Transcript of the podcast:
MARK RIEPE: Prognostication is a time-honored ritual. And it’s interesting to look back over history and see who got it right—and who got it wrong. One prediction that didn’t come true is from 1948. The Chicago Tribune was in the grips of a printers’ strike. In order to make the morning edition headline, it had to predict the result of the presidential election before all the votes were in. The editors selected “Dewey Defeats Truman” for the headline on the front page.
The only problem was that Truman won.
And while the Tribune attempted to gather all the papers with the wrong headline, they didn’t get them all. One made it into the hands of Harry Truman, and the picture of him holding it became iconic.1
Then there was Lieutenant John C. Ives, the topographical engineer who surveyed the Grand Canyon in 1858. Ives felt that while the canyon was beautiful, it was essentially a wasteland that nobody would want to see. He wrote in his report, “After entering it there is nothing to do but leave.”2
Ouch. Today, Grand Canyon National Park has approximately five million visitors each year, and they seem to be enjoying themselves just fine.
I’m Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab. It’s a show about financial decisions and the cognitive and emotional biases that can cloud our judgment.
For today’s episode, I’m not going explore any habits or biases that get in the way of investing decisions. Instead, I’m going to ask four of our strategists what they think 2022 has in store.
We strive to be more like civil engineer John Elfreth Watkins who made several accurate predictions in 1900. He foresaw television, mobile phones, digital color photography, and the large-scale farming of hothouse vegetables (remember, this was back in 1900). However, he also predicted that the English language would drop the letters C, Q, and X from the alphabet.2 So you can’t win them all.
And I’m sure we won’t either, as we’re well aware of the overconfidence bias here.
Nevertheless, just because the future is hard to predict, it doesn’t mean you should ignore it. And I think you’ll agree that we’ve got some interesting perspectives to share. All my guests on this episode have been on the podcast before, so you’ll hear some familiar voices.
First, we’ll hear from Liz Ann Sonders, our chief investment strategist. Liz Ann is a keynote speaker at numerous industry conferences, and she is regularly quoted in financial publications including The Wall Street Journal, The New York Times, Barron’s, and the Financial Times. She appears as a regular guest on CNBC, Bloomberg, CNN, Yahoo! Finance, and Fox Business News.
In addition, Liz Ann has been named “Best Market Strategist” by Kiplinger’s Personal Finance, and Barron’s has named her to its “100 Most Influential Women in Finance” list.
MARK RIEPE: Liz Ann, great to have you back on the show.
LIZ ANN SONDERS: Oh, thanks for having me, Mark.
MARK: Your 2022 Market Outlook piece, it … very first thing, it starts off with kind of a stark reminder of … that the fact that the pandemic isn’t really completely behind us by any means. What have we learned, or what have policymakers learned about the pandemic up to this point that’s going to influence their reaction in 2022?
LIZ ANN: So it’s a great question. I think it’s not that we learned that locking down the economy was a bad thing. I think that was a necessity at the time, given the absence of information that we had about trying to contain it. But I think at this stage, even with serious waves that we can’t seem to put in the rear-view mirror, I think the likelihood that policymakers either at the federal level or at the state level become that draconian again, even if they sort of up the mask wearing and the commentary around the benefit of vaccines.
I also think that in terms of monetary policy, you know, when Jerome Powell recently suggested to Congress that they would up the pace of tapering, that came only two and a half market days after the really big hit to the market when we got the initial Omicron news. And I don’t think it was his purpose to send a message, but I think implicit in the timing was that you shouldn’t expect the Fed to step in if there’s market volatility tied to virus-related news, that they’re going to have to maintain this path toward slightly tighter monetary policy.
So I think that’s the way at this stage in the virus, we should think about both the government policy, as well as monetary policy.
MARK: Yeah, it’s like in March, April, May, June of 2020, the virus was the only thing. And now it’s just one thing that the Fed is looking at, right?
LIZ ANN: That’s right. And the virus has contributed to the inflation problems that they’re starting to fight now with this move toward tighter monetary policy. So I don’t think they’re going to do a 180, even if there is market volatility.
MARK: In your report, Liz Ann, you mentioned that the consumer is pretty healthy, but the way that the consumer is actually spending their money has changed quite a bit. I was hoping you could talk a little bit about that. In what way has it changed, and do you think that’s going to continue into 2022?
LIZ ANN: Sure. And I know you remember, Mark, back in the early days of the pandemic we talked a lot about the K-shaped nature of the economy, the winners and the losers, and how many divergences we were seeing. And one of them was the consumption numbers if you separate out between the goods side of the economy and the services side of the economy. And that does date all the way back, of course, to the lockdown era, because when fed with all the stimulus provided by both monetary authorities and fiscal authorities, and an environment that had services, for all intents and purposes, fully locked down, consumption then automatically was geared toward goods. And that persisted, that demand stayed relatively high, even when we opened the economy back up. And although we shifted some of that demand to services, the ability to meet the demand with supplies on the goods side just wasn’t there. And that’s what we’re still battling with.
I think we are likely to see some diminution in goods demand because metrics like buying intentions for homes, for vehicles, for large household durables, quite frankly, have crashed because of high prices.
MARK: And I think there’s also an element of how healthy is the consumer because of just the robust job market? It’s been, you know, a lot of recovery since the worst parts of early 2020. What are the important trends that you’re watching that are going to, again, drive that underlying dynamic into 2022?
