Dangers to U.S. Economy from Without and Within

MIKE TOWNSEND: With the midterm elections less than two weeks away, inflation remaining stubbornly high, and a bear market upon us, it's a tough time to be an American investor.

But at least we're not the United Kingdom.

With last week's resignation of Prime Minister Liz Truss after just 43 days in office, and the elevation of Rishi Sunak—who lost the race for prime minister just seven weeks ago—as the new head of state, the U.K. is facing one of its most challenging political and economic environments in decades.

And that's not the only spot on the globe making headlines. Russia and Ukraine remain locked in a grisly stalemate whose humanitarian toll continues to rise, with no end in sight and increasing fears that chemical or even nuclear weapons could be the next step. The implications of the ongoing war on the global economy, particularly when it comes to oil and food supplies, are only going to worsen.

And in China, President Xi Jinping was named to a third term as head of the Communist Party and ensured that he was surrounded by loyalists as he consolidated power to a degree not seen in decades, leaving open some tough questions about his intentions with regard to China's economy and its relations with the United States.

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.

Coming up in just a few minutes, I'm going to talk with Jeff Kleintop, Schwab's chief global investment strategist, about the absolutely wild change of leadership in the U.K., the solidifying of the leadership in China, the latest in the ongoing Russia-Ukraine war, and what all of these international developments mean for investors.

But first, with Congress out of session this month and the election upon us, there has not been as much news out of Washington as usual. But here are a couple of recent developments that are worth noting.

There was an important series of announcements last week from the IRS that underscores the impact inflation is having on so many aspects of daily life. At the IRS, annual inflation adjustments cut both ways. For 2023, those adjustments mean, for example, individuals can save more for retirement next year, but payroll taxes will increase. Here's how that breaks down.

For retirement savers, the 2023 limit for contributions to an employer-sponsored retirement plan, like a 401(k), will increase to $22,500. That's up $2,000 over this year—the largest increase ever. And if you're 50 or older, you will be allowed to contribute an additional $7,500 in what is known as a "catch-up contribution."

For individual retirement accounts, or IRAs, the contribution limit will increase from $6,000 to $6,500 next year. And the IRA catch-up contribution, however, will stay at $1,000.

On the tax side, the tax brackets are adjusted annually for inflation. The tax rates don't change, just the amount of income that you can earn before you move into the next tax bracket. Those income amounts will increase by about 7% for each bracket in 2023.

But high earners will pay more in payroll taxes, specifically, Social Security taxes. Currently, the 6.2% tax for Social Security is assessed on the first $147,000 in income. Next year, workers will pay the tax on the first $160,200 in income.

The IRS also announced the estate tax exemption will increase in 2023, from $12.06 million this year to $12.92 million per person next year. And the amount you can gift tax-free to another person, such as a child or a grandchild, will increase from $16,000 to $17,000 next year.

Elsewhere, there was a major court ruling that has left Washington's newest financial regulatory agency facing uncertainty. The Consumer Financial Protection Bureau, created after the 2008 financial crisis by the Dodd-Frank Act, has been controversial from the moment it came into existence. Last week, an appellate court ruled that the agency's financing is unconstitutional. The CFPB gets its funding from the Federal Reserve, with no oversight or input from Congress. Last week's decision said that the funding mechanism violates the Constitution's separation of powers, since Congress is supposed to control federal purse strings.

This is not the first time that the Consumer Financial Protection Bureau has come under court scrutiny. A 2020 ruling by the Supreme Court determined that the agency's structure was unconstitutional because its director had too much power and was not subject to removal except in the rarest of circumstances. But the Court rejected arguments that the entire agency should be disbanded and instead gave the president the ability to fire the agency's director at will.

The Consumer Financial Protection Bureau has a broad portfolio, overseeing the mortgage market as well as auto loans, private student loans, credit cards, payday lenders and other consumer products. Because of the agency's broad oversight powers over everyday products, the appellate court ruling last week could create turmoil in the consumer market. Some have said that the decision calls into question the legitimacy of everything the agency has done—all the rules it has put in place, all the sanctions and fines it has imposed on bad actors in the consumer lending space—since it opened its doors 12 years ago. It's expected that the decision will be appealed by the agency and a second trip to the Supreme Court is a real possibility. And ultimately, Congress may have to step in and rewrite the law that created the agency in the first place in order to bring its funding under the usual appropriations process. For an agency that touches the lives of literally every American consumer who has a credit card or another kind of loan, even if many of those consumers may not know it, this represents an existential question about the agency's very right to exist.

On my Deeper Dive today, I want to focus on three global trouble spots that seem to be consistently on the front pages, explore how recent developments are shaping the global economy, and consider implications for investors. And I want to look at the ramifications of a strong dollar on economies around the globe, especially emerging markets, and what it means for investing opportunities. To provide some perspective on these issues, I'm pleased to welcome back to the podcast Jeff Kleintop, Schwab's chief global investment strategist.

Jeff, thanks so much for joining me today.

JEFF KLEINTOP: Always great to be with you, Mike.

MIKE: Well, Jeff, there's obviously a lot going on around the world that I want to get to, but let's begin with the United Kingdom, which has had a crazy couple of months, capped by last week's stunning resignation of Prime Minister Liz Truss after just six weeks on the job. So what are the takeaways from all the U-turns we have seen recently in the U.K.?

JEFF: We often think of it as a one-way street: Investors react to policy changes. But markets can push back and drive changes to policy and we saw that in the U.K. After the new U.K. government's decision in September to propose aggressive fiscal stimulus while inflation was still very high, markets responded with a rapid drop in the pound and rise in U.K. government bond yields. In fact, the U.K. 10-year yield more than doubled, from 2.0% in August to 4.5% in late September as investors sold the bonds since they were unsure about how the U.K. would eventually repay its debts. The resulting turmoil inflicted on pension plans that tend to have exposure to long-term bonds that plunged in value, prompted the Bank of England to intervene in the U.K. government bond market and delay plans to start quantitative tightening—or selling the bonds it had bought over the years through its quantitative easing program. Even more importantly, the market drove Prime Minister Truss to abandon the plans as she resigned.

MIKE: The U.K. has made a remarkably quick pivot to a new prime minister, Rishi Sunak. What do you think he needs to do to win back the confidence of U.K. investors?

JEFF: While Sunak is prime minister, the markets seem to be in charge. The U.K. is dependent upon foreign investors to fund its budget deficit, so keeping interest rates from soaring and the pound from plunging will be key. Britain's new prime minister will helm an economy heading into recession. It's got a sagging currency, punishing inflation, and a hawkish central bank. To avoid a crisis, I think the lesson for the next PM is that if policymakers appear to be departing from established economic theory and don't have a clear and transparent plan for the future, the markets will show their frustration. The new normal in the U.K. is probably very much like the old: Don't fight the markets and expect to win.

MIKE: Jeff, can you put into context for us just how much the U.K. market crisis of the last few weeks matters to U.S. investors? There were reports last week that the Federal Reserve and White House officials talked to economists and market experts around the world about whether the kind of market crisis that happened in the U.K. could happen here. And the answers that came back were that it is not likely, but that it is possible. During Truss's 43 days as prime minister, the U.S. and the U.K. bond and stock markets plummeted. That seems to indicate that there is more of a connection between the two economies. So what should investors make of this connection?

JEFF: Mike, as you know, the U.S. is also dependent upon foreigners to find our budget deficit. But we aren't seeing investors abandon the dollar the way they fled the pound, so while interest rates in the U.S. are rising, we aren't seeing a crisis erupt when it comes to funding our overspending. The bigger question for the U.S. and other major economies is what precedent the U.K. sets for the rest of the world. Will other countries follow its return to fiscal austerity in the face of market resistance or forge ahead with the experiment in 1970s-style stimulus and price controls and risk the markets backlash? I don't know if fiscal austerity is in the cards, but I'd say we've seen the limits set by the markets on the latter.

MIKE: Well I certainly think the story is going to continue to be told about the U.K. economy over the next several weeks. It'll be interesting to watch. Let's move over to another headline dominator, and that's the ongoing war between Russia and Ukraine. Russia's President Putin recently said he would use "all available means" to defend Russian territory—which he declared includes four provinces of eastern Ukraine that Russia has attempted to illegally annex. He also argued that the atomic bombs the United States dropped on Japan in 1945 "created a precedent." Then President Biden delivered a blunt warning earlier this month that the war in Ukraine could devolve into a nuclear Armageddon. So what does the threat of nuclear war mean for markets?

JEFF: I don't know what's in Putin's head. But I can give you a few thoughts on why I think markets are not reacting specifically to nuclear threats. First, the primary utility of a tactical nuclear strike, as part of a last-ditch effort to halt the Ukrainian counteroffensive, would be to threaten to make parts of the country uninhabitable. But the risks for Putin could easily outweigh any gains. The largest groupings of Ukrainian troops are now in areas along Ukraine's eastern border—zones Moscow now claims are sovereign Russian territory and where Russian troops and citizens would all be exposed to radioactive fallout if nuclear strikes were used. And depending on the winds, the radiation released by Russian weapons could easily blow back into Russian territory.

Second, Russia, through its sham vote, claims the disputed nuclear plant is now on the territory of the Russian Federation and should be operated under the supervision of their agencies. Blowing up their own nuclear power plant would just threaten "Russians."

And third, the U.S. would probably see Russia prepare a nuclear attack. The weapons need to come out of storage and the units involved alerted. Putin would likely want the world to see his preparations if his goal is to extract concessions to meet his demands. American officials say they've seen no evidence that Russia is moving any of its nuclear assets, especially in the stockpile of about 2,000 small tactical weapons that would be of most use in Ukraine. And even though Putin called for his nuclear forces to go on alert in late February, there has been no evidence that they did.

And finally I'd say, markets are probably at least somewhat reassured that a strike would not be the start of a nuclear WWIII. France's president made this clear in October, and, in the U.S., for months, administration officials have said they could think of almost no circumstance in which a nuclear detonation by Russia in Ukraine would result in a nuclear response from the United States. Many of the options under discussion involve nonmilitary steps, including a chance to bring India and China, along with much of Asia and Africa, into the effort to impose sanctions on Russia, taking away some of the biggest remaining markets for its oil and gas— further backfiring on Putin were he to launch a tactical nuclear strike.

MIKE: Well the fact that we are even talking about nuclear weapons being used is a pretty frightening thought, but it's good to hear that you're not as concerned as some are around the world.

Let's talk about oil for a minute. When we talk about oil, we often refer to the cartel of suppliers known as OPEC who recently cut production in response to weakening global demand. That failed to lift prices for oil. But what may be the outcome of an attempt at putting together a buyers' cartel to force lower prices on Russian oil?

JEFF: Yeah, this is really interesting. So OPEC+ is a group of 24 oil-producing nations. It's made up of the 14 members of the Organization of Petroleum Exporting Countries—that's OPEC—and 10 other non-OPEC members, including Russia. Now the members of OPEC+ agreed on October 5 to cut their oil production target by two million barrels per day, starting in November through December of next year, the largest production cut since the COVID lockdowns of April 2020, so a big move. Now the announcement raised concerns about energy-led global inflation pressure at a time when inflation is already the highest in decades. Now the price for Brent crude oil, which is the global crude oil benchmark, stabilized at around $93 on that announcement but remains well below the 2022 peaks of over $120 during the spring and summer. And the impact on global inflation might be far less than some fear for a couple of reasons. First, OPEC production changes haven't led trends in oil prices in the past and the actual cuts might be a lot less than those announced since OPEC was already producing 1.3 million barrels per day below its production ceiling.

And there's this buyers' cartel to consider as well. So starting December 5, any buyers of Russian oil using insurance, or financing, or shipping provided by companies in Group of Seven countries or in the EU will be required to abide by a price cap. It's possible that China & India may demand Russian oil continue to be shipped and insured by G7 providers to get to buy oil at the capped price.

Alternatively, China & India could demand even deeper price cuts from Russia to compensate for the loss of certainty and efficiency that comes along with G7 services on their Russian oil shipments. Either way that could mean lower prices. Now a risk is if Russian crude of 5 to 6 million barrels per day is withheld in protest of the sanctions. But it seems more likely that Russia would continue to export, even at capped prices, since it needs revenue and would like to avoid well shut-ins that would damage its long-term oil production.

MIKE: Since we're talking oil, what do you make of President Biden's announcement that he is releasing 15 million barrels of oil from the strategic reserves? How does that fit into this larger global game of chess around oil production?

JEFF: I guess it's something he can do to appear to be taking action and pushing back against the OPEC cuts that he was unable to dissuade Saudi Arabia from agreeing to. But a total of 15 million barrels―it's such a small amount it really doesn't do anything to impact global prices in a world that consumes nearly 100 million barrels every single day.

MIKE: Well, Jeff, let's switch gears to China, because another major world event last week was China's 2022 Party Congress, which may give us some signals about the next stage of U.S.-China relations. The market has been clearly reacting—a Nasdaq index that tracks U.S.-listed Chinese stocks hit its lowest point in more than nine years earlier this week. So what were your takeaways from China's big meeting?

JEFF: You know, overall it revealed an unsurprising but landmark third term in power for President Xi Jinping. Xi's report to the congress lasted over two hours, and I've read the transcript. Unlike his speech from five years ago that signaled major shifts in the direction of policy that had a big impact on the markets, I really couldn't find anything that stood out this time from an investor perspective. Now this is a high level, visionary kind of speech—it's not heavy on policy details. But if you pay close attention to this stuff on a regular basis, as we do, this report was notably short compared to the last one in 2017 and really signaled, I think, broad continuity in policies. There were no new elements that might signal another wave of regulatory crackdowns or military actions, but also no signs that policy is becoming more market-friendly either.

As we expected, he did not announce an end to zero-COVID policies or signal stronger pro-growth policies in the near term. In fact, the leader of Shanghai, who oversaw an economically disastrous lockdown earlier this year, was promoted to the number two most powerful position in China. And that's not a sign that China's learning from its mistakes, and it's a reason Chinese stocks fell at the conclusion of the congress.

China hasn't lightened up on COVID restrictions at all since the end of last year, according to the Oxford Stringency Index. But relatively slow growth for China, it isn't all bad in a world where hot demand has helped to drive up prices. The disinflationary impact of weaker demand in China is a help for the Fed and European Central Bank—though it does pose risks for companies with China-exposed sales, most notably in the Consumer Discretionary sector.

In his speech, President Xi emphasized that growth remains important for China, but his primary focus is on building a geopolitically resilient economy through leadership in AI, robotics, semiconductors, green tech, and other key areas of growth, reducing dependence on the U.S. And that won't be easy.

Now, I'd characterize his comments on Taiwan as unwavering—but nothing new and didn't suggest to me rising risk of an invasion. Some phrases or sentences could be taken out of context, but it looked relatively tame to me after seeing similar language from China for years. I think the red lines on Taiwan independence remain in place—and Taiwan is far from having enough domestic support to declare independence from the mainland.

MIKE: Well I appreciate your thoughts on Taiwan. That is one of the issues that investors have been asking me about over the last few months. There's clearly a lot of investor anxiety about tensions in the Taiwan strait, so good to hear you don't think that the risk is rising there. I do want to pick up on something you mentioned just a moment ago, and that's the potential global impact of an end to China's zero-COVID policy. With no signals in the speech, when might China end that policy?

JEFF: That's a key question. You know, China's elderly population is under-vaccinated relative to other countries. Since severe cases are disproportionally in older people, an exit from the zero-COVID policies that are holding back China's growth would potentially overwhelm China's hospitals. So in the absence of a rapid uptake in vaccinations by the elderly, broad access to antiviral pills to give to people with infections and prevent severe cases might be what's needed. Now, as of late September, China now as two anti-viral pills approved for use. And Merck agreed to allow China's Sinopharm to distribute and import its COVID-19 antiviral in China if the drug is approved for use there. The antiviral pill has been touted as a potential game changer for treating COVID-19. Paxlovid, a rival drug made by Pfizer, has been widely used in the U.S. pretty successfully. But we don't know when this highly effective antiviral pill will be broadly available in China, but it might only be months away.

Ending the zero-COVID policy could, of course, unleash growth within China but could also have an inflationary impact on the rest of the world, as commodity consumption and domestic consumer spending could increase. And that would potentially benefit the sales of multi-national companies that sell into China, but central banks need global economic growth to slow to tamp down on inflation. So, depending on the timing, if China's growth reaccelerated, it could result in the need for central banks to remain hawkish for longer and prompt the end to China's series of rate cuts.

MIKE: Well, Jeff, one of the most striking developments over the course of 2022 has been the strengthening of the dollar. The dollar has reached near parity with a variety of foreign currencies, and it's led China's leadership to take steps to adjust its currency. Of course, from the Fed's perspective, a strong dollar is a good thing in that it helps in the inflation fight. The Fed's mandate though is domestic in nature. But is there a point at which a strong dollar becomes a problem that the Fed has to address or at least acknowledge? What are the implications for investors of a strong dollar on the global economy? And how worried are you about emerging markets potentially defaulting?

JEFF: Well, thanks to an improvement in their vulnerabilities compared to decades ago, emerging-market currencies are actually performing much better against the dollar than developed-market currencies, like the euro, or the pound, or the yen. In fact, the MSCI Emerging Market Currency Index is down 9% this year through October 23, while developed-market currencies measured by the MSCI EAFE Currency Index are down 16%. Now this is in part due to many EM countries raising interest rates earlier and by more than more developed-market countries have. And inflation can benefit some emerging market economies that produce commodities. Emerging-market countries used to have to issue debt in dollars, and when the dollar went up so did the cost of that debt, but that really isn't the case so much anymore. Now they borrow in their own currencies, so the risk of default with a dollar surge just isn't what it used to be. But, that said, the very strong dollar is still a problem. Despite the U.S. only accounting for 10% of world trade, around 40% is invoiced in dollars, resulting in higher import costs acting as a further headwind to the already weak outlook for world trade. Higher import prices make inflation outside the U.S. higher than it otherwise would have been. And if other central banks raise policy rates even higher to prevent further currency depreciation, well then global financial conditions could tighten even more sharply and deepen a global recession. Now an eventual pivot by Fed policymakers away from aggressive tightening is inevitable, but inflation has yet to come down enough to prompt a shift away from the jumbo rate hikes that are lifting the dollar.

MIKE: Jeff, this has been a great conversation about a lot of different issues affecting the global economy. Given the challenges facing so many countries, what are you telling investors who want to remain invested internationally as part of a diversified portfolio? Are there opportunities out there?

JEFF: I think, rather than focus on the one sector or country that's up this year, all this year we've focused on "quality" stocks that are outperforming across most sectors and countries. Now we define quality in different ways. One way we have been defining high quality stocks is "short duration." Shorter duration stocks help manage the risk of rising rates. Put more simply, stocks with more immediate cash flows, rather than cash flows way out in the distant future, have outperformed this year and have been doing so since interest rates bottomed in August of 2020. The way we find short duration stocks is using the price-to-free-cash-flow ratio―the lower the price to free cash flow, the shorter the duration. Now another way we've been defining high quality stocks this year is dividend payers. Generally a sizeable dividend is a sign of financial strength and good cash flow. High dividend paying stocks have outperformed during past recessionary bear markets, and they're outperforming again this year in the U.S., in Europe, in Japan, even though the overall stock market has suffered double-digit losses. Now there can't be any guarantees, but these stocks may continue to reward investors even as the global economy struggles.

MIKE: We know the efforts to fight inflation, both here and abroad, take time to work. The U.S. got a late start on this fight, but are you seeing the effect of all the rate hikes around the world? Is there an end in sight? And what does all that portend for the U.S. economy?

JEFF: Well there could be some good news here on the rate hike front. Given the sheer volume of rate hikes from around the world lately, it might have been easy to miss some signs that global central bank hawkishness could be nearing a peak. The central banks that were among the earliest to hike a year ago, they are now signaling they may be done. The central bank of Brazil, one of the largest emerging-market countries, signaled rate hikes ended in August, and they confirmed it with no move at their September meeting. And the National bank of Poland, that's the largest emerging-market economy in Europe, surprised with a halt last month. Norway's central bank signaled it may be close to its final rate hike after a 50 basis-point hike last month. Norway was the first among the Group of 10 central banks to hike rates one year ago, and now it's signaling it may be the first to halt. Australia surprised with a dialed back rate hike of just 25 basis points in October, and the Bank of Canada is expected to downshift to 25 basis points at the upcoming meeting and then pause.

Why now? Well, in part, there are signs that excess inflation might soon recede—but there is even more evidence stacking up that a global recession started in the third quarter. If central banks respond to a weakening economic and labor environment and stop hiking too soon or cut rates while the real policy rate is still firmly negative, there's a chance inflation might rebound. And if it does, then even higher rates might ultimately be needed to quell inflation. That scenario played out in the '70s and early '80s among major developed markets' central banks in Europe and the U.S.: rate hikes followed by rate cuts followed by even more rate hikes to even higher levels.

Now stocks and other risk assets might rebound as more central banks signal an end to hikes in the next couple of quarters, but that could reverse if it becomes apparent inflation is reviving and policy rates would need to be hiked again. And that whipsaw pattern may support a continued environment of volatility and the wide market swings that we've seen all this year. But if we don't see this whipsaw pattern in policy rates, there could still be some volatility as the economic outlook may be far from the V-shape we saw in 2020. Instead, I expect a much flatter and sluggish recovery in 2023 as demand remains muted, excess inventories take time to clear, and policymakers avoid reversing their rate hikes and remain vigilant for any sign of a revival in inflation.

MIKE: Well, Jeff, it's certainly been a tumultuous few weeks around the globe, and you've done a great job at helping provide some clarity to all those developments. So thanks very much for joining me today.

JEFF: My pleasure. Thanks for having me on, Mike.

MIKE: That's Jeff Kleintop—you can follow him on Twitter @jeffreykleintop.

Well, that's all for this week's episode of WashingtonWise. We're going to change up our schedule a little bit in order to have our next episode come out after the midterm elections. So we'll be back with a new episode on November 17. Take a moment now to follow the show in 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.