MIKE TOWNSEND: For a lot of investors, what’s happening in the markets right now is quite literally something they have never seen before.
Stocks are down―this is the worst year-to-date performance since 1970, with the S&P 500® down more than 18% since the start of the year.
Bonds are down, too, moving in tandem with stocks in a way that many younger investors haven’t experienced before.
Some cryptocurrencies have lost a third or more of their value since the beginning of the year. And stablecoins aren’t living up to their name―they have been anything but stable recently. Even gold, that perceived safe haven, is down more than 7% from its 2022 high in March.
And in Washington, the Federal Reserve is projecting a rapid series of interest rate hikes at a pace that critics say is both long overdue and likely to send the economy into recession.
So is there anywhere an investor can turn?
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, Schwab’s chief global investment strategist, Jeff Kleintop, will join me to talk about why international stocks have been outperforming U.S. stocks in recent weeks and whether that is something that investors can expect going forward. We’ll also touch on the implications of U.S. companies pulling out of the Russia market permanently and whether companies are losing patience with the lockdowns in China.
But before Jeff joins me, I have some quick updates on four key issues unfolding here in Washington.
First, this week saw final approval in Congress of a whopping $40 billion aid package for Ukraine. That’s nearly three times the size of the package approved just two months ago and $7 billion more than the president’s request that he made at the end of April.
Support for Ukraine continues to be the one issue that produces a sense of unity on Capitol Hill, though some cracks in that unity are starting to appear. Fifty-seven Republicans in the House voted against the aid package―some were objecting to the rushed process, which saw the final version of the bill introduced and circulated among lawmakers just hours before the vote. But some Republicans are growing concerned with the fact that this money is not being offset with any revenue raising measures, and others worry that this won’t be the end of the money flowing to Ukraine. But overwhelming majorities in both chambers supported the aid package, and this week, Treasury Secretary Janet Yellen, traveling in Europe, called on other countries to step up their financial support for Ukraine as well.
Second, last week the Senate finally confirmed the three nominees to the Federal Reserve Board of Governors that have been in limbo for nearly three months. Senators approved Jerome Powell for a second four-year term as chair by an 80-19 margin and supported the nomination of economist Philip Jefferson to one of the open seats on the seven-member Fed board by a 91-7 vote. Economist Lisa Cook was also confirmed, but her vote was a razor thin 51-50 margin that required Vice President Kamala Harris to cast the tie-breaking vote.
Cook and Jefferson will now join the board as voting members in time for the next Federal Open Markets Committee meeting in June. The Fed has sent plenty of signals that it will raise the fed funds rate by 50 basis points at both the June and July meetings, and Cook and Jefferson have indicated that they will support that approach.
Where Cook and Jefferson may have more long-term influence at the Fed is on the regulatory side. Both are expected to be strong advocates for more aggressive Fed policies in areas like income inequality and climate change risk in the months and years ahead.
Third, cryptocurrency has been in the headlines for a variety of reasons recently―not many of them good. Popular cryptocurrencies like Bitcoin have seen their value plunge during the stock market downturn, with Bitcoin down more than 37% in 2022 as of the end of last week. And the stablecoin Terra collapsed last week after it become un-pegged from the dollar, triggering what many investors described as an old-fashioned “run on the bank.”
By coincidence, last week was Treasury Secretary Yellen’s semi-annual testimony before the House and Senate in her role as chair of the Financial Stability Oversight Council. That’s the umbrella group of all the financial regulators in Washington that was created to monitor financial system risks in the wake of the 2008 financial crisis.
Not surprisingly, given the volatility in the cryptocurrency space, questions about how the administration is thinking about cryptocurrency issues was one of the dominant themes of both hearings.
Yellen told lawmakers that she was concerned by the collapse of the Terra stablecoin and that stablecoins could present risks to broader financial stability. She called on Congress to help create a consistent federal framework that would regulate stablecoin issuers. In doing so, she found rare common ground with Senator Patrick Toomey from Pennsylvania, the top Republican on the Senate Banking Committee. Toomey asked Yellen whether she thought a goal of having legislation done by the end of 2022 was realistic, and Yellen replied that she thought that was an appropriate timeframe, given the growing risks in the cryptocurrency space.
Yellen also said that the Treasury department was hard at work producing a report in response to President Biden’s executive order on cryptocurrency that he issued in March. That order called on nearly two dozen government agencies to report on how the explosion in cryptocurrencies is impacting everything from national security to taxes to criminal activity, with the goal of creating a government-wide regulatory strategy. With cryptocurrency experiencing heavy volatility and price declines, that executive order has moved to the front burner in Washington.
And finally, an update from the SEC. We’ve talked on this podcast about the unusually fast pace at which the SEC is issuing major rule proposals and the financial services industry’s growing frustration with abbreviated 30-day comment periods that make it feel like the SEC isn’t really interested in comments and feedback.
Last month, more than two dozen trade associations in Washington wrote to SEC Chair Gary Gensler, pointing out that, historically, the SEC provided at least 60 days for comments on most rules, and 90 days or more for comments on major rule proposals. Over the last year, however, the SEC has had more 30-day comment periods than over the last seven years combined.
That position was backed up by a group with much more influence over the SEC―Congress. Forty-seven members of Congress―including 28 Democrats―recently wrote Gensler asking for additional time for public comment on certain rules.
Last week, Gensler blinked. He extended the comment periods for three recent major rule proposals, including the proposal that would require public companies to disclose more about climate risks and their impact on climate change.
That’s a signal that the SEC may be slowing down its frantic pace of rulemaking, which would give investors more time to understand the changes and their potential implications for the markets. In the end, that’s a good thing.
On my Deeper Dive today, I want to take a closer look at the movement in the markets, both here and abroad, and understand the influences that are at play. Jeff Kleintop, Schwab’s chief global investment strategist, is here to help us connect the dots between the war in Ukraine, rising inflation, and the impact on economies around the world―in Europe, Russia, China, and here at home in the United States. Jeff, great to have you back. Thanks for joining me today.
JEFF: It’s great to be with you, Mike.
MIKE: Well, Jeff, the U.S. markets are having a rough go of it since the start of the year. In April the S&P 500 was down by nearly 9%, the Nasdaq off more than 13%. But recently you have been talking about international stocks being a bit of a bright spot, outperforming U.S. stocks in April by the second largest margin of any month in the last 20 years. So why is that happening?
JEFF: Stocks have been getting close to a bear market, a 20% decline from their peak this year. International stocks have performed similarly to U.S. stocks this year when measured in dollars—but that’s actually quite a feat. The dollar is up over 9% this year, so that means the return on international stocks in local currency has been pretty outstanding with a loss of only 6% for the MSCI EAFE Index of developed market stocks as of May 16. That compares to a more than 15% loss for the S&P 500. In fact, some markets like the U.K.’s FTSE 100 Index have actually posted gains this year.
MIKE: So is this something of a blip in time, or are there fundamentals behind it that make you think this could be sustainable for international stocks?
JEFF: Well, I believe there are a few reasons that may sustain the relative performance.
Even as estimates of economic growth have been falling, estimates of earnings growth have been on the rise. And it isn’t because economists and analysts have different views; it’s because they have different tasks. For example, higher energy prices can act as a drag on the economy, leading to lower GDP forecasts, but they can actually boost the earnings outlook for the companies that make up the major indexes, since it lifts earnings for energy companies. Europe’s earnings growth has been stronger than the U.S., aided by more exposure to companies that benefit from higher inflation and commodity prices. Earnings growth for companies in the U.K., Canada and Japan, they’ve been rising steadily, and they’re now expected to be near 20% this year, up sharply from the start of the year. And that compares to just about 10% earnings growth for the U.S. Earnings growth is the main driver of the stock market over the intermediate and longer term, so this is a plus for international companies.
And another factor supporting outperformance is that price-to-earnings ratios for non-U.S. stocks are back at pandemic recession lows at around 12 times earnings, thanks to slumping prices and rising earnings. International stocks’ P/Es, they’ve never been much lower than they are now other than in a recession. So this may also be cushioning some of the downside.
And the last factor I will mention is a lack of internet platform companies. That’s a relative plus for Europe, given the pummeling tech has taken amid the Fed’s aggressive tightening.
And that’s because as interest rates have climbed, investors have punished longer duration stocks, meaning those with more of the bulk of their cash flows further out in the future in contrast to short duration stocks, which offer more immediate cash flows. Generally speaking, tech stocks are long duration stocks with high price-to-cash-flow ratios. And if rates continue to rise, investors may continue to avoid longer duration stocks, which are much more prevalent in U.S. indexes.
MIKE: Well, it sounds like there are at least some opportunities out there for international stocks. I want to dig a little deeper into some of the international specifics, and let’s start with Russia’s announcement that it is cutting off energy supplies to Poland and Bulgaria. At the same time, with the U.S. ban on Russian oil imports and the sanctions the West put in place on Russian banks and cargo ships, Russia’s oil trade has taken a severe hit. And now the European Union has proposed banning all Russian oil across Europe within six months. So what are the implications—both for Russia in terms of finding other buyers and for Europe in finding other sellers?
JEFF: Russia’s announcement that it will halt the flow of piped gas to Poland and Bulgaria, after those countries said they would not comply with Russian demands for payment in rubles, did little to push up European prices for natural gas. In fact, gas is back down to where it was at the time of the invasion. And that’s because it seems like an empty threat. Poland, for example, has greatly reduced its reliance on Russian gas over recent years, which allows it to make a gesture by rejecting Russia’s demand for ruble payment. And Europe’s gas buyers can still pay in euros; they just have to pay a Russian bank, and the Russian bank then converts the euros to rubles, and that’s already happening. It’s allowed by the EU.
Unlike with Russian gas pipelines where gas is either sold to where the pipes go to in Europe or not sold at all, Russian oil is a lot more flexible. The world’s oil suppliers and buyers can be re-balanced, but it takes a few months. With a European boycott of Russian oil, China and India can buy more oil from Russia—which is trading at a pretty attractive 30% discount right now, and that frees up more oil from the Middle East to flow to Europe. And as long as all the oil goes somewhere, a European oil boycott doesn’t result in a worsening global oil shortage.
But, of course, there’s a wrinkle or two. Europe is also considering not allowing European flagged tankers to ship Russian oil. And that could mean a shortage of transportation to get the oil to non-European destinations and potentially result in some oil not being sold because it just can’t get where it needs to go. So to try to get around this, it appears that ship to ship transfers are being used to blend Russian oil with that of other producers offshore to kind of blur the source of the crude. But this is a time-intensive and an inefficient process, and it can result in some slowdown in oil supply. And the result is oil has been drifting higher in price in recent weeks to back over $110 per barrel, but hopefully it doesn’t deliver a shock to the global economy.
MIKE: Well, Jeff, obviously, the EU still needs oil, and Qatar seems ready and willing to provide it. So is Qatar the real winner here?
JEFF: Well, all commodity producers have really been “winners” with Russian supply being derailed at least temporarily. I mean, we’ve seen Norway, and Brazil, and Saudi Arabia, and Qatar and other producers in the emerging world do pretty well. The stock markets of all of these countries I mentioned, they posted gains this year, bucking the double-digit declines we have seen here in the U.S.
MIKE: Qatar became an official strategic partner of the United States in March, but it’s certainly not a country whose foreign policy positions are always aligned with the United States. So how important is this relationship, and how do you think the U.S.-Qatar relationship impacts relations with other countries?
JEFF: Yeah, those positions may not always align in the future either. Well, I mean Europe clearly needs Qatar’s gas, but demand's rising elsewhere. Almost 80% of Qatar’s current liquified natural gas exports go to Asia. China became the world’s largest LNG importer last year when it signed a 15-year deal with Qatar to import 3.5 million metric tons of LNG annually. The first shipment of that Qatari gas just arrived in China last month. So Qatar has a deepening relationship with China, and that may put it in a difficult position when the policies of the West and China clash.
MIKE: Well let’s talk further about China, because the U.S.-China relationship. well, never seems to be far from the headlines. China continues to pursue its zero-COVID policy, and that’s led to lockdowns in recent weeks in Shanghai and parts of Beijing. Is that having an impact on the already strained supply chain?
JEFF: Yes, but it’s not easy to discern exactly how much. You know, I see news stories about how, like, X number of cities in China representing Y percent of China’s GDP are “under partial or full lockdowns or face some degree of movement restrictions.” But “partial” and “some degree” mean it’s just wrong to discount that Y percent to get an estimate of the actual impact on GDP or output from China’s factories.
The specific China supply chain indicators we watch have been getting worse despite the efforts to maintain output even during the lockdowns by having workers quarantine at the factory. But, overall, our supply chain dashboard, which looks at many indicators of supply chain efficiency around the world, has been pretty steady in the past couple of months—not good, but not worsening. For example, through April, the percentage of global companies indicating delivery times are worsening is still better than it was during the fourth quarter. Overall, producers are indicating that their inventories of supplies have climbed pretty sharply, and while there are some companies still talking about production curbs, most have the supplies they need. But if the restrictions in China worsen or if the current lockdowns lengthen indefinitely, it’s likely to eventually catch up with us, and restrict production and raise prices.
MIKE: Jeff, as you look at China’s economy, you’ve been talking recently about the likelihood that China has slipped into a recession. So what is China’s plan in the short term to boost its economy, and what are the implications longer term, particularly for U.S. companies that have major operations in China?
JEFF: I do think the world’s second largest economy has likely slipped into a recession, at least by China’s standards. Severe lockdowns in response to the latest COVID-19 outbreaks have resulted in a pretty sharp economic slowdown. In fact, many economists have downgraded their China GDP growth targets for this year, citing risks from the zero-COVID policy.
In the short term, China’s economic outlook largely depends on the success of its COVID strategy. There are some indications that May could be better than April. Around 16.7 million of Shanghai’s 25 million people are now allowed to leave their neighborhoods as of May 5, following a sharp decline in new cases. But getting cases under control everywhere has been difficult. Cities in China are now requiring residents to test at least once a week, striving towards shorter and more targeted lockdowns that might reduce the economic costs over coming months.
China’s policymakers appear to be targeting higher growth in the second half of the year to make up for lockdown losses in the first half and achieve their 5.5% growth target for this year for GDP. And they haven’t changed that, despite the slowdown. The Chinese government’s announcements of additional economic stimulus policies that have replaced the surge in regulations that we saw last year may not really gain much traction until the lockdowns ease and those incentives can finally be put into action.
Over the longer term, any extended disruption to consumer spending and business output is a risk to China-exposed businesses. Beyond the rising risk of a short-term earnings miss, there might be a risk that global businesses slow or stop investing in China over the longer term.
U.S. and European businesses actually continue to invest in China and grew that investment at a pretty steady pace over the past decade, even during the height of President Trump’s trade war with China. And during the waves of global COVID infections in 2020 and 2021, China won more business as the government found ways to keep factories running.
But more recently though, China might be losing its edge. A survey by American Chamber of Commerce in Shanghai conducted in late April and early May showed that 53%, so just over half, of U.S. companies operating in China say they will reduce their investment in China if the current COVID restrictions remain in place into next year. And 59% of companies now report their production did slow during the present outbreak due to a lack of employees, or inability to obtain supplies, or even explicit factory halts resulting from the lockdowns. Although only 6% said they would completely shut down their operations in China were that to occur.
But should major companies begin to turn away from China, it could result in some big costs―both in terms of lost sales and higher production costs. For example, we’ve seen some high costs associated with businesses abandoning their Russian operations, like the $5 billion reported by Shell. A step back from China would probably entail much greater costs, given how deeply integrated China is into the world’s supply chains and, of course, as a consumer market as well.
MIKE: Let me follow up on your comment you just made about companies pulling out of Russia. We are starting to see the impact of those actions. McDonald’s, for example, announced this week that it was permanently exiting Russia and would be pursuing the sale of its more than 800 restaurants in Russia to a local buyer. It also announced it would take an accounting charge of more than $1 billion as result. And there’ve been some eye-popping numbers from other companies. As you mentioned, Shell announced it would take a $5 billion write down, while BP announced it would take a $24 billion write down.
We just wrapped up the Q1 earnings reporting season, which was actually better than expected, but a few mega-caps had disappointing results that dragged the markets down. Should we be preparing for a similar impact on the markets from the Q2 earnings as these new write downs take effect?
JEFF: Well, most of the listed foreign companies operating in Russia are energy companies, and with their earnings soaring on high prices and strong demand, the divestments may not be a big concern for investors.
Maybe a bigger risk to Q2 earnings could come from the extended disruption to consumer spending and business output in China. Apple warned of a hit of up to $8 billion from COVID-related disruptions, and General Electric reports that lockdowns are suppressing demand as well as causing supply-chain problems. But, as in Q1, the bad news is likely to be company-specific rather than across the entire market.
MIKE: Jeff, earlier this year the Commerce Department announced that the trade deficit increased by a record amount in 2021, to its highest level ever, due to the pandemic. So what will it take to get that back down again? And how concerned are you about that number?
JEFF: The surge in spending on goods during the pandemic has boosted imports. But trade deficits are only a bad thing if they mean there’s a lot of domestic workers who can’t get jobs or if the U.S. dollar is plunging and making them more expensive. But neither of those are happening now. Instead we have worker shortages, and the dollar is the strongest in 20 years. As spending shifts more towards services, like travel and dining out, the growth of imports relative to exports may slow down. I don’t worry about the trade balance anywhere near as much as I worry about the budget balance.
MIKE: One of the other numbers that’s attracted a lot of attention recently is the fact that GDP fell during the first quarter of 2022, which I think caught a lot of economists by surprise. So what’s behind that? Is there a connection to the trade deficit? And what are you expecting in Q2?
JEFF: Well, GDP is a measure of output. I mean you could knock down all of Washington, D.C., with your construction equipment and then rebuild it with the same equipment just as it is, and it would add to GDP. So it isn’t the best way at looking at the value of an economy. We use it to track domestic output—like all the stuff we make or do. But in contrast, a company’s earnings reflect the value of what it sold, less the costs and less any losses it might have suffered, like a fire, or damage to a factory. So GDP is not America’s earnings report by any means, and we shouldn’t think of it that way.
The Bureau of Economic Analysis that puts together the GDP report is not able to discern the import content of goods and services produced in the U.S. So what it does is it adds up total domestic consumption—all the stuff we buy—and then it subtracts imports, assuming that what’s left must have been produced domestically. Since imports surged in Q1, as a lot of delayed products and supplies finally arrived on our shores, the GDP number came in negative despite the positive total consumption growth for the quarter. Q2 growth is expected to be positive, just with less of an import surge acting as a drag on GDP.
MIKE: Well, Jeff, you’ve given us a lot of great information and explained a lot of these unusual data points. But I want to wrap-up with a question that is more domestically focused. Obviously, the big news of last week was the Fed’s decision to hike the fed funds rate by 50 basis points―the first time it has done that in more than two decades―and also accelerate the winding down of its balance sheet. At the same time, unemployment remains very, very low, and, as we just talked about, we’ve just wrapped up an odd earnings season where a few high-profile companies like Netflix and Amazon seemed to propel the market downward all by themselves. And, of course, we still don’t know how the Ukraine-Russia war is going to play out and what its longer-term implications for the markets could be. So how should investors be thinking about what seems to be a pretty unusual set of data points and information that they’re watching?
JEFF: An often-overlooked hero of times like these is diversification. There are some stock market sectors that are up this year, helping to offset those that are down. And that’s true for countries, as well. And, as I mentioned before, short duration stocks are flat this year while long duration stocks are in a bear market. The degree of divergence is remarkable. In fact, the correlation between major stock markets around the world has fallen to the lowest levels in 25 years. And that means that markets are not falling in sync with each other. We’ve been used to markets moving in sync with each other, rising and falling together—maybe by different amounts, but moving in the same direction, most of the time. For one of the few times in a generation, that isn’t happening now.
We are seeing the benefits of broad diversification pay off. Now, that doesn’t guarantee you won’t see losses, but if you are concentrated in one sector or country, the volatility in your portfolio may be uncomfortably high as all the developments impact the markets right now.
So we’ve been suggesting investors be broadly diversified across asset classes and sectors, not because we don’t have any good ideas—but because diversification itself is an especially good idea right now.
MIKE: Well, as usual, Jeff, great perspective on a challenging environment. Thanks for making the time to talk to me today.
JEFF: My pleasure, Mike. Great to be with you.
MIKE: That’s Jeff Kleintop, Schwab’s chief global investment strategist. You can follow him on Twitter @JeffreyKleintop.
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.
