Anxious Markets Eye Speed Bumps Ahead

MICHAEL TOWNSEND: For months, investors have been watching a series of approaching deadlines on Capitol Hill, waiting to see how―or if―Congress would resolve them. 

Here in mid-October, we have at least a partial answer: Congress has addressed these deadlines, not by resolving them, but by creating another set of deadlines.

The threat of a government shutdown at the end of September? Postponed until early December.

The mid-October deadline to stave off a catastrophic default? Postponed until early December.

The late September deadline to pass a popular infrastructure bill? Postponed indefinitely.

And the push for a massive bill that would increase taxes to help address climate change, health care, and social programs? Well, there's no official deadline on this one, but progress has slowed to a crawl.

So what's an investor to make of it all?

Welcome to WashingtonWise, an original podcast 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. 

For weeks now we've all been watching the unfolding drama in Washington. And we've watched market volatility kick in with each twist and turn.

But there's plenty more going on that has the potential to roil the markets, from the state of the economy, to inflation, to the national debt and a host of other concerns. In just a few minutes, Liz Ann Sonders, Schwab's chief investment strategist, will join me for the first of a two-part conversation to share her insights on what investors should be watching as we close out the year.

But before Liz Ann joins me, let's catch up on some of the news out of Washington. And at the top of the list: Congress punts on the debt ceiling.
You've heard me say many times that the debt ceiling battles come along every year or two and have long been controversial and tense. And yet Congress has always managed to find a way forward to ensure the United States does not default on its debts. 

But this time felt different. Republicans were adamant that they would not help Democrats raise or suspend the debt ceiling. They wanted to force Democrats to use the budget reconciliation process to trigger a special set of rules that would allow them to avoid a filibuster and pass an increase without any Republican votes. Republicans hoped that by doing so, they would be able to blame Democrats for the rising national debt and paint them as fiscally irresponsible in ads during the upcoming midterm elections.

Democrats were adamant that debt ceiling votes have always been bipartisan, because the debt was accumulated under both parties' leadership, and that this time should be no different. Neither side appeared willing to give an inch. Faced with a stalemate, markets were starting to get jittery about a possible default.

Last week, rumors began to percolate that Democrats were at least considering the idea of invoking the so-called "nuclear option": changing the rules of the Senate to prohibit filibusters on debt ceiling votes. That apparently spurred Senate Minority Leader Mitch McConnell of Kentucky to offer a short-term solution. He said Republicans would work with Democrats to approve an increase in the debt ceiling that would cover about two months' worth of expenditures. It was a surprising change in stance by the minority leader and it was not embraced by all Republicans, many of whom felt their party leader buckled under pressure. 

Ultimately, the two parties struck a deal to raise the debt ceiling by $480 billion, which should allow Treasury to continue to borrow to pay the country's bills through early December. Eleven Republicans joined with the 50 Democrats to overcome a procedural hurdle that required 60 votes to end the filibuster. No Republicans voted for the actual bill to raise the debt ceiling. The House, which was not scheduled to be in Washington this week, came back on Tuesday to narrowly approve the bill, sending it to President Joe Biden for his signature. 

So there will be no market-rattling default next week. But it's a deal that pleased no one, on either side of the aisle. As I so often talk about on this podcast, Congress has once again proved that its greatest skill is finding ways to put off the tough decisions.

In this case, what we have shaping up now is a repeat of the uncertainty and the potential return of market volatility in less than two months.
Complicating things is the fact that Congress already kicked another big issue to early December: The temporary agreement reached at the end of September to fund government operations and avert a government shutdown runs out on December 3. That's roughly the same date as the new debt ceiling deadline.

There is absolutely no reason to think these issues will be any easier to solve at the beginning of December than they were over the last few weeks. 

So get ready for another high-wire act right after the Thanksgiving holiday when lawmakers will be confronted with both a government shutdown and a potential default at the same time. 

Meanwhile, internal negotiations are continuing among Democrats as they try to find a way to save the president's economic and social policy agenda. The popular infrastructure bill remains in limbo while Congress wrestles with the second bill, the $3.5 trillion package that focuses on health care, climate change, and social programs, as well as tax increases. 

