Transcript of the podcast:
MARK: 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.
We've done about 70 episodes of this show, and when we look at the download statistics, the most popular episodes tend to be the ones where we share our outlook on markets for the next year. So that's what we're going to do today. This is our 2023 Market Outlook episode.
First, we'll hear from Liz Ann Sonders, our chief investment strategist. Liz Ann is a keynote speaker at numerous industry conferences and is regularly quoted in financial publications including The Wall Street Journal, The New York Times, Barron's, and the Financial Times.
She also appears as a regular guest on CNBC, Bloomberg, CNN, Yahoo! Finance, and Fox Business News. Finally, 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: Welcome, Liz Ann Sonders. I think you were on the first episode of this season, and now you're on the last episode. So glad to have you back.
LIZ ANN SONDERS: I'm happy to be the bookend, Mark … bookends.
MARK: One of the favorite images, at least for me, from the 2023 Market Outlook, at least your section of it, is what I call the dominoes chart, and that shows the different dominoes that need to fall that are part of the typical economic cycle. And we're talking in early December of 2022, many of the dominoes have, in fact, fallen, some are teetering, and others are unscathed. And people can see the image for themselves in the report, and we'll link to that in the show notes. But maybe let's just start out—can you summarize where we're at?
LIZ ANN: Sure. So, yeah, to your point, Mark—and the image is in the outlook—interestingly, though, it already needs an update. So what's interesting is I show as red the dominoes of things like stock prices, and PMIs, and volatility, yield curve. They're all red because they've already fallen. Then you have what were three things that tend to fall in advance of a recession that were mixed. One of them as of today has now fallen into what I call the red zone, and that's a contraction in ISM manufacturing to under 50. So we even can change that color if we're sort of doing, you know, in the moment. And then the last two that are still green in this case would be an earnings-per-share recession. Although excluding the energy sector, we're looking now at three quarters in a row of negative year-over-year change in S&P earnings, so maybe even that could arguably be yellow. And then the final thing that tends to happen well after the fact is you get the declaration by the NBER that it's a recession and when did it begin. So that one is still officially green.
MARK: Let's talk about the labor market in more detail. It's been a source of strength, but my question is, is that strength all it's cracked up to be or are there some kind of cracks there that may not be obvious to the typical investor?
LIZ ANN: So, in general, the labor market has been resilient, and there's no denying that. And certainly if you limit yourself to the traditional headlines around payrolls and the unemployment rate, it supports that view. But, you know, embedded in your question, there were cracks, and there are cracks. And one of the important things to do when assessing any economic data, certainly labor market data, is to understand which indicators are leading in nature and which are lagging in nature. And to mention the unemployment rate, probably the most popular of all labor market metrics, it's also the most lagging of all labor market metrics, and you need to move into the leading space, and this is where you are starting to see cracks.
So there's not really any formal metric for it, but the announcements of hiring freezes, we're seeing more and more anecdotes of that. There is a metric for layoff announcements—it's Challenger, Gray & Christmas puts that out. And the latest reading, which just came out last week, showed an increase of more than 400% year-over-year in layoff announcements. As you may know, Mark, out there in the Silicon Valley area, a lot of that is concentrated in the tech space. You saw a decline in job openings, a decline in the quits rate. And then even within the monthly Jobs Report, there's the Establishment Survey, which generates the payroll numbers. And then there's the Household Survey, from which the unemployment rate is calculated. And the Establishment Survey suggests that 2.7 million new jobs have been created in the U.S. in the last eight months. The Household Survey says it's 120,000. Now, the answer is probably, the real answer is probably somewhere in the middle.
But for what it's worth, the Household Survey. at least as a directional signal, tends to be a bit of a tell when you're at a turning point, particularly down in the economy. So I'd also say keep a close eye on that differential in future Jobs Reports.
MARK: So, Liz Ann, what is the bottom line on the economy in 2023? The Fed is looking for a so-called soft landing. You've pointed out many times that their track record is poor on that front. What should people be looking out for?
