MICHAEL TOWNSEND: The concept of volatility is one that investors know all about.
But that understanding doesn't change the reality of the discomfort when volatility hits hard and is relentless.
It's been a rocky beginning to 2022 for the markets, to say the least. The S&P 500® was down more than 5% in January, then down another 3% in February. March saw the market rebound, with the S&P gaining more than 3.5% for the month. But April? Down another 6% as of the end of last week.
Year to date, that decrease is a painful 11%. And a lot of investors are growing anxious that things may get worse before they get better.
Inflation is at its highest rate in 40 years, yet unemployment remains low. The Federal Reserve is scrambling to hike interest rates quickly and fending off accusations that it misread the economic picture and is acting too late. And there are ongoing uncertainties of how the war in Ukraine will affect the global supply chain, particularly when it comes to energy and food. It's a perplexing environment for everyone, and investors are no exception.
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.
In just a few minutes, I'm going to talk with the person I always want to talk to when the market starts to get a bit squirrelly―Liz Ann Sonders, Schwab's chief investment strategist. She'll join me to discuss how investors should be thinking about the inflation numbers, what to expect from next week's Fed meeting, and how investors can respond to this challenging investing environment.
But first, a quick look at a couple of the other issues making headlines here in Washington.
Congress has returned after a two-week break for the Easter holiday, and it feels like this is the start of one of the most critical stretches of 2022 for the Democrats. The Senate will be in session for the next five weeks, and the House for four of the next five, before the Memorial Day break. If the Democrats want to get some big things done before the looming midterm elections start to make that impossible, then this is a crucial time to make some progress. There are three big issues I'm watching.
At the top of the list is another round of aid for Ukraine. Most of the nearly $14 billion that Congress allocated for Ukraine back in March has been spent, but both parties would like to do more. Details of how much aid and how it should be directed were being worked out early this week, so I expect something will happen in fairly short order.
Second is a $10 billion COVID relief package that has already passed the House but stalled in the Senate prior to the Easter break. The money is mostly focused on testing, therapeutics, and vaccines, including for children under 5, which could be approved this summer. But the $10 billion does not include $5 billion that had been earmarked for vaccinations in other countries―something that many lawmakers believe is important. The COVID relief bill has also become mired in an unrelated dispute over immigration policy. Now, it's likely this will all get sorted out in the next few weeks and get pushed across the finish line, but you never know exactly how things will play out in the 50-50 Senate.
And the third thing to keep an eye is how big a push the White House makes in the coming weeks to jumpstart negotiations over an economic package―some kind of slimmed-down Build Back Better Act, though it won't be called that. The White House said earlier this month that talks with moderate Democratic Senator Joe Manchin of West Virginia on a smaller package have resumed. It was Manchin who refused to support the $2 trillion Build Back Better Act at the end of 2021, effectively killing it.
Manchin has said he is open to a smaller package that addresses climate change, reduces the federal deficit, and helps families deal with higher prices caused by inflation. The White House has floated ideas like lowering prescription drugs costs and providing assistance with childcare and elder care. But Democrats on Capitol Hill have a lot of priorities outside of those narrow parameters that they would like to include. And it remains to be seen whether a compromise can be forged. The White House desperately wants to pass something that helps ordinary Americans by summer so there is something positive to point to in the run-up to the November midterm elections. Of the three big issues on the agenda right now, this one seems like the hardest to get through Congress.
Finally, we have also been watching the debate in the Senate this week over the nominations for four slots at the Federal Reserve. After a long delay, the Senate voted earlier this week to confirm current Governor Lael Brainard as the Fed's vice chair. The Senate was also poised to confirm economist Lisa Cook this week to one of the open seats at the seven-member Fed Board of Governors―but that vote was pushed back after two Democratic senators and the vice president tested positive for COVID-19 and went into isolation. Cook's nomination has not attracted any Republican support, so her confirmation vote will be pushed off until all Democrats are available to vote and the vice president is available to break a likely 50-50 tie.
Two other Fed nominees enjoy broad bipartisan support and are also expected to be easily confirmed, though the timing of their votes was also thrown off by the mini COVID-19 outbreak in the Senate. At some point soon, Jerome Powell will officially be confirmed for a second four-year term as chair, while economist Philip Jefferson is set to be confirmed for one of the other open seats at the Fed.
But the situation means that Cook and Jefferson won't be seated in time for next week's Federal Open Markets Committee meeting, where it is widely assumed that a 50-basis-point hike in the fed funds rate will be approved. But they should be on board for the next meeting, set for mid-June.