Moderates in the Senate continue to make it clear that they won't vote for anything close to a $3.5 trillion bill. Senator Joe Manchin, the Democrat from West Virginia, has repeatedly said he wants to see a package of about $1.5 trillion. Even assuming a compromise of around $2 trillion, that would require an enormous cut from $3.5 trillion. And that's not just trimming around the edges―that means eliminating entire policy proposals from the package, proposals that are priorities for Democrats, some of whom have been waiting a decade a more for an opportunity like this to push legislation on issues that they care about most. 

Picking what's in and what's out of a smaller bill will be very difficult, and the end result will be very disappointing to a lot of Democrats. So will they be able to unite around a smaller bill? We should get an answer in the next several weeks.

Of course, that answer will also impact the new proposals to increase taxes on corporations and wealthy individuals. A significantly smaller package will require less money to be raised from changes to the tax laws, so it may be that Congress drops or reduces some of the tax increases currently on the table. Fewer tax increases could improve the chances that the spending package actually gets passed.

And speaking of taxes, there is one other notable development to mention. Last Friday, 136 countries signed on to a minimum 15% corporate tax. The agreement, which was led by the Organization for Economic Cooperation and Development, or OECD, is a huge priority for the Biden administration and for Treasury Secretary Janet Yellen in particular. The United States has been championing the effort that officials say will end tax havens and reduce a decades-long effort by global companies to shift profits to low-tax jurisdictions. 

Under the agreement, countries have a target date of compliance by 2023, given that most countries would need to update their tax laws. Congress will now have to pass legislation to bring the U.S. into compliance with the tougher rules. Yellen expressed confidence over the weekend that Congress would do so and suggested that the necessary changes, including raising the tax that American companies pay on foreign profits from 10.5% to 15%, would be included in the final economic package that is currently being negotiated on Capitol Hill. 

Whether that happens is unclear, but it's an issue to keep an eye because it has significant implications for the global economy. The OECD estimates that the change would result in about $150 billion in additional global tax revenue each year.

On my Deeper Dive this week, I want to explore how investors should be thinking about the ongoing policy and political debates in Washington as well as a host of other concerns that could impact the markets. There is so much to cover, and I am pleased that Liz Ann Sonders, Schwab's chief investment strategist, is here to share her insights and guidance on what it all means for investors.

Liz Ann, thanks so much of being here today for this kickoff of this two-episode discussion. This is the first time we have done this, but with so much going on right now, and the year starting to wind down, it seems appropriate to put in the time to really dig into a wide range of concerns that investors have.

LIZ ANN SONDERS: Yeah, there sure is a lot to talk about. And, as always, Mike, I love talking about them with you, so thanks for having me.

MIKE: Well, Liz Ann, let's begin with the debt ceiling. We know from past experience that uncertainty around when and whether Congress will act on the debt ceiling has sparked market volatility, and we saw a little bit of that over the last few weeks. But this week, Congress abruptly reached a temporary solution, a two-month fix that basically just kicks the can down the road, but ensures that we will have another one of these cliffhangers before the end of 2021. So how do you think the market has been reacting to this?

LIZ ANN: So, Mike, and I'm sure you have perspective on whether the can-kick makes it an easier process of agreement or a harder process. I'm thinking maybe it's slightly more on the harder process side. But as I know you agree, one thing we have found that both parties do quite well, a game they play very well, is kicking the can, and that appears to be the case this time. I think the market implications, to some degree, are implications through which we've been living recently, although it's hard to segment out precise volatility drivers. You can easily add that to the list of what has conspired to elevate risk in the market, add to volatility, bring the drawdown in the case of the major averages to at least a slightly more significant place than we've seen for much of the pandemic era. And I think uncertainty, broadly, with regard to Washington and fiscal policy―monetary policy―but also the debt ceiling, and I think memories of the 10-year anniversary we just passed in August when we had the last real debacle associated with the debt ceiling and the downgrade of U.S. debt, and what led to a near bear market in stock. So, you know, memories go back that far, and I think those have all been factors.

