Transcript of the podcast:
MIKE TOWNSEND: What a week it was. The most common question I've been getting from investors over the last few days is whether it was the craziest week I've ever experienced in my 30 years in Washington.
In a word: Yes.
The removal of the Speaker of the House on October 3 was, quite literally, something no one has ever seen before.
While the House struggles to sort out its leadership vacuum, it is paralyzed—unable to consider legislation to fund the government, provide money for Ukraine, or do anything at all.
But that was hardly the only drama that investors have been eyeing.
Last week also saw a spike in volatility, not just in the equity markets, but in the normally calm bond markets. Last Friday's jobs numbers, which came in twice as high as expectations, exacerbated the volatility. The 30-year Treasury bond yield briefly was above 5 percent for the first time since 2007. Mortgage rates approached 8 percent—they haven't been that high in more than two decades.
Higher rates are impacting companies here in the U.S. After more than a decade of low-cost borrowing, companies are beginning to rethink their investment plans and are implementing, or at least considering, cost-cutting measures including job losses.
And the higher rates are being felt in Washington, too, putting a spotlight on the rising cost of the interest on the nation's staggering $33 trillion in debt. According to Bloomberg, in the 11 months that ended in August, the interest on U.S. debt was $808 billion, more than six times the $130 billion over the same period in the previous year.
Through it all, the Fed is sending a clear message that it sees no reason to lower rates after more than a year of rate hikes. The "higher for longer" message that the Fed has been sending appears to be sinking in.
Given this investing and political backdrop, it's no wonder investors are casting their eyes around the globe, trying to determine whether there are opportunities overseas.
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 Jeffrey Kleintop, Schwab's chief global investment strategist, about how the turmoil here at home is affecting the rest of the world and where opportunities might be for international investments. We'll talk China, Japan, Europe, and more.
But first, a brief update on what is making news right now here in Washington.
And this week, there's really only one story in the nation's capital: the chaos in the House of Representatives.
Last week's ouster of House Speaker Kevin McCarthy was the first time in history that the speaker has been voted out of office. It has paralyzed the House until a new speaker is elected, though when that would happen and who it would be remained up in the air as this week began. That uncertainty was put into stark relief with the shocking attack on Israel last weekend: Without a speaker, the House cannot vote on aid to Israel or even on a resolution condemning the attacks.
There's been a ton of noise as all of this has unfolded. So here are my three big takeaways about how we got here, where things stand, and whether investors should care.
First, the government remains open and operating through November 17—and out of everything that has happened over the last two weeks, that's probably the biggest one for investors and the economy. Frankly, it's a big surprise that we did not have a government shutdown.
On Friday, September 29, it seemed like a shutdown 24 hours later was a done deal. But overnight and through the day on September 30, a last-minute agreement quickly came together to keep the government funded for about six weeks. The bill included $16 billion in emergency funding for victims of recent natural disasters like the wildfires in Hawaii and the hurricane in Florida. Notably, however, it did not include any additional funding to help Ukraine in its ongoing war with Russia. There was an unwritten agreement by Congressional leaders to try to move a Ukraine aid package separately in the coming weeks, but with the impending change in leadership for House Republicans, the prospects for a stand-alone Ukraine bill have dimmed.
The bottom line is that we are now in a 45-day reprieve on the government shutdown. One side effect is that the Federal Reserve will continue to have access to all the economic data it needs before its next meeting on October 31 and November 1. The Bureau of Labor Statistics does not collect or publish its economic data during a government shutdown. So averting a shutdown meant that the agency was able to put out last week's blockbuster jobs numbers on schedule. This week will see the release of the Producer Price Index and Consumer Price Index numbers, the PPI and CPI. All of this month's data will be available to Fed decision-makers at the end of the month when they meet to decide what the next move will be on interest rates.
My second big takeaway, however, is that the situation in the House puts a government shutdown squarely back on the table for November. Even lawmakers on Capitol Hill have publicly used the word "inevitable" this week when discussing the prospects for a November shutdown.
That's because the underlying dynamics in Congress have not changed a bit. The Senate still has not passed a single one of the 12 appropriations bills that fund every federal agency and program. The House managed to pass four of the 12 bills last month but was stymied on how to move forward on any of the others even before the chaos over who will run the House broke out. And the House is still insisting on spending cuts that the Democrat-controlled Senate will never support.
The ouster of House Speaker Kevin McCarthy came 48 hours after he made a deal with Democrats to avert a government shutdown. The new speaker, whoever it is, probably won't be able to make the same deal next month. And that puts Congress between a rock and a hard place—the Senate won't vote for what the House puts forward, and the House won't vote for what the Senate puts forward. How that gets resolved is anybody's guess, but it sure feels like a government shutdown is all but unavoidable.
And if a shutdown does happen next month, the timing is certainly not ideal. Some 850,000 government workers could be furloughed at the beginning of the holiday season. And that could impact shopping and, in turn, the broader economy. It's another factor contributing to growing investor anxiety that we've been seeing over the past month or so. I have said on previous episodes of this podcast that, historically, government shutdowns have not been a big market mover on their own, and, in fact, the market has risen during the last five shutdowns. But the broader economic and market circumstances are more concerning this time. A November government shutdown won't be the catalyst to a market meltdown, but it will add to the growing list of concerns that investors have.
And my third big takeaway is that the situation throws into uncertainty the entire policy agenda, not only for the remainder of 2023, but for 2024 as well. It's much harder to see the path forward today even on some issues that have shown signs of bipartisan cooperation on Capitol Hill. If Congress can't come together to fund basic government operations, is there much chance of finding common ground on issues like creating some regulatory guardrails around cryptocurrency or artificial intelligence? What about big, looming problems like the Social Security system, which is projected to run out money to pay full benefits in a decade? Or Medicare, whose financial problems are even more acute.
It's been a long-held belief of many investors that gridlock in Washington is good for the markets, that the market performs best in divided government. And there is some evidence that that's true—over the last 120 years, the Dow Jones Industrial Average has seen its best returns in years when there was divided government.
But a gridlocked Washington that can't function, that struggles in its most basic responsibilities like funding the government each year, will inevitably take a toll on investor confidence, both here and abroad. There are many contributing factors to the current chaotic stock and bond markets, not the least of which is the current political dysfunction.
Government dysfunction is why Standard & Poor's downgraded the U.S. credit rating during the debt ceiling crisis of 2011. It's why Fitch Ratings downgraded the U.S. earlier this year, citing the "erosion of governance" as a significant factor. And the third major rating agency, Moody's, warned that its own downgrade could be coming, noting, in something of an understatement, that "fiscal policymaking is less robust in the U.S. than in many triple-A rated peers."
No one is really certain how things on Capitol Hill will unfold over the next week, the next month, or the next year after the unprecedented events of last week. But investors would be wise to keep one eye on Washington as it struggles to extract itself from a mess of its own creation.
For the last couple of months, the conversations I've had with guests on the show have focused on the concerns here at home—with our economy, interest rates, the equities market retreating, and bond yields at multi-year highs. On my Deeper Dive today, I want to turn my attention overseas and take a look at some of the key issues affecting the international investing landscape. To help me do that, I'm pleased to welcome back to the podcast Schwab's Chief Global Investment Strategist Jeffrey Kleintop. Jeff, thanks so much for joining me today.
JEFFREY KLEINTOP: Thanks for having me back, Mike.
MIKE: So it's nice to have you here to change the focus because there is a lot going on in the global economy that can impact and influence investors around the world. But I want to begin with last weekend's shocking attacks against Israel. Obviously, it's an incredible tragedy in a part of the world all too familiar with tragedy, and one that's certainly not over yet. But I do want to look at market implications. So could this affect global markets, particularly the oil markets? I mean, while there's not a direct impact on oil supply, it certainly increases tensions in a region that's home to about a third of the world's oil supply.
JEFF: And, of course, the human toll is unimaginable, but the market's assessment is that the latest outbreak of war in the Middle East is not likely to be a material risk to long-term investors. You're right, Mike, historically, the primary spillover from conflicts in the Middle East has been felt in the oil and gas market. Notably, the rise in oil and gas since the attacks began isn't nearly as significant as that of back in February of 2022 when Russia attacked Ukraine. Oil prices are up about 4% since the attack this time, in contrast to the 35% rise over the two weeks starting the day before Russia's invasion back on February 24 of last year. The larger impact makes sense. Russia supplied over 10% of the global oil and gas market, which were directly threatened. The current conflict seems to put supplies only at risk.
Now, of course, there are risks of escalation. A strong reaction from Israel could upset Saudi-Israel relations and make any oil supply increase, any reversal of those supply cuts by Saudi Arabia over the summer, maybe less likely in the near term, and the U.S. could potentially bolster sanctions against Iran. The U.S. was quietly allowing Iran to ship more oil, in violation of sanctions lately, given the very tight oil supply situation. If the U.S. cracks down on those shipments, it could further tighten global oil supply.
But oil prices have had diminishing reactions to Middle East instability over the years, perhaps because the developments have typically not resulted in sustained disruption of energy supplies. If we look at the impact of higher oil prices, they do have the potential to bolster inflation pressures. But the oil price right now is below where it was during September's U.S. CPI reading. So it's actually down from where it was when we took the survey of oil prices for that September reading for the CPI. Both oil and gas are pretty small contributors to inflation in most developed countries. For example, in the U.S., energy, goods, and services account for about 7% of the overall CPI, and they're excluded from the core measures that the Fed tends to use as a policy guide.
Looking at the stock market, past geopolitical events involving Israel saw muted moves in U.S. and international stock markets. Initial reactions were often reversed over the subsequent five days. And that's why it's important to remember that geopolitical risk is ever present and specific developments may affect the markets from time to time. Long-term portfolio performance tends to be more dependent on the economic cycle than geopolitical developments. You know, during periods of even modest economic growth, the global market's response to perceived threats has tended to be pretty short lived, Mike.
MIKE: I appreciate your thoughts on that, Jeff. Obviously, a terrible situation. The whole world is watching to see where things go from here.
Well, let's shift gears and talk about the second- largest economy in the world, China, which has been a major driver of the global economy over the last couple of decades. All that kind of went by the wayside with COVID. There were great expectations for a rebound as the Chinese economy emerged from the far-reaching COVID lockdowns, but that hasn't really happened. Instead, there's a lot that hasn't gone right with China's economy. And in the headlines right now is a major real estate crisis, with Evergrande at the precipice of collapse. It's just one factor that has contributed to a lack of confidence among the Chinese people. So is this changing your outlook for China?
JEFF: China took a big step forward this year with the reopening, and then a big step back, and it seems to be stumbling. It reminds me of how if you look very closely at your computer screen, it's just a bunch of jumbled dots of different colors that seems kind of like chaos, but when you pull back, you can see the bigger picture, and it starts to make some sense. Well, in the case of China, anyway, a little more sense.
You mentioned China's Evergrande Group. That was the giant property developer whose financial travails have weighed on Chinese markets for two years now. Well, the company has now admitted that the debt restructuring plan proposed in March is no longer feasible and disclosed that its chairman is under criminal investigation, and that regulators are not allowing it to issue any new debt. Now, we've been pretty confident through the back and forth that Evergrande would fail, and this year it's been Country Garden, another developer that's been under pressure.
But the bigger picture is what's important here. This isn't a spiraling crisis like the housing crisis in the U.S. back in 2008, after some lenders began to fail. First, consumers and banks in China aren't leveraged. It's the home builders that are, and that's a huge difference in economic impact. This is like if Toll Brothers or Pulte or Lennar in the U.S. were at risk of going under, as opposed to the big banks or the consumers that did the borrowing, right? A very different scale in terms of its economic impact.
Second, because Chinese investors preferred real estate to stocks, home prices were soaring. and investment in key businesses in China was not. But now housing prices are no longer going up at a pace that was creating a social problem, as people, you know, couldn't afford to buy a place to live. The government has achieved its goal of stabilizing housing prices. They are flat from a year ago, technically down 0.5% year-over-year. So that's pretty flat. And instead of real estate speculation, money can potentially now flow into Chinese stocks, making them less dependent on foreign capital.
And third, the bankruptcies we're seeing among developers are … well, they're engineered by the policy changes put in place two years ago. They're not a market-driven development. They're intentional, and there are no signs that it's spreading to other parts of the markets. In fact, although the price of Evergrande and Country Gardens' bonds that are maturing in a few years here in 2026 are trading at just 5 and 7 cents on the dollar, other high-yield bonds from issuers like the Bank of Communications and Industrial and Commercial Bank of China, those are the two largest bond issues in the China high-yield bond index, they're trading near par value. And that suggests to me two things. One, markets do not expect Evergrande or Country Garden to get bailed out, but they also don't expect their probable failure to cause contagion even among other junk bond issuers or banks within China. So a further spill over to foreign market seems pretty unlikely.
But Mike, there is a problem, of course. Concerns have increased about losing down payments of 30 to 50%, which are typically made in cash, years before the delivery of a completed home. And because property comprises about 70% of the wealth of Chinese households, worries about the housing market appear to be eroding overall consumer confidence and the pace of spending on goods.
MIKE: So, Jeff, how is the Chinese government reacting to all of this?
JEFF: Well, to address the economic downturn, China has enacted an almost daily drip feed of targeted stimulus measures, especially since the July Politburo meeting. As these incremental policy measures begin to bear some fruit, we've been seeing some positive surprises in the releases of official data, supported by the non-traditional measures of economic activity that I like to watch on China, things like rising air pollution, which bottomed in July and began to creep up in August and September, uncharacteristically. Normally, that's not a period of time we see air pollution like NO2 emissions or particulates rising in China. But they were, and that was telling me that economic activity was coming back online in terms of manufacturing production and transportation. And sure enough, as the data began to be reported for the month of August in September, we indeed saw that. The Manufacturing Purchasing Managers Index, a survey of businesses in China, ticked back above 50, and that's signaling expansion or growth. Retail sales grew 4.6% in August after just 2.5% in July. Factory output, industrial value-added growth, accelerated to about a 4.5% pace in August from 3.7 in July. And inflation ticked back into positive territory. Believe it or not, China was experiencing deflation in July, with prices on a year-over-year basis falling 0.3%. That's how weak demand was, but they ticked back into positive territory in August as demand picked back up. Oh, and the unemployment rate fell from 5.3 to 5.2%.
So to sum it up, given the property market overhang, coupled with high youth unemployment, China's economic growth is unlikely to see a V-shaped rebound. It may remain sluggish, and sluggish for China, somewhere around 5% GDP growth, but, still, that's below what they've gotten used to in recent years. But with more stimulus announcements and upward surprises on economic data suggesting that they're beginning to work, that could lift sentiment and stocks with China exposure.
MIKE: I'm curious, Jeff, how all this may affect U.S. companies. I think most investors know that U.S. companies—Apple, Tesla, Ford, GM, lots of others—have large manufacturing connections in China, and they also of course get a portion of their revenue from China. I find it particularly fascinating that there are 8,600-plus U.S. companies doing business in China, and some of them derive an outsized portion of their revenues from China. So I'm talking about companies like chipmaker Qualcomm, which reported 67% of its revenue coming from China; Texas instruments, with 49%; and even non-tech companies, Las Vegas Sands, the casino company, clocks in at 68%; and the list goes on—Starbucks, Nike, Coca-Cola. So I guess I'm curious if there's a China risk factor at play here, not only for these companies, but also for the U.S. consumer if these companies need to make up revenue, and they do it by raising prices here at home.
JEFF: Slow growth in China could lower U.S. companies' prospects. You've talked about a number of those businesses there, really across the spectrum, that have a lot of exposure to the Chinese consumer, which they have pulled back. But here I think the gloomy sentiment might be missing a bigger picture. It's very early in the earnings season, so we'll get more updates soon. But looking back, Starbucks indicated they saw a 46% rise in same-store sales in China when they reported back in August. And there were long lines at Apple stores in China in response to the iPhone 15 launch, despite the revival of a Huawei phone. So they're certainly still spending, particularly on some luxury items, taking place within China. And European luxury retailers are still focused on China. DFS group, the travel retail arm of luxury conglomerate LVMH, they just announced plans last week to build a major shopping and entertainment complex in China in a bid to capture a growing market that's generally showing resistance to slowdowns in the U.S. and Europe.
So while China's in its own little slowdown at the moment, in general, we've seen better growth from Chinese consumers through downturns in the U.S. and Europe, and that's important in diversifying their revenue base. And so I expect we'll continue to see that. I'll be watching very carefully to see if we see that overall consumer spending pace pick up as more of this drip feed of stimulus is directed towards Chinese consumers.
MIKE: Well, Jeff, from a Washington perspective, U.S.-China relations is never far from view. I'm really interested in what's going on right now in terms of the diplomatic relationship between the two countries. In August, President Biden issued an executive order that restricts U.S. private equity and venture capital investment in China in certain sensitive technologies—semiconductors, quantum computing, artificial intelligence. Of course, on Capitol Hill, there's a new House Select Committee on the Chinese Communist Party that has been pretty aggressive in examining the dangers China poses economically, technologically, and militarily. Yet at the same time, the last few months have seen a parade of top U.S. officials to Beijing—Secretary of State Anthony Blinken in June, Treasury Secretary Janet Yellen in July, Commerce Secretary Gina Raimondo in August. It's widely assumed here in Washington that all of that is laying the groundwork for a face-to-face meeting next month between President Biden and President Xi of China. So what is the U.S. strategy here?
JEFF: I think the goal is to try to create some space between the floor and the ceiling, establishing a floor preventing a crisis that neither side wants, but the ceiling for the relationship remains low in terms of room for actual improvement. The growing momentum behind a meeting between Biden and Xi at the APEC Leader Summit in San Francisco in mid-November is to establish an important window for dialogue before Taiwan and U.S. politics heat up in 2024.
There seems to be a desire on both sides to reduce geopolitical tail risks heading into a year full of potential flashpoints next year. In January, Taiwan will hold its presidential election. The front runner is the current vice president, who has been more outspoken on issues surrounding Taiwan's independence, and he's running against a Chinese nationalist. So this is a political proxy war between Taiwan and China, or at least two versions of its future. And of course the approaching U.S. presidential and congressional elections in November of 2024 will further limit the scope of the Biden administration to be seen as weak on China and add to the provocative and mostly symbolic legislative proposals in Congress.
There is a chance that the administration could maybe lower tariffs on some consumer goods from China, while maintaining and likely increasing them on imports subject to Chinese industrial policies and U.S.-China strategic competition, with the idea of further dampening U.S. consumer inflation, while not appearing soft on China. So maybe that could come out of a Xi- Biden meeting. A constructive meeting could maybe improve the odds of some of that happening. And in response, China could approve more Chinese airlines, maybe to place orders with Boeing, or something along those lines. Not a major but symbolic action and a recognition that neither side believes that true decoupling is feasible.
MIKE: Well, lots going on in the China relationship, no question.
Let's zoom out a bit from China. Last week we saw continued strong jobs numbers here in the U.S. How is the job market fairing in other countries?
JEFF: It's pretty strong. Europe's job market is really strong, and so is its wage growth, which has shown some slowing in the U.S., but it's still pretty strong in Europe. I expect that to soon change, though, and that should allow the European Central Bank to keep rates on hold, as the Fed is expected to do, and many even cut rates next year. Eurozone employment now stands at an all-time high. There are 5.3 million more jobs in the Eurozone than before the pandemic. And at the same time, there's currently 10.9 million people that are unemployed in the Eurozone. That's 1.3 million fewer than before the pandemic. And the unemployment rate is now 6.4%. That's in line with the all-time low, which was set in June. Remember, the Eurozone has only existed since the late '90s, so we don't have a hundred years of history on that. But at least going back over the last, you know, 25 years or so, that is the low.
Yet leading indicators of the labor market in Europe are showing signs that this strength might soon ease. For example, in Germany, the number of people who filed unemployment claims rose for an eighth straight month in September, and the number of reported job vacancies in Germany continued to slide in September. And the Manufacturing Employment Purchasing Management Index, the Purchasing Managers Index, the survey on employment in the manufacturing space, is pointing to a falling employment in the coming months. And Europe has four times as many services jobs as manufacturing jobs, and this former strength in services employment appears to have started to weaken. European company management communications on earnings calls and shareholder presentations also reveal a rising trend of mentions of things like job cuts, or worker furloughs, or headcount reductions, phrases like that, along with a falling trend in mentions of labor shortages or new hiring initiatives. So that might begin to show some signs of weakening up in Europe. A low unemployment rate implies higher wage growth, which could force the ECB to continue to hike rates and consequently put more downward pressure on the economy and the stock market.
So worryingly, from this perspective, anyway, wage growth has remained stubbornly high in Europe, even as it's eased in the U.S. It peaked later in Europe than in the U.S., and higher inflation gave workers the opportunity to demand larger pay increases in a tight labor market. But looking forward, European households' expectations for inflation over the next 12 months have already fallen sharply. And if headline inflation continues to recede over the coming year, as we expect it will, it seems likely that inflation expectations will track lower, prompting workers to eventually settle for lesser pay increases.
And maybe we're already starting to see this. Indeed.com, which is an online job site, they derive wage numbers from job postings on the site, and they are reporting lower wage growth in July and August. Now, obviously, there's different jobs being posted in different months and a lot of different things to factor in there, but it's noteworthy that that's been coming down. And so if the unemployment rate remains low and inflation continues to fall, there might be little need for the rate hikes by the European Central Bank.
MIKE: Well, turning our eye to Japan, kind of a bright spot right now. The stock market there is performing the best of any developed country since the start of the year. And last week a Wall Street Journal columnist called Japan "the most exciting market in the world," which is not a phrase that is often associated with Japan's stock market. So do you agree?
JEFF: To say the least, I can tell you I'm almost never asked about Japan's stock market. It's the second-largest stock market in the world, Mike. No one ever asks me about it. The main reason is it hit its high in December of 1989 and has never gotten back there. But that's a long time to go without hitting a new high, but it's on its way back. And it has really recovered most of that and stands not too far away from a new all-time high. I imagine that will be covered in-depth in The Wall Street Journal when it does.
Japan's been a strong performer lately, this year outpacing the S&P 500®. It's got a lot going for it. For one thing, pro-market reforms are pushing companies to improve shareholder returns. Japanese companies have long hoarded cash. It's a cultural thing. Just in the last quarter, it reached 2.5 trillion U.S. dollars worth of cash sitting on balance sheets in Japanese companies. And that's bloated the book value of these companies, but it's offered very little return in a country where interest rates on cash are still below zero. No hikes by the Bank of Japan on interest rates. So they're not earning anything on all that cash.
Currently, about half of the firms listed on the Tokyo Stock Exchange have price-to-book ratios below 1.0, including some very large well-known companies like Honda. Earlier this year, the Tokyo Stock Exchange had made changes requiring these companies to provide plans to boost their price-to-book ratios above one as soon as possible. And that regulatory push is meant to encourage putting that idle cash to use in the form of stock buybacks and other measures to improve shareholder returns. So that's been working to help lift valuations in Japan.
But there are other factors helping drive Japan's growth, the most substantial of which may be something the Japanese economy hasn't consistently experienced since the 1980s, inflation. After decades of flat-to-falling prices, the year-over-year pace of inflation in August was 3.2%, and it's now been running above the Bank of Japan's target of 2% for 17 straight months. Mike, this is the first time an entire generation of consumers and businesses have experienced sustained inflation in Japan. Previously, falling prices provided an incentive to delay consumption to just buy things more cheaply as prices fell, which handicapped economic growth. But now, rising inflationary expectations could lead to positive changes in consumption and investment by Japanese individuals and corporations, helping to drive stronger growth. And I'd add one more thing to the list. Japan may be benefiting from the de-risking of supply chains in Asia. Japan widely used as a friendly destination for manufacturing within Asia.
Now, despite the strong performance of Japanese stocks this year and last year, they remain inexpensive. Japanese stocks currently trade at a price-to-earnings ratio of 14 on a 12-month forward earnings estimate basis, which is below the 20-year average for the MSCI Japan Index. And that compares to an above average 19 for the U.S. S&P 500 index.
Now, the falling yen has been a drag, but if the Bank of Japan starts raising rates, and the U.S. Federal Reserve signals an end to those hikes or even starts to cutting rates, this could benefit the yen and give a currency boost to U.S. investors in Japanese stocks.
MIKE: All right, Jeff, you've convinced me, the Japan stock market is exciting. I want to switch back to Europe for a moment. You've been writing about a possible surprise to the upside in Europe. So what are you looking at? What are you watching for?
JEFF: Well, we've been saying for over a year that Europe, in particular, Germany, was the most at risk of a recession among any major country, in part because of the war in Ukraine. And it's now been four straight quarters of no growth in the German economy, assuming that the Q3 numbers come in, as I expect, very flat. Overall, the Eurozone's economic indicators have continued to surprise on the downside since April. So not only has data been weak, it's been weaker than economists thought it would be. But the performance of Eurozone equity markets isn't reflecting that. The average European stock is outperforming the average U.S. stock. And we can see that in the equal-weighted MSCI EMU Index, that's European Monetary Union Index, outperforming the equal-weighted S&P 500 this year, despite the big gap in economic momentum. Europe is growing much more slowly than the U.S., particularly in the third quarter.
Now, during the summer, Europe struggled amid record heat. It created unexpected issues with transportation of cargo by river. Some of the rivers in Europe fell below 100 centimeters, and you couldn't move anything. That added to the string of data missing economist estimates. But this wasn't just a 2023 issue. The seasonal pattern of downside economic surprises, meaning missing economist estimates during the summer and then beating those estimates during the winter months, has persisted for 20 years in Europe.
I don't know why economists can't seasonally adjust this, but given the change in seasons, European data could start surprising on the upside. And with stocks in Europe having been braced for a recession in terms of valuations and just pessimistic outlook, it's worth considering what could go right. Sentiment towards the European economy and stocks is pretty low. Valuations are pretty low relative to history. So the stocks could react positively to upside surprises on economic data here as we move through the fourth quarter. Markets tend to react more to data being better or worse than expected, rather than good or bad, per se. In other words, stocks can rise out of weak data if it's at least better than expectations, and that may be what we get from Europe in the fourth quarter.
MIKE: Well, Jeff, we've talked a little bit about rate hikes around the world, and, certainly, here in the U.S., everyone is watching the Fed to see what it does next on rates. But what about quantitative tightening that is going on around the world? What does history tell us about how much QT can still put a damper on economies? And if those economies stay tight, what impact could that have on U.S. companies' revenues?
JEFF: We talked about quantitative easing so much over the last decade. We all just started saying QE and just assuming everybody knew what we met. Well get used to that with QT, quantitative tightening, we're all going to be talking about QT, when central banks reverse their forward QE program asset purchases by either not reinvesting maturing bonds or by outright selling them to reduce the overall size of their balance sheets. QE and QT policies can impact the stock market primarily through what we call the portfolio rebalancing effect. And that's where investors take more risk in search of return in markets in response to QE pushing yields lower, or they reduce holdings in risky assets like stocks when QT drives yields higher and make bonds more attractive. And we can see this in the sharp rise in the S&P 500 price-to-earnings ratio during the pandemic-related QE program, and its subsequent decline in 2021 and '22 as the Fed tapered that QE program. And it happened to a lesser degree elsewhere as well.
Now, limited experience with QT really prevents us from being too confident in using history as a guide to what the stock market might do during the period of QT. But the previous two periods of QT—that was Japan in 2006 and 2007 and the U.S. from 2017 to 2019—it had similar effects on the stock market. During both periods, stocks saw elevated volatility, much higher volatility than the usual. And in both cases, there was a 19% peak-to-trough decline in the stock market. So not quite a bear market, but just on the threshold. And the period of QT ended for stocks very close to where it began, so essentially flat over that whole period. So it certainly acted as a drag overall.
Now, the current QT-driven shrinking of central bank balance sheets may be increasingly acting as a drag on the overall stock market. It's just hard to see because a handful of artificial-intelligence-related stocks have been able to pull the stock market higher. In the U.S., these magnificent seven stocks that are headquartered here, the S&P 500 would be negative this year if we were to take those stocks out. And if central banks continue QT, it may be increasingly hard for stocks to post gains on such narrow leadership. And it's one of the reasons why the MSCI EAFE Index of international stocks is actually down since central bank balance sheets began to shrink at the end of the first quarter.
MIKE: Well, per usual, Jeff, whenever you join this podcast, we've done quite a whirlwind tour of issues and countries. So I think it would be helpful to wrap up if you could just summarize your key takeaways for investors trying to make sense of the global investing environment right now.
JEFF: Sure. First, I'd say just a reminder that geopolitical risk is ever present, and specific developments can affect the markets from time to time. During periods of even modest economic growth, though, the global markets' response to perceived threats have tended to be short-lived. So I know it can be tempting to jump out of the market and with the intention of coming back in once the geopolitical environment is clear. The geopolitical environment is never really very clear, and jumping back out and back in again can be very difficult, especially because we know that these moves can often be reversed in just a few days. Already, stocks are, you know, above where they were ahead of those attacks.
Second, it's probably news to most listeners that the average international stock is outperforming the average U.S. stock this year. And, again, we can see that in the equal-weighted indexes that track the performance of the average stock. And the reason that no one seems to notice is that seven AI-driven mega-cap stocks, which make up more than 30% of the S&P 500 capitalization-weighted index, where the largest stocks get the most weight, have pulled the overall market higher. Without those stocks, the S&P 500 would be negative this year. Now, where I like to focus at the asset class level is where you've got a great number of stocks, a large number of stocks, helping to push the overall market higher. I don't work at the individual stock level. I have no idea where seven individual stocks might go. I work at the asset class level. So when I see the broad market pushing the market higher in Europe, where the average international stock continues to outpace the average U.S. stock. offering a broader base of support for developed international stocks, I'm more attracted to that market.
And third, the world's second-largest economy appears to be stabilizing. China's property problems aren't going away, but they also aren't likely to trigger a financial crisis. But they also mean China is not likely to see a V-shaped rebound as maybe many had expected when they reopened after their COVID lockdowns. Growth may be sluggish in China. Though for China, that's a 5% growth rate, which we would consider rapid anywhere else, but for China, that's much slower than the average pace of the last 20 years.
And so the takeaway is that global growth is likely to remain sluggish, as well, as are earnings, with higher than usual volatility. And that means the closer you look at the markets, the more chaotic they may seem on a weekly, daily, or hourly basis. But if you can pull back, I think you'll see a global economy that's relatively stable, if sluggish, in some markets like those in Europe, that are braced for something worse, leaving some upside potential.
MIKE: Well, great advice as always, Jeff. Thanks again for making the time to talk today.
JEFF: My pleasure, Mike. Thanks for having me on.
MIKE: That's Jeffrey Kleintop, Schwab's chief global investment strategist. He's a must-follow on X, formerly known as Twitter, @JeffreyKleintop. And you can find his latest commentary at Schwab.com/Learn.
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. Those really help 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.
After you listen
The recent attacks in Israel are a reminder that geopolitical events can happen at any time, but when it comes to global investing, it’s often the big picture that tells the real story. Jeff Kleintop, Schwab’s chief global investment strategist, joins Mike Townsend to assess the ever-present nature of geopolitical risks that can have far-reaching impact in today’s interconnected economy.
Mike and Jeff also dive into the headline issues that are affecting China’s economy, including the troubles with its largest property developers, and explore the renewed efforts in Washington to improve U.S.-China relations. They also discuss whether Europe is turning the corner and why Japan is seeing its best stock market performance in decades. They zoom out to see beyond the short term and look at where opportunities for investors may be emerging.
Mike also addresses the latest news from Washington, where chaos in the House of Representatives is increasing worries about a government shutdown in November and imperiling the broader policy agenda.
WashingtonWise is an original podcast for investors from Charles Schwab.
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