LIZ ANN: So, the short answer is all of them. I think we have to, in this environment, go well beyond just the standard employment metrics like the ones we get in the monthly jobs report—the payroll gains, the unemployment rate, the weekly unemployment claims. Those are important, but I think we have to broaden the lens quite a bit. Certainly, two metrics that have become very popular as gauges of the unique characteristics of the labor market right now are job openings, which are well above the number of people unemployed. So even though we’re still a couple million payroll jobs shy of where we were pre-pandemic, job openings well exceed the number of unemployed. So there are some kinks sort of in the system right now with a skills gap and fairly anemic improvement in labor-force participation rate, which we think will improve a bit more in 2022, but that’s very good news and shows the tightness in the labor market.
And then, of course, the other metric that tends to go along with that is the quits rate, which did come down a little bit in October from the September all-time-record high of 3%, meaning in one month we saw 3% of the entire workforce quit their jobs.
Now, that feeds into what has been a rising wage environment. And one good piece of news in this environment of rising wages is that more of the wage gains in percentage increase terms are accruing to folks on the lower end of the income spectrum, not on the higher end of the income spectrum. And that’s particularly beneficial because the inflation problem as it persists acts as more of a regressive tax on lower-income folks.
The rub, of course, is that wage gains, although robust, are still lower in percentage increase terms than the inflation rate. So, unfortunately, we’re still in negative real-wage-gain territory. But if we start to see some easing in inflation pressures and wage growth remains healthy, that’s fantastic news for workers. It does bring up concerns about profit margins. So far, they’ve been healthy, but I think that’s something we definitely want to keep an eye on in 2022.
MARK: Yeah, you mentioned inflation, and that reminds me that I think the favorite sub-headline in the report was, “Inflation, putting the genie back in the bottleneck.” What do you mean by that, and what’s the inflation outlook for 2022?
LIZ ANN: So we’re all now keenly aware of all of these supply bottlenecks. Some of them get more attention than others. Probably the one that has received the most attention, I think rightly so, is semiconductors because of how much they are used in so many different types of goods, not least being automobiles. And that has really fed into not only what we’re seeing in some of the economic metrics, but certainly in the inflation metrics, and some of the big spikes that we’ve seen on a monthly basis over the last six months or so have been driven by that vehicle side, both new cars as well as used cars.
But there are bottlenecks everywhere. We’re not in healthy territory yet, but things are getting less worse. So we anticipate that we’ll see an improving situation, especially if the buying intentions that I talked about earlier do mean a bit of an easing on the demand side.
MARK: All right, so that’s the macro picture. Let’s talk a little bit more specifically about investments, and why don’t we start out with the overall stock market. You’ve already mentioned that the Fed is widely expected to raise interest rates in 2022. What impact is that going to have on stocks?
LIZ ANN: So I think it’s having an impact already in terms of some of these ongoing bouts of volatility more recently I think have been directly tied to either comments out of the Fed or just the way the market is anticipating the trajectory looking like, whether it’s on the tapering of the balance sheet or eventual rate hikes.
What, ultimately, I think, drives the equity market more than anything else is once the Fed starts tightening policy, what is the pace at which they’re doing so? There are really three types of rate hike cycles if you go back to the mid-1940s.
One of them, interestingly, you could consider a non-cycle. So there have been three or four times where the Fed raised rates once or twice and then stopped. So it didn’t really turn into a cycle. There were myriad reasons why they stopped. Then you have slow cycles, which are cycles where the Fed is not raising the fed funds rate at every consecutive FOMC meeting. They might be taking a meeting off, sometimes even two meetings off. So it’s still a cycle, but they’re going more slowly. And then fast-tightening cycles are when the Fed is generally raising rates on consecutive FOMC meetings.
Big difference in how the market has behaved going all the way back to the mid ’40s. The non-cycles and the slow cycles, the average annual return for the one year after rate hikes is between 10.5 and 11.5%. So nice healthy double-digit gains. During fast tightening cycles, it’s −2.7%. So a big difference, at least based on history, whether they’re going to move slow or fast.
MARK: Another big driver for stocks, historically, have been company earnings, of course. 2021 was a great year on that point. But as you’ve already alluded to, it’s a little bit less clear whether that momentum can be sustained going into 2022. Could you dig into that a little bit more?
LIZ ANN: Sure. There was no question that the second quarter of 2021 was going to be the peak in the earnings growth rate, because earnings grew at close to 100% year-over-year. That’s just the math of the comparison being to the second quarter of the prior year, which, of course, was the worst part of the pandemic during the lockdown phase. So we knew we were going to see a deceleration in growth, although even through the third quarter, analysts had still set the bar too low. We had yet again a sixth or seventh in a row record beat rate in terms of percentage of companies beating estimates, and very wide percentages by which companies were beating estimates.
There’s an Earnings Revisions Index that’s put out by Citigroup, and it looks at the ratio of companies that are seeing their forward estimates move up versus forward estimates move down. That has rolled over and recently was floating right around the zero line, meaning about the same number of downward revisions versus upward revisions. So I think most of that heavy tailwind that was behind earnings in terms of analysts just each quarter setting the bar too low, another gangbuster quarter, I think a lot of that is behind us. And it’s due to ongoing virus. It’s due to the inflation pressures, possible profit margin pressures.
So I think as we get fourth-quarter earnings, I would pay a lot of attention to, of course, the earnings trajectory, but also what companies are saying, not only about the outlook for earnings, but profit margins, to see whether we’re at that inflection point where, especially as labor costs continue to go up, which for most companies that’s the single largest input cost, whether we have also lost that tailwind of record profit margins. That’s what I’m keeping a close eye on as we get to that fourth-quarter earnings season.
