that came up in the queue as we were talking earlier about where does the current level of inflation and/or interest rates suggest valuations to be? And, interestingly, it does kind of land in that 12 zone.
Historically, the sweet spot, by the way, for valuations in terms of inflation zones is in the sub 2% CPI range. We’re, clearly, a ways away from that. But the market can also start to react to a decline if you’re going from a higher inflation zone to a lower inflation zone. In fact, historically, a lot of market bottoms have occurred around inflation tops, assuming they were legitimate tops. And we continue to see inflation come down, not sort of a near term peak and then a reacceleration. So that’s yet to be seen.
So I think right now in the high teens, that’s probably still a fairly rich multiple. Of course, the rub is that the denominator in that equation is now starting to descend. So all else equal, not that that’s ever the case in the equity market, there is now going to be upward pressure on multiples by virtue of deteriorating E, while at the same time, still high inflation based on history continues to put downward pressure on multiples. So it’s a little bit of a push and pull right now. The net is that I think the market is still on the more expensive end of this spectrum, not at the extreme where we were about a year ago, but not cheap by any means.
MARK: Thanks, Liz Ann. Jeff, let’s go to you. What are your thoughts on global earnings?
JEFF: Well, Mark, what Liz Ann said about the US earnings picture is also true for the rest of the world. Analysts are looking for mid single-digit earnings growth next year, not just in the US, but in Canada, in Europe, in Japan, pretty much everywhere we look, and that follows solid growth in 2022. But that may be optimistic. As I mentioned earlier, the PMI is pointing to a weaker environment for earnings, and the track record of the PMI leading global earnings by three months is phenomenal. It’s on my Twitter, I posted a week or two ago. And it’s incredible. I mean, really, is very predictive here of where we’re headed.
Mild declines, I think, are likely, and might begin to show up in guidance soon. I would focus, though, on growth in dividends, overgrowth in earnings for investors right now. In every recessionary bear market, high dividend-paying stocks did outperform the overall market, sometimes posting gains during the bear market. And I think with balance sheets stuffed with cash and companies still likely to see sufficient cash flow to maintain their dividends, but likely earnings downturn may not mean worries about dividend cuts. High dividend-payers continue to outperform by a wide margin here this year in the US, Europe, and in Japan.
MARK: Thanks, Jeff. Why don’t we go to some of the live questions? And I’ll send the first one to you, Jeff. ‘Can you comment on ongoing geopolitical risks?’
JEFF: I can comment on them. I don’t know how much my comments are worth. I’m not a geopolitical strategist. Markets are hard enough. I can tell you that at least… you know, I’ve talked previously on this particular broadcast about China versus Taiwan, so I won’t get into that here. I will talk about Ukraine’s latest success. I don’t think it’s likely to shorten the war. Russian forces still have a pretty firm grip on the Donbas region and on land along the Black Sea coast, and on territory that connects those two together.
More worrisome is that Ukraine’s advance may also make the war more dangerous. Putin now finds himself in a tight spot, and that may worry market participants who fear an expansion of the war. Russia’s president has shown no signs during his entire political life that he’ll admit a mistake, certainly not as big as this one, and reverse course. And although he insists Russia is at war with the West and its military alliance, and that’s probably a claim that’s made more credible by all the Western military and financial backing that’s helped to aid Ukraine’s army here, he’s avoided changing the rules of engagement and widening the conflict beyond Ukraine’s borders. But, you know, the more pressure that’s put on, there’s the more potential for him to do that.
So it still looks like, you know, an environment where we’re not seeing any kind of near term resolution to the war, and we may have raised the risk of the war broadening a little bit here. And that’s not a major factor for the market right now, but it’s certainly something that remains in the balance.
MARK: Thanks, Jeff. Kathy, got a couple questions about bond market liquidity here. One of them is ‘How likely is illiquidity in the treasury market to disrupt the market and how concerned are you?’
KATHY: Well, there has been a drop in liquidity in the treasury market. It’s been driven by a couple of factors. One is simply dealers are holding less inventory of all types of bonds these days, and that is, you know, due to regulatory pressures and cost structure, and so it’s a less liquid market. But having said that, it may be less liquid than it was 10 years ago. It’s still probably one of the most liquid markets in the world. So I’m not terribly worried that it’s going to be disrupted. A lot of people are concerned about quantitative tightening and the impact on reserves in the system, that we might have a recurrence of what happened in March of 2020, and we have a liquidity squeeze there. I think the good news is the Treasury and the Fed are way on top of this right now. They’ve put together a number of tools to address that.
