Transcript of the podcast:
MARK RIEPE: Welcome to 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.
This episode is the start of our new season. In addition to this one, we've got three more that we're working on, and they'll be available every two weeks.
The format of today's show is a little bit different from the typical episode. It's one of our Market Outlook episodes. We've done these before, and they tend to be among our most popular. In this case, it's our Mid-Year 2023 Market Outlook.
Back in December, we shared our Market Outlook for 2023, and so now that we are about halfway through the year, we're going to see what happened in the first half of the year and then look ahead to the second half of 2023.
First, we’ll hear from Liz Ann Sonders, our chief investment strategist and one of our managing directors.
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.
Liz Ann, I don't think you've been on since last December when we did the 2023 Market Outlook episode. So welcome back.
LIZ ANN SONDERS: Well, thanks. I always enjoy our conversations. Thanks for having me, Mark.
MARK: I reread the transcript to that episode I just referenced. And one thing that struck me was your statement that the best-case scenario is not really, the best-case scenario for the economy, is not really a traditional soft landing, but it's more of a rolling recession that continues to kind of go through the economy. That's pretty much held up. Do you agree with that?
LIZ ANN: It has held up and there's no denying that segments of the economy went in recession. Whether they've definitively moved out of recession, time will tell, but a lot of the early pandemic lockdown beneficiaries, housing, housing related, a lot of consumer-oriented goods, especially in the electronics space, had pretty significant downturns in terms of their behavior during the pandemic, and we've had the offsetting strength in services.
Now we're starting to see potentially some stabilization, or in the case of housing actually a bit of a lift, which could serve as an offset if services weakens further from here. So for now I still think that's the best way to think about this cycle is the rolling nature of it, and that's quite unique relative to past cycles where recessions have been more … an "everything all at once" type phenomenon.
MARK: Yeah, it seems like we've got a lot of different signals out there as of the time that we're recording this. We've had many months of declining leading economic indicators, but we've got a labor market that remains strong. Manufacturing is weak, but the services side of the economy is strong. How do you think that's all going to shake out going forward?
LIZ ANN: Well, a couple things. One, I'd argue that services is starting to show some weakening. ISM services, which is a monthly survey-based reading—it's a PMI—that most recently was worse than expected and actually fairly close to the dividing line between contraction and expansion. And manufacturing has been below that dividing line for some time now. So we may be starting to see some weakness in services.
In terms of the leading economic index, and maybe why we haven't yet seen declared a traditional recession, is the makeup of that index. There's 10 subcomponents to that index, a few of which are financial components and given the bear market in stocks, the inversion of the yield curve, some of the weakness we've seen in the banking system, that's manifested itself in significant weakness in those components. And then the remaining components have more of a bias on the manufacturing side of things than on the services side of things. That's not a fault of the index. Manufacturing indicators tend to be leading in nature, and they do tend to lead what ultimately happens with the consumer end services. But that helps to explain maybe the fairly wide gap of time with now 15 or 16 months of declines in leading indicators and not yet an obvious sign of contraction or coming contraction in the economy.
MARK: Another wild card that's out there is this, the state of the banking system. It's been a few months since the spate of forced bank closures that we had earlier in the year, and that's a good thing, of course. How worried are you that the threat of a recession, as well as banks concerned about their own well-being, will lead them to tighter lending standards, and that could ripple through the economy?
LIZ ANN: So, in terms of tighter lending standards, that's been in play for a while now, even predating the start of what we think of as this era's banking crisis, which was specifically March 8th when we had the failure of Silicon Valley Bank.
The data that's most widely watched looking at lending standards across the spectrum of consumer loans, commercial industrial loans, is only done quarterly. And we got a release in May, which showed a further worsening, meaning lending standards getting tighter. But the reality is that the report that came out prior to that, which was in February, which for the most part covered into year-end last year, a little bit of time into the beginning of 2023.
But of course, all of that data predated the start of this banking crisis. And even in that February report, you saw lending standards had tightened pretty significantly into recession territory, in fact, to levels that have never occurred in the past other than during or in the lead-in to recession.
So we were there already, and maybe no surprise, the data that came out in May, inclusive of a good chunk of the time post the failure of SVB, only got worse. But of course, there are, as Milton Friedman once said, long and variable lags in terms of the impact of tightening policy on the part of the Fed, tighter financial conditions in terms of the lending environment. So we may not yet have felt the full brunt of that.
MARK: Liz Ann, let's shift to the stock market for a second. The Fed is expected to pause their interest rate hikes. Let's imagine for the moment that actually happens. Does that tell us anything about how the stock market is going to perform over the next several months?
LIZ ANN: The short answer, Mark, is not really. And you know, and I detail this in the Outlook report, it is certainly possible, and we've done it, to take an average of the 14 rate hiking cycles, meaningful rate hiking cycles, in the history of the Fed as we know it now, and look at what the average performance of an index like the S&P has been in the lead-in to what ends up being the final rate cut and then all the way out to six to 12 months after the final rate cut. And you can easily construct an average. And in my outlook, I have a chart that shows the average. I also wrote a column about this in the Financial Times a few months ago.
But given that 14 is not a large sample size and the fact, and I show this in a subsequent chart, the range of outcomes around that average is quite significant. In fact, in that six-to-twelve-month subsequent period following the final rate hike, the range is from negative 30% returns to positive 30% returns, which is why I harken back to, I don't know who coined the phrase of "analysis of an average can lead to average analysis."