MARK: And at that point, once you have a sense as to earnings, how much are people going to be willing to pay for earnings? And that really comes down to a question of valuation. And I think, I don’t know, I’m guessing in 2021, you and I did maybe 20 different events together, and I think at every single one of those events, multiple people ask the question, “Is the market getting ahead of itself? Is it too optimistic? Is it too frothy?” So what is your answer to that right now?
LIZ ANN: Well, I think there’s been a tremendous amount of frothiness and speculative fervor during certain parts of the time in the last year or so, and I think we’re probably going to continue to see pockets of that, but that doesn’t necessarily mean imminent doom for the market. Mark, as you know, I’ve been a big sentiment watcher for 35 years, and … sentiment and valuation, which by the way, I think of valuation as not so much a sentiment indicator, but an indicator of sentiment, and that may explain why valuation, whatever version you’re using, a P/E ratio, price-to-sales, equity risk premium, it’s a terrible market timing tool. It doesn’t tell you anything about what the market is going to do over, say, the course of the next year. And that’s because it tends to be tied to sentiment. You get these very enthusiastic, optimistic, sometimes euphoric eras in the market like we had for many years in the late ’90s, and valuations can get stretched and stay stretched for an extended period of time. And if you have strong momentum and strong breadth, that tends to be an offset. So, as we head into 2022, I think keeping a close eye on the sentiment environment is important, especially because valuations are stretched. But I wouldn’t suggest using it as a market-timing tool, especially if the internals of the market remain fairly healthy. Again, that tends to be a positive offset.
MARK: All right, Liz Ann, final question, a question everyone wants to know: “What should I do?” And, obviously, we can’t make recommendations on a podcast. We’ve got way too many different types of listeners, but can you give us some sense as to how people should translate everything we’ve just been talking about into a strategy that makes sense for them?
LIZ ANN: So here’s what we’ve been saying most consistently, certainly for the vast bulk of this year, is that we’ve been in this very, very choppy environment where at the index level there’s been very limited downside. The S&P has had no more than a 5.2% drawdown at any point in 2021, at least as of the recording of this. But under the surface, the weakness has been more significant. In the case of the S&P 500, 93% of the index constituents have had at least a 10% drawdown, and the average across all 500 stocks is 19%. The average across all the stocks in the NASDAQ, by the way, is −42%. So massive churn under the surface reflecting pockets of weakness, offset by pockets of strength, driven by virus trends at times, inflation trends, long-term interest rate moves. I think that will persist.
And the best way to sort of approach an environment like that is, first of all, maintain your discipline, especially around diversification. Make sure that at the asset class level, at the sub-asset class level, you take advantage of the volatility by trimming into strength, adding into weakness, staying in gear by sort of reacting to this underlying churn, underlying volatility. Sector rotation has been unbelievably rampant. Energy is the best performing sector year-to-date in 2021, but it’s spent as many months at the very bottom of the ranking as it has at the very top of the ranking. You would drive yourself crazy trying to anticipate that in advance, but apply that rebalancing methodology there. And factors have actually been more consistent performers than sectors. So if you’re a stock picker, focus on quality, focus on strong balance sheets, and strong earnings trends, and strong free cash flow. I think the low-quality era is largely behind us. So I think that’s the way to approach this environment, kind of bring back in those disciplines, and let that volatility work in your favor.
MARK: All right, we are going to leave it right there. Liz Ann Sonders is Schwab’s chief investment strategist. Liz Ann, thanks for joining us today.
LIZ ANN: Thanks for having me, Mark.
MARK: Next up is Kathy Jones. Kathy is a managing director here at Schwab and our chief fixed income strategist at the Schwab Center for Financial Research. Kathy has analyzed global bond, foreign currency, and commodity markets extensively throughout her career as an investment analyst and strategist, working with both institutional and individual clients. Kathy makes regular broadcast appearances on CNBC, Yahoo Finance, Bloomberg TV, and many other networks and is often quoted by The Wall Street Journal, The New York Times, Financial Times, and Reuters.
MARK: Kathy, welcome to the show.
KATHY JONES: Thanks for having me, Mark.
MARK: So it’s hard to talk about the bond market and interest rates without talking about the Fed. So why don’t we start right there? What do you expect from the Fed in 2022?
KATHY: Well, we think the dominant theme in the market for fixed income is the gradual withdrawal of this easy money by the Fed. Now, that usually means higher yields and higher volatility. We’ll see how that plays out. We look for the Fed to speed up the pace of its tapering of its bond holdings. So they’ll probably double the pace after the first of the year, and that would put them on track to end their bond purchases by the end of the first quarter or so.
In the interim, we expect the Fed will probably signal some rate hikes in the second half of the year. It will be up in the air as to how quickly they move. That will certainly depend on how inflation develops and the economy develops. So we expect one, possibly two rate hikes in 2022, starting in September. Again, it comes down to really a question of how inflation and the economy are stacking up. A faster taper gives the Fed the option to, you know, change policy, but it doesn’t necessitate it. So it’s an option they’re giving themselves.
The other possibility, which I think is a low probability, is the Fed could start quantitative tightening next year. Now, that means they would actually begin to shrink the balance sheet by not reinvesting the principal and interest on its bond holdings. That could make sense if it really wants to send a strong signal about fighting inflation, but it could also be pretty disruptive to the market. So I don’t think that that’s likely, but it is an outside chance that it could happen.