On my Deeper Dive, I'm delighted to welcome back to the podcast Liz Ann Sonders, Schwab's chief investment strategist to help us sort through a lot of confusing economic signals, how the market is reacting to it all, and how investors can stay calm amidst this extended period of uncertainty. Liz Ann, thanks so much for joining me today.
LIZ ANN SONDERS: Oh, my pleasure, Mike. I always enjoy these conversations, so thanks, as always, for having me.
MIKE: Well, Liz Ann, right now inflation is the word on everyone's mind, so let's start there. In April, we hit the highest level of inflation in four decades and I think we can all feel it. The cost of groceries is up 10%. The cost of gas up 48% from just a year ago. So in your view, have we reached the peak? And if so, what does that mean for the next few months?
LIZ ANN: So maybe, I think, is the honest answer to that, and none of us have the ability to know precisely when the peak is at hand. It's also a function of whether you're talking about headline measures of inflation or core measures of inflation, with headline measures, inclusive of food and energy, and sadly these days, that has become largely at the mercy of the war, and that's the ultimate unknown in terms of the volatility associated with those particular items. And then you even have cross currents within core measures of inflation. You're starting to see some downward pressure on components of inflation that are biased toward the goods side of the economy. Of course, that's where the initial surge was largely concentrated, because when we saw the real massive demand surge happen, thanks to stimulus and the economy reopening last year, that was forced largely into the goods side of the economy because services were essentially still shut down.
So now you've got the question that I don't think anybody has a direct answer to is, are we likely to see enough services demand on the upside and pricing power to offset some of the weakness that we're probably going to see on the goods side. And, sadly, the pandemic still comes into play to some degree there.
So it wouldn't surprise me if the March data was the peak, but I don't think this is going to look like an upside-down V. I don't think we see inflation decelerate at the same pace or magnitude as we saw it accelerate. That's for sure, even if March does represent the official peak.
MIKE: Well there's so much discussion about what the Fed is trying to do here. They're trying to reduce inflation without increasing unemployment and triggering a big economic slowdown. So what makes this so difficult, and do you think the Fed is up to the task of engineering a so-called soft landing?
LIZ ANN: You know, I'll start with the second part of that question first, Mike, which is can the Fed likely engineer a soft landing? Keep in mind that we've had 13 interest rate hiking cycles … or I should say the past 13 interest rate hiking cycles, which is really the era that we have data on the fed funds rate, we've had 10 recessions and three soft landings. So the simple math of history points to recession being the more likely outcome than a soft landing.
But interestingly, the last time the Fed had to be pretty aggressive, somewhat in keeping with their current stance, in fact, it was the last time we had a cycle that had a 75-basis-point increase, was 1994. And that was a brutal period for the bond market, in particular, because of how much rates and yields moved up, but that actually was an environment where we ended up having a soft landing. Now, we had the massive tailwinds behind the economy of the internet boom and the revolution there. So I think that's, clearly, a different environment that we're in right now.
What makes the current environment a bit of an orange compared to, you know, a history of apples is that the economy is already slowing. Normally, when the Fed starts hiking, it's in a very, very strong economy, but expectations for the first quarter growth are only about 1%. And, of course, they're trying to tackle a 40-year high in inflation while also simultaneously starting to shrink a $9 trillion balance sheet with a war going on that's also had a feeder into inflation with the unique, not so much uncertainties of supply chain problems, but that's not something the Fed can directly tackle. So their job right now is to try to rein in aggregate demand so that you get some supply catch-down to a lower level of demand.
Whether they can do that without a recession, we'll have to see. But I think one of the interesting things recently, and I know you listened to it, Mike, the confirmation hearing of Chair Powell, when Richard Shelby asked him the question about whether the Fed would be willing to accept a recession as a condition for bringing inflation down—I'm paraphrasing here—he said, "'I think the history will show that the answer to that question is yes.' Now, that doesn't mean the Fed believes there has to be a recession or is trying to engineer one, but they know that that might be sort of a necessary condition. They might have to tighten sufficiently enough in order to combat inflation that brings on a recession. But, again, there are a lot of really unique circumstances in this cycle that make historical comparisons more of a gray area.
MIKE: A couple of follow-up questions come to mind from what you just said, Liz Ann, and one is this word "recession." Everyone reacts to the word "recession," and investors react to the word "recession." How important is it whether we are in a recession or not? Is that semantics? Is that psychological? Is that why it's important?