MIKE: And I agree, Liz Ann. I do think this is going to be actually even trickier in December than it has been so far. But one of the things that I want to ask you about is kind of a larger question, which I think gets lost in the debt ceiling fight, and that is, what is the actual impact on our economy and on individuals of the massive amount of debt itself. I don't think the average person understands much about how or even if the national debt affects them in any way. So does it matter to individuals? How?

LIZ ANN: It certainly does matter, but I also think you're right that, I think many folks don't quite understand exactly how it matters, why it matters, and maybe, more importantly, when it matters. And, quite frankly, I think that there's also ongoing somewhat simple confusion even when terms like "the deficit" and "debt" are used, and they're often used interchangeably, even sometimes by politicians who arguably should know better. So, of course, when we talk about the deficit, and I don't mean the trade deficit, but generally when just the word "deficit" is used, we're talking about the budget deficit, which, of course, is the mismatch on an annual basis of what's coming in via revenues and what's going out via spending. If you continue to run deficits, then you are adding to debt, so debt is a cumulative effect of running deficits. So even if you have an improving deficit situation like we did just before the pandemic, you're still adding to debt. You might just be adding to debt at a different pace. But people think of the implications of this high and rising burden of debt, which now in terms of federal government debt sits at more than 100% of GDP, is something prospective down the road. And, surprisingly, a lot of people think the implication of that at some point is skyrocketing interest rates or skyrocketing hyperinflation.

Now, I know we're going to talk about inflation, and it's a problem right now, but it's not a problem driven by the high level of debt. The implication of a high and rising burden of debt—especially when debt growth is faster than economic growth—is, in and of itself, it acts as a suppressant on economic growth. It acts as a kind of a wet blanket on economic growth, which, interestingly, is part of the reason why over the decades, really since the post-World War II era, a higher burden of debt has actually been accompanied by not just lower economic growth, but lower inflation, because weaker growth tends to also suppress inflation. And that's the environment in which we've been living.

So this notion that we haven't suffered the consequences suggests that you misunderstand the impact on growth. In fact, for all the cheering of the pre-pandemic expansion being the longest in history, which it was. It went from June of '09, when the global financial crisis recession ended officially, until February of 2020, when we started the COVID recession. That was the longest economic expansion in U.S. history. The problem or rub was that it was also the weakest, and it was the weakest by far, not even close to what was the second weakest. And I think one of the contributing factors there was this high and rising burden of debt because you have every dollar of increased debt is not only generating less than a dollar of economic growth, that less than a dollar, that dollar amount it's generating, is declining at a fairly rapid pace. 

So we're living with the implications. This is not just something in the future.

MIKE: Is the national debt a problem that needs to be solved, or maybe the question, even better question is, is it even a solvable problem at this point?

LIZ ANN: Well, it's not a solvable problem if someone who is looking for a solution thinks that it's something that can happen quickly, a wave of a wand, a debt jubilee, default. That's not the real solution. Ultimately, the solution, number one, is to get to a point where economic growth is faster on a persistent basis than debt growth because then, quite simply, you start to eat away at the problem. At least, right now, there doesn't seem to be much support for getting to that point. And that's another interesting area where there seems to be bipartisan support either implicitly or explicitly, which is not really worrying so much about the debt problem. It's just a question of what are the priorities in terms of where we spend, how we tax. So I think that that's an ongoing problem.

Also, the reality is that to really think about long-term solutions to this debt problem involves, I think, adults getting in the room together and having an honest conversation about the impact of entitlements and the future debt associated with unfunded entitlements. But talk about a topic that's not popular to discuss by politicians, especially in our perpetual election cycle world in which we live. 

MIKE: It's very true. You know, I like to think of the talk about debt is actually in inverse relation to the size of the debt. So the higher it gets, the less talk there seems to be about it. That's been my experience here in Washington.

LIZ ANN: You're so right.

MIKE: Well, let's shift gears a little bit. Liz Ann, there's a perception that September and October are typically the worst-performing two-month period of the markets. September this year, certainly a rough month. What do you see for October, and do you think the temporary agreements that Congress has made could make this a better month for the markets or maybe just delay the reaction for a couple months until we come back to these issues in November and December?