MARK: So the Fed raising rates one or two times, that’s the base case, if you will. But the Fed … as you’ve mentioned many times, the Fed really only controls the short end of the yield curve, which is really important if you’re investing in cash or things like short-term CDs. What about the rest of the yield curve? What is the shape of that yield curve going to look like in 2022?
KATHY: Yeah, the yield curve is already showing signs of flattening. It’s begun to flatten. That is, the difference between short- and long-term yields is narrowed. That typically happens during periods of Fed tightening. As the Fed raises short-term rates, it sends a signal that it’s setting policy to slow growth and lower inflation down the road. And that tends to be, actually, a factor that prevents long-term bonds from … yields from rising as much as short-term bonds. So that flattens that yield curve. Again, it’s already flattened a lot, even though the Fed hasn’t started tightening, so I would expect that trend to continue.
Although inflation is currently high, inflation expectations are actually pretty close to the Fed’s long-term target of roughly 2 to 2.5% if you look out five to 10 years. So the recent pattern of flattening is consistent with the historical pattern.
MARK: Let’s talk a little bit about the spreads between, say, Treasuries and other types of bonds that have some risk associated with them. Spreads are quite tight right now. What is the bond market trying to tell investors?
KATHY: Yeah, in both the corporate bond market and the municipal bond market those spreads are very, very tight. For corporate bonds, it signals that the market is anticipating the economy to continue to grow at a healthy pace, that companies’ earnings will be strong, and that will allow them to pay their bond holders without much trouble, in terms of the paying off the debts that they have on the books. It really reflects an economic outlook that’s pretty healthy and one where bond investors are willing to invest without getting a lot of risk premium.
Similar story in the municipal bond market, where municipalities and states have benefited greatly from the rebound in the economy and some of the fiscal stimulus, and investors are willing to accept lower yields relative to Treasuries, simply because they are not too worried about downgrades or defaults. And, of course, in the municipal market, there’s also a reflection of the demand for tax-exempt income. We don’t know what tax policy will be like going forward, but there is a feeling that investors want to have some tax-exempt income.
MARK: So those tight spreads, essentially, are projecting some optimism. Do you think that’s sustainable over time?
KATHY: I think it’s sustainable for the time being, but it’s certainly a risk that investors need to monitor. So any deterioration in the economic outlook or signs of weakness in corporate earnings would certainly change the outlook. Right now, we don’t see signs of it, certainly, for 2022. But spread movements tend to be cyclical, so the better the economy does, the more those spreads narrow. And if the economy looks like it’s in trouble, they tend to widen out.
And that’s especially true in the high-yield market, you know, the below-investment-grade market. These are companies that have weaker growth to start with, higher debts, and more leverage to economic growth. And when … right now, there isn’t a lot of risk premium in those spreads. So that’s where I would be the most focused in terms of the possibility that conditions could change.
MARK: So let’s continue on with that kind of line of thinking. Given the outlook, how should bond investors start to be thinking about their portfolios?
KATHY: Well, on the duration front, we’ve been suggesting keeping the average duration on the low end of whatever an investor’s typical benchmark might be. And that’s because of the risk of rising rates. Now, for 2022, we’re looking at the potential for those rates, those longer-term rates, to probably peak maybe in the 1¾ to 2% area. And so we’re suggesting that you could use a barbell or a laddered approach to average into higher yields over time. It’s very difficult to time the market, and yields may not rise as much as many investors anticipate, so using an approach that spreads out maturities over time makes sense to us.
When we look at exposure to credit, whether it’s in corporate bonds or municipal bonds, we definitely think that the conditions, the fundamentals, are still quite positive, but the prices already reflect a lot of the good news. But we’re neutral there, and we would just be cautious about the lower-rated bonds, particularly, in the high-yield market.
MARK: Kathy Jones is Schwab’s chief fixed income strategist. Kathy, thanks for dropping by today.
KATHY: Thanks, Mark.
MARK: Now I’m joined by Jeffrey Kleintop. Jeff is Schwab’s chief global strategist.
Cited in The Wall Street Journal as one of “Wall Street’s best and brightest,” Jeff frequently appears on CNBC, Bloomberg TV, and CNN. He’s also quoted frequently in The Wall Street Journal, Barron’s, and the Financial Times.
Jeff, thanks for stopping by.
JEFFREY KLEINTOP: My pleasure. Thanks for having me on.
MARK: So, Jeff, the global GDP, that’s actually surpassed pre-pandemic levels in 2021 already. Probably, you know, a lot of people are surprised by that. So, essentially, the global economy is already recovered. But I guess, my question to you is will that momentum continue into 2022?
JEFF: Well, growth will probably be slowing, but not be slow, if that makes any sense. According to the IMF, the International Monetary Fund, and the World Bank, and other think tanks that forecast global GDP, 2022 looks to be the second year in a row of global growth well above the 3% long-term average. In fact, we haven’t seen back-to-back years of growth as strong as 2021 and 2022 are expected to be in nearly 50 years.
One reason for strong growth is Europe, the only country or region of the world to get an upgrade in the latest IMF World Economic Outlook. In the last global economic cycle from 2009 to 2019, global GDP growth was slower than average, due in part to an era of austerity in Europe. Austerity was the word used to describe tight budgets imposed to help ensure fiscal stability in the aftermath of the great financial crisis. I mean, put simply, each dollar spent by a government beyond what it collects should boost GDP by at least that amount. In the last cycle, Europe had a budget surplus, as the government increasingly took in more money than it spent, and that resulted in a pretty substantial drag on Europe’s growth. But now, in this new economic cycle, we see budget deficits as far as the eye can see, as government spending exceeds income. And that helps to boost growth to an above-average pace, going from a drag of Europe’s GDP of maybe more than 1% in the last cycle to maybe more than a 1% boost in this cycle.