LIZ ANN: It's not really semantics, although, yes, it's absolutely psychological, to a large degree. But as you know, Mike, the market is driven by psychology. I think the economy is driven by psychology. Even inflation is driven by psychology. It's the power you get in an inflationary environment. The '70s, you know, wage price spiral, the power that workers felt in order to continually ask for higher wage increases, the power that corporations feel they have to pass on higher costs to a consumer. So I think there's psychology in every cycle.
What we do know is that you can have market corrections and even bear markets without an accompanying recession, but when you put the two together … and they're never perfectly in sync—the market almost always tends to lead the economy. But when you've had recessions and bear markets, they tend to be more severe, both in lengths and magnitude of decline, when, ultimately, you have an accompanying recession, and they tend to be a little bit more mild and shorter-lived in the absence of a recession. But even in soft-landing scenarios, you often have choppiness and volatility when you have a Fed moving rates higher. You almost have never historically avoided that in a rate-hiking cycle. It's just a question of, ultimately, whether conditions are supported enough for soft landing.
And it's not purely how the Fed engineers this. As I mentioned with regard to '94, there were lots of other really powerfully positive forces occurring in the economy that time that there was that absorption of the effect of rate hikes. I just think it's a bit different. We don't have that growth cushion right now, unfortunately.
MIKE: Well, you talked about the Fed, and, obviously, the Fed is meeting next week, so we'll get the next big signal from the Fed. It seems like a 50-basis-point hike is very much on the table. It seems like maybe it's becoming consensus view that we'll have back-to-back 50-basis-point hikes in May and June. Does that seem appropriate to you?
LIZ ANN: It does, and I think without the Fed having announced some predetermined path, they have been pretty obvious in their telegraphing that 50 is on the table for at least the next two meetings, and that is what the market has priced in now, even a high likelihood of 50 at the third meeting.
But I think the parlor game of how many rate hikes, ultimately, will have occurred in 2022, by the end of the year, that, I think, has a potential to fluctuate quite a bit. I mean, one of the reasons why the Fed wants to front-end load this is to really kind of pull the bazooka out and try to tackle this problem more forcefully and more quickly, which could change the trajectory of what the rest of the year looks like. It also is a function of how tight financial conditions become, whether that gives them some leeway to back off.
So I'm not sure what is currently 10 rate hikes priced in matters all that much. I think because the Fed isn't on a predetermined path, either on rate hikes or the balance sheet, they've said very explicitly they're going to be data dependent. And that's what we all have to do is focus on the data on a month-to-month basis to gauge how aggressive they're going to have to be after what they've effectively telegraphed, which is an aggressive out-of-the-blocks move, notwithstanding that they've already given us one 25-basis-point hike, but what's coming down the pike in the next few months.
MIKE: Well, let me shift gears a little bit to a Washington angle to all of this that has to do with the national debt. Currently, our national debt stands at a little over $30 trillion, and at the end of 2019, just before the pandemic, the debt was at 22.7 trillion, so it's increased by about 34% just in the last 28 months. That's not surprising given all the fiscal stimulus that Congress has pushed into the economy in response to the pandemic in 2020 and 2021. But for years we've heard from lawmakers that the cost of financing the debt is historically low because interest rates are so low. That's kind of the justification, or one of the justifications, here in Washington for, I guess, not worrying too much about accumulating the debt. Now, obviously, that environment is changing. So what are the implications of this kind of massive debt level in a rising-interest-rate environment, and are there things that the government should be doing to address this?
LIZ ANN: So, again, I'll tackle the last part of that question first. It's an unfortunate answer, but it's the easiest one, which is, maybe, actually getting some adults in the room on both sides of the aisle to have an honest conversation about this. There seems to be almost bipartisan support for kicking this can down the road. You know, it's a game that both sides play a bit better than they have in the past. I mean, what can you ultimately do about it is less about waving a wand and having debt suddenly start to disappear, but, you know, how about the concept of having the economy grow faster than debt? So if you're growing the economy at a faster rate than you're growing debt, you start to chip away at the problem.
Now, one caveat that may, in an absolute sense, not seem like good news, but I think in a relative sense is good news, and for reasons you're quite familiar with, Mike, the spending spigots, which were opened during the worst part of the pandemic, have since been closed. And as a result, the expected decline this year in the deficit won't break a record but looks to be on path to be the greatest annual decline since coming out of World War II era. So, of course, debt is a cumulative effect of running deficits. Now, it's still a deficit in the, you know, 7 to 8% range, but that's been cut in half relative to where we were during the worst part of the pandemic.