And I think that is absolutely a play, and it frustrates me when I read a comment like, "well, the typical performance of the market is X," when given a small sample size and a wide range, almost by definition, there's been no experience that actually looks like the average. And it really just points out that there's a myriad of other forces around the stock market and what drives it than simply monetary policy, even though the "don't fight the Fed" mantra, I think, is still valid. So I think there's a lot of other things we have to look at to get a sense of this cycle and what it likely means for equities.
MARK: Yeah, very true. I mean, the stock market, I think going back to 1926, is up on an average 9% per year, but it actually rarely is up in that 8% to 11% range. It's usually much more volatile than that. So another issue with the stock market has been, it's been a pretty good year so far, but most of the gains have been concentrated in the biggest companies. Is that inherently a good thing? Is that a bad thing, or frankly, it doesn't matter one way or the other?
LIZ ANN: Well, to some degree, it's inherently a more common thing than I think a lot of people believe when you're dealing with these cap-weighted indexes. It's often the case that the larger cap names in a cap-weighted index are going to drive more of the performance. The problem arises when the majority of other stocks other than say the top five or top 10, which in this market environment, that's been where the dominance is, are significantly underperforming the market. And that's one of the things that we address in our Outlook.
At the recent low, which was right about the point where May was transitioning into June, you saw what we believe is a record low. We're limited in terms of how far back the data goes, but we believe it was probably a record low of only about 15% of S&P stocks were outperforming the index over the prior three-month period of time. And that's even well below where we were, say, in late 1999, early 2000, the last time we had other than 2020, which got a lot of skewing because of the pandemic.
But that was the last time we saw a concentration like this. The benign way for a concentration, if you want to call it a problem like this, to resolve itself, is where those large-cap names maybe fall under a little bit of pressure of profit taking, but you start to see the market broadening out where you see greater participation down the cap spectrum manifested in things like equal weight doing fairly well relative to cap weight.
So, you get a convergence that comes in both directions. Of course, our overarching message for investors is, number one, FOMO is not an investing strategy. So be careful about either chasing outsized returns or by virtue of not rebalancing, letting your own portfolio become overly exposed to a small handful of names, because at some point there will be a reversion to some semblance of a mean, even if it's a benign type convergence of larger-cap names giving way a little bit to broader participation down the cap spectrum.
MARK: Well, Liz Ann, you mentioned earnings, and we all know that ultimately the stock market is driven by the earnings of companies. And analysts, we're recording this in Q2. Q2 is not done yet. Analysts collectively don't seem to be expecting much for company earnings in the second quarter, but see a decent recovery for the second half. What's your assessment? Do you think they're overly optimistic, overly pessimistic, or maybe somewhere in the middle?
LIZ ANN: Well, not to backtrack, because we're on here talking, Mark, about our outlook, which is not about the past. But first quarter this year ended up, I think analysts ultimately got too pessimistic and the bar was set a bit too low. I believe at the worst point, there was an expectation of near double-digit decline for earnings, S&P earnings in the first quarter year over year. And it ultimately turned into about a flat performance. Now there is a mid-single-digit decline expected for the second quarter. You know, it's hard to judge on a quarter-to-quarter basis whether that bar has been set, you know, equally low as the first quarter was and whether we'll have another quarter of a beat.
But your question specifically was the latter part of this year. Right now, the consensus for third quarter is a mild move into positive territory for earnings and then back into double-digit territory by the fourth quarter. That's where I think estimates are probably too high, in part because of the long and variable lags that we talked about. One of the charts I have in our Outlook is lending standards, which we already touched on, have a, are a pretty good leading indicator for earnings, and that suggests some more downside from here.
I think what's unique in this cycle, Mark, and you know, three years ago, when we were in the worst part of the pandemic, a record percentage of companies simply stopped providing any guidance to Wall Street. Now, many of them have started providing some semblance of guidance again, but the combination of unique uncertainties in this environment, not to mention a lot of companies, quite frankly, almost taking the pandemic as an excuse to stop providing quarterly precise guidance, because that's not how businesses are run.
So I think as a result of that, analysts are sort of keeping their estimates close to the vest, so to speak, meaning they might make adjustments out a quarter or so based on what companies are saying during the current earnings call. And they're sort of leaving aside the numbers that are two, three, four quarters out. So I think that may reflect why there hasn't been much movement to that pretty lofty estimate by year end is the combination of not having that guidance, but also waiting for each quarter's earnings season to get those more precise outlooks from company management.
MARK: Another thing we hear a lot about, clients asking us about, is the inflation rate. It's coming down. That's a good thing for many reasons. But one of the things I liked about your report was that it highlights the influence that the inflation rate can have on the typical price-earnings ratio seen by the stock market. What is that relationship, and what is it telling us now?
LIZ ANN: Yeah, so it is an interesting relationship historically, and there's a table in the Outlook that looks over a very extended, many, many decades, at various ranges for the Consumer Price Index.
So that's the proxy for inflation in this analysis, and then what the average P/E has been in those eras. And importantly, going back to that "analysis of an average leads to average analysis," we also show the range from highest P/E to lowest P/E, and this is all for the S&P 500®, when in those various inflation ranges. And what it shows, maybe coincidentally, maybe not coincidentally, is that the sweet spot in terms of when the market has traded at the highest P/E ratios has been in and around 2% BPI. If you get much lower than that into deflation, you start to see a bit of a compression in valuations. And of course, if you move up in terms of inflation into hyperinflation, you know, 8% plus kind of zone, that's when you really see compression on multiples.