So it’s never great that liquidity is lower than it used to be, but of all the things we worry about right now in the bond market, lack of liquidity is probably lower on the list than some other things, simply because it has been addressed. The tight spots have been addressed by the standing repo facility that the Fed has put into place, and some of the moves that the Treasury is making to adjust issuance to match up with where demand is.
MARK: Thanks, Kathy. Liz Ann, here’s a question for you. Does inflation help to support earnings for companies in nominal terms, or at least lessen a decline in earnings in nominal terms?
LIZ ANN: So, yes, it does. Inflation is tied, typically, to both top line growth and bottom line growth. And at least at the outset of inflation, particularly, if demand is strong, that tends to lead to not just prices increasing, certainly, from an input perspective, which could hurt companies, but their ability to pass on those higher prices.
But here’s an interesting kind of an accounting rub to how at least S&P earnings are calculated. And I don’t want to get to arcane here, but there’s something called the IVA, which is the inventory valuation adjustment that is not added into S&P earnings. And that has to do during the early stage of a surge in inflation, if companies have excess inventories on their books, if you’re in a strong demand environment, if you’re in a strong pricing power environment, they can basically dump those excess inventories into the market, get rid of them at higher prices, it’s almost like a capital gains increase. And that’s not adjusted into S&P earnings, and I think we’re well past the beneficial stage in this process right now. And more than anecdotally, we’re hearing an increasing number of companies saying they have too much inventory, and you are starting to see the price discounting associated with it.
In addition, even though a lot of input costs have come down, you have labor costs, which, typically, are the largest input cost, but they represent a level of percentage of input costs that would suggest profit margins need to come down. Where labor costs are relative to S&P 500, companies cost basis suggest margins should be around 13%, and as of second quarters, margins were more than 15%. So I think that’s another inflation inventory-related adjustment that we will likely hear more about when we get to third quarter reporting season, which is in about a month.
MARK: Thanks, Liz Ann. Kathy, this one is for you. ‘Should we expect a sustained strong dollar considering the likelihood the Fed keeps rates elevated for some time?’
KATHY: Well, I wouldn’t fight it. You know, the dollar has been rising for the better part of the last decade. It’s certainly gotten a big move up here, combination of the Fed being more aggressive in the rate hike cycle, the US economy being further along in the pandemic recovery, and then the safe haven buying that we’ve seen associated with a lot of the geopolitical events, like the war in Ukraine. We also see a very, very large drop in the Japanese yen as the Bank of Japan has refused to kind of follow the rest of the central bank along with tightening policy, and as Jeff mentioned, weakness in the yuan, because of the problems in that economy. So you put that all together and you still have a pretty strong case for a strong dollar to continue.
Having said that, you know, the inflection point may be near us in the next couple of months. It really will depend on when there’s a perception that the Fed is done tightening relative to, say, other countries. And that may be a function of how much the strength of the dollar has a negative feedback effect on exports, etc. But for the moment, I would say there’s no real reason to doubt that the dollar can continue to go higher from here.
MARK: Thanks, Kathy. Another one for you. ‘When would you recommend moving into longer duration bonds and away from short-term bonds?’
KATHY: Well, I would be making that move gradually right now. It’s when you get these big jumps in yields that I think averaging in, moving a little bit further out on the yield curve makes sense. The closer we get to a peak in the cycle, the more you’re going to see this convergence of short- and long-term rates. That’s usually where yields peak between the Fed Funds Rate and the 10-year. And so, you know, we’re already inverted from 2 years to 10 years. That’s a sign that we’re getting late in the cycle. Now, we could still get a shift up overall in yields, but given where we are right now, given the trajectory, I would start moving out to at least closer to benchmark duration now. If you use the AG, that’s still 6.7 years, which is still a little bit long and risky at this stage of the game. But having said that, I would not be sitting in all short-term at this stage of the game. I think that we’ll probably see some convergence with short-term yields around 4%, but the continued move down in long-term yields or flattening out of long-term yields. And that’s really when you want to start extending duration of most cycles.
MARK: Thanks, Kathy. Jeff, this one is for you. What are your expectations for China GDP for the near future?
JEFF: So China’s GDP target is 5-1/2% for this year, and it might be extended to 5-, 5-1/2% for next year. They’re coming in short of that, but they’re putting a lot of stimulus in place to try and juice those numbers. Later in the year, we’ve got an election coming up in October, which is an important one to make sure that President Xi Jinping has the support of the politburo that he wants to enact that things that... there’s a lot of money being spent now to ensure the economy is on a more rapid growing trajectory as we get towards the end of this year. But Chinese GDP growth is going to be somewhat lackluster. Consumer demand is critical here, as it relates to the rest of the world. The Chinese consumer is a voracious consumer of products made around the world. You know, half of GM’s cars are sold in China. So it’s a very important destination market for many, even US, the manufacturers.