In terms of interest rates, based on CBO projections, incorporating an expected upward trajectory of rates, it's still going to be a fairly easy environment from a financing perspective. Now, that gets thrown out if for whatever reason the trajectory of rates is sharper or longer, and then it starts to come in into play because, of course, the more that the government has to spend in financing the debt, the less there is for productive investments elsewhere.
But, Mike, you and I have done entire segments of these things on the subject of, OK, what is the implication of a high and rising burden of debt, if it's not at least near-term the inability to finance it, which has not been a problem? It just acts, in general, as a constraint on growth, and that's not just a U.S. phenomenon, and that's pretty much everywhere in the world. And I think one of the reasons why, notwithstanding the surge in economic growth that came out of the lockdown phase of the pandemic, we've been in a pretty subpar pace of growth. In fact, the last expansion, the pre-pandemic expansion, which was the longest in history, going from June of '09 to February of 2020, that's great. It was the longest in history, but it was also the weakest, not just by a marginal degree, it was the weakest by far. And I think there were a lot of factors contributing to that, but I think the high burden of debt is one of them. There just doesn't seem … I don't know whether it's constituents start to fuss about it a bit more―I'm not sure what the trigger is going to be to finally start at least having honest conversations about this, but I think the implications of the constraint on growth, that doesn't go away, even in an environment where financing the debt is not onerous.
MIKE: Well, Liz Ann, you've probably heard me say that Congress has one great skill, and that is kicking the can down the road, and if they can find a way to do that, then they always will. I will say that, I would say just in the last four to six weeks I'm hearing more conversation about deficit reduction and more concern about the rising debt level in a rising-interest-rate environment than I've heard, obviously, over the last two, three, four years. So we'll see whether that actually translates into action.
Well, I want to shift gears again and talk about the markets, because the market, obviously, had a rough time to start out the year, and then had a little bit of a rally in March, and now things have turned south again here in April. But I've heard you talk recently about how you can't just look at what the S&P 500 or the Russell 2000 is doing as a major average. You've been saying that when you peel the onion down a layer and look at what's going on below the surface that things may be actually even more worrisome. So what are you seeing?
LIZ ANN: So a couple of things, one to just focus in on what's been going on so far this year. We had the corrective phase, or the move into bear market in the case of the NASDAQ and the Russell that began pretty much as the calendar moved into 2022. January 3 was the peak in the S&P. And we had, again, a correction in the S&P, but a more severe decline in those other indexes. S&P bottomed around March 8, and there was a lot of hope and even assumption that the rally that occurred over the remainder of March was maybe a sign that recession risk was easing, that the Fed could indeed engineer a soft landing, that maybe the, albeit fast and short-lived inversion of the yield curve, you know, it was different this time. But even during that three-week span of time, the … peel the onion one layer back, what was the leadership profile was, actually, decidedly a weaker economy message. Most of the industries that are very tied and leveraged to the economy's cyclical areas significantly underperformed, and what was outperforming was actually a lot of the low-quality areas that in the past, recent past, had been largely driven by speculation. Some of those thematic areas, even the meme stocks, got a bit of a lift, the non-earnings companies, the negative earnings companies. So I think that was more of a short-covering rally, maybe even some of the quant-based and algo-based, algorithm-based, trading structures, just looking to bottom fish—it was kind of a reversion to the mean sort of trade.
So I think even during that rally phase, the market wasn't sending some, "Skies are clearing here. We're off to the races in the economy." And now that we're back in this corrective phase, the market is still sending that same message, with classic defensives, like utilities and consumer staples, doing well. And those are areas that tend to outperform in the lead into recessions. Now, they often also outperform in the lead into soft landings. And then once the market realizes we're going to come out of a soft landing, then you see that bias shift back to cyclicals.
But even last year, with a year that was seen as quite resilient for the averages, there was a lot of churn under the surface. One example of that is the S&P last year, just calendar year 2021, didn't have any more than a 5% pullback. It was concentrated right around the September period of time. And that was the maximum drawdown for the index, 5.2%. But the average maximum drawdown for the members, if you just look at each 500 of the stocks and looked one by one at what each of their maximum drawdown was and then average it, that was minus 19%. And for the NASDAQ, it was minus 44%. So that's why I've been calling it this rotational correction at best, arguably a stealth bear market, if you're looking more under the surface.