And I think that just helps to explain the unfolding of the bear market that began at the beginning of 2022. It came in conjunction with the Fed moving off the zero bound, the most aggressive tightening cycle in 40 years, and an expensive market gave way in an environment where high inflation did not justify the equally high levels of P/E ratios. That's starting to improve with disinflation, but there's probably more work to be done.
MARK: Liz Ann, you spend part of your day focusing on hard economic numbers, hard numbers about the market, but you also spend time thinking about how investors are behaving, how investors are feeling. So, market sentiment, what are you seeing right now in that area?
LIZ ANN: So even in investor sentiment, you can think of it in both attitudinal terms and behavioral terms. It's kind of like the difference between consumer confidence and consumer spending. Consumer confidence is a survey of consumers, what they're saying. Consumer spending is obviously what they're actually doing. And you can see differences that arise with those types of measures for investor sentiment too.
In fact, about a year ago, when we had the first big move down in the market, attitudinal measures of sentiment actually went to record bearishness, but behavioral measures of sentiment didn't even come close to matching that. Investors were still very heavily exposed to equities. The October low of last year, you started to see a better sentiment environment, meaning you were seeing it both on the attitudinal side in terms of bearishness and on the behavioral side. And I only say that was positive in the sense that at extreme, sentiment tends to act as a contrarian indicator, not with any kind of perfect timing. You can see sentiment get to an extreme and stay there for a while.
But I'd say now fast forward today, we're starting to see some froth build. Again, it's not the meme stocks this time. It's anything AI related and that helps to explain the bias of concentration amongst the large-cap names. The good near-term news is a move up from more pessimistic territory into more optimistic territory for aggregate measures of sentiment usually serves the market well. If that continues and gets to a real extreme, that's when you start to run into problems. So that's something I'll be watching as we get to the middle part of the year, is whether some signs of froth turn into more overt signs of froth, and then I think that becomes a risk factor for the market. But right now it's a decent backdrop.
MARK: There's a lot of great ground covered in the report itself. And that's, of course, what I hope you listeners really do is actually go and go to the show notes and click through to the report on Schwab.com. But maybe, Liz Ann, I will give you a chance to just kind of summarize your overall Outlook.
LIZ ANN: Yeah, so coming into the year, we thought a downturn in the economy beyond just the rolling nature might show itself and hit the labor market. And that seems to have been pushed out. The market behavior in the first half of the year on the surface looked very resilient, looked great. But under the surface, beyond that small subset of stocks, you did see much weaker performance. And I think it reflected the macro environment.
Thinking about the second half of the year, the potential for an actual declared recession by the NBER1 clearly has been pushed out a bit. I'm not sure that that's a better scenario for the market than if it had already happened or was clear in the first half of the year. One of the things that we're looking for is to see if there's a continued broadening out of the market beyond just the small subset of large-cap stocks. I think that would be a good sign for the market. But from a fundamental perspective, I think we probably need to get to the point of stabilization for forward expected earnings growth. Notice I didn't say a return to strong earnings growth. I just said stabilization. We have to remember that the stock market is a leading indicator, and it tends to have some of the best moves on the upside when earnings have stopped deteriorating and start to stabilize, not at the point where they're booming again.
So those would be some of the key things that we're looking for in addition to getting past this fog of uncertainty with regard to Fed policy. That's an obvious one.
MARK: Liz Ann Sonders is Schwab's chief investment strategist. Liz Ann, thanks for being here today.
LIZ ANN: My pleasure. Thanks for having me, Mark.
MARK: Now I’m joined by Jeffrey Kleintop. Jeff is Schwab’s chief global strategist and one of our managing directors.
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 frequently quoted in The Wall Street Journal, Barron’s, and the Financial Times.
Welcome to the podcast, Jeff.
JEFFREY KLEINTOP: You bet. Thanks for having me on, Mark.
MARK: Jeff, you’re expecting milder returns to international stocks for the rest of the year, and the root cause of that seems to be the expectation of a slowing global economy. What’s the thinking behind that, and where do you see evidence of that happening?
JEFF: Well, it’s official that Europe entered a recession back in Q4 and Q1. But it’s its mildest ever, and that probably isn’t too surprising. But it’s also probably too much of a generalization. During the typical global recession, all areas of the economy—like manufacturing, trade, services, retail, construction—they all tend to turn down around the same time. But over much of the past year, only manufacturing and trade seem to be in a global recession—and not just in Europe, but on a global basis as well, and we can see that in indicators like industrial production, worldwide trade volumes, job growth by industry, surveys of purchasing managers at manufacturing companies, and many others.
So I’m referring to this as a "cardboard box recession," because things that are manufactured and shipped tend to go in a box. And also because demand for corrugated fiberboard, which is what most cardboard boxes are made out of, has fallen similar to what we've seen in past recessions.
MARK: Jeff, I think of boxes, and I think you think about it the same way, boxes represent the manufacturing side of the economy. So what’s happening with the service side of the economy given that that's such a, you know, it's pretty prominent in its own right?