Now, taken as a whole, Europe’s economy is the second largest in the world, second to the US and bigger than China. So faster growth there is a plus for overall growth.
MARK: Jeff, that sounds encouraging, but how is that going to happen given the ongoing supply shortages and supply bottlenecks that we’ve all been experiencing?
JEFF: Yeah, it’s been a big problem this year. Supply shortages lifted inflation and slowed production all year, as strong demand outstripped supply, and, of course, that’s been worsened by the supply-chain logjams. But I think that was the story for 2021. I recognize that a surplus of goods and material seems a long way off at the present, but history shows us that shortages often lead to gluts. And should a supply glut emerge in 2022, it could lead to a fall in inflation as excess inventory prompts price cuts.
I mean, the speed at which shortages can turn into gluts can be really rapid, really surprisingly rapid. And we saw that last year in the share price and earnings estimates for the world’s biggest maker of disposable gloves. The pandemic created a shortage of masks and gloves and other personal protection equipment in the first half of 2020, as we all remember. Top Glove is a Malaysian company, and it’s the biggest maker of disposable gloves in the world, and it saw its earnings prospects and stock price soar. Analysts’ earnings estimates jumped by 1,400%, and the stock price rose by over 400%. But by midyear, production had caught up, and by the time vaccines were announced in the fourth quarter, customer inventories were overstocked, and as demand began to return to normal, earnings forecasts plunged, resulting in the stock giving up nearly all of its gains.
In the past, the market seemed to have moved suddenly from pricing in a shortage to a glut, and after a year of supply shortages, we might be closer to the end of the supply chain problems in the beginning. I mean, markets, you know, they tend to look six to 12 months ahead, so they might soon begin to consider the possibility that by the second half of next year, some shortages may have started to ease, and gluts may have started to form. In fact, we might have already seen this in the coal and natural gas prices this year, which have both crashed in the past month or so.
Should a glut begin to emerge by late next year, manufacturing inputs, like semiconductors, and even finished goods, like cars and phones, may see supply outrun demand. And already there are some signs that shortages are easing for semiconductors. Major manufacturers of semiconductors, like Intel and Samsung and TSMC, for example, are all expanding their chip-making facilities. And automakers are saying that they’re probably past the worst quarter of semiconductor shortages and the worst of the supply issues that have slowed global production. And many finished items in short supply now might become widely available once those chips arrive. We know auto manufacturers are building partially completed cars and storing them until final inputs arrive. And last week’s German industrial production data shows that the turnaround in semiconductor supply is happening, and the output of cars is beginning to surge back.
So it’s reasonable to consider that this might be the case for other durable goods, and it may be welcome news for markets as a key driver of inflation pressure eases and is accompanied by improving confidence in a slow tightening cycle from central banks, but the market could also impose a risk to some industries that have thrived on the pricing boost from shortages.
MARK: I think this point about the market is expecting or look … or investors are looking at, you know, six to 12 months ahead, I think that’s an important point.
And I think another thing investors are looking at, though, is the news, and prices are supposed to be reflecting all available information at any given point in time. So do you think … these factors that you were just talking about, do you think the market has already priced that in or is there still some upside when you start thinking about global equities?
JEFF: Well, you know, I think equity valuations aren’t cheap, but they’re not at extreme levels either outside the U.S. You know, the MSCI EAFE index, which tracks non-U.S. developed market stocks, currently trades at 15 times forward earnings. That’s pretty close to the 20-year average. It came down this year, actually, even as stocks posted gains because earnings grew even faster. Of course, in 2022, the favorable backdrop for stocks might be accompanied by rising volatility, as central banks begin to slowly hike rates as inflation pressures ease. But, you know, there’s a lot of concern already, I think, priced into those somewhat average multiples.
Stock markets outside the U.S. are more economically sensitive, which contributed to their lag in the last economic cycle from 2009 through 2019, when global growth and inflation were below average. Now, when global growth is above average, even when the growth rate is slowing, as it’s expected to be in 2022, they tend to outperform when looking back over the last 50 years. So I think there’s the potential for global markets to keep moving higher on fresh leadership from stocks that lagged in the last cycle and don’t have the high valuations or overly optimistic expectations.
MARK: So when investors start looking at non-U.S. markets, they frequently just as a, you know, easy rule of thumb, they divide the world into developed markets and emerging markets. The emerging markets are dominated by China. So what’s your outlook with China and with the emerging markets in general? And, in particular, any thoughts you have on the property developers in China that have come under some pressure recently?
JEFF: Right. Over the past few quarters, Chinese authorities have clearly been on a mission to restructure China’s property sector. And that’s a big deal for China. It’s sort of in line with the idea that housing should be primarily a place to live and not an investment vehicle. You know, China is kind of a closed economic system in a lot of ways. It’s hard to move money in or out, and so often that creates investment bubbles inside of China, and a lot of money has been driven into property. China wants to drive private investment, instead, into other industries where they can compete globally, like AI, or robotics, or green technologies, or semiconductors, not housing.
Evergrande announced its overall debt restructuring last week, which is inevitable as Evergrande kind of gets sold off in pieces. There are a few other property developers that may follow, like Kaisa Group, for example. But on the other side of this economic drag is that the same day as the reorg of Evergrande was announced, China cut bank reserve requirements by 50 basis points, providing more fuel for growth. And in another sign of support for the property sector, China pledged to ease some regulations.