That is a real function of what is going to happen with COVID, right? So we’ve got some mega cities in China that are alternately, you know, shutdown for weeks at a time, and that really is having an impact on consumer demand. We saw this particular harvest, the fall harvest travel time, a big period of time for vacation and travel in China, and travel was down by about 30% or so. That’s a big impact on hotels, and gift giving, and all the kind of things. So just seeing that trajectory is concerning. You’ve got a lot of China’s economy is driven by the consumer, most of it, and that is shown signs of weakening here on these COVID concerns.
So very difficult to predict, Mark, but I’d say those numbers are likely to come in a little bit weaker than expected, but with the government attempting to try and stimulate those pretty aggressively.
MARK: Thanks, Jeff. Liz Ann, I’ll give this one to you. ‘Given the view that inflation has been driven in part by unprecedented amounts of fiscal stimulus, should there be concern that all of the new spending coming out of Washington will only add to inflationary pressures in the US? What do you think about that?
LIZ ANN: I think it’s too soon to make that judgment. The environment we’re in right now, in terms of some of that added stimulus, is so different from the environment in 2020, where, first of all, the size of the stimulus, entirely different than versus now. It was direct payments to individuals, as well as to businesses at a time when we had limited supplies, also unlimited access to services. So I don’t know that we can do that at comp, just the sheer size difference. We also have an environment where consumers have already been retrenching because of inflation. You’ve seen revolving credit pick up. So there is a benefit to somebody who has less exposure now to their student loans by virtue of that change. But I don’t think that we can extrapolate that into sort of quick and immediate discretionary consumption.
So I think that it’s, I suppose, easy to stand on the side of the argument that the last time we saw this stimulus, it was a contributor to this huge inflation problem, this is going to exacerbate it. I just think that there’s a lot of nuances to the picture right now, not to mention the fact that this is spread out over an extended period of time. I don’t think that we can make assessments of the impact it’s likely to have on metrics like CPI.
MARK: Another one for you, Liz Ann. ‘Given labor quality shortages in terms of structural employment, will employers risk losing their best and brightest or just raise prices to maintain profits?
LIZ ANN: So that’s what I mentioned earlier. I think unique to the pandemic cycle is maybe the desire for companies to hang on to labor longer than they otherwise would. We have seen three months in a row of an increase in layoff announcements, there’s anecdotes of right-sizing needing to be done, but you also see it in the data with a limited number of actual firings. You haven’t seen the kind of weakness in payrolls, but you have started to see hours worked come down. And that does tell you that we’re seeing a weakening in demand. But for now anyway, a desire to maintain employees and just maybe, just shrink the number of hours that they are working.
An increase in the labor force participation rate, which we have started to see, and that was to the disadvantage of the unemployment rate. In the most recent Jobs Report, the unemployment rate jumped by two-tenths, but it jumped for what we often say is the right reason because of that increase in labor force participation. If that continues to accelerate, then companies, because there’s a broader pool in terms of access to labor, might decide they have that flexibility to right size. But, interestingly, in the NFIB data that came out this morning, the concerns about inflation as the number one expressed problem, actually came down, where concerns about the quality of labor ticked back up again. So that could define what is a very unique cycle, in that there’s a bit more labor hoarding than is typically the case in any kind of economic downturn, even if it’s not, ultimately, declared a recession.
MARK: Thanks, Liz Ann. Kathy, I’ll send this one to you. ‘How is the Fed measuring financial conditions and gauging whether they’re tightening, and what is the current trend as a result of quantitative tightening?
KATHY: Sure, so the Fed… well, there are a number of different ways to measure financial conditions, and the Fed having, you know, several hundred Ph.D. economists on their various staffs has created a number of them. But they all work off the sort of the same principle, and that is that financial conditions tighten when the cost of money and availability of credit declines. And so what we see as credit spreads, the difference between, say, treasury yields and investment-grade or high-yield bonds, when those widen the cost of capital to businesses goes up. Those are the kinds of things that the strength of the dollar, because that tends to slow economic growth and pull down inflation. There’s a number of components that go in, no matter how you measure quantitative tightening, will play into that. It’s not the primary mechanism to tighten financial conditions. Really, the rate hikes are the primary condition for that. And what you’re seeing is asset prices come down. This is all feeding into tighter financial conditions. And it’s harder to borrow, it’s more expensive to borrow. Asset prices decline, which means your ability to leverage off of those assets to borrow or to expand goes down. And then, of course, the cost of capital through rate hikes. Those are the real primary ways that they tighten financial conditions.