JEFF: Yeah, well you know, in contrast to the cardboard box recession, service industries, which, yeah, make up the bulk of economic activity, they've continued to grow. The global services PMI remains well above 50—that's the threshold between recession and growth. As consumers have turned to shopping for experiences over goods, we've seen that shift towards services. As an example, the airline industry’s International Air Transport Association—that's the trade group for airlines—they doubled their estimate for global profit in 2023 on the surge in flying. So this kind of explains why this is the mildest ever recession—part of the economy is in a classic downturn, while part of the economy is not.
MARK: Jeff, the economy is one thing. Company earnings are another thing, and of course that’s really important to equity investors. How do you see company earnings holding up, and do you see the same kind of divergence between manufacturing firms and service firms that you were just talking about?
JEFF: Yes we do. The divergence also extends to this mild earnings recession taking place on a global basis. Historically, the global manufacturing PMI survey leads earnings growth for global companies by about quarter or so. It currently continues to point to low-to-mid-single-digit year-over-year percentage declines for earnings per share. Now, falling earnings are never great news, but this drop is barely noticeable when we compare it to prior recessions where they fell 20% or more when kind of everything was falling at once.
If we look further ahead, the gap between earnings expectations for cardboard-box-type industries and services industries is double-digit. Over the coming year, analysts’ forecasts for the earnings growth of companies in manufacturing industries is for growth of about 4% versus 15% for services. And now these forecasts by analysts are often, kind of tend to be overly optimistic, but the wide gap between them is what's important here. It highlights how the economists and analysts are aligned on the current nature of the recession.
So I'm more worried that services industries begin to weaken than I am hopeful that cardboard box-type industries rebound in the second half of the year both economically and profit-wise. And that's because the change from shortages to gluts in the global market for goods that took place in mid-2022 may now be shifting to the global labor market.
MARK: Yeah, let's talk about that a little bit because a hallmark really of the U.S. economy over the past couple of years has been its strong labor market. What do you see overseas? Do you see those same dynamics playing out?
JEFF: Yeah, it's been pretty solid as well, but that could be changing. Company communications on earnings calls and shareholder presentations reveal a rising trend that I'm tracking of mentions of job cuts. I'm doing these text screens on all of these communications that come out, and I'm finding phrases like "reduction in force," or "layoffs," or "headcount reduction," or "furloughs for employees," or "downsizing," or "personnel reductions." All those types of phrases are on the rise, along with a falling trend in mentions of labor shortages, including phrases like "inability to hire," or "difficulty in hiring," or "struggling to fill positions," or "driver shortages," which was a popular one for a while. So we're seeing that big shift from labor shortages to maybe labor gluts emerging in the coming months.
Also, corporate cash flow has been declining based on business bank deposits in Europe. And this tends to lead trends in job growth. And lending conditions may also contribute to the weaker jobs outlook. There is a clear and intuitive leading relationship between banks’ lending standards and job growth. The magnitude of the recent tightening in lending standards from banks in the U.S. and Europe points to a potential shift from job growth to job contraction in the coming quarters. This weakness in manufacturing job growth could begin to spread into services industries in the second half of the year.
MARK: So one thing we haven't mentioned yet is inflation, and central banks in other countries seem just as eager to fight inflation as the Fed has been eager to fight it here in the U.S. What's your sense? Are they achieving any success on that front?
JEFF: Generally yes. For example, inflation's been coming down in Europe from, it was 10% in October, it's about 6% now. And that decline could accelerate in the coming months. This is where the cardboard box recession may be good news. The manufacturing PMI survey has an output prices question, which signals the trend in prices charged by manufacturers. And it's consistently forecast six months beforehand both the direction and level of inflation in Europe, the U.S., and the United Kingdom. Europe's latest PMI price index shows inflation may track from the current 6% to near 2% during the next six months. And that means inflation might just continue to recede as fast as it rose.
If inflation appears on track to reach their target of 2% by year-end, the European Central Bank may pause rate hikes this summer. And that could mean a shift away from all the market’s attention revolving around central bank actions in the first half of the year.
MARK: So let's turn from, kind of, the economy and the macro environment to what's going on in the markets. A popular way of dividing up the world is to put a bunch of countries into the developed-market category and a bunch of other countries into the emerging-market camp. So let’s start with developed markets. What are you seeing there for investors?
JEFF: Outside the U.S., the bull market has actually been really broad. An equal-weight index represents the “average” stock. I like to look at that—each stock gets the same weighting. Since the end of October—that month when the world's stock markets bottomed, the message from the performance of the average stock is that a new bull market seems to be underway.
The equal-weighted international stock market index know as the MSCI EAFE Index is up over 20%—measured in U.S. dollars—since the end of October, meeting the technical definition of a new bull market. Yet, the equal-weighed S&P 500 index is up only 6% since then. In general, the greater the number of stocks that are helping push the overall market higher, the more support the market has. While U.S. and international stocks are up a similar amount measured by the more commonly cited capitalization-weighted indexes this year, the average international stock continues to outpace the average U.S. stock, offering a broader base of support for the bull market in developed international market stocks.
MARK: Yeah, I'm glad you pointed that out, because in the U.S. it's been such a concentrated market. Just a handful of companies, you know, are driving most of the returns for the first half of the year. Very interesting to see the contrast between the two. Let me turn to one country in particular, and that you’ve highlighted, and that is Japan. What makes Japan special right now?