So on net, it’s not clear yet if this turnaround, this stimulus, can re-accelerate growth versus just helping stabilize it. We’ll have to keep watching timely indicators like interbank lending, and bond yields, and the yuan-dollar exchange rate for signs of more aggressive stimulus, particularly after China’s leaders expressed more support for growth at last Friday’s annual meeting.
So far, home prices are still rising on a year-over-year basis. We’ll get another update on that this week. And they’re holding steady on a month-over-month basis, even after many months of Evergrande kind of melting down.
So the property issues are a drag, but it doesn’t appear to be any kind of crisis. And stress doesn’t seem to be spreading to other high-yield bond issuers in China. With more stimulus on tap, the news flow on China could go from a focus on crackdowns in 2021 to propping up key industries in 2022.
MARK: All right. Jeff, you also … not surprisingly, you spend a lot of time thinking about the geopolitical environment, as well. Just within the last couple weeks, tremendous amount of saber-rattling on the part of Russia and Ukraine, mostly Russia. How do you factor that in? What do you think is going to play out there? And to a certain extent, that’s not forecastable, so how should investors be thinking about that potential conflict?
JEFF: Right. Geopolitical conflict is a kind of an always present risk of investing. It’s very difficult to forecast when it’s going to flare up. It’s just something that … you know, it’s one of the reasons why we diversify, because it’s one of those unknowables. But certainly on the front of Russia and its threats towards the Ukraine, things have been escalating. The German foreign minister called Ukraine sovereignty non-negotiable, I think, just about a week or so ago, and said Russia would pay a big price if it invades Ukraine. And Germany has a new chancellor, Chancellor Olaf Scholz. And he said about a week ago that any Russian invasion of Ukraine would be a very dramatic violation of the rules that would force Germany to react. So it sounds very threatening, like we’re on the cusp of some military engagement.
But, you know, what does it really mean for markets? I think it’s unlikely to entail a military confrontation. Germany and others are really talking about economic sanctions, not missile launches. You know, a Russian invasion of Ukraine would trigger EU economic sanctions and would almost certainly cause Germany to block this controversial Nord Stream 2 pipeline. It’s a natural gas pipeline that moves Russian natural gas to Europe, if it gets approved. Since the pipeline gives Russia continued influence over Europe and its supply of gas, while also bypassing Ukraine as a transit, it achieves Russia’s objectives without a conflict, but German energy regulators have been pushing back against the pipeline. So what’s happening is Russia’s using these threats as a means of coercion to get this pipeline approved.
It’s not something that’s likely to be a big issue for stocks, I don’t think. Natural gas prices in Europe are certainly not reacting to the threats. They’ve actually fallen sharply over the last month and are expected to fall another 25% in the coming year if you look at the futures markets. We’ll continue to keep an eye on the tensions, but I don’t anticipate a market-moving development, given the situation and the past events and their prior market impact.
MARK: All right, we will leave it there. Jeffrey Kleintop is Schwab’s chief global investment strategist. Jeff, thanks for being here today.
JEFF: My pleasure, Mark. Thanks for having me.
MARK: Let’s wrap up with the Washington outlook from Mike Townsend, our chief Washington strategist. Mike has nearly 30 years of Washington experience, and he’s also the host of Schwab’s WashingtonWise podcast. Be sure to search your podcast app for “WashingtonWise” if you don’t already subscribe.
MARK: Mike, great to have you back on the show.
MIKE: Thanks for having me, Mark.
MARK: Mike, one thing Washington got done this year was to pass the infrastructure bill with bipartisan support. But it’s one thing to pass a bill, and it’s another thing to see that actually start to have an impact on the economy. So when do you think we’re actually going to start seeing some of those shovels get into the ground?
MIKE: Well, Mark, as you know, the infrastructure bill will end up putting around a trillion dollars into all kinds of projects over the next several years, from roads and bridges, railways, public transit, to things like upgrading the nation’s electrical grid and expanding broadband access to rural areas. When President Biden signed the bill into law in November, he said that we would see shovels in the ground on projects within two to three months. Now, that may be technically true, but I think it’s more realistic to say that we’ll start to notice it by the second or third quarter of 2022. That’s when the new money will start to impact the backlog of projects that are already in the queue. But a lot of projects won’t get going for a year or even a few years. I mean, this is a multi-year spending plan. Moody’s recently estimated that the bill could create about 800,000 new jobs, but it will take until the second half of this decade to get there. That’s not a bad thing, of course, but I do think that the idea that this will be a big economic mover in the short term is a little bit overblown.
MARK: Yeah, that’s definitely a good point. I want to talk a little bit about the government shutdown, as we’re recording this, that was averted just a few days ago. But is it really averted, or is that just a temporary stopgap thing that was put in place, and by the time, I don’t know, early next year, we’re going to be having this conversation again?
MIKE: Yeah, that’s right. This is definitely a stopgap solution. Congress voted to extend government funding, but only through February 18th. So Congress is going to be right back in the same place in early 2022, facing another arbitrary deadline and a potential government shutdown in February. I think that one of the things that maybe gets lost in all of the back-patting over avoiding a government shutdown in early December is the fact that Congress still has not passed a single one of the 12 appropriations bills that fund every government agency and every federal program each year. And this is really one of the most basic responsibilities of Congress, to pass a budget that funds the government. They’re supposed to do that by October 1st—that’s when the government’s fiscal year begins—but this actually marked the 12th year since the beginning of the 21st century that Congress has failed to pass even one of the 12 bills by the deadline. So it’s become almost an annual rite of passage to have these last-minute temporary deals to keep the government open and operating. And, right now, there’s not much talk in Washington about moving forward with those appropriations bills. So I do expect we’ll have to have another short-term extension in February.