The trend has been tightening. By most indices that we follow, financial conditions are tight. And now they loosened up a little bit when we had that rally in the stock market and just shrinking credit spreads a little while ago, but now, today, they’re definitely tightening again. So we’ve been in tight financial conditions for several months, and that would suggest that, you know, the risk of recession is rising.
MARK: Thanks, Kathy. Liz Ann, I’ll give this one to you. ‘What sectors in the equity market would you overweight and which sectors would you underweight?’
LIZ ANN: I’m tempted to just say none and leave it there, but that would be not very helpful. As maybe some people know, we’ve talked about it on these calls before, about six months ago, seven months ago, we went to effectively a sector-neutral approach, in part due to pretty rampant month-to-month, even week-to-week, sector volatility, making it really tricky to try to even trade around those moves, but also a strong view that factor-based investing makes a lot more sense in this environment than sector-based investment. And, Mark, as you know, we’ve been doing a lot of work internally on factors. Factor analysis is the basis of Schwab Equity Ratings. It’s always been embedded in how that team, the SER team, rates individual stocks, but their deep analysis of factors can also be used by us from a more macro perspective. And the idea behind factor investing, of course, is you’re investing based on the characteristics of companies. And you can apply that analysis, that screening, whatever you want to call it, across the spectrum of sectors without having to make a sector call or two, knowing that within a sector, you might have really attractive names that screen well on the factors that have been working or you think or we think will continue to work, but there also might be a lot less attractive names. So you can really amp up the fundamental basis and quality by taking that factor approach.
And the kind of factors that we think have been working, leaving aside some low quality kind of shifts that occurred during the market rally from mid-June to mid mid-August, are higher quality areas. In fact, in this type of environment where you have weak economic growth, where you have now declining earnings estimates, it’s factors like return on equity, return on assets, positive earnings revision, strong balance sheet that tend to do consistently well. Conversely, negative earnings, you know, weaker things like balance sheet and cash flow, more volatility, both in terms of the revenue side of things, as well as the stock price side of things. So that’s just the way, at least for now, we’re going to continue to approach markets, is focus more on factors than sectors.
MARK: Thanks, Liz Ann. Jeff I’ll send the last question to you. ‘Is it still a good time to rebalance into international and emerging markets at this point? And would you recommend dollar cost averaging into those sectors right now due to the uncertainty?’
JEFF: Well, I think dollar cost averaging always makes sense in, particularly, this kind of a volatile market. When I look overseas, Kathy talked about maybe the potential for a dollar inflection in the coming months, but, you know, if you set the dollar aside for a second, the Nikkei 225, Japan’s major stock market index, is flat this year, even through today. The FTSE 100 in the UK, flat, continuing getting a 0% return. So no bear market’s there.
I think the fundamental outperformance of those markets might begin to shine through if we get a break in the momentum of the dollar’s performance here, reflecting the fact that there is better earnings growth. And a lot of those characteristics Liz Ann just talked about—high quality, high dividend, better cash flow, and certainly lower valuation can be found overseas. So a lot of those characteristics that we found favorable in the US market really apply even more significantly to international markets right now.
So, yeah, I think it’s an opportunity here to dollar cost average into those markets on overall broad weakness.
MARK: All right. Thank you. Jeffrey Kleintop, Liz Ann Sonders, and Kathy Jones. Great insights, as always. If you would like to revisit this webcast, we will be sending out to you a link with an opportunity for you to watch a replay. If you’re interested in continuing education credit, live attendance, and only live attendance will qualify for one hour of CFP and CIMA credit. If you watch the replay, you will not be eligible for that credit. When you registered for the webcast, you were given the opportunity to submit your ID number for either the CFP or CIMA organization. If you went ahead and entered that number, don’t worry about it. We will submit that on your behalf. If you didn’t enter your number, you should be seeing a box at the bottom of the screen where you can go ahead and type in your number. And, again, it’s very important that you specify whether the number you enter is for CFP or for CIMA. Finally, you can also download a CFP or a CIMA certificate for your own records, and then submit that. The next call in this series will be October 4th at 8:00 AM. Jeff, Liz Ann, and Kathy will be back as the panelists. Until then, if you would like to learn more about Schwab insights, feel free to reach out to your Schwab representative and everybody have a nice day.