LIZ ANN: It is poor not because they're incompetent at what they do. You know, it's a pretty big engine, the U.S. economy, and it's tricky to engineer a soft landing, especially given the variable lags in terms of the effect of monetary policy changes on the economy. I think the recession-or-soft-landing debate misses some important nuances in terms of the nature of this cycle driven by the pandemic, which is that we are in recession already for segments of the economy. There's no denying that. Housing broadly, but also some of the tentacles, many segments of the goods side of the economy, are in recession. And that's just the aftermath of what was the outset of the pandemic, the stimulus era, when all that demand was forced to be funneled into the goods side of the economy because there was no access to services. That helped launch the economy out of the recession, but it was more focused on the goods side of the economy. It also became the breeding ground for the inflation problem with which we're still dealing. However, that's morphed both on inflation and growth from goods to services. And so you've got these recessionary pockets, but so far it's offset by strength in services. And because services employs a larger, much larger percentage of the economy, that has kept at least traditional measures of the labor market afloat. But I think it's not just a matter of time because of the way cycles work, but it's a matter of purpose for the Fed to see a further weakening in the labor market.
So, to me, best case scenario is not really a traditional soft landing; it's that a rolling recession continues to come through, and that when you get the inevitable weakness in the labor market, maybe you start to see a lift in the non-services side of the economy that was hit the most. So I view just a continuation of a rolling recession the better descriptor for best case scenario than soft landing.
MARK: So let's turn then to the stock market. As you know, we think it's a bit of a fool's errand to make highly specific forecasts about where the Dow is going or where the S&P is going and where it will end up, you know, one year from now, but, nevertheless, there are some trends that can be useful for telling us at least the possibilities and what to expect. So let's start talking about the stock market after the Fed stops hiking rates. What can we expect there?
LIZ ANN: So, Mark, it's funny, I've seen a lot of research reports and analysis and charts around about what the average performance is following the final rate hike. And, of course, the Fed has only been in existence for a little over a hundred years, and it's not like rate-hiking cycles are coming every year, so it's not a tremendous amount of history. But I don't remember who said it first—it was probably decades and decades ago—but what I find always almost humorous about analysis that's of an average is, as it's been said, "Analysis of an average leads to average analysis." So especially when you're not talking about a large sample set, you have to be very careful with an average.
So, yes, you can look, and I have a chart in the outlook that shows the average performance out to 400 days following an initial rate hike. And it tends to be in the positive end of the spectrum, at least for the first, I don't know, 250 days, and then weakens a bit. But the range of individual experiences around that average is quite significant. You had three periods where the Fed halted rate hikes—1979, 1989, and 2006—where for most of that time out to 400 days after the final rate hike, the market did well better than the average. Conversely, you've got periods like 1973, 1980, and 2000 where you were well below that average path.
If there was one theme associated with which cycles had better performance and worse performance is that the labor market was improving in the periods following the final rate hike for those eras that, as I mentioned, where you saw better market performance. And that's, in part, because the Fed typically halted rate hikes because of deterioration already in place in the labor market, setting up that point for improvement. The problem now is they're still fighting to weaken a labor market. So even if they go into pause mode, unless the labor market weakens, they could stay in pause mode and not, to use their … or the market's language, pivot to rate cuts as soon as a lot of people expect.
MARK: Of course, companies are having to deal with all of this stuff, and company earnings are a key driver of stock prices. And for much of the year, you've been cautioning investors that analysts have been on the slow side when it comes to kind of marking down earnings to reflect some of the economic weakness. Do you think that's still the case, or have they caught up?
LIZ ANN: I think it is still the case. And, by the way, that's not abnormal in any cycle. Analysts tend to be a bit late as they try to digest the macro environment and get a sense either broadly on their own or via the, you know, input they're getting from companies about the impact to the bottom line. But then you add into the mix all the unique characteristics of this cycle, the fact that throughout the cycle, especially during the immediate aftermath of the onset of the pandemic during the lockdown phase and even coming out of it, a record number of companies simply withdrew guidance and didn't provide any guidance to analysts. So for quite some time there they were left with very little information, and left to their own devices. In the first, call it, year and a half after the lockdown phase of the pandemic, they aired on the side of keeping estimates low, and they didn't extrapolate each quarter's better numbers. Then to some degree they caught up. Now I think, and here's where it gets to be the case where it's sort of normal when you're in a slowing economy, analysts tend to be a bit slower to reflect that in earnings. And now, again, we've got an increase in the number of companies that are either withdrawing guidance or couching guidance with a lot more uncertainty than has been the case in the past.
So at this point, given all the macro conditions we look at and the tie in to earnings, yes, cuts have come pretty significantly since the summer. You've hair-cutted about 10 percentage points out of expectations, but expectations are still for positive earnings growth in 2022 and positive earnings growth in 2023. And I think at some point in the next, call it, two to three quarters, we're likely to get to a point where earnings growth disappears, meaning the year-over-year change in S&P earnings will go into negative territory including the energy sector. It's been the case for three quarters now, excluding the energy sector. But I think, overall, even inclusive of energy, I think we'll get there sometime in the next couple of quarters.