JEFF: Japan is the world’s largest stock market outside of the U.S., and it hit a 33-year high last week following 10 weeks in a row of gains. Japan’s Nikkei 225 Index has widely outperformed the solid gains for the S&P 500 this year—when measured in dollars as well as in local currency—as it did last year. And there are several reasons why Japanese stocks might continue to surprise investors and help lift the performance of overall international markets: First, a regulatory push meant to encourage putting idle cash to use in the form of stock buybacks and other measures to improve shareholder returns is being put in place. Second, Japan’s GDP growth is exceeding the U.S. and other Group of Seven nations this year. And third, Japan may benefit from the “de-risking” of supply chains in Asia, and foreign investors are increasingly seeking exposure to Japan with Warren Buffett among them. You know, despite this 10-week-in-a-row rally, Japanese stocks remain inexpensive, trading at a price-to-earnings ratio of 14 on a 12-month forward earnings estimates basis, which is below the 20-year average for the MSCI Japan Index. That compares to an above average 19 for the U.S. S&P 500 Index. So Japanese stocks are pretty inexpensive relative to U.S. stocks today.
MARK: Yeah, let's now turn to emerging markets. And if we're going to talk about emerging markets, the big kahuna, if you will, is a neighbor of Japan. And that's China. So what's going on there?
JEFF: Yeah, that's a different story. We are still neutral on the performance of emerging-market stocks this year, which still seems dependent upon that U.S.-China relationship as much as China’s continued economic recovery. The reason China's so important to emerging-market stocks is it's directly the largest weight in the MSCI Emerging Market Index. It's over 30%. But there's a lot of indirect exposure among all the other countries that kind of feed off of China's growth, effecting the Emerging Markets Index as well. Now, geopolitical tensions seemed to have had little impact on China’s domestically driven economic growth, but they did appear to weigh on China’s stocks. Despite the strong and better-than-expected economic performance in the first quarter, China’s stock market fell after the spy balloon controversy erupted in early February. And that slump disrupted a 60%, that's six-zero, three-month rebound from the end of October until this year’s peak on January 27.
Now, leaders on both sides have signaled that U.S.-China relations may soon thaw as U.S. policymakers schedule meetings with their counterparts in China. In fact, Secretary Blinken met with Chinese officials this past weekend. But tensions have the potential to remain strained in the near-term with a Biden administration executive order to restrict U.S. outbound investment into China possible in the coming weeks, so that transition may not be smooth. The momentum in China’s economy did slow after the initial post-zero-COVID rebound, but more aggressive stimulus seems to be forthcoming here to reinvigorate that recovery.
MARK: So obviously we encourage people to go read the report on Schwab.com, but Jeff, final question. What’s your elevator speech? How do you sum up your mid-year Outlook?
JEFF: Well, to sum it all up, I'd say this mild cardboard box recession could see weakness spread into services industries if job growth eases—so we will be keeping a close eye on that. On the positive side, easing inflation should allow most central banks to go on hold sometime this summer—although cuts to rates seem unlikely. And I still expect international stock market leadership may continue here in the second half of the year.
MARK: Jeffrey Kleintop is Schwab’s chief global strategist. Jeff, thanks for being on the show.
JEFF: My pleasure, Mark. You know, for more on these and other insights, listeners can check out my Twitter feed @JeffreyKleintop or find me on LinkedIn. And of course, they can find content to aid investment decision-making from me and all of our experts on Schwab.com.
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 both an investment analyst and a strategist, working with both institutional and individual clients.
Kathy makes regular broadcast TV 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.
Welcome to the show, Kathy.
KATHY JONES: Thanks for having me, Mark.
MARK: The first observation in your Mid-Year Market Outlook is about how there was really a lot of change in the bond market and volatility and turmoil, etc., in the first half of the year. But in many ways, not a lot changed. What do you mean by that?
KATHY: Well, when you look at where Treasury yields are today versus where they were at the start of the year, what you notice is that it's only short-term yields that are higher. The Fed rate hikes have pulled up short-term yields, but for bonds with maturities of two or three years or more, yields are about unchanged in the Treasury market or even a bit lower.
There has been a huge amount of volatility, partly due to the rapid pace of rate hikes by the Federal Reserve and partly due to the ripple effects of those rate hikes through the banking system. But the overall trend has actually been for a more inverted yield curve. That is, short-term rates moving up, but intermediate and long-term rates staying flat or actually moving lower.
Short-term rates are generally up because they directly reflect the Fed's rate hikes, while intermediate and long-term rates reflect the expectation the market has for where rates are going in the future and for the growth and inflation in the economy.
It's similar on the credit side. Although yields in corporate bonds have moved up along with Treasuries, the spread between those yields and Treasuries is very close to starting levels for the year. In some cases, that spread has actually narrowed a little bit, which is not what you typically see in a tightening cycle. Usually there are concerns that when the Fed hikes rates, the economy will slow down, defaults will rise. This time around, the market's not pricing in a significant rise in defaults. It really has been a somewhat unusual tightening cycle in that way.
MARK: Kathy, I think the last time you were on the show was last December for our 2023 Outlook. And your theme was "bonds are back." Investors, of course, care about returns. Not surprisingly, 2022, not a great year for the bond market in terms of returns. How is 2023 shaping up so far?
KATHY: Well, so far so good in the bond market in 2023. You know, in the Outlook, we talked about how bonds are back. And what we meant is really filling that traditional role in portfolios—generating income, providing capital preservation, and diversification from stocks. And now, due to the higher starting yields and the inverted yield curve, returns have been positive for just about every category of the fixed-income market we track.