Now, that's not a bad way to go through a bear market is to have it happen through a process of rotation versus the bottom falling out all at once, and the NASDAQ dropping by 44%, but it does highlight that there's been more churn under the surface than what you would pick up if you just looked at the averages. What's changed this year is part of what kept the averages afloat last year is that the big, large-cap dominant stocks that make up a huge disproportionate portion of these cap-weighted indexes fared fairly well. This year, we're starting to see a bit more weakness, even in those large-cap areas, which is why the weakness, now you're seeing a bit more at the index level, not just under the surface.
MIKE: Well, Liz Ann, I always like to wrap up these conversations with some practical thinking for investors. So what are the key trends that you're watching and going to be watching over the next few months to get a sense of how things will play out? And then, of course, what's your perspective on what anxious investors should be doing right now?
LIZ ANN: So as is always the case when you are trying to gauge whether we're at or in the midst of an inflection point in the economy, we know it's slowing, but it's, ultimately, where do we land? Does it land in a recession? Does it land softly? And so focusing on leading indicators, every variety of leading indicators, making sure that that's where your eyes are set versus the more coincident indicators that don't give you a heads-up. In fact, a lot of the coincident indicators, even things like job growth and retail sales, they tend to be at a peak when recessions start, because that's the nature of how recessions are dated—the NBER goes back to the peak. And human nature is we often focus on these very popular economic indicators, but they're not going to give you a heads-up. That's why you want to focus on leading indicators. Look to see if the rate of change has started to shift down. Those are the types of heads-up indicators. And I'd say, right now, it's a mixed bag. There are some indicators that are pointing toward recession; others decidedly that are not. Absolutely, keep an eye on labor market indicators because this notion that the Fed can be as aggressive as they're likely to be without much of an impact on the unemployment rate, history suggests that's probably not the case. So we want to focus on employment, unemployment, unemployment claims, job openings, the whole kind of kit and caboodle of labor market indicators, given how strong the labor market has been.
And I think housing is really key, too, in this rising rate environment. So much about what's driven this strength in the goods side of the economy has been directly or indirectly related to the housing boom that we have been in. So I think the labor market and housing could potentially either represent a sign that things are getting better, or maybe canaries that things are getting worse.
So there's a lot of other things that I pay attention to, but I think that those are really key due to this unique cycle, especially the sort of goods-versus-services breakdown that is very different in this cycle than any other cycle in the past.
MIKE: So given that, what's your recommendation for what investors should be doing?
LIZ ANN: So a couple of months ago, right around, not exactly, but when Russia invaded Ukraine, which is also when the uncertainty with regard to Fed policy, given that they hadn't laid out a playbook, we went to neutral in terms of our tactical recommendations at the broad asset class level, which basically means we're telling investors don't make any big bets right now relative to your strategic asset allocation. We also went to a sector neutral approach, thinking it's a very difficult environment to try to make a sector call or two.
What has been more consistent are factors. So where leadership has been more consistent is with a broad umbrella of quality, value characteristics. So when I say value, I'm not talking about the value indexes. Even in a sector like tech, value factors have been outperforming. So I think you want to have a value mindset. You want to focus on quality. You don't want to take excessive risk.
And then we've also been suggesting that sometimes rebalancing, if you're doing it on your own, you might do based on the calendar. You might rebalance on a quarterly basis or at year-end. And heightened volatility actually provides an opportunity to let your portfolio be your guide as to when to rebalance, kind of forcing investors to trim into strength and add into maybe areas that have underperformed and stay in gear through that combination of disciplines of diversification across and within asset classes, but periodic rebalancing. It is kind of a back to those core disciplines, which anytime volatility is heightened, we want to reinforce that those are not … it's not a free lunch, but it helps smooth out the ride in a trickier environment.
MIKE: Well, Liz Ann, always great to get your thoughts on the market, but I think this was a particularly useful conversation today. So thanks so much for taking the time to talk to me.
LIZ ANN: Always happy to be here. Thanks for having me, Mike.
MIKE: That's Liz Ann Sonders, chief investment strategist here at Schwab. You can follow her on Twitter @LizAnnSonders.
Well, that's all for this week's episode of WashingtonWise. We'll be back with a new episode in two weeks. 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, a podcast for investors. Wherever you are, stay safe, stay healthy, and keep investing wisely.