MARK: So we've talked about the Fed. We've talked about companies, and other key players are, of course, investors themselves. Their attitude, sentiment, is one way of measuring that. What are you watching for there? A bunch of metrics I know you pay attention to. Which ones are the key ones in 2023?
LIZ ANN: Well, I will say it's an incredibly mixed bag right now, and I was almost hesitant to write about sentiment in the outlook because it can change so dramatically, especially some of the short-term measures of sentiment. I did put an amalgamated index of sentiment indicators in the outlook, which is the panic/euphoria model originally developed out of Citigroup by my late, great friend Tobias Levkovich. And then fashioned in a similar way by SentimenTrader. And it looks at a whole bunch of metrics, even bringing in some more economic sentiment measures, not just market sentiment measures. And at the recent lows in October, that went well into panic territory, not quite to historic extremes but pretty close, and then started to reverse from there. And in the past when that's happened, the outlook for the market with, say, a one-year time horizon was pretty universally positive, but not without a lot of volatility that could happen in the near term.
Speaking of the near term, some of the shorter-term sentiment indicators … you know, Ned Davis Research has their short-term Crowd Sentiment Poll. It looks at sentiment with more of a one- or two- or three-week time horizon. That's moved well into optimistic territory. You've seen a pullback in the put-call ratio. That had been showing extreme pessimism, not so much anymore. And then also SentimenTrader does what they call the smart money/dumb money indicators, which are real money gauges of what those cohorts are doing. And the so-called dumb money, which tends to be the non-contrarian indicator, that has shot up into extreme optimism territory. And, again, that tends to be the contrarian indicator.
So I'm a little worried right now because of some of the frothiness that crept back in, maybe some weakness like we're seeing today as we tape this might alleviate some of that. But I do continue to think that short-term sentiment swings, in addition to Fed commentary and inflation data could help define some of the shorter-term swings in the market. But I will say that the setup at the recent mid-October lows in terms of sentiment provided a pretty decent outlook. Again, if your time horizon is more than a quarter or two.
MARK: All right, Liz Ann, maybe let's wrap it up here with, I think, probably the most important question for a lot of listeners. Where do you see opportunities in the U.S. stock market in 2023?
LIZ ANN: Well, Mark, as you know, we have been much more focused on a factor-based investing and screening versus maybe the more simple and more historic focus on sectors or, you know, simplistic style box indexes like growth and value. And I think, in particular, an environment like this, where you're seeing a move away from cap-weighted performance to more equal-weighted performance, fundamentals being reconnected to stock prices, in part because there is a risk-free rate now. We're off the zero bound in interest rates. There is now that rate that gets plugged into fundamental analysis. I think that's great for stock-pickers and for active managers.
But we're also still in a constrained macro environment, of course, and what you tend to want to do with factors is you look at the bigger picture environment to see what's dear, to see what's missing, what's lacking, and then try to find companies that are displaying characteristics that are more broadly lacking. So examples of that in this environment would be positive earnings revisions and/or positive earnings surprises if you were in earnings season. An environment of deteriorating earnings revisions, that's a factor that tends to work. During bouts of volatility, you want to look for stocks that have lower volatility. In a rising-interest-rate/high-inflation environment, you want to look for companies that have strong balance sheets with lower debt, higher cash flows. Related to that with the ability to pay net interest. As rates go up, you want companies that have that cash flow that can pay the interest on their debt. In general, it's sort of a quality wrapper around factors, but also a bit of a short duration wrapper. You don't want to focus on companies that have their, you know, cash flows or profitability way out into the future because now with higher interest rates, that makes those far-in-the-future cash flows and profits less valuable. So that would be the collection of factors.
I think there will be an opportunity to go a little bit more risk-on, kind of slightly down the quality spectrum to get leverage to a pickup in economic growth. But as we've already touched on, I don't think we're at that point in the cycle quite yet.
MARK: That's right, good companies with solid business models right now. Is that an oversimplification?
LIZ ANN: No, it's not an oversimplification, but, in particular, things like that strong free cash flow, not a lot of debt, and able to maintain that upward earnings trajectory in an otherwise challenged macro environment.
MARK: All right, let's leave it there. Liz Ann Sonders is Schwab's chief investment strategist. Liz Ann, thanks for being here.
LIZ ANN: Nice to be here. Thanks, Mark.