In general, returns are generated by the income stream that the bonds throw off, plus or minus the price change. Short-term bonds, by definition, tend to have very little exposure to what we call duration risk or interest rate risk because they roll over so often, you're reinvesting at those higher rates, so investors largely earn the current yield. For bonds with more duration, the higher starting yields have offset the price declines by and large. And that's, you know, resulting from this inverted yield curve.
So the price declines have been quite modest because the yield curve has gotten more inverted. In other words, prices for long-term bonds haven't fallen much at all. So investors are earning the income stream, which is higher, and that's throwing off a total return that's positive.
MARK: Kathy, the Fed matters a great deal to bond investors. What are you expecting from the Fed for the rest of this year?
KATHY: Well, the Fed's made it pretty clear that it wants to continue to increase the fed funds rate in the second half of the year, at least hold it steady. Strategy all along has been hike rates first, get to a level that they're comfortable will reduce inflation and hold it there for a while until inflation comes down and then recalibrate in the future by cutting rates somewhere down the road.
So we seem to be in this transition from the hike to hold phase. but we can't rule out another rate hike this year if inflation doesn't come down faster and further.
So the signal from the last Fed meeting was that there was a consensus estimate for one more rate hike this year, but there actually were a few Fed governors who voted or indicated that they were willing to raise rates even higher than that, and then there were some that were lower. So, it's just a median estimate. There's a range of estimates, and it always just comes down to the data.
Now, I'm optimistic that inflation will continue to fall, but it is up to the Fed to decide if it's coming down fast enough toward their 2% target to go into a holding pattern. My guess is that the Fed will want to see more evidence of falling inflation in the service sector, where it's been kind of sticky or stubborn and a cooling off in the job market. Those trends are happening, but probably not fast enough to say that the peak in rates is behind us.
MARK: One of the sections in your report that I found especially interesting was a section called "Holding Is Tightening." What do you mean by that, and why does it matter to bond investors?
KATHY: Well, I think it's important for investors to understand that even if the Fed isn't hiking rates, the process of tightening monetary policy is continuing. Now, there are two reasons for this. One is that the Fed is still allowing its balance sheet to decline, this process of what they call quantitative tightening. So, when the bonds it holds mature, they aren't replaced, and that shrinks the balance sheet.
So far, the balance sheet is down from nearly $9 trillion at its peak to about $8.4 trillion, so roughly about $600 billion or so. To the extent that it reduces the amount of money in the banking system, it's a way to tighten policy, and it's kind of going on in the background. And the Fed is indicating they're going to continue to do that even if they stop raising rates. What we've heard is that they want this to continue possibly for several more years to get the balance sheet significantly lower, maybe somewhere in the $4 or $5 trillion level. So, a long way to go on that.
But the second reason that holding is tightening is that real interest rates are rising. So even if the Fed isn't raising nominal interest rates, the real rate adjusted for inflation is rising if inflation continues to fall. So higher real rates are one way the Fed tightens policy. It makes it much more expensive for households and businesses to borrow, to consume, to invest, and that slows down the economy. So, as long as inflation is falling, and nominal rates are steady, that means real rates are continuing to move up.
MARK: All right, Kathy, last question. What actions are you suggesting that investors consider to prepare them for the latter half of this year as well as beyond?
KATHY: So our guidance has been for investors to consider extending duration in their bond portfolios—that is, add some intermediate to long-term bonds at current yields.
So, with the Fed in tightening mode, the outcome is likely to be slower growth and lower inflation. That's what the yield curve is telling us. Bond investors expect yields to fall in the future. So in that environment, bonds tend to do well.
We also see reinvestment risk from sitting in cash or very short-term investments. For example, it's tempting with six-month or one-year T-bills yielding over 5% to just stay very short, just sit there and earn that income. But the problem is that when those mature, there's a very good chance that you'll have to reinvest at lower yields. And so, we think it makes sense to lock in some of that income stream from intermediate and longer-term bonds, even if it means getting a slightly lower yield.
But we also want to stay in higher-credit-quality bonds, those with higher ratings and lowest risk of default. So for example, yields on investment grade corporate bonds are now roughly in the 5%-ish area, and that's for bonds with average duration of five to 10 years. We think that's an opportunity for investors where the risk reward is pretty attractive. You can lock in those cash flows for the future.
Similarly, we think investment-grade municipal bonds at current yields are attractive for long-term investors in higher tax brackets. So we're a lot more cautious about lower-rated bonds, like high-yield bonds or junk bonds, because they are vulnerable to a potential downturn in the economy, and the risk-reward there doesn't look as attractive. But bottom line is that we are seeing opportunities in the bond market that we haven't seen for a long time to lock in yields at what we think are attractive levels for investors who are looking for that long-term income in their portfolios.
MARK: Kathy Jones is Schwab's chief fixed income strategist. Kathy, thanks for being here today.
KATHY: Always glad to be here. Thanks, Mark.
MARK: And finally, we have Mike Townsend to cover Washington.
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 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.
Thanks for joining us today, Mike.
MIKE TOWNSEND: Great to be with you, Mark.
MARK: Mike, I was just looking at the transcript from the episode we did last December for our 2023 Outlook. The very first thing you called out was how difficult it would be to get stuff done in Congress, and the debt ceiling was your exhibit number one for that.