LIZ ANN: Much as I would love to have a precise answer to that question, what does the rest of October hold, I never have a crystal ball, let alone one that has any clarity to it. I think there are somewhat myriad reasons, historically, why that two-month stretch has been the worst of all rolling two-month stretches. A lot tends to happen in that environment. You're coming out of the summer slowdown where liquidity tends to be lighter. You're often moving into policy season. Obviously, you're often in the lead in to an election, be it a midterm election or at a presidential election. So there's lots of factors that tend to cause a lot of volatility and weakness to be concentrated in that September-October period of time. And we're not without a long list of risks and uncertainties in the current environment—not just what I know we're here largely to talk about, and you live, eat and breathe every day, which is what's going on in Washington and policy. But add to the mix more significant monetary policy uncertainties, a unique period of time with not just the prospect of tapering, but some of the trading scandals that have happened inside the Fed, the possibility of a change in leadership at a time where I think the Fed has become increasingly important in terms of the action in financial markets. And then, of course, COVID. We would have all hoped that 18-plus months into this we would be definitively talking about the post-COVID environment. And I don't know if we're ever going to be able to use that terminology. So we're still at the mercy of virus waves. 

So whether or not we can eke out a gain by the end of October to offset the weakness in September, I mean, the honest answer is I don't know. Quite frankly, I don't think me not knowing or you as an investor not knowing really matters to whether you have success as an investor. I think the better approach is to think that this is a higher risk period of time with unique uncertainties that, in many cases, are virus-related—weaker economic growth, much hotter inflation. And this is a time where you want to really wrap your arms around many of the traditional disciplines of diversification and rebalancing. And I think that's going to help navigate what I believe will continue to be a very choppy environment, with a lot of churn under the surface and a lot of rotations in terms of where leadership resides. In some cases, big shifts that can happen on a day-to-day basis, a week-to-week basis. And those shifts which have been happening for much of this year, sometimes, are driven by what's going on in Washington, and sometimes the movement in the Treasury yield, sometimes the Delta cases and hospitalizations, you name it—there's lots of triggers for what I think will continue to be a very rotational nature to this market.

MIKE: You mentioned the Fed, and I agree with you that I think the Fed is in an incredibly important moment in time for a variety of reasons, and we'll come back to that in just a moment. 

Before we get to that, I want to ask you about a topic you mentioned a few minutes ago that I expect is at or near the top of the list of questions that you're hearing most frequently from investors, it's certainly one that I'm hearing most frequently from investors, and that's inflation. Inflation seems to be persisting for longer than expected. So what's driving that and how worried should investors be? 

LIZ ANN: First, kind of a big picture way to think about inflation over long-term cycles, and then I'll answer specifically the question with regard to, you know, what exactly are the culprits to this most recent surge. And I think there's a tie-in between the bigger picture, longer-term thought process and some of what's going on shorter-term. 

You have these long-term secular forces over time that tend to sort of shift the equilibrium, such that you have a prevailing kind of force of either inflation or deflation over long cycles. And then you have the backdrop of how central banks, broadly, if we're talking globally, or the Fed specifically in the U.S. decides to address it.

Obviously, more specifically to this unique period of time is COVID and its impact on the inflation cycle. You basically had the onset of the pandemic cause a huge compression in demand when supply was still fairly ample. And that was a deflationary force in the early days of the pandemic. And then as we opened things up, you had this surge in demand exacerbated or boosted to an unprecedented degree by the massive amount of liquidity that was pumped into the economy, both on the fiscal side and on the monetary side, and we just had supply that was unable to keep up with that surge in demand. So that led to an inflationary part of this cycle.

And I think the other issue is for … this is where the blend of long-term and short-term come into play. I think we're also in the midst of a possible shift from kind of this era of abundance to an era of scarcity. And it's across a spectrum of goods and services, and it hits into important areas, like energy and food. And there's lots of different timeframes associated with it, where the supply chain bottlenecks are, how quickly those bottlenecks can be solved. 