MARK: Next up is Kathy Jones. Kathy is a managing director here at Schwab and our chief fixed income strategist. 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, there is more interest in bond markets right now than there has been in years, so it's great to have you here.
KATHY JONES: Well, thanks for having me, Mark.
MARK: Kathy, before we go to the 2023 Outlook, maybe let's put it in context by talking just quickly about 2022. It was a pretty tough year for the bond market. How tough was it, and in your estimation, what were the root causes?
KATHY: Well, you're right, Mark, 2022 was a really tough year, and, in fact, it was one of the worst in decades. I think the problems were, first, that we started the year with extremely low bond yields, near zero for short-term rates. And then the rate of increase in interest rates was so fast that there was simply nowhere to hide as a bond investor. It hit bonds all across the board.
MARK: You mentioned rising interest rates there, and you mentioned in your outlook that the Fed's rate raising was extraordinarily fast compared to past periods. Why were they so quick about it?
KATHY: Well, in a word, inflation. The Fed had miscalculated the inflationary impact of the economy rebounding so fast from the COVID downturn and the persistence of supply problems, along with the energy shock due to Russia-Ukraine war. So all that combined to keep inflation much higher than was anticipated for longer, and, consequently, the Fed had to play catch up in terms of tightening. They really had to scramble to get interest rates up to levels that would start to slow the economy enough to curb inflation. In fact, it was the fastest rate hiking cycle in terms of rate of change in modern times.
MARK: And one of the things we always talk to people about is not just assuming the recent past will automatically continue into the future. So let's kind of pivot a little bit into 2023. You're pretty upbeat about the prospects or bonds in 2023. So why is that? What's driving that?
KATHY: Well, we think 2023 is likely to be very different, and there are three main reasons.
So, first, starting yields are much higher now, and that means even if interest rates do move us somewhat higher from here, there's still a good likelihood that returns for fixed income investors will be positive. So that's because the current income, or the coupon income, you earn from bonds can provide a cushion against price declines. Typically, the bulk of what you earn in a bond is the income stream, and all income is positive. So, with coupons higher and prices lower, there's a much greater potential for bonds to produce positive returns.
The second reason is that the bulk of the Fed rate hikes is probably behind us. The market is already discounting a rise in the fed funds rate to about 5% or so, and that's reflected in what the Fed is signaling to us. Even if the Fed raises beyond that, it's not likely to affect the bond market that much because it's already been discounted.
And the third reason is inflation is abating. Inflation is still high, but the indicators point to lower inflation down the road. So we've seen a big drop in wholesale prices for a wide range of goods, like energy, materials, lumber, you name it. Those have declined pretty sharply, and, actually, some are lower than they were prior to the pandemic. So there's still relatively high inflation in the service sector, but we think that's going to ease as the economy slows down as a result of Fed tightening.
So all that's good news for the bond market. Lower inflation makes bonds more attractive because the cash flow you get from the bond holds its value much better.
MARK: Kathy, given the influence that the Fed has on the bond market and on interest rates, how will we know when they're done raising rates? I can imagine, you know, listeners thinking, "Well, a lot of this makes sense, but why don't I start investing in bonds after they're done with the tightening cycle?"
KATHY: Actually, history tells us that waiting for the last rate hike isn't typically the best strategy. I mean, first of all, nobody rings a bell. We don't usually know it was the last rate hike until later. In fact, the people at the Fed don't even know for sure when the last rate hike will be or how large it will be. They're reacting to the changing economy and inflation, as well. But, more importantly, the markets anticipate changes in policy.
You know, one way we can usually see it is by the shape of the yield curve. The inverted yield curve, where short-term interest rates are higher than long-term rates, is already a signal that the market is expecting rates to fall in the future. It's also a pretty reliable recession indicator. So, currently, the market is pricing in a rise in short-term rates to roughly about 5% in the first half of the year and then a start for rate cuts in the second half of 2023. That actually seems pretty reasonable to us. But 10-year yields have already dropped from a high of about 4.25, 4.35 or so in October, and we don't think we're likely to see those highs again. That's why we've been suggesting, actually, that investors increase duration or add some intermediate or longer-term bonds to their portfolios to lock in those higher yields while they're still available.
MARK: So cash and short-term bonds are very popular right now. Investors see kind of the high yields and the inverted yield curve, and they ask themselves, "Well, why should I take on more risk buying longer term bonds, given that I can get higher yields in cash or short-term bonds?" You know, are they being shortsighted, or what do you think on that?