MARK: I think that’s really interesting. So we get this big bipartisan bill passed for all these infrastructure projects, but we don’t have a budget. So do you need a budget to be able to start, you know, kickstarting those projects?
MIKE: Well, really, what this is doing is just extending the funding that was put in place the year before. So in that sense, you don’t need a budget because you’re just extending the funding at the rate it was already at. So that means that there are no decisions made on, you know, whether a particular program is a good idea or a bad idea, whether it should be funded or not—it’s just being funded automatically. So in some ways it just doesn’t make sense at all, but that’s the way this Congress is operating.
MARK: Got it. Good background there. Another kind of perennial thorn in the side of the markets has been the debt ceiling issue. Again, as we’re recording this, it looks like some kind of fix has been crafted by Republicans and Democrats, but is that actually going to put the issue to bed so that it’s not something people need to be worrying about in 2022, or is this another stopgap measure?
MIKE: Well, a little bit of both. I think it’s a stopgap measure that probably means that people won’t have to worry about it until 2022, very end of 2022, or very early in 2023. Basically, Republicans on Capitol Hill don’t want to vote for a debt ceiling increase. But at the same time, they understand that the United States actually defaulting on its debt would be a catastrophe for the markets and the economy. So they’ve worked a deal that will allow the Democrats to skip a bunch of procedural hurdles and pass the bill without any Republican supporters. Republicans need to vote to create this special process, but then they won’t need to actually vote to raise the debt limit. And that’s what they wanted in the end.
While all these details were being worked out, I think it’s the plan for the Democrats to lift the debt ceiling by enough to take this issue off the table until after the 2022 midterm elections. And, really, Republicans want that too. Basically, nobody really wants to be talking about this in the run-up to the elections. So this will probably get extended until the new Congress takes office in January 2023.
But sort of like I mentioned a moment ago with the government shutdown, this basically does nothing at all to address the underlying issue of the government continuing to accumulate more and more debt. This just basically says, “OK, go ahead and accumulate more debt.” So we have another one of those situations where, you know, there’s a lot of back-patting and enthusiasm about solving a problem that doesn’t really solve the problem itself.
MARK: All right, let’s turn to taxes. You’ve told me many, many times that taxes are always the number one question you get at different client events. So what’s your best guess as to what changes in the Tax Code that investors will need to be worrying about in 2022?
MIKE: Well, of course, what we’re watching here is the Build Back Better Act, which is the roughly $2 trillion bill focused on climate change and social programs that passed the House back in November. When that bill was first introduced in the House earlier in the fall, it contained a wide array of tax increases. It had a corporate tax rate increase, it had an increase in the top individual income tax rate, it had a new top rate for capital gains, it had changes to the estate tax, and a whole bunch of other things. But as that bill made it through the Washington sausage-making process, all of those tax changes were dropped from the bill, and the end result is a bill that means that the vast majority of investors won’t see any tax changes at all.
So what’s in the current version of the legislation is a new wealth tax. It’s a 5% tax on income above $10 million and an additional 3% tax on income above $25 million. There are also some new taxes that would be imposed on large retirement savings balances, but they would only apply to balances above $10 million, and they wouldn’t even kick in until 2029.
Probably the one that we’re watching most closely, though, is the state and local tax deduction, also known as the SALT deduction. That was capped to $10,000 in 2017. That cap has disproportionately affected taxpayers in high-tax states like California, and New York, New Jersey, and others. Lawmakers from those states banded together to push for an increase, and they succeeded. The Build Back Better Act that passed the House last month increases that cap to $80,000. However, there has been pushback in the Senate about that, and negotiations are underway now to try to reduce that number or perhaps make it apply to only people below a certain income threshold. So while those details are still being worked out, we’ll have to see how that ends up. But I certainly would not be surprised if that $80,000 cap for the state and local tax deduction came down a bit in the Senate.
The sense here in Washington is that there’s probably not enough time remaining to pass the Build Back Better Act through the Senate before the end of the year, so don’t be surprised if this issue and the associated tax implications aren’t resolved until early 2022.
MARK: So, Mike, does that mean that in the event there are changes, they won’t be applicable to the 2021 tax year?
MIKE: Yeah, so that is actually one of the mysteries here, as to whether, you know, they will be retroactive to the beginning of 2022, which wouldn’t be that big a deal if they passed the bill, say, in, you know, mid- to late January, or whether they will be reset to start in 2023. So that decision hasn’t been made, but that’s, obviously, one of the key factors we’ll be watching as this unfolds.
MARK: So 2021, completely off the table, is that right?
MIKE: I think at this point 2021 is off the table.
MARK: All right. We’ve spent a lot of time talking about Washington and what Congress is doing, but let’s not forget that Washington is also a place where regulations are made, and we’ve got a very ambitious agenda on the part of the Securities and Exchange Commission. What do you think they’re going to be doing in 2022?
MIKE: Yeah, Mark, I’m actually expecting a big year in 2022 on the regulatory side of things. And, in fact, for investors, I think it’s likely that there will be more coming out of the regulators next year that could impact the markets and investing, than there will be coming out of Capitol Hill and Congress. So let me mention three things to watch for.