And the good news is the debt ceiling was resolved, so that's great. But the deal created some consequences for Congress and the president to grapple with this fall. I was hoping you could tell me a little bit about what those are and how they'll affect investors.
MIKE: Sure. Well, you know, Mark, the first thing that investors should know about the debt ceiling itself is that it's just off the table until mid-2025.
The new law suspends the debt ceiling until January 1st, 2025. But at that time, Treasury will be able to take its so-called "extraordinary measures" again, which, as they did this year, will likely last several months. So that pushes the next default deadline well into 2025 after the next election and with a new Congress in place. So that's probably a good thing for the markets.
But as you said, the debates over the budget and spending are just beginning. The debt ceiling deal requires Congress to pass the 12 appropriations bills that fund every government agency and every federal program by the end of the year. And if they're not all passed by then, then there is an automatic, across-the-board 1% cut in federal spending, and that's everything, defense, not defense, all spending. So that's a pretty powerful incentive to try to get the annual government funding process done properly this fall.
MARK: Mike, you've told me in the past that when you first came to Washington, those appropriations bills were in fact passed on time. And that was just the normal way of doing business. But it seems to me that that hasn't happened again in quite some time. So what's the real story there?
MIKE: Yeah. You know, based on recent history, it's not something Congress has a lot of a success at. Congress has actually not passed all 12 appropriations bills since 2005, and in a split Congress this year, I think it's kind of a stretch to think that they're going to be able to do it this year.
What has ended up happening in recent years is that Congress ends up sort of lumping all of the appropriations bills, sometimes all 12, sometimes a handful of them, into one giant omnibus package. Or the other thing that they tend to do is they just end up passing an agreement that extends all the funding at previous levels for another year. Either way, that means that not many specific decisions are getting made about whether each program is working or not, and frankly, whether it deserves to be funded for another year. So if you just extend funding for everything, there's no fiscal discipline there.
So we'll see how it plays out this year. I'm skeptical that a divided Congress will manage it. And as is always the case at the end of the year, if it doesn't get done, Congress could just pass a law that postpones those automatic cuts. So, we'll see whether this really results in anything new or anything different.
MARK: As we're recording this, some House Republicans are unhappy with the deal, the debt ceiling deal I mean, and how are they venting their frustration, and do you think that's going to have any meaningful impact on, you know, what gets done for the rest of the year?
MIKE: Yeah, this is a pretty unusual situation. In early June, right after the debt ceiling was settled, a small group of House Republicans managed to block, for several days, any legislation coming to the House floor for debate and votes.
Every bill that gets to the House floor goes through the Rules Committee, which like its name says, literally sets the rules for debate on that particular measure—how long the debate will last, what amendments will get voted on. It's usually a pretty routine process. The majority party votes for the rule. The minority party votes against the rule.
In this case, a small group of Republicans voted against the rules proposed for several bills, which effectively blocks any legislation from even getting to the House floor for consideration. And to give you a sense of how unusual this is, no rule had been defeated in the House since 2002, so very unusual.
As to meaningful impact, I'm not sure it's going to have much long-lasting impact, but it's certainly a headache for the Republican leadership in the House, and it's a reminder of just how narrow a majority Republicans have where just a handful of Republicans can get together and pretty much disrupt and derail things.
MARK: Mike, another point you made last December was that when Congress doesn't act, the regulatory machinery of the executive branch can jump in and fill the gap, and that seems to be what's happening in the area of cryptocurrency. Congress hasn't really done anything. And the SEC is jumping in with all sorts of enforcement actions. Is that how you see it?
MIKE: Yeah, Mark. I think that's right. Congress has been talking for a couple of years now about legislation that would create a better regulatory apparatus for cryptocurrency and better protect investors. Both parties actually support doing that, but as is typical in Congress, the problem is finding consensus on the actual mechanics of doing that. That consensus has been very elusive, and the result, as you say, is that Congress really hasn't done anything at all about it. While there is expected to be an effort later this summer to move a bill in the House of Representatives, it's likely that the Senate is going to have a different approach, and it's a typical recipe for not getting much done.
But as you mentioned, the SEC has kind of taken matters into its own hands, particularly with the two high-profile lawsuits it filed in early June against the two largest crypto exchanges, Coinbase and Binance. Basically, the SEC is saying that these are exchanges and that certain digital assets are trading like securities, but the exchanges aren't registered with the SEC and aren't being subject to the oversight that other exchanges are.
At the heart of this is really a question about how different cryptocurrencies should be classified. Are they securities? Are they commodities? Are they currencies? I think we're probably headed eventually for the courts to figure out who's responsible for overseeing the crypto space. Whether it's the SEC or the CFTC2, maybe some combination. But the bottom line, we are a long way from having this sorted out.
MARK: Another thing that's on the mind of the SEC are the equity market structure overhaul. So you talked about that last December. Where does that stand now?
MIKE: Well, as you mentioned last year, the SEC proposed a package of four rules that would fundamentally change how the stock market works today. Among many possible changes, the proposals would require most retail trades to go to an auction system at the exchanges. Stocks also could be quoted and traded in increments smaller than a penny, and there'd be more transparency for investors about how and where their trades were executed.
I think the concern is that the SEC has proposed a series of incredibly complex changes to the way the markets work today without being certain about what will happen, how it's all going to work together, and in the end whether individual investors will benefit. There's a lot of concern in the industry that this is kind of a solution in search of a problem.
Where things stand right now is that the SEC is reviewing the comments that were submitted by the public and other interested parties. And they'll decide, based on that feedback, how to proceed. We expect final decisions by the SEC sometime this fall. But even once that happens, this is likely to see a legal challenge. So we'll see how it all plays out.
MARK: ESG investing is another hot button issue, and the SEC has been focused on the E, or the environmental part of that label, especially in the area of climate disclosure. So what is the SEC proposing?
MIKE: Yeah, the SEC last year proposed a very controversial rule. Basically, it would require public companies to disclose more to investors about their impact on climate change, as well as the risks that they face in the future from climate change. And the rule would require some companies to go all the way down their supply chain to determine the climate impact of the different steps in the process of bringing a product to market.
Businesses are concerned about the cost and the complexity of providing this information. There's a lot of skepticism about whether it would even be useful to investors, whether it would be sort of comparable across different companies. So this is another rule that the SEC is expecting to finalize later this year. And this one too could face a legal challenge. In fact, I'd say it's almost certain to face a legal challenge.
More broadly, this is just one fight in a much larger battle over ESG investing. Something we're seeing play out in the states. Some states have cracked down on asset managers for the perception that they're pushing some sort of political agenda. We're also seeing it play out across the federal government.
So I think this is going to continue to be a hot topic that really is dependent on which party is in charge. And we may see a lot of flipping back and forth as the two parties really have different views about this whole topic.
MARK: The Secure Act 2.0 was passed late last year. A great, great bill with a lot of good things in there for investors, but now there's some controversy about how catch-up contributions are being banned. Is that right? And why is this, if that is right, why is this just getting attention now?
MIKE: This is actually kind of an amazing thing. It appears that there was just a simple mistake in the drafting of Secure 2.0 that resulted in the inadvertent dropping of some language, the effect of which appears to prohibit catch-up contributions starting in 2024. The ironic thing here is that the intent of Secure 2.0 was actually to expand catch-up contributions for people, particularly people in their early sixties.
The Republican and Democratic leaders of the key tax-writing committees in both the House and Senate recently wrote a joint letter to the IRS indicating that the intention of Congress was of course not to outlaw catch-up contributions. But this probably will take some kind of technical fix to be passed by Congress to make the issue go away. The tricky part is how and when that technical fix will get included, probably in a larger bill that's going to pass later this year. So we're definitely keeping our eyes on it. The sense is that one way or another, Congress will make it clear that this was a mistake, and that catch-up contributions will continue next year.
MARK: Mike, I want to finish up with the banking sector. Back in March and April, when a handful of banks were closed by the FDIC, you predicted at the time that nothing much is going to happen soon due to the complexity of bank regulation. Where are we now?
MIKE: Yeah, I think we're moving toward consensus on three different tracks.
First, I think it's clear that tougher regulations for mid-size banks are coming. Regulators are looking in particular at banks in that asset range of $100 billion to $250 billion in assets. The failed Silicon Valley Bank, Signature Bank, and First Republic—all three were in that range. I expect regulators to propose, probably in the next month or two, tougher stress testing for that type of bank along with new capital and liquidity requirements and more for these banks. But as you point out, because the regulatory process takes so long, we're probably talking a year or more, probably maybe even 2025 before those actually go into effect.
Second, there's been a lot of talk about changes to the deposit insurance system. It seems like there's an emerging consensus to leave the individual deposit insurance cap at $250,000 per account where it is now, while setting a higher cap for business accounts that use those deposits for payroll and other types of payments. Details on that still need to be worked out, but I think there will be an effort to set up that kind of system later this year.
And then finally—this is not unusual whenever you have kind of a scandal—there's real movement on Capitol Hill to put in place tougher penalties for executives at failed banks—you know, clawing back of bonuses and stock compensation. There's a key Senate committee that plans to consider legislation along those lines in the coming weeks, so that's something I also think has a good chance of happening.
MARK: Mike Townsend is a managing director in Schwab's Office of Legislative and Regulatory Affairs and the host of the WashingtonWise podcast. Mike, thanks for talking with me today.
MIKE: Thanks for having me, Mark.
MARK: That was a lot to cover, so if you’d like to learn more about our 2023 forecasts, as well as our ongoing market commentary, go to the "learn" tab at Schwab.com. It's at Schwab.com/learn.
You can also follow me on Twitter @MarkRiepe. M-A-R-K-R-I-E-P-E.
Financial Decoder is a production of Charles Schwab & Co.
This episode was edited by Kory Hill and produced by 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.
For important disclosures, see the show notes and Schwab.com/FinancialDecoder.
- Read the full 2023 Mid-Year Market Outlook from the Schwab Center for Financial Research.
To kickstart Season 14, Schwab experts look ahead to consider what investors might expect in the second half of 2023.
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.
Next, Jeffrey Kleintop—Schwab's chief global investment strategist—discusses the possibility of a slowing global economy and what this could mean for the world's markets.
Then, 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 remainder of 2023.
Finally, Mike Townsend, managing director in Schwab's Office of Legislative and Regulatory Affairs, offers his outlook for what's next for Washington now that the debt ceiling drama is resolved.
Follow Financial Decoder for free on Apple Podcasts or wherever you listen.
Financial Decoder is an original podcast from Charles Schwab.
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