KATHY: Well, the problem with staying in very short-term investments in the bond market is that you'll need to reinvest at some point in the near future, and there's a good chance that those yields will be lower when you go to reinvest. So we look at past cycles. You know, intermediate and long-term rates tend to peak before the Fed is done hiking rates, usually somewhere in a timeframe of four to six months, around that time. And, you know, that's because the markets are forward looking, and they're discounting the likelihood that if the Fed is tightening policy, we'll get a slower economy and less inflation down the road, and that will drive down yields. And, again, you can see it from the current yield curve that's inverted—it's already happening. Short-term rates are significantly higher than long-term rates. The spread between, say, two-year Treasury yields and 10-year Treasury yields is a negative 70 basis points or so. That's the widest since the early 1980s when we had very high inflation.
MARK: Kathy, you've mentioned many times that there's no one bond market. You know, just like stocks, a lot of different types of stocks, a lot of different types of bonds. So are there particular segments of the bond market that look more attractive to you than others?
KATHY: Well, we think that in an environment where the economy is slowing, it makes sense to focus on higher-credit-quality bonds, or what we call core bonds—Treasuries, other government-backed bonds, investment-grade municipal bonds, and investment-grade corporate bonds. These are bonds that typically are less volatile because there's less risk of loss. In contrast, you know, we're not as favorably inclined towards, say, junk bonds, high-yield bonds or emerging-market bonds. They're much riskier, especially in a weakening economy. The issuers have less in the way of resources to weather a recession. And, also, some of these bonds are going to have to be refinanced over the next couple of years, and for a weaker issuer to have to refinance at higher interest rates could be difficult. So we think it's too early to add that kind of exposure because the risk-reward just isn't that attractive.
MARK: All right, last question, kind of a big-picture question here. We are kind of coming out of this cycle of kind of a zero-interest-rate policy. Do you ever see yields falling back down to zero or near zero like they were in the last couple years?
KATHY: Well, I never say never, but it looks like we are exiting the zero-interest-rate world that prevailed for many years. And after the recent bout of inflation and ongoing potential for supply disruptions, I think central banks are likely to be a lot more cautious about aggressively easing policies. Coming out of a zero-interest-rate policy is proving to be very difficult for them, and it's much easier to go into it than come out of it. So we may be back in a world where there's a positive real interest rate that is nominal interest rates above inflation. And that, actually, should be the normal course of things in the bond market.
MARK: Kathy Jones is Schwab's chief fixed income strategist. Kathy, thanks for being here today.
KATHY: Thanks for having me, 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, the world is more interconnected than ever before, and that means it's more important that investors stay connected with overseas events. Thanks for being here.
JEFF KLEINTOP: My pleasure, Mark. Great to be with you.
MARK: Jeff, you pointed out in your 2023 Market Outlook that that stock markets seem to be taking their cue from central banks in 2022. And as of the time that we're recording this, that's actually led to a nice increase in international stock prices in the fourth quarter. What's behind that? Give us some context there.
JEFF: Sure. Yeah, well, the stock markets offered thanksgiving for signs central banks are slowing their rate hikes with an early Santa Pause rally. The MSCI World Index of Global Stocks is up over 15% in October and November. That's the strongest gain for a quarter since the pandemic rebound in the second quarter of 2020. Now, while a pivot to rate cuts doesn't seem likely in the near term, central banks do seem to be signaling a step down in the size of the rate hikes, and in some cases even a pause. We know the Fed has signaled, maybe a move from 75 to 50 basis points in December, and that follows the Bank of Canada stepping down from 75 to 50 basis points back in late October, and just here in December signaling they may be done after the 50-basis-point rate hike they put in place this month. We've also heard from the central banks of Australia and Norway, which stepped down from 50 to 25 basis points back at their meetings in October and November. And now the central bank of one of the largest emerging-market economies, Brazil, along with the central bank for the largest emerging-market economy in Europe, Poland, both paused, leaving rates unchanged. The broad trend seems to be a step down in the aggressive pace of rate hikes that took place for much of this past year, and that change that took place at the start of the fourth quarter aligned with the shift in market performance from the bear market that unfolded in the first three quarters of the year to this fourth quarter rally.
MARK: So, Jeff, do you see that continuing into 2023? Is that kind of good or bad for stocks, given the movements we've already seen? And I guess maybe I'll throw one more question in there. Any risks to this trend?
JEFF: Great question. The market is pricing in most major central banks halting their rate hikes around the end of the first quarter of next year, and that suggests we may be nearing the end of the global rate hike cycle. And stocks are welcoming an end to the increasing drag on the global economy from the rising cost of finance spending and investment.
But the market could be wrong. One of the biggest risks to stocks in 2023 could come from China. China's authorities are preparing to reopen and end the zero-COVID policies that have held back their economy for the past three years. In reaction, the MSCI China Index was up 29% in November. That compares to just 5% for the S&P 500® index. That surge in Chinese stocks really propelled outperformance by emerging-market stocks, but the potential reopening does pose an upside risk to inflation, and that comes just as central banks appear to be stepping down their rate hikes. Despite the fact that China has started to shift away from its zero-COVID protocols, we think a full reopening is unlikely before the end of the winter when respiratory infections typically rise. COVID cases have already climbed to new highs, according to China's National Health Commission, and the geographic spread of the virus is the widest it's ever been, with 203 cities reporting outbreaks in November.
China's reopening might look like most other countries reopening experiences with economic growth accelerating and inflation picking up. Any surge in demand from reopening may not be balanced by a similar surge in supply. While China's authorities attempted to keep production going to avoid any disruptions to production and supply chains, they really focused on a slump in demand. So any reopening beginning in March or April is likely to be gradual, but it could lead to a surge in pent-up spending by China's 1.4 billion consumers in the world's second-largest economy. That could lead to a rebound in global inflation for both commodities and goods. And the timing's not ideal, as it may come just as the point where central banks were planning on pausing their rate hikes.
Now, as China moves toward reopening in 2023, we'll be watching developments carefully to assess the balance between the impact of this reopening excitement and the inflation worries on the stock market.
MARK: Jeff, I spoke to Liz Ann Sonders earlier, and one of the risks we talked about in that interview was the possibility of a U.S. recession. You know, obviously, we don't have a crystal ball, but what are your thoughts on the possibility of a global economic recession?
JEFF: Well, inflation is still stubbornly high. Central banks stepping down the pace of rate hikes is more about responding to weak economies than making progress on lowering inflation. One important signal of an already underway global recession is the leading indicator for the world economy. It's produced by the Organization for Economic Cooperation and Development. It's a global think tank. They've been around for a very long time. And whenever there's a drop in that index they produce below 99, it tends to happen right around the start of every global recession for the past 50 years. It's a repeating story, and it's dropped below 99 again, signaling another recessionary period.
And another important global indicator, the Global Purchasing Manager's Index, is also signaling a possible recession is underway, having slipped below 50, and that's the threshold between expansion and recession, and that happened during the third quarter. The Global Composite PMI gives us a pretty broad rate on the global economy. It's compiled from surveys of business leaders for around 27,000 companies in over 40 countries that account for 89% of global GDP. So it gives us a pretty good read on the broad global economic environment, and it's not good.
But, fortunately, the depth of this potential recession appears to be mild, at least so far. Some parts of the global economy and some countries are growing, offsetting others that are contracting. For example, there remains strength in services. You can see it in travel and leisure around the world. Just try and book an airline ticket right now. Heck, I live here three miles from the Magic Kingdom at Walt Disney World. You got a 90-minute wait to get on Space Mountain right now. But at the same time, the demand and manufacture of goods has been weakening. We can see that in rising inventories and slowing sales even this holiday season.
So the recession is rolling through different parts of the global economy at different times, in contrast to what I would call the everything, everywhere, all-at-once recessions back in 2020, and, of course, in 2008 and 2009.
MARK: So given all of that, given the economic risk you just laid out, given the central bank, you know, activities that are going on with respect to interest rates, where do you see opportunities in the international stock market right now?
JEFF: Well, I think we can expect more volatility, so we should position for that. The stock market has moved up or down by 5% or more in each of the past six months. I think it was up more than 5% in July and October-November, and down more than 5% in June, August, and September. That might continue in the coming months, as the global recession lingers, central banks step down rate hikes, and China's reopening introduces upside risk to inflation.
But efforts to rotate among groups of stocks to try and insulate from elevated volatility or try to time a recovery might be unnecessary. I think that investors can simply stick to what's been working in 2022. For the past year, we've been highlighting characteristics of stocks that are outperforming, focusing on quality, which we've defined in different ways.
One way we've been defining quality stocks is high-dividend payers. Generally, a sizable dividend is a sign of financial strength and good cash flow. High-dividend-paying stocks have outperformed during past recessionary bear markets, and they've been outperforming again this year across sectors and countries. In fact, the MSCI World High Dividend Index suffered a loss in total return of 2.6% in 2022 through the end of November, nearly flat and much better than the double-digit loss for the overall stock market. More importantly, high-dividend stocks outperformed both when the market was going down during the first three quarters of the year and when it was rising here during the fourth quarter.
And another way we've been defining high-quality stocks is focusing on stocks with more immediate cash flows rather than cash flows in the distant future. We call these short-duration stocks, and these have outperformed since rates bottomed back in 2020, and they also outperformed in 2022, when the market was falling and in the fourth quarter when it rebounded. The easiest way to find these is use the price-to-free-cash-flow ratio to sort stocks. The lower the price-to-free-cash-flow, the higher the quality.
And, finally, I'd say since signs of stepping down began to emerge at the start of October, the MSCI EAFI Index of International Stocks has climbed 20%. It's now slightly outperforming the S&P 500 on a year-to-date basis. It's been a long time since we could say that. And that's despite this year's big gain in the U.S. dollar. The outperformance by international stocks might continue in 2023. International stocks tend to possess more of the characteristics, like high dividend yields and lower price-to-cash-flow ratios that have contributed to outperformance within and across sectors and countries this year. Earnings growth is also stronger outside the U.S. and is expected by analysts to remain so in 2023. And combined with lower valuations, this has really helped international stocks outperform, which may become more pronounced with a pause or reversal in the sharp rise of the dollar that characterized much of this past year.
Of course, there can be no guarantees, but investors may be able to navigate 2023 simply by sticking with what has been working in both up and down markets during 2022.
MARK: Jeffrey Kleintop is Schwab's chief global investment strategist. Jeff, thanks for being here today.
JEFF: My pleasure. Thanks for having me on, Mark.
MARK: Let's wrap up with the Washington outlook from Mike Townsend. Mike is our managing director of legislative and regulatory affairs at Schwab and our chief Washington strategist. Mike has nearly 30 years of Washington experience, and he's also the host of Schwab's WashingtonWise podcast. I suppose I'm biased, but I think it's one of the clearest discussions of the impact that Washington has on investors that you'll find. Be sure to search your podcast app for "WashingtonWise," all one word, if you don't follow it already.
Mike, with the midterm elections behind us, what's the balance of power in Washington going to look like in 2023?
MIKE: Well, Mark, we're going to have a split Congress. Republicans were able to capture the majority in the House of Representatives, though they did so by a much smaller margin than many expected. The count will be 222 Republicans and 213 Democrats, though it will actually begin as a 222-212 advantage after the death of a Democratic congressman from Virginia at the end of November. That seat will have to be filled by a special election later in 2023. But it's going to be a very narrow majority for the Republicans. It's going to be tricky for the Republican leaders to manage.
Meanwhile, Democrats managed to retain their majority in the Senate. After the special runoff in early December in Georgia, the Democrats will have a 51-49 majority. Democrats actually managed to gain one seat in the Senate, which is unusual for the president's party in a midterm election.
MARK: A split Congress is usually a recipe for gridlock on Capitol Hill. But don't the markets actually tend to like gridlock?
MIKE: Well, historically, yes, markets tend to like divided government. Over the last 120 years, using the Dow Jones Industrial Average, the market has performed best when there is a Democrat in the White House and either a split Congress or Republicans in control of both chambers.
But what the markets really like is just getting past the midterms. The S&P 500 has risen in the 365 days after every midterm election since 1950, and the average return has been more than 18 percent. Of course, past performance is no guarantee of future results, but I think that's an outcome we would all support.
MARK: Mike, what are the implications for investors for some of these key policy issues next year?
MIKE: Well, I think it's going to be very difficult for the two parties to find common ground on big issues in 2023. I really don't anticipate any major tax or spending legislation will be able to move forward until after the 2024 elections, for example.
The split Congress makes me particularly worried about an issue that the markets will be watching carefully, and that's the looming debt ceiling fight. The debt ceiling is the cap Congress puts on the total amount of debt the United States can accumulate—it's currently at about $31.4 trillion. We'll hit the cap soon, and that means Congress will have to raise it in order to ensure the United States does not default on its debts. The two parties are already at odds about how to do that, with Republicans saying they will only support a debt ceiling increase that is paired with spending cuts, and Democrats saying they won't negotiate on the issue.
Next year's debt ceiling battle actually has a lot of echoes to the summer of 2011, which was probably the most difficult debt limit battle Congress has ever had. We had a split Congress then, too, and there was a standoff that brought the nation to within days of defaulting. Market volatility spiked. Standard & Poor's downgraded the U.S. credit rating for the first time ever. Just a couple of days before defaulting, Congress made an agreement to raise the cap that calmed the markets down. Generally speaking, the markets do not like uncertainty about when and whether Congress will lift the debt limit, but I think uncertainty is what we will have as we head into a difficult fight, probably in the second or third quarter of 2023. We could see a lot of market volatility.
MARK: Is there anything the two parties might be able to work on together?
MIKE: Yeah, I think you'll see continued bipartisan support for Ukraine in its war against Russia, although there are starting to be some cracks in that support. Congress has passed three aid bills this year, totaling $66 billion in military, humanitarian, and economic assistance to Ukraine. All three of those bills passed with strong bipartisan support. There's growing concern, however, about the lack of accountability, the tracking of how aid dollars are spent. I expect we'll see more strings attached to any future aid package, but I think we'll still see strong support for Ukraine in Congress.
Another potential area for the two parties to work together is cryptocurrency regulation, particularly in the wake of the implosion last month of FTX, the second-largest crypto exchange. Even before the FTX collapse, there were several bipartisan bills in the works to try to put a better regulatory structure, including better investor protections, around cryptocurrency. Now I think the issue has become even more urgent, and there is genuine interest among the two parties in working together. So we could see something come together in the first part of 2023.
There is also bipartisan interest in strengthening oversight of Big Tech. Both parties would like to rein in some of the dominant platforms by revising antitrust laws. And after a decade of bickering, there is some common ground on privacy legislation. But getting everyone to rally around particular bills will still be difficult.
MARK: Capitol Hill isn't just about Congress; it's also about the executive branch and the regulatory function. So what about the regulatory environment for next year?
MIKE: Well, typically, Mark, when Congress is divided like it will be for the next two years, that signals a more aggressive regulatory environment. Regulation and executive orders can sometimes be the only way for the president to push forward his agenda when facing a divided Congress. So I expect regulators to continue to be very busy in 2023.
Most of our focus will be on the SEC, which is already in the midst of a huge regulatory agenda. Early 2023 should see the SEC move to finalize its controversial climate-risk disclosure proposal, which would require public companies to disclose more to investors about their impact on climate change and the risks they face from climate change in the future. There's a lot of pushback coming from the business community and from Republicans, who question whether this is even something the SEC should be focusing on. So I expect we will see a court challenge whenever the SEC puts out its final rule.
There are also a host of other issues in the queue at the SEC, including money market fund reforms; new rules requiring more transparency from private funds; new restrictions on special-purpose acquisition companies, or SPACs; and new disclosures from investment advisers about cybersecurity, about how they consider environmental, social, and governance factors when giving advice, and requiring new oversight and disclosure when they use third parties to provide various investing services.
Finally, a big issue that we're keeping an eye on is that we expect a series of rule proposals from the SEC overhauling how the equity markets work. So that's something that could affect every single investor. It's definitely something we're going to be to watching closely in 2023.
MARK: Mike Townsend is a managing director of legislative and regulatory affairs here at Schwab. Mike, thanks for being with us today.
MIKE: Thanks so much for having me, Mark.
MARK That was a lot to cover, and so if you'd like to learn more about our 2023 forecasts, I would encourage you to check out our special collection of articles on the "Learn" tab of schwab.com. Just go to Schwab.com/Learn.
That's it for us in 2022. We'll be back in the spring with more episodes.
Normally this is where I say, "Thanks for listening" and remind you to leave us a rating or a review—and also remind you that you can find the show on any podcasting platform. All that's true, of course, but what's more important is to call out the many people who make this show possible.
Big thanks to the producer and editor of this episode, Matt Bucher. Supervising producers are Patrick Ricci, Tami Dorsey, and Helen Loh. Special thanks to Colette Auclair, Pete Knezevich, Deborah Hinton-Brown, Mary Fong, and Alice Ng.
Enjoy the holiday season.
Financial Decoder is a production of Charles Schwab & Co.
For important disclosures, see the show notes and Schwab.com/FinancialDecoder.
After a tough year for the markets, what's in store for 2023? 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 inflation, 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 2023 might hold for the global economy and markets.
Finally, Mike Townsend, Schwab's managing director of legislative and regulatory affairs, offers his outlook on what to expect from a divided Congress and a busy regulatory environment.
Subscribe to Financial Decoder for free on Apple Podcasts or wherever you listen.
Financial Decoder is an original podcast from Charles Schwab.
If you enjoy the show, please leave us a rating or review on Apple Podcasts.
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