But, importantly, I think what we need to watch for, and, ultimately, what steps in to differentiate what so far is the current environment versus, say, a systemic 1970s wage-price-spiral, stagflation-for-years environment is psychology. And you know, Mike, when I talk about the market, and I talk about cycles in the market, I focus much more on the psychology of investors and sentiment, and how that comes into play, especially at major inflection points. We can think of inflation in long cycles as having a psychological component. It's almost about power. The 1970s was this feeder of the psychology getting embedded, and then the power that workers felt they had to demand higher wages aided by more unionization. And then the psychology that kicks in to kind of the power that producers have to boost prices into companies, those input prices. Then companies through that psychology and having the power to pass on those higher prices to the end consumer. And then it becomes the spiral, and it feeds on itself. 

I don't think we're yet in that kind of situation, but I also don't think we are out of this … call it stagflation-lite or lowercase "s" stagflation, using just a simple definition of waning growth and high and/or rising inflation. I don't think we get out of that anytime soon. And what I really do worry about is what's going on in the energy space and the shortages and the crises that are starting to develop in parts of the world, in parts of Europe, specifically, the U.K., in China and India and Brazil, in the U.S. with regard to gasoline prices. And I'm surprised that there isn't more attention on this issue, in particular, and how we start to solve some of these problems. 

So transitory, even if it is, is going to be a longer time period than what I think many folks using that terminology, including the Fed, felt that it would be, but I don't think we yet are looking at the groundwork for that '70s-style inflation. But I think this is an uncomfortable part of the broader economic story right now.

MIKE: I guess that leads me to the question about the Fed. In particular, has the Fed miscalculated when it comes to inflation? And maybe this goes to the psychology that you were talking about of the investor, in terms of as the pandemic got going, the Fed really stepped in aggressively, and it was sort of, "OK, the Fed is on the case here." And then the Fed sort of told us as investors that we were coming out of this. And now it feels like maybe the Fed was a little off. Is that a fair statement?

LIZ ANN: Yeah, so I don't … I think it's fair to suggest that they were probably a bit off in terms of their projections around what this inflation period would look like. But I don't know if we're yet at the point where we can say that they've made some sort of policy error. I think the … you know, we can debate whether the massive infusion of liquidity through the combined forces of fiscal and monetary was too much, not enough, not the right variety, didn't have the right timeframe associated with it. Went too far in terms of things like enhanced unemployment benefits, which of course is not a Fed mandate, but, you know, will be sort of questioning this. But the problem is most of those questions or assessments involve the counterfactual. You know, you get the folks that think this was way overdone, that would say it would have been better, however one defines better, if this hadn't been done. And then others on the other side, "Well, you know, we'd be in a better situation if we had done even more." But we'll never know, so we're going to debate that probably forever. 

But I think, ultimately, what's more important is what is the Fed's reaction function if this inflation situation at present either persists for a very extended period of time or gets worse from here? Because we know, in theory, that an inflation problem largely driven by severe supply bottlenecks is not solved by the Fed pushing ahead, or making the speed of tapering more aggressive, or pulling forward rate hike expectations. That doesn't solve the limited access to semiconductors. But the rub is what if the Fed feels compelled to step in to squash demand, either because aggregate demand exceeds aggregate supply or the only way to narrow the timeframe between now and when we can start to see a real easing in the supply bottlenecks is to squash demand. That would, obviously, be both an economic negative and I think a market negative, too. 

There are plenty of people who think all along the Fed has been making mistakes by pumping liquidity. And it certainly has exacerbated things like the wealth divide. And it has until recently not been accompanied by inflation in the real economy, but we've had plenty, boatloads of inflation. It's just been in asset markets. It's been in the equity market, other asset markets, commodities. It's been in real estate. And that's been to the great benefit of asset owners, less so to the part of the world that doesn't own assets. So I think there's some legitimate criticism associated with that. But looking back at what was going on during the worst part of the pandemic, I think doing nothing was certainly not an option either.

MIKE: Well, one of the interesting questions about how the Fed is going to react is who is going to be doing the reacting at the Fed. And maybe we could end with this. We're at an interesting time in the Fed's history in so many ways, but one of those ways is that the players may be changing. So we have the possibility that Jerome Powell will be renominated for another term as chairman, but there're certainly people on Capitol Hill who are calling for that not to happen. And I think his reappointment has been complicated by the trading scandal that's going on, that has gone on at the Fed, not involving him, but involving other leaders there. And then something else that may contribute to President Biden's thinking about Jerome Powell is that he has the opportunity to appoint as many as three other members of the Fed. The vice chair, Randal Quarles, his term as regular governor is going to go on, but his term as vice chairman ended October 13. There is a vacant seat that has been vacant for more than a year. There's another governor whose term is ending. So there's a possibility of really reshaping the Fed in terms of its outlook on monetary policy. So how do you think the market is looking at that, and how would the market react to potentially quite a number of new policy-making faces at the Fed?

LIZ ANN: I think that the market, and it's funny sometimes when we talk about it using that terminology of the market—which is, obviously, a massive group of individual investors that might have different perspectives, so there's not one monolithic thing that is the market. But to the extent you can try to glean what's priced in and what's not priced in fully or partly, I'm not sure an extreme shift, meaning Powell doesn't get renominated, and you see maybe a more progressive shift in terms of the backdrop of the key Fed players, I'm not sure that is priced into the market, especially if, ultimately, the goal is to focus on the regulatory side of the Fed's purview. And we can sometimes almost liken it to the focus that folks certainly have along partisan lines on what can happen inside the Supreme Court, with shifts in one direction or another. And I think shifts that might occur, especially as it relates to things like regulation or approach toward things like modern monetary theory, either explicitly or implicitly, has a huge bearing on the behavior of financial markets and even the behavior of the economy.

So, I think, collectively, at least we at Schwab that think about this, we're probably more biased toward Powell maintaining his role, but then when the trading scandals kicked in, I think that really changed the calculus around kind of likelihood. I think some of it depends on market volatility. You would think that a change would not be seen as improving the market in a highly volatile state. So a month ago I would have put higher odds on Powell keeping the chairmanship than I would today.

MIKE: Well, Liz Ann, this has been great, but we have a lot more to get to, and that's why I just could not be more grateful that you have agreed to come back and continue our conversation on the next episode of the podcast. So thanks for being here today, and we'll talk to you again soon.

LIZ ANN: Thanks, Mike.

MIKE: That's Liz Ann Sonders, Schwab's chief investment strategist. You can follow her on Twitter @lizannsonders. And be sure to come back for part two of our conversation on October 28.

Finally, on my Why It Matters segment, I like to note something interesting that is happening in Washington that may have been below the radar screen and explain why I think it's important. 

SEC Chairman Gary Gensler has been doing a lot of testifying lately, first before the Senate Banking Committee last month and then last week before the House Financial Services Committee. Both times he outlined an extensive list of regulatory initiatives on topics ranging from equity market structure to cybersecurity to money market funds.

But there was an interesting addition to his testimony this time around. With lawmakers focused on cryptocurrency, Gensler said that the SEC has no plans to implement any kind of ban on cryptocurrency. Why does this matter? Well, last month China instituted an aggressive crackdown on cryptocurrency in that country, issuing a blanket ban on all cryptocurrency transactions as well as crypto mining in China. In doing so, China's leaders talked about how environmentally unfriendly crypto mining is because it takes so much computer power. But it's likely that the real reason behind China's ban was that China's central bank is in the process of launching its own digital currency, and China does not want competitors.

Given that the Fed is in the early stages of developing its own digital currency, you might think that U.S. regulators would be thinking along the same lines. But Gensler said he was more worried about investor protections and that Congress has the ability to ban cryptocurrencies if it wants. With so many in Congress backing cryptocurrency, that's not likely to happen anytime soon.

Well, that's all for this week's episode of WashingtonWise. We'll be back with a new show in two weeks, featuring the second part of my conversation with Liz Ann Sonders. Please take a moment now to follow the show in your listening app so you don'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. Wherever you are, stay safe, stay healthy, and keep investing wisely.