First, the SEC is very likely to come out early in 2022 with a proposal to require public companies to disclose more to investors about the impact of climate change on their business and the risk that climate change poses to their business in the future. Current requirements for public companies on climate change were set in 2010, and, obviously, we’ve had a lot more information, a lot more data, about climate change than we had then. But we also have a lot more investor interest in this information. So I think these new disclosures would probably be a good thing for investors.
Second, the SEC, really in response to the so-called meme stock trading frenzy earlier this year, has been considering a number of changes to the way our equity markets work. This includes things like the gamification of the stock market, which really is about whether apps on your phone are making it too easy for inexperienced investors to make maybe more frequent trades than they might otherwise make or make more sophisticated and complex trades than is maybe appropriate for their level of experience. So the SEC is looking at that. They’re also looking at what happens inside the market plumbing, whether there are conflicts of interest inside the system that may result in investors not getting the best execution on their trades, and the law requires that they do. They’re also looking at whether they can speed up trade settlement times. So there’s a lot going on in this space that I think is going to be interesting to watch next year.
And, finally, you know, one that I get asked about all the time is cryptocurrency. Regulators at the SEC are very worried that the rapid rise of cryptocurrency is leaving investors unprotected from fraud and abuse, and that there just isn’t the regulatory apparatus around cryptocurrency that would make it a better mainstream investment. On top of that, central banks around the world, including the Fed, are looking at digital currencies—some are looking at creating their own digital currency. They’re also looking at stablecoins. And even Congress is considering whether legislation is needed in the cryptocurrency space. So I think a lot of these issues will play out in 2022, and they could have long-lasting impact on cryptocurrency acceptance and growth in the future. So I think this is a really important issue for investors to be keeping an eye on in 2022.
MARK: All right, Mike, last question. We can’t talk about 2022 without recognizing the fact that there’s an election going to be happening in November 2022. So I won’t ask you to make a prediction about which party is going to win which races, but what’s at stake, and what should people be looking at and paying attention to as the campaigns start to really heat up?
MIKE: Well, the first thing to know is that midterm elections are notoriously terrible for the president’s party. Statistically, the president’s party has lost seats in the House of Representatives in 17 of the last 19 midterms and lost seats in the Senate in 13 of the last 19 midterms. So no crystal ball here, but, historically, at least, it’s looking like an uphill climb for Democrats to retain their majority in the House of Representatives.
I think the real intrigue in 2022 is going to be the battle for control of the Senate, which is, of course, a 50-50 tie right now. There are 20 Republican senators up for reelection and 14 Democrats. Five of the Republicans and one of the Democrats have already announced that they are retiring and won’t be running for reelection, so there will be at least a half dozen seats up for grabs that are open seats. But the most interesting thing to me is how each party is going to be fighting for control, and the way that’s going to play out is likely to come down to the same small group of battleground states that typically determine the presidency. So whenever we have a presidential election, we’re talking about, you know, eight or 10 states that are really the tipping points on the Electoral College. Well, this fall, in 2022, the six states that were closest in the 2020 presidential race, all six of them have a Senate race on the ballot. So that’s Arizona, Georgia, Nevada, North Carolina, Pennsylvania, and Wisconsin. So those are really going to be the states to watch, and I think, those half dozen states are going to be the states that really determine which party controls the Senate coming out of the election. So it’s going to be very interesting to watch.
MARK: Mike Townsend is a managing director of legislative and regulatory affairs here at Schwab. Mike, thanks for being with us today.
MIKE: Great to be with you, Mark.
MARK: Thanks for listening to this special episode. If you’d like to learn more about our 2022 outlook, check out our special collection of articles on the Insights tab of schwab.com. You can also follow all our guests on Twitter—just search for their names. You can also follow me on Twitter @MarkRiepe. M-A-R-K-R-I-E-P-E.
If you’ve enjoyed this episode, please leave us a rating or review on Apple Podcasts. It helps others discover the show. This is our last episode of 2021 and Season 9. Be sure to tune in for Season 10 in February. In the meantime, have a happy new year!
For important disclosures, see the show notes and Schwab.com/FinancialDecoder.
Andrews, Evan, “7 Failed Predictions from History,” history.com, August 29, 2018
2 Ten 100-year predictions that came true - BBC News
Geoghegan, Tom, “Ten 100-year Predictions that Came True,” BBC Newsmagazine, January 11, 2012.
After another full year of the COVID pandemic, what’s in store for 2022? In this year-end bonus episode, Schwab experts look ahead to consider what investors might expect from the markets in the new year.
First, Mark talks with Liz Ann Sonders, Schwab’s chief investment strategist. Liz Ann offers her perspective on the direction of the U.S. economy and stock market. She and Mark discuss consumer spending, interest rates, company earnings, and the job market, among other topics.
Next, Mark speaks with Kathy Jones, Schwab’s chief fixed income strategist. Kathy looks at what bond investors might expect from the Federal Reserve and fixed income assets in the new year. Then, Jeffrey Kleintop—Schwab’s chief global investment strategist—joins the show and examines what 2022 might hold for the global economy and markets.
Finally, as we head into a year of midterm elections, Mike Townsend, Schwab’s managing director of legislative and regulatory affairs, offers his outlook for what to expect in politics and policy next year.
Subscribe to Financial Decoder for free on Apple Podcasts or wherever you listen.
Financial Decoder is an original podcast from Charles Schwab. For more on the series, visit Schwab.com/FinancialDecoder.
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