Another Big Rate Hike: Does the Fed Have a Plan?

MIKE TOWNSEND: To almost no one's surprise, the Federal Reserve last week announced a third consecutive 75-basis-point rate hike. But what concerned the markets more was that the Fed's target for where it thinks rates will need to go keeps rising. The new target is north of 4½%, which implies another 150 basis points of rate hikes are coming later this year and early in 2023. Fed Chair Jerome Powell has been very clear that the Fed's goal is to reduce inflation, regardless of what that may do to unemployment and consumer confidence, regardless of whether it pushes the economy into a recession.

But Powell and the Fed seem genuinely unsure of where the numbers will go. As the Fed chair told reporters after last week's meeting, "It's very hard to say with precise certainty the way this is going to unfold." And if there's one thing that causes investors anxiety, it's when key policymakers project uncertainty.

Welcome to WashingtonWise, a podcast for investors from Charles Schwab. I'm your host, Mike Townsend, and on this show, our goal is to cut through the noise and confusion of the nation's capital and help investors figure out what's really worth paying attention to.

This week, I'm devoting the bulk of the episode to a conversation with Liz Ann Sonders, Schwab's chief investment strategist, where we will dive into last week's Fed decision, the implications for the economy and the markets, whether the Fed has a realistic plan to bring down inflation, and how investors should handle the uncertainty. But, first, just a quick update on a couple of the stories making headlines in Washington right now.

At the top of the list is tomorrow's deadline to extend government funding before the government's new fiscal year begins on October 1. Lawmakers are expected to finalize an agreement to extend government funding through mid-December, ensuring that there will be no government shutdown. The bill includes a third round of aid for Ukraine in its ongoing war with Russia, bringing the total amount of aid to Ukraine this year to more than $65 billion. The expected passage of the government funding bill means that House members can go home and hit the campaign trail for the next five weeks. Senators are expected to be in Washington for at least a bit of October to wrap up some other business before they, too, will head home to focus on the midterm elections.

But the passage of a temporary fix for government funding also sets up what will be a contentious and challenging post-election session of Congress, with a new government funding deadline in December. Once they return to Washington after the election, Congress will likely try to combine the 12 appropriations bills that fund every government agency and program into one giant package. That massive bill is also likely to be the vehicle for lots of other issues, including a retirement savings bill that we've been following all year. Depending on the outcome of the election, that December debate could be very messy. If Republicans win the majority in either the House or the Senate in November, they may seek to force another temporary extension of funding until they take over in January, when they could have a larger hand in shaping the funding agreement. But, for now, the issue appears settled and we don't expect any significant legislative activity until after the election.

There were also some interesting congressional hearings earlier this month that are worth noting. SEC Chair Gary Gensler testified before the Senate Banking Committee and devoted a considerable portion of his opening remarks to the equity market structure overhaul plans that he outlined in a speech in June. He told senators that the national market system that governs equity trading has not been updated since 2005 and that he's concerned that the current system is not a level playing field for all investors and all markets. He said he has asked the SEC staff to make recommendations for a series of rule changes governing best execution, disclosure of execution quality, tick sizes, payment for order flow, and improving order by order competition. All of these issues could have significant implications for individual investors, such as potentially altering the way trades are routed on Wall Street and providing more information about whether you benefited from a better price at one trading venue over another. We'll be watching carefully for rule proposals that emerge from the SEC later this fall.

Gensler also took tough questions from senators on two hot topics. One was the SEC's controversial proposal on climate change risks facing public companies. That rule proposal would require companies to disclose their greenhouse gas emissions, as well as the climate impact down their supply chain, and it's already received an incredible 15,000 public comments. While the SEC would like to finalize the rule this fall, it almost certainly will face a legal challenge ensuring that this proposal remains in limbo well into next year.

Cryptocurrency regulation is the other topic that generated considerable interest among senators on the committee. Interestingly, at the same time as Gensler was testifying before the Senate Banking Committee, the chair of the Commodity Futures Trading Commission, Rostin Behnam, was testifying in support of a bipartisan cryptocurrency bill before the Senate Agriculture Committee. The bill seeks to clarify the regulatory jurisdiction for cryptocurrency by giving primary responsibility to the CFTC while retaining SEC oversight for digital assets that trade like securities. While it's unlikely that the bill is passed before the end of the year, the issue of improving cryptocurrency regulation is likely to be on the front burner in Washington in 2023. There is broad agreement among both parties on Capitol Hill and with the Biden Administration that better investor protections need to be in place for cryptocurrency. As usual, the details over how to make that happen are tricky. I expect that jockeying between the SEC and the CFTC for regulatory authority will continue into 2023. But look for more real movement on this issue in the new year.

On my Deeper Dive today, I'm really pleased to welcome Liz Ann Sonders back to the podcast. Liz Ann is Schwab's chief investment strategist and someone who has a real gift for helping investors to make sense of the confusing market and economic environment we find ourselves in right now. Liz Ann, thanks so much for joining me.

LIZ ANN SONDERS: Oh, thanks for having me, Mike. I always enjoy our conversations.

MIKE: Well, Liz Ann, let's start with last week's action by the Federal Reserve. It's clear that reducing inflation is the overarching priority of the Fed. Last week, they raised interest rates another 75 basis points, and they're on record as saying they will raise rates another full percentage point, or perhaps more, by the end of the year. And they aren't going to back off, promising more hikes in 2023, until the rate reaches 4.6%. That's definitely in restrictive territory. Add to that the quantitative tightening, and a lot of people are concerned that the Fed may be going too far, pushing us into a recession.

I've been traveling a lot lately and talking with investors, and the most common question I receive is some version of does the Fed know what it is doing? So let's start with that. Does the Fed know what it's doing?

LIZ ANN: That's a loaded question, Mike. I think they know what they're trying to do, whether they're ultimately going to be successful in the timeframe they'd like to be successful in while not disrupting the landscape too much is yet to be seen. I think it is somewhat pie in the sky to hope for a soft landing, not much deterioration in the labor market, while commensurately bringing down a 40-year high in inflation, at the same time shrinking a $9 trillion balance sheet. So the hole in the needle they're trying to thread is fairly narrow, and although the Fed certainly knows this, I think that the tricky part for central bankers everywhere, not just the Fed, is that they are sort of gearing monetary policy based off inflation data that by its nature is lagging, and then the effects of raising interest rates, the effects of tighter monetary policy are in the future. So the combination of those lags is a pretty wide span, and a lot can happen during that span.

MIKE: Well, I want to pick up on two things you mentioned in that answer. And, first, let's talk about what the Fed is tracking. The Fed, of course, uses the CPI to track inflation. But is that the best gauge? Because, for instance, gas prices came down steadily for more than 90 days until ticking up a bit last week. Rents that had been on kind of a wild ride upward, starting to fall in some places. But food is still up there. New cars, people are still paying over list. So it feels harder than usual to get a sense of what's happening. So what data are you watching as you try to figure out where inflation goes from here? And do you think the Fed is looking at the right things to measure what's going on?

LIZ ANN: I do think it is harder in this cycle. There's so many unique aspects to this cycle, not least being the pandemic, which had the effect of sort of spreading out the impact on the economy and inflation over a longer span than is typically the case. When we had the initial emergence from deep lockdown and the demand surge that was accompanied by all that stimulus, it caused a massive increase in demand and spending that had to be concentrated on the goods side of the economy because there was just no access to services at the time, and that was the breeding ground for the inflation problem we're still dealing with. Then as you saw the economy more fully open up, and we basically had met all the demand on the goods side of the economy, that started to falter, you started to see disinflation there, but we offset that by the pickup in services on the demand side in the economy within inflation data. And some of those services components are stickier in nature, and they're certainly offsetting some of the downside in areas like commodity prices.

The Fed understands all of this, but what's interesting is, yes, they do seem to have shifted a little bit more toward CPI as a proxy for inflation, where, historically, they've not only said PCE was their preferred measure, they focused mostly on core PCE. And now, both directly and indirectly, they're focused as much on headline inflation as core inflation because inflation expectations, which they're also focused on, tend to be driven more by what's going on in areas like energy and food, which is where the headline inflation numbers come.

So the net answer back to the first part of your question is it is different this time. It is a bit more confusing this time, but a lot of the unique aspects to this cycle in the economy, in inflation, how it's manifesting itself, is due to the very unique path of the pandemic, and, of course, on that front we are comparing today's orange to history's apples.

MIKE: Liz Ann, you also mentioned the lag time, and I think this is a really interesting question. How long is the lag time, maybe looking back at history, from Fed action on rates to seeing a corresponding cooling of inflation? And maybe the more important question is does that lag time increase the risk that the Fed acts too aggressively, because that's what I think a lot of investors are worried about?

LIZ ANN: So the impacts of rising interest rates are more than just on inflation, obviously, but most of the direct impacts that you see from a rising interest rate environment, a tightening cycle, the lag tends to be in the year-plus range. But when combating inflation in the past, what happened in the late '70s and into the early '80s, ultimately leading to Volcker having to get as aggressive as he did, is there were too many fits and starts. So there were cycles within that span of time of rising interest rates, and then that eased and rates were cut, inflation eased back, but then it accelerated again.

So it was sort of fits and starts both in monetary policy and the actual tracking of inflation. And I think that's what Powell is trying to fight against this time, and one of the reasons why he has been emphasizing that once the Fed gets to their so-called destination―right now, the market expects it, as you pointed out, to be around 4.6―what he's really been trying to reinforce when he spoke at Jackson Hole during the press conference is when they get to their destination, they're going to stay awhile. And I think that's in the interest of having the effect on inflation being lasting. And he's also talked about the necessity of more pain in order to bring inflation down in a sustainable way. And I think "pain" is code word in Powell-speak for recession.

So the idea that, you know, a recession could be pushed off to 2023 as being a better scenario, I'm not sure I see it that way. If, indeed, recession is what it's going to take to bring inflation down and keep it down, then I think we should wish for it sooner rather than later instead of drawing out the process.

MIKE: Well, of course, we're all painfully aware of how the market's been reacting to all this. Earlier this week, the Dow hit bear market territory, but I think the question of what's going to happen next seems particularly vexing right now, based on the unusual circumstances that we have. And just in the past week, I've seen a prominent, respected market analyst say that he thinks there's a chance the market declines by another 20%, and I've seen another prominent analyst say he thinks the market will be in positive territory for 2022 by the end of the year. Now, of course, there are always bears and bulls, and these kinds of predictions are, frankly, never worth much, but I'm struck by how wide the range of possibilities seems to be—different analysts looking at the same economic and other data and coming to wildly different conclusions. So do you think it's the unusual economic conditions that we have right now that are to blame for this kind of uncertainty?

LIZ ANN: So yes and no. To your point, Mike, I think at any point in time you can find analysts and strategists that are at different ends of the spectrum, and I think the differences probably relate to scenario analysis and putting maybe percentage likelihoods on various scenarios. So a more positive case, I think, would potentially rest on not only inflation maybe starting to come down a bit more quickly than what is expected, but for that, maybe, and continued slower growth, if we started to see a mild dent in the labor market, can the Fed see a green light sooner rather than later to not necessarily pivot to rate cuts, but to at least pause. And I think any hint that they might be able to pause, just take a breather, probably would be a scenario in which the market could move significantly higher.

I think the scenario analysis on the more negative end of the spectrum probably has a multitude of facets to it. Inflation doesn't get under control. We see a continued tight labor market, which keeps the Fed in this aggressive stance that we haven't yet seen. The full re-ratings of earnings estimates is probably necessary, given the weak economy, and under that scenario, you, I think, could see … I know some of the well-known analysts out there saying it could be another 20% down. A lot of those comments were made a couple of weeks ago, and we've already had some of that downside already. But, yes, I think maybe the range, the spread, in terms of outlooks very much is dependent on that scenario analysis.

I would put myself, I suppose, somewhere in the middle there. I wouldn't be shocked if we have a bit more downside. I don't think we're out of the woods yet. I'm also not on the end of the spectrum that says, "Nothing to see here. Everything is fine. We're going to, you know, shoot straight up between now and year-end."

So I think the easier call is that volatility is going to persist, and we'll be both up and down between now and year-end. So how's that for a forecast?

MIKE: Well, speaking of unusual economic circumstances, I want to ask you about what's going on in the U.K.

The new government there has announced an ambitious economic plan focused on tax cuts and deregulation. The pound briefly fell to an all-time low against the dollar earlier this week, and the Bank of England has begun aggressively raising interest rates. So what do you make of the situation in the U.K., and are there implications for the U.S. or the global economy?

LIZ ANN: There certainly is, rightly so, a swirl of interest in what's going on there. To your point, they just announced this fairly significant fiscal package, and I think the rub impacting their currency market, as well as yields, gilts yields, is that there were not offsetting changes on the spending front. So in an environment where, much like many central banks are having to combat an inflation problem, you've got the rub of this potentially adding to inflation. And without the corresponding spending cuts, there's the likely need to issue more debt, which, in turn, means rates have to go even higher in order to track demand for that.

So to just put it in perspective, we know that rising 10-year yields has been a pretty significant issue in the U.S. market. But on August 1 of this year, 10-year gilts yield was about 1.8%, and now it is 4½%. That is a huge move in a very short period of time, well beyond the almost as huge move we've seen in the U.S. And that's causing a swirl of problems, especially as we head into the winter season, and much like everywhere in Europe, dealing with a potential economic crisis via the energy shortages.

MIKE: Well, Liz Ann, let's turn to a recent development here in Washington, and that's the passage of the Inflation Reduction Act. We talked about the details of the new law in the last episode, but I'm interested in how you look at a big piece of legislation passing, and how you assess its impact on companies, on earnings, on the markets. This new law has tax implications for big companies that are notable, including the new 15% corporate minimum tax and a tax on stock buybacks that kicks in this January. So what do you think the impact of the new law will be? Will companies just kind of take that in stride, or do you think down the road you start to see them make different choices?

LIZ ANN: Well, with any policy, there's the on-the-surface things that change and oftentimes somewhat knee-jerk assumptions that are made. OK, hit to buybacks, which have been the sectors with the biggest buybacks, they're automatically hurt. But there are always so many other factors that influence why stocks are doing what they're doing. And I think too often when you're in the midst of a policy change or you're in advance of an election, there is sort of this tunnel vision of what is the direct impact of this policy change without regard to all the other forces that happen. In addition, sometimes the lead-in to a policy change, you see bigger moves in the affected stocks or the stocks perceived to be affected than, ultimately, occurs after the policy is actually implemented.

You know, again, on the surface, it may appear to be harmful to companies' bottom line, but that masks several differences under the surface at the sector level, whether it's around buybacks, whether it's around tax rates. And, yes, there are certain sectors that'll face larger hits than others, even for those starting at larger reductions in buybacks or profits, but they may already be in a relatively stronger or weaker position to withstand the hit. You also have―some of the sectors that might get hurt more by buybacks are not the ones that are going to potentially be hurt with the corporate tax changes.

So I don't want to say, "Nothing to see here. Everything is a complete offset." I just wouldn't invest or make decisions about companies because of either of those components of this policy change, especially if you've already seen some movement in some of those stocks by traders or investors trying to sort of game that as we approach the actual effect of these policies.

MIKE: Well, Liz Ann, you've gotten to what I think everyone really wants to hear from you, which is sort of where to go next as an investor. Obviously, bonds have acted strangely much of this year. Even so-called safe havens like gold are down. Other countries are plagued by high inflation and economic challenges. So where should investors put their money right now? Are there any opportunities, companies, or sectors that are actually thriving―maybe "thriving" isn't the word, but just not doing terrible—that investors should be looking at?

LIZ ANN: Sure. Let me start with the first part of that question, which is there's not been too many places to hide. And to some degree, we are in the aftermath of what many were calling a bull market in everything, and it wasn't just the equity market, it was fixed income, it was housing, it was private investments, it was the fixed income side of things. And we're in, kind of the bear market in everything, but that doesn't mean there aren't opportunities, aren't places to look for value, to look for opportunities.

Mike, as you know, in your question you mentioned, are there sectors or areas? Sectors is, decidedly, something we think is trickier to try to hone-in for leadership or where to avoid. Earlier this year, at the beginning of the year, we went to a sector-neutral stance where we don't, and haven't currently had any, overweights or underweights on sectors, but have really been emphasizing factor-based investing.

And for those listeners that don't know what factor-based investing is, another word for "factor" would just be "characteristic." So you're screening for investing in companies that have a certain set of characteristics. As opposed to just trying to pick a sector or two, you're looking for actual characteristics. And you can apply factor-based analysis across all segments of the market, across all 11 sectors. You can apply factor-based analysis to large-caps, to small-caps, to stocks that are housed in growth indexes, to stocks that are housed in value indexes. And what we've been emphasizing, if you want to think about a wrapper around the factors that have been working, and we think at least near-term will continue to work, it's sort of a quality wrapper. It's sort of a combination of growth-oriented factors and value-oriented factors.

So in this environment, when you have a dearth of certain characteristics in the broader economy and market―I already talked about earnings estimates coming down for the second half of this year and the first half of next year―so declining earnings revisions. In an environment like that, you want to look for companies that are bucking that trend, that have positive earnings revisions. We're in a rising-interest-rate, high-inflation environment. That tends to put downward pressure on what would be considered longer-duration stocks, companies that their cash flows and earnings are well into the future, and instead emphasize companies that are generating cash flow in the near-term, so strong free cash flow, higher dividend-paying companies that can sustain those dividends because of those shorter-term cash flows. We're in an environment, again, higher interest rates, where debt burdens are starting to be felt more acutely. So you look for companies with strong balance sheets―higher cash on balance sheets, lower debt on balance sheets.

So some of those are more typical value-type characteristics, but in the case of positive earnings revisions, that's more of a growth-type factor. So it's sort of this hybrid mix of factors, but, without a doubt, with this quality wrapper. And at least for the near-term, we think that's the focus you want to have versus trying to pick a sector or two.

MIKE: Liz Ann, let me wrap up with a question I'm guessing you're hearing a lot from investors when you're on the road and talking. What are the opportunities for buying the dip? The Wall Street Journal wrote earlier this week that the buy-the-dip trade in 2022 hasn't been working out, I guess, obviously, because the market keeps dipping. We know that in a business cycle, a bear market follows a bull market, and then a bull market follows a bear market. At some point, we will come out of this bear market, and stocks will likely go up again, but it's, obviously, hard to invest when you think the market may still go lower. So how does an investor know when to take advantage of the dip? I guess that's the age-old question for investing.

LIZ ANN: It is the age-old question, and I don't have a perfect answer for that. The first thing I would say is market tops, in general, and market bottoms, in general, tend to be processes over time. They don't tend to be very precise moments in time. You have some exceptions to that, the most recent one being the COVID bear market, which, by the unique nature of what caused it, you had a very particular top that then had a really, really fast and sharp move down into bear market territory, and then you ultimately had the ultimate V-shaped bottom courtesy of just massive amount of monetary and fiscal stimulus. That's not the norm. But you also had a situation like the crash of '87. That bear market happened effectively in a day, had a more distinct top, although the bottom there was a process over time. So always think of tops and bottoms as processes. And rebalancing, especially if you don't take a calendar-based approach to rebalancing, but maybe take a volatility- or portfolio-based rebalancing, your portfolio is going to let you know when you may want to add to positions. That doesn't mean you're going to look back and say, "My adds were right at each of the bottoms, and my trims were right at each of the tops" as you go through this process. I don't think anybody should attempt to have that goal, but market volatility, portfolio-based rebalancing can guide you along the way. To be more specific in that answer, I think there's several things to look for.

From a macro perspective, it's different each time. I think somewhat clearly in this environment, you want to look for continued sign that inflation is peaking and starting to come down sustainably, consistently, to a point where we can start to envision a scenario where the Fed can go into pause mode, not necessarily pivot to rate cuts mode. I think the earnings revisions trend probably has more to go on the downside, but getting a sense of when those downward revisions start to stabilize, and the forward estimates maybe start to lift again. So those would be two examples of more macro things to look for.

From a technical, under the hood of the market, what you tend to want to look for is when you get these retests, or sometimes a breaking the prior low and going to lower low, that can continue to happen, but what tends to happen under the surface is with those successive lows, either a retest of a prior low or a new low, under the surface, the breadth conditions start to improve. So, down-to-up breadth ratios, percentage of stocks declining versus percentage of stocks rising, volume of the declining names versus the rising names, those underlying breadth statistics, you tend to see a washout, for instance, like we did in the fall of 2008. Of course, the market didn't bottom until March of '09, but as you were seeing those retests, or lower lows, the breadth was less bad.

And, as you know, Mike, I've said for years, better or worse tends to matter more than good or bad. And that goes to the heart, in this case, of what I'm talking about. Just seeing things under the surface get less bad―the technicals, the breadth less bad, even as the market is retesting or going to lower lows. We haven't seen that yet, but that's what I'll be looking for in the near term.

MIKE: Well, as always, Liz Ann, I really appreciate your perspective on a market and an economy that I think really has just about everyone on edge. So thanks so much for joining me today.

LIZ ANN: My pleasure. Always fun, Mike. Thank you.

MIKE: That's Liz Ann Sonders, Schwab's chief investment strategist. You can follow her on Twitter @lizannsonders.

Well, that's all for this week's episode of WashingtonWise. We'll be back in two weeks with a new episode. Take a moment now to follow the show on your listening app so you won't miss an episode. And if you like what you've heard, leave us a rating or a review. That really helps new listeners discover the show. For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript. I'm Mike Townsend, and this has been WashingtonWise, a podcast for investors. Wherever you are, stay safe, stay healthy, and keep investing wisely.