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. Every week we analyze what's happening in the markets and discuss how it might affect your investments.
Well, hi, Kathy. Since our last episode, we did get the updated employment numbers from May. It was interesting: probably, both the economic optimists and pessimists could find something to point out to support their case in what was slightly better on the surface, but some mixed details. So what do you think the pattern is, if there is one? And in particular, how do you think it feeds into the thinking by the Fed? We have a Fed meeting next week, I believe.
KATHY: You know, Liz Ann, I think we're probably on the same page with this. Looked pretty good on the surface, but soft underneath. A couple of things that are troubling, the drop in the size of the workforce. I don't know whether that's deportations or, you know, other limitations due to immigration, whether it's loss of opportunities and people just dropping out of the labor force. I think it remains to be seen what the driver of that was, but that is actually what held down the unemployment rate.
And that's not a good reason to keep the unemployment rate down, as you know. Also, just the general pattern is lower hiring. It's not bad. It's still at a level that would keep the unemployment rate, all else being equal, kind of steady, in the low 4% area. But the trend is down and some specific soft areas happening as well.
And then a little tick up in wage gains. So, not a good combination. I think what the Fed does with that is stay on hold. You know, you're not seeing enough, probably, deterioration in the labor market for the Fed to be concerned that they need to cut rates right away. But you're not and you're also not seeing enough decline in the wage growth component to have the Fed address it, cut rates because of slowing wage growth. So it's more just staying on hold for them, but I'm sure they're keeping a very close eye because we have so many now opposing forces working on the economy. It's going to be really tough for them, or for anybody, to keep track of where we're going longer term, and they have to set policy for longer term. But I do think this is one, another one, that keeps them on hold, but probably with their antenna up about what's going on in the economy. What were your thoughts on it?
LIZ ANN: Yeah, I think you're right to point out that we're we've seen an easing back in hiring, but we're not seeing any kind of commensurate significant pickup and firings. So you have this not quite equilibrium, but the… you know, no hiring, no firing. And that is similar to what we saw in the past couple of years, the two different recession scares we had, you just never ultimately saw a pickup in firings and that kept confidence fairly high in the labor market. I'm not sure we have as much of a likelihood this time of that persisting, but I think that's key to watch. Things like layoff announcements, which obviously is the ultimate leading indicator that then leads to initial claims picking up.
The other, speaking of claims, the other example of that, less hiring but not a lot of firing, can be picked up by looking at the differential between initial unemployment claims and continuing claims. Now initial claims have started to trend higher and that bears watching but they're still relatively low, yet continuing claims are just around a cycle high. So that's an example of you get laid off you file for unemployment insurance initially, those that continue to be on them, unemployment insurance suggests that they're having a harder time finding a job. So that's another pair of metrics that's reflective of that. And we put some of that data in our outlook piece as well. So I think you're right, though. I think the labor market really holds the key. It holds key to the consumption part of the economy. And it holds the key, I think, even more maybe than the near-term inflation trajectory to what the Fed decides to do.
KATHY: Yeah, I would agree. I think the fixed income market, we're all just on hold right now. You know, yield just kind of churning around. We've had a big move up and down this year and ending up pretty close to where we started in many parts of the market. And it has been an OK year so far in spite of all the volatility. But what about you? You what do you think in terms of equities and the big shifts, any leadership changes taking place?
LIZ ANN: Yeah, it's really been interesting these recent past few weeks as we've been in the midst of this rally, just some of the leadership shifts, we've kind of had this stealth outperformance on the part of industrials, who are the best performing sector year-to-date, and they don't tend to be market darlings, retail darlings, so that's why I use the term stealth. But I think it is reflective of an economy that at least so far has been pretty resilient in the face of all this tariff-related uncertainty because that's sort the ultimate cyclical side, but I think it has some unique story drivers to, particularly in areas like spending on defense. So that's an interesting one to watch. And then also interesting is I think the second best performer from a sector perspective year-to-date is communication services and that's one of what I call typically the growth trio of sectors: communication services, tech, and consumer discretionary and it's those three sectors that house the Magnificent 7 group of stocks. for those, actually, I don't need to say which seven because what I'm about to say will mention the seven stocks.
But what's interesting is, you know, for the past several years, those stocks have generally moved somewhat in tandem. You've had divergences. Tesla's kