Midyear Outlook: Equities, International & Washington

LIZ ANN SONDERS: I'm Liz Ann Sonders.

KATHY JONES: And I'm Kathy Jones.

LIZ ANN: And this is On Investing, an original podcast from Charles Schwab. Each week, we analyze what's happening in the markets and discuss how it might affect your investments.

So this week we are bringing you our outlook halfway through the year. Last week, Kathy and her team focused on the fixed income outlook for the second half of 2024. And this week, my colleague Kevin Gordon and I will discuss the equities market. In a future episode, Kathy and I will come back on, and we'll have more of an in-depth conversation on our outlooks in terms of the economy and the Fed. So stay tuned for that. Also today, in addition to Kevin, we've got our Schwab colleague Mike Townsend, who will analyze what's happening in Washington—always interesting these days. And I'm also going to interview Jeffrey Kleintop, Schwab's chief global strategist, about the international market. So we've got a lot of ground to cover today and in upcoming episodes.

So Kathy, I know we did a deep dive into the fixed income markets and portions of it in particular last week, but is there anything you want to add to that in terms of how investors should be thinking about yields, locking in returns as we move into the second half of the year?

KATHY: Yeah, Liz Ann, I think the bottom line is that it's going to be volatile. There are a lot of moving parts to the outlook for the second half. We have to see how inflation evolves, what the Fed decides to do. We've got a lot of international developments right now to consider. And then, of course, the elections are coming up. So it's going to be volatile. But at the end of the day, as long as the trend in inflation continues to move lower, which we think it will, we're optimistic for the outlook for fixed income.

I think the theme of our outlook for the second half is "look beyond Treasuries," however. There's a lot of opportunities outside of the Treasury market for investors to kind of capture some of these yields for a longer time period than just, you know, very short term. So with that, Liz Ann, I'll turn it over to you and Kevin to tell us what to expect in the equities market.

LIZ ANN: I want to start out by saying you can find the full in-depth written versions of all of our market outlook reports, complete with charts and graphs, at schwab.com/learn. There's a lot more detail in those written reports, and you can really dig into the charts and graphs on our website there.

Speaking of charts and graphs—Kevin Gordon is with me now, and Kevin has been a guest several times on the show already. He is my research associate. I think of him as my right arm in many ways, and works with me day in and day out providing analysis on the economy and the stock market for Schwab's clients. He helps develop deep-dive projects as well as content for Schwab's public website, internal business partners, social media outlets. He's a frequent guest on CNBC, Yahoo Finance, Bloomberg TV, CBS News, and has been quoted in The New York Times, Forbes, MarketWatch, CNN, The Wall Street Journal, Bloomberg, and Financial Times.

And also exciting—not all that long ago, Kevin has joined the ranks of those of us on social media, which sometimes has pros and cons, but you can find him on X and LinkedIn @KevRGordon. And I will personally say, although I'm biased, he's a great follow. 

So follow him on both. But most importantly for today, Kevin, thanks for being here.

KEVIN GORDON: Thanks, Liz Ann. Thanks for the plug and the shout-out. I appreciate it.

LIZ ANN: In a near-term future episode, Kathy and I are going to just riff a bit on our outlooks with a little bit more from my perspective, with a focus on the economy.

But, Kevin, what we're going to do today in our conversation is focus what's always top of mind in our world, which is the equity market. And our overarching theme, really in our outlook, was about kind of this K-shaped environment that has come about in the economy, within the market, bifurcations and splits. And I'll touch on a lot of that in terms of the economy in the aforementioned near-term episode. But I want to focus today on the equity side. So starting from the top down, what are the K-shaped trends—the bifurcations, the splits, whatever you want to call it—that we're seeing in the stock market? And walk through how we see them reconciling in the second half of the year.

KEVIN: Yeah, so, you know, at the big kind of top-down 30,000-foot level, I think what's been most interesting—and this is kind of the first visual that we kick off the equity section with in the outlook—is this massive spread between large-cap and small-cap performance. And specifically, if you date it back to October 12th of 2022, which is when we had the bear market low for the S&P 500®—so technically the bull market started right after that—we've been in a bull market since.

So you know, since then, it's been a pretty great run for the S&P 500®, and we'll get to some of the, you know, deterioration under the surface a bit later. But when you look at something like the Russell 2000, the broader small-cap world, it's been a struggle. And the spread between both indexes over that time period has been about 30% in favor of the S&P. And one of the reasons that that's interesting, maybe frustrating for some investors, is that it's not typical to see that in the earlier years of a bull market. And certainly, if you look at just the first year of the bull market, small caps were actually down. And that's really never happened before, especially when you look over what is typical in a cycle.

But as you and I have talked and written a lot about, this is not a typical cycle. And we think that a lot of, you know, the weakness, particularly for smaller-cap companies, is stemming from the fact that rates remain elevated. You've gone through a very aggressive rate-hiking campaign, as we all know, from the Fed. So not only the speed with which we got to where we are, but the fact that we've been still hanging around here for almost a year now, it seems that that's been, you know, a pretty big depressant on small-cap performance.

And I think it's interesting, even when you look within the small-cap universe, the best performing stocks in an index like the Russell 2000 or even something like the S&P 600, those have been ones with higher interest coverage, stronger profitability. So you can still find outperformance. It's just the fact that with 40% of the Russell 2000 having no earnings over the past 12 months, any scenario where you have rates going up as much as they have and hanging around at higher levels—you know, in some cases, multi-decade highs—that puts a lot more pressure on their performance.

So that's kind of the big picture view. And it's interesting, if you look at the chart, it literally—and maybe this was sort of just by design in how we wrote the report—but it literally forms a K, where you've got the S&P moving much higher than the Russell, kind of forming that bottom portion of the letter.

LIZ ANN: And one of the things we touched on is that—you know, obviously large caps have driven the market to a large degree—but even within large caps, there are divergences, there are splits, there are bifurcations worth pointing out. So dive into some of those specific to the large-cap grouping.

KEVIN: Yeah, it's fascinating when you look at just the premium that's been placed on higher-quality parts of the market. And specifically, you know, we've been tweeting out a lot of these charts from the Goldman Sachs baskets that are out there that became pretty popular actually, right as the pandemic was happening and sort of post-pandemic. But one of the visuals that we have that's pretty glaring in the report is the spread between performance when you're looking at the so-called strong balance-sheet stocks versus the weak balance sheet stocks. And we have descriptions in the actual report of what's included in there, but it's really just separating companies that have higher profitability scores, you know, less leverage, better interest coverage, all the things that would fit in a higher-quality bucket.

But we specifically looked at performance since the Fed's last rate hike in July of last year. And since then, the strong balance sheet index has outperformed considerably, almost by 15% to 16%. And if you look at the weak balance sheet cohort, it's barely up over the past year. So perhaps not surprising, but also kind of, I guess, dispels the myth that you're only going to get this significant outperformance or significant divergence in performance and extreme bifurcation at the small- versus large-cap level. It's happening within large caps.

And even if you take it one step further—at the large-cap sector level—what's been fascinating, I think, is that over the past year and a half, dating back to, you know, the beginning of 2023, right before we had the mini banking crisis, before you had this really significant move on the part of investors into the larger-cap growth areas of the market, the so-called growth trio that you and I call it—it's the tech, communication services, and consumer discretionary pairing—that has started to fray a little bit with consumer discretionary falling back in terms of performance. But then tech and communication services still chugging ahead.

And what's interesting is that this divergence started to happen over the past year, where since the beginning of 2023, you've had solid performance from a sector like discretionary—it's up by 40%. But if you look at tech and communication services, they have nearly identical performance at up 80%. And I think a lot of that comes down to the—I guess the single-name bias within these three sectors, because they do house the Magnificent Seven. You've got massive names like Apple and Microsoft in tech. You've got Meta and Alphabet in comm services. But then in discretionary, you have Amazon and Tesla. Amazon has been doing relatively well, but Tesla has been a significant underperformer in that broader group year-to-date. It's down by almost 30%. So that, I think, has been, maybe understandably, the main driver of underperformance by discretionary. But at the same time, you've got a lot of investors with exposure to that name, whether it's directly or via the sector.

So it's kind of been a theme that we've noticed at this large-cap level where you've gone from the growth trio to the growth duo. And I'm not sure how much that gap closes until you get something of significant outperformance from Tesla. And as you and I talk about a lot, we don't cover individual stocks. So we're not going to give an outlook on an individual stock, but you would need to see a much stronger rebound in that name or in something like Amazon. But that would have to account for all of the underperformance that you've had from Tesla.

LIZ ANN: And obviously another big whopper of a name that's been a driver of performance is Nvidia. And let's tell people that they should go to the report because we do have some interesting stuff in there, but won't dive into it.

Another interesting thing that popped into my head that relates to the strong-balance-sheet/weak-balance-sheet spread is what we looked at. It's not a chart that went in the report. If you and I were left to our own devices and we were unconstrained, we'd probably have 387 charts in every report that we write, but you have to cut it off at some point. But if you remember a week or two ago, we looked at, within the Russell 2000, the performance spread between the so-called zombie companies—which are companies that don't earn enough cash flow to pay interest on their debt, let alone fund operations without having to take on more debt, relative to the non-zombie companies. And that was just another example of kind of this quality trade that's been in play that has manifested itself in things like strong balance sheets doing better and, you know, the profitable companies doing significantly better.

But I want to narrow the lens even more given that you talked about the growth trio and the housing of the maybe not-so-magnificent-anymore Magnificent Seven. And we've discussed what seems to be maybe a bit of rebranding that is happening from the Magnificent Seven to the Fab Four—and being, you know, a rock chick, as many people know, I like that reference. But in this case, we're talking about the four big drivers of performance.

So talk about that narrowing of the small handful of major drivers of these cap-weighted indexes, and walk through the risk of this concentration problem, this top heaviness, looking ahead toward the end of the year.

KEVIN: Yeah, so if you were purely looking at performance—I'll plug the table that's in the report, but also makes its way on your particular Twitter, or X, feed every day, Liz Ann—this significant divergence that's happened. And even if you take the best performer in the Magnificent Seven—one of the best performers in the S&P this year—it's Nvidia, no surprise. So at the time that we were looking at it, it's up 144% year-to-date. If you look at the worst performer in the Magnificent Seven—which also happens to be one of the worst performers in the overall index, the S&P 500®—which I just mentioned in the prior discussion, is Tesla. It's down almost 30%. So you've got almost max dispersion when it comes to the best performer and the worst performer, not just in that Mag Seven cohort, but within the index itself. And if you add on the fundamental aspect and earnings growth expectations for a lot of these companies, there are a couple that just don't necessarily belong in the Magnificent Seven anymore.

So if you were to take the so-called Fab Four—and we put a chart together with this, and it's Nvidia, Microsoft, Meta, and Amazon—and you look at that slimmed down group, their performance, you know, no surprise, it's a similar divergence that you have even with the Mag Seven versus the rest of the market. But their performance is pretty stellar year-to-date. You've got this huge spread opening up between them and the rest of the market. So if you took them out of the S&P 500®—and that's just something we do for illustration or kind of experimentation—the S&P is only up by 6.6% year-to-date. So you haven't had as strong of a rally. But at the same time, it makes sense as to why they've contributed such a hefty gain. There's such a significant portion of the index itself. And I would say that it's becoming a little bit less worrisome as we move throughout the year. Because from an earnings perspective, if you look at that group's collective earnings growth rate—and you averaged it and did it on a cap-weighted basis—the first quarter of this year, their earnings growth was almost 50% year-over-year. The rest of the market, excluding those names, was less than 5%. So that is a huge gap, obviously worrisome. But if you start to look at estimates that we pull from the LSEG Group—which is formerly known as Refinitiv—throughout the year, that gap is expected to narrow fairly significantly. So by the beginning of 2025, you're looking at a growth rate for the Fab Four of slightly less than 20%. You're looking at a growth rate for the rest of the market of just under 15%. So it's a much narrower gap, still in favor of the Fab Four.

But I would argue maybe right now, rightfully so, just because when you compare the largest companies today to any other period when you've had this massive concentration risk, there is more of a fundamental foundation there. It's not to say that, you know, you can't get euphoric at times and prices don't get to really extreme or stretched levels, but I think that it's an important distinction to make, especially because, you know, we hear this a lot—but there's so many comparisons being drawn to the late 90s and when you had the internet boom and when you had the bubble, not just for the biggest stocks at the time, but really the rest of the market. And for many reasons, we don't think that today is exactly a repeat of back then, especially when it comes to earnings. And when you look at fundamentals and when you look at what's leading the market, one of the highest correlated factors to the S&P 500®'s performance back in the late 90s was negative earnings. Today, that is not the case. So I think it's an important distinction to make.

LIZ ANN: It's a really important distinction because we write about and talk about factors a lot, and momentum is considered a factor. But I think of momentum more as a concept. It just means that stocks that have been working continue to work. What those other characteristics are can vary. And I think it's important that you point out that momentum as a factor, if you want to consider it that, was as dominant in the late '90s as it has been recently. But the factor most correlated to that high momentum back then was non-profitable companies. And obviously the factors correlated to momentum this time are generally much higher-quality factors. So I think that's an important distinction.

You know, you mentioned some of the data that we put out on a daily basis. And one table that you create every morning that goes on my Twitter feed really highlights—and we've talked a lot about this large-cap bias in indexes like the S&P and in the NASDAQ—but what's really glaring is what's going on under the surface. And the problem in this environment of everybody so focused on indexes and the popular indexes that are cap-weighted is you sometimes don't get the full picture or story of what's going on under the surface. And it's quite stark for the NASDAQ. So talk about the bifurcation between very healthy index level gains but much weaker member-level performance, much more churn and rotation, and what our thoughts are about that continuing, or at some point does the gap start to narrow? 

KEVIN: Yeah, and this table, I know whenever we bring up the data, Liz Ann—if you and I are talking to the media, or if we're talking to anybody in the business—it always elicits that "wow" reaction. Because if you just look at the indexes—the major ones, S&P, the NASDAQ, the Russell 2000—you've had no worse than a 9% drawdown from peak-to-trough year-to-date, and the worst one being the Russell 2000. For the S&P, the worst drawdown you've had so far, again, at the index level, is down 5%. For the NASDAQ it's down 7%, but that doesn't really tell that much of a story, especially when you start to look at the individual member activity. So if you took the average member's maximum drawdown for the S&P year-to-date, just from a year-to-date high, it's down 15%. If you look at the Russell, it's down 28%. And if you look at the NASDAQ, it's down 37%. So you know, as you and I mentioned a lot, that's a good way—"good" in quotes—to go through a corrective phase or to go through a bear market in the case of the Russell or the NASDAQ. And so far, it's been OK for the headline because you haven't had the bottom fall out all at once. You've had this kind of happen in a rolling fashion. It's happened in fits and starts in different sectors at different times. The risk is that if you continue to see that happen, but the headline and cap-weighted indexes continue to move higher—which is actually what you're starting to see within the NASDAQ 100 specifically, so really the large-cap tech names—that's when you start to run more of the risk, especially if sentiment remains relatively frothy or optimistic, which we're sort of in that environment now. But if that divergence continues, you start to open up a scenario kind of like 2021, especially late 2021, where cap-weighted indexes were moving higher, but you had breadth deteriorating under the surface. And that's when you really started to see, you know, a total breakdown that ultimately led to a bear market in 2022.

So as of now, it's not really our base case, but I think that one thing we're definitely going to keep our eye on is if you do see that divergence in that split and if that bifurcation grows more severe, especially as sentiment starts to kind of pick back up from here, I think that would be a risk, and you probably have some potential for, you know, a so-called catch-down of the indexes to what the average member has done so far this year.

LIZ ANN: Let me just close by saying that we focused here on the equity market, but what's interesting—and we do touch on quite a bit in the written report—is that a lot of these bifurcations within the market have relationship to some of the bifurcations that have happened in the broader economy, and that's what Kathy and I will dive into a bit more in this future episode.

But in the meantime, as always, Kevin, thank you for joining us today.

KEVIN: Always great to be back. Thank you.

LIZ ANN: So joining me now is Jeffrey Kleintop. Jeff is Schwab's chief global strategist and one of our managing directors. Cited in The Wall Street Journal as one of Wall Street's best and brightest, Jeff frequently appears on CNBC, Bloomberg TV, and CNN. And he's also frequently quoted in The Wall Street Journal, Barron's, and the Financial Times.

So Jeff, the downturn in the global manufacturing sector that you've been terming a "cardboard box" recession last year seems to have staged a bit of recovery in the first half of this year. So on that topic, what is the outlook for the second half in terms of the global economy?

JEFF: Liz Ann, 25% of the world was in an official recession last year, including major regions like Europe and the United Kingdom. But fortunately, that ended early this year as that "cardboard box" recovery that I talk about took hold.

We had a recovery in both manufacturing and trade, things that often go in a cardboard box when they're produced or they're shipped. And we even saw a rebound in demand for cardboard boxes, further confirming the recovery seen in factory output and surveys of business leaders in manufacturing. In fact, the Global Manufacturing Purchasing Managers Index, that PMI, rose to 50.9 in May. That's a 22-month high. And even the profits of manufacturing firms are on the rise again.

In the first quarter, Europe and the U.K. saw GDP growth that matched or exceeded growth in the U.S., with annualized GDP of 1.3 % in Europe and 1.6 % in the U.K. It has been a long time since we could say growth in Europe was at least as good as growth in the U.S. So that was nice to see. And economists forecast that that growth is going to continue over the rest of the year. It's not booming growth. It's modest. It's not V-shaped as it was coming out of prior recessions, but that may be a good thing if we want to avoid reigniting inflation pressures.

LIZ ANN: Now, bring China into the mix here. Obviously, they had a pretty long and painful bear market, and growth has been weaker than many expected. But China's stock market suddenly became the best performer in the world in the second quarter. So what changed there, and how does that fit into your global growth outlook in the second half of the year?

JEFF: Incredible double-digit stock market performance in China in the second quarter, but very little fundamentally changed in China. Domestically, the property market remains the primary source of trouble. Home prices continuing to fall across 70 different major cities in China. And that's prompted consumers to pull back on their spending with retail sales remaining weak and consumer confidence near all-time lows. We only have about 20 years' worth of consumer confidence in data in China. It's shorter period than we have for the U.S., but still all-time lows in consumer confidence.

And on the international front, things haven't been going well either. The Biden administration revoked Huawei's U.S. chip license. They passed legislation banning TikTok, or at least forcing its parent ByteDance to divest, and recently unveiled new tariffs on China. So there's no good news there. And although China's President Xi visited Europe for the first time in five years in early May, he didn't come away with trade deals or any kind of agreements. Instead, we have the French president and the European Commission president both pressing to address China's trade imbalances and to use his influence on Russia's President Putin to end the war in Ukraine.

So the world's second-largest economy is just kind of muddling through this year with growth generated not organically by consumers, but by government-incentivized production, particularly of cars—notably electric vehicles—and solar panels, just to name two areas where China now leads the world. But the stock market performance might be explained by valuations. Things are not going well for China, but the stock market P/E had fallen to the low end of its 20-year range. The price-to-earnings ratio was about eight. And when P/Es are that low, it doesn't take much to get them to bounce.

So China isn't out of the woods on its property market or firmly on a sustainable growth trajectory, but its stocks may have tested their lows. I think we need to see a lot more effective stimulus and support in China to turn the consumer around by putting a halt to the slide in the value of their biggest personal investment asset—their homes. And I don't see that happening in the near term, so China's Q2 bounce may soon stall out.

LIZ ANN: Let's shift now, given the improved global growth outlook, to central bank policy. We know there's been an obsessive focus on the Fed this year in the United States and what they're going to do. We are taping this in advance of what is an expected cut by the European Central Bank. But talk about that maybe specifically, but also the outlook for just global central banks, in the face of what, for now anyway, seems to be patient-and-pause mode for the Fed.

JEFF: Well, we've seen following the lead of central banks in Sweden and Switzerland—and Canada, the first G7 central bank to cut interest rates—we're probably going to get the ECB to cut rates for the first time this cycle by 25 basis points. The interest rate futures market is expecting two or three rate cuts this year for the ECB, including the one on June 6th. So signals on whether they skip a meeting or pause for a few meetings will likely move the euro and European stocks that are sensitive to financial conditions.

There's little new data coming in July, but more information, along with updated ECB projections, come in September in order to judge whether inflation remains on track. For what this means for investors, I think it means small caps might benefit. You know, unlike in the U.S., where the Fed's expected to keep rates steady, in Europe, small cap stocks have been outperforming large caps here in the second quarter by nearly 4 percentage points. They're up, while large caps are pretty much flat. Investors are seemingly beginning to factor in lower borrowing costs in Europe later this year, along with improved economic momentum. Europe's market has been led by utilities and real estate here in Q2. Those are traditionally beneficiaries of lower interest rates, and that's despite longer term rates actually rising in Q2 so far. So investors seem to be looking ahead. And generally speaking, easier global financial conditions and a re-steepening of the yield curve could be good for banks. And that's the second biggest sector among small caps in Europe.

So I'm kind of obsessed with Europe and those rate cuts right now, given that it involves so many countries in a major part of the world. And they seem to be pricing in a more favorable outlook for financial conditions.

LIZ ANN: So let's widen the lens again, Jeff. We know that central bank policy is sort of perpetual uncertainty these days globally, but of course so is geopolitical risk—and it's these days seemingly an ever-present part of investing. But it can take on greater significance when investing outside the United States. So how are you considering geopolitical risk these days?

JEFF: You know, geopolitical developments, including the immeasurable human toll of the conflicts in Ukraine-Russia and Israel-Gaza, will likely contribute to market volatility. But I think they're unlikely to derail the global economic recovery. 

You know, the impact of geopolitical events on the markets is most often felt through sudden and sizable moves in oil prices, especially when it involves the Middle East or a major exporter like Russia. We certainly saw that back with Russia's invasion of Ukraine back in 2022. But since the events of the Hamas attack on Israel on October 7th, we haven't seen a big move in oil prices. In fact, oil is down slightly since then. Now there's a possibility that the widening of the conflicts could lead to a large and sustained upward move in oil prices that could negatively impact inflation and economic growth. But this seems unlikely to me with soft demand growth, 4.5 million barrels per day of excess capacity within OPEC+, and U.S. production now double that of Saudi Arabia. So all that, to me, reduces the risk of prolonged disruptions in energy supply from these geopolitical conflicts.

Separately, in Asia, China has long described reunification with Taiwan as a goal. But the main trigger for any military action would be a formal declaration of independence by Taiwan. But even after this year's election and Taiwan's new president taking office in late May, there remains lack of popular support within Taiwan to declare independence from the mainland. In fact, the share of the population in favor of independence has been falling in recent years—hardly a driver of military action by China. The Taiwanese prefer to maintain the status quo. And so we're maintaining our long-held view that an invasion of Taiwan by China is a low probability event over the intermediate term.

So geopolitical risks, an ever-present part of investing, but probably not the main risk to the markets in the second half of the year.

LIZ ANN: So I'm going to ask you the question I'm sure you get all the time—I know I get all the time—the ever-present "what keeps you up at night" question. So aside from geopolitics, what do you see as maybe the biggest risk for investors in the second half of the year that they might not be factoring in?

JEFF: Yeah, it's a great question. I think sometimes the biggest risks are often hiding in plain sight. I see election risks as one of, if not the biggest, risk to international markets in the second half of the year. You know, election campaigns in other countries are much shorter. For example, in Mexico, the campaign is 90 days long. In Australia, it's 38 days. In the U.K., 25 days. In France, the presidential campaign is only 14 days long, and in Japan, it's only 12.

LIZ ANN: I couldn't be more jealous right now, as I'm sure all Americans are.

JEFF: Haha! Yeah, what do they do with all that free time?

But the duration of those campaigns and the correspondingly less media coverage doesn't mean they're not important. For example, in both India and Mexico, the stock market was down 6% in one day on election risk. But for opposite reasons—in India, for example, the concern was that the ruling BJP party, Prime Minister Modi's party, was surprisingly losing seats in the legislature—while in Mexico, the new president's Moreno Party surprisingly may end up with a supermajority.

But in both cases, markets are concerned about a shift towards more populist policies. European parliamentary elections kick off on June 6th, and markets appear to be pricing little, if any surprises that would heighten trade-war risk. Europe's industrials, in fact, are outperforming this year on the global recovery of manufacturing. And this may be because many of the proposals are just sort of maybe being assumed to be part of populist campaigning—or because maybe when faced with the actual trade-offs that come from tariffs and other restrictions, the actual policies may not change that much. But if we see a strong showing by populist parties, particularly in these European elections, markets may begin to worry about manufacturing exports, which have just started to recover, and become concerned about the threat to inflation amid widespread tariffs and import restrictions.

Of course, the big election with global impacts is the U.S. election in November, but all of the elections in 2024 matter to the global companies that make up the major indices in most countries that have sales scattered and operations scattered throughout the world. So these policies are going to be increasingly important as we move through the second half of the year.

LIZ ANN: Thanks, Jeff. Let's wrap it up with maybe the most fundamental topic and question I have for you relevant to investors, which, I think, most investors that at least have some semblance of discipline know that diversification is an essential element of successful long-term investing. So in this environment, how should investors be thinking about international allocation and diversification?

JEFF: It's an important question now because international markets have underperformed for just so long. But since the current bull market began back in October of 2022, the total return for the International Developed Stock Market Index, the MSCI EAFE Index, has outperformed the S&P 500®. It's a narrow margin thanks to the performance of the U.S.'s Magnificent Seven stocks. But it's worth noting since it's been a full global economic and market cycle since international markets have outperformed.

Each global economic cycle has seen leadership reverse between U.S. and international markets over the past 50 years. And that appears to be happening again this time. And it's likely that many investors have below target exposure to international stocks after an entire cycle of underperformance. But it isn't too late to consider rebalancing back into international markets, even after a year and a half. Importantly, many of the factors that the market is rewarding this cycle are more prevalent in markets outside the U.S., as is the weighting of the sectors that we favor most, including financials, energy, and materials. These sectors have a much higher representation in markets outside the U.S.

LIZ ANN: Great thoughts, Jeff. Thank you so much for sharing a broad overview of your outlook.

JEFF: My pleasure, Liz Ann. Thanks for having me on.

KATHY: Thanks, Liz Ann. I'm happy to bring in Mike Townsend, who is a managing director of legislative and regulatory affairs at Schwab and our chief Washington strategist. Mike has nearly 30 years of Washington experience, and he's also the host of Schwab's WashingtonWise podcast. If you haven't listened to it, you really should. It's a great podcast. Be sure to search your podcast app for WashingtonWise, all one word, if you don't follow it already. Thanks for joining us today, Mike.

MIKE TOWNSEND: Well, great to be with you, Kathy.

KATHY: Definitely a few things going on in Washington. We'll clearly be watching the second half of this year. And I'm pretty sure you're going to be a very, very busy person. So thanks for taking the time to come on the podcast.

MIKE: Well, sure thing. It is a crazy time. The presidential election year is always like my Super Bowl year all season, so it's going to be quite a six months ahead.

KATHY: Well, first, let's start with Capitol Hill before we get to the presidential election. So we've seen a little bit of dysfunction from Congress over the last year or so. But what do you anticipate will take the top of the legislative agenda over the second half of this year?

MIKE: Yeah, Kathy, it's been very dysfunctional this year, but actually Congress did manage to come together earlier this spring to pass the major spending bills that fund every government agency and program, as well as the $95 billion foreign-aid package. So with those in the rear view mirror, Congress actually has very little in the way of must-do items on the agenda between now and the election. I expect a lot of confirmations of judges in the Senate. Both chambers will probably pass a lot of what we call messaging bills that they can use on the campaign trail, but probably don't have any realistic chance of becoming law.

But one interesting issue that I am keeping an eye on—last month, the House approved a bill that would put a regulatory framework around cryptocurrency for the first time. Crypto, of course, doesn't have the kind of regulatory protections that other types of investments have. But this bill would give regulatory oversight responsibility to the CFTC—the Commodity Futures Trading Commission—relegating the SEC to a secondary role. It would have new requirements for crypto exchanges, custodians, and other players, and it would create some investor protections. The bill passed the House by a surprisingly strong bipartisan vote, which I think represents kind of a shift in momentum on Capitol Hill. Earlier this year, the SEC approved the first Bitcoin exchange-traded funds, which are helping to make crypto more accessible to ordinary investors. And Congress seems to realize that crypto is not going away and that it would be better to have a regulatory structure in place. So they've passed this bill in the House. It now goes to the Senate, which may or may not act this year. But I do think there is increasing momentum that could see this happen next year if it doesn't happen by the end of 2024. So that's an interesting one that I'm keeping my eye on.

KATHY: So we got something out of Congress so far this year. There may not be much legislation on Capitol Hill right now, but 2025 looks like it's going to be a pretty important year, particularly in the area of taxes. Everyone's interested in how the big tax debate is going to shake out. What's your assessment of that right now?

MIKE: Yeah, 2025 will be dominated by two huge issues.

First, the debt ceiling—which is the cap on the total amount of debt that the U.S. can accumulate—that comes back at the beginning of 2025, and it will have to be raised by Congress again. That's always really tricky. Failing to do so could see the U.S. default on its obligations for the first time ever. And markets tend to get volatile around these debt ceiling debates. Timing on that is likely to be spring of 2025.

The other big issue looming next year, as you mentioned, is taxes. And that's because all of the 2017 tax cuts—which includes lower individual income tax rates, higher standard deduction, and the increased amount of assets that can be inherited without triggering the estate tax—all of those are set to expire at the end of 2025. So Congress will need to decide whether to extend some of those for a few more years, let them expire—which of course would be a tax increase for a lot of people—or do some combination of both. 

And already we're seeing both parties here in Washington kind of lay the groundwork for next year's tax fight. They're thinking about what other tax provisions, not just things that are expiring, that could be included in that package. So you know, both parties are looking at tax cuts in other places, maybe some tax increases to pay for it, but the details are still being hashed out. The reality is that we won't know how this will play out until after the November elections, after we see what the configuration in Washington is going to be in 2025.

For example, if Republicans were to sweep control of the White House, the Senate, and the House of Representatives in the election, well then the next tax debate in 2025 will probably look very different than if there is a split Congress next year, and the two parties will have to find a compromise.

So probably the most common question I'm getting out on the road is, "When will we know about the tax prospects?" And the answer is, "Talk to me after the election. We'll have a better idea then."

KATHY: We're definitely going to have you back after the election to talk about all these issues and how it looks for 2025. What about the regulatory agenda? What are you watching that could impact the market?

MIKE: Well, it's not unusual in a time when you have a dysfunctional Congress that regulatory agencies get really busy and active and try to sort of fill in the gaps. We've certainly seen that in the last year or two, not just in the financial sector, but across all sorts of different parts of the economy. Regulatory agencies are increasingly aggressive and ambitious. We, of course, focus a lot on the SEC, which regulates the markets. They have been very busy. But what's interesting to me is that many of their important proposals are ending up being challenged in the courts. And the SEC's track record in the courts frankly has not been very good.

Earlier this year, the SEC approved a controversial rule that would require public companies to disclose more to investors about the risks they face from climate change, as well as their contributions to climate change via greenhouse gas emissions. That rule, however, currently has eight different lawsuits pending. And implementation of these new requirements has actually been paused pending the outcome of these legal challenges, which of course can and probably will take a very long time.

Just last week, the SEC's new rule requiring hedge funds and private equity funds to disclose more to investors in terms of fee reports and quarterly performance reports and other information—that was struck down by the courts, and the court ruled that the SEC had exceeded its authority in crafting the rules. That's a big blow to the SEC's agenda. They have a whole bunch of rules in the queue for finalizing, including a series of proposals to overhaul how retail trading works, one that would impact mutual funds, one that deals with the use of different technologies by investment advisors to provide advice, and several others. But it feels increasingly like these regulations are just going to be ultimately decided by the courts. So we're ending up watching the courts as much as we watch the regulatory agencies themselves.

KATHY: You've talked a little about how what's going on in Washington next year will of course be affected by the election outcome. So let's get to the election. We're still about five months away from election day. What are you expecting? Let's start with the presidential race.

MIKE: With the presidential race, I'm expecting craziness. It's already crazy. It's going to get much, much crazier. You know, so much about this race is historic. First rematch since 1956, first sitting president versus a former president since 1892—God bless Grover Cleveland—the two oldest candidates we've ever had, one candidate facing sentencing next month from a series of felony convictions. It's just an incredible series of historic things in this election.

You know, the race right now, it's essentially tied at the national level, but of course, presidency is not determined by national polls. So it's going to come down to likely six battleground states—Arizona, Georgia, Michigan, Nevada, Pennsylvania, and Wisconsin. You might see a couple more—maybe North Carolina gets in that mix—but I'm really focused on those six states.

What I think is truly interesting about this race is the huge numbers of people who are just not happy with the options. There was a poll taken by Pew Research Center in April that found that 49% of voters would change both candidates if they could. And that's extraordinary. So this race, I think, is going to be decided by this group that pollsters have dubbed the "double haters," people who don't like either candidate. And double haters are going to do one of three things: They are going to hold their nose and vote for one of the candidates, they're going to vote for a third party or an independent candidate, or they're not going to vote at all. And I think it's impossible to know now in June what those voters are going to do. I don't even think they know what they're going to do. So I would really take polls that are coming out now with a huge grain of salt.

I'm also watching the independent candidacy of Robert F. Kennedy, Jr., who has polled nationally in the double digits. He could definitely play the role of spoiler in this race. One thing to keep an eye on is how many states he ends up on the ballot. He's only on the ballot in a handful of states right now, and he is working hard to try to get the required signatures and go through all the processes in every state to get on the ballot. But that's a slow process, so we'll have to keep an eye on how many states he's actually on the ballot.

And then finally, we have our first debate in less than two weeks. President Biden and former President Trump have decided not to wait until the traditional fall debates that are usually organized by the Commission on Presidential Debates. Instead, they're going to debate on June 27th at CNN without a live audience, just in the studio, and then again on September 10th. So I think obviously those are very important dates to watch to see how things unfold. But we are in for a crazy time. It's going to be a bumpy, crazy ride for the next five months, and we'll see what happens.

KATHY: Hence why you're going to be a very busy man over the next six months or so. Now, I've heard you say that the battle for control of Congress is often more important to the market than who wins the presidency. Can you explain why that is, and how do you think that's going to play out this fall?

MIKE: Yeah, Kathy, presidents can make all sorts of policy proposals and pronouncements, but ultimately it is Congress that has to actually pass things into law. So when I talk about the debt ceiling or next year's tax fight, I mean those are things that Congress will be doing that will have a direct impact on the markets.

So as I look out over the battle for the House and the Senate—you know, the Senate right now, 51-49 for the Democrats—there are 23 Democrat senators up for re-election and just 11 Republican senators who are on the ballot. So I think the landscape really favors Republicans to capture the couple of seats that they need in order to win back the majority in the Senate. But I actually think the Democrats have a reasonable chance of taking over the House of Representatives. That's also a very narrow majority. Right now it's 218 for the Republicans, 213 for the Democrats. So Democrats would only need to flip a small handful of seats to capture the majority. There are a number of opportunities for them to do so. You know, we look at congressional districts where a Republican is in a district where President Biden won that district in 2020. There are a number of those that are options and opportunities for Democrats to take over. So I don't think it's a slam dunk, but I think Democrats may be a slight favorite to take over the House of Representatives. And if that happens, it'll be the first time in history that the House and Senate have flipped in opposite directions in the same election. But I do think the bottom line for Congress is it's likely to be very, very narrow majorities, no matter which way they go. So it's going to be difficult for either party to have the ability to just move anything they want given that it's likely to be very narrow majorities in 2025 and beyond.

KATHY: So ongoing divided government sounds like a key takeaway. So what are the big takeaways for investors from all this?

MIKE: Yeah, Kathy, I'll hit three.

You know, number one, I don't think we can expect a lot of market-moving developments coming out of Washington, really between now and the election in terms of policy and legislation, that sort of thing. But I do think 2025 is shaping up to be a huge year with big market-moving issues on the front burner like taxes and the debt ceiling fight.

Number two, you'll hear a lot over the next few months about what the market wants out of the election. Historically, however, markets don't really care much about the election outcome itself. And there's no correlation between who wins the election and market performance. You know, ultimately it has much more to do with what policies are actually passed by Congress. And that's a much slower process. So the election itself, I just don't think is going to have a huge impact on the market.

And finally, this is probably the most important takeaway. This election is going to be very emotional. It elicits a lot of strong feelings now. Just imagine what it's going to be like on November 6th, the day after the election. And emotion and investing decisions, as you know, Kathy, not a good mix. So really important as an investor that you don't make investing decisions based on what you think might happen in the election, how you feel about whoever is winning or losing. Really take a step back and think about your long-term goals, talk to your financial advisor, and try to avoid those decisions driven by emotion.

KATHY: Great information and great advice for investors to take it all maybe with a grain of salt and a long-term perspective. There is definitely a lot we're going to be watching in the second half of this year, and I'm pretty sure you're going to stay on top of it for us. So thanks for coming on the podcast.

MIKE: Thank you for having me, Kathy.

LIZ ANN: So as always, thank you so much for listening. That's it for us this week, but you could always keep up with us in real time on social media. I'm @LizAnnSonders on X and LinkedIn.

KATHY: I'm @KathyJones—that's Kathy with a K—on X and LinkedIn as well.

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LIZ ANN: For important disclosures, see the show notes, or visit schwab.com/OnInvesting, where you can also find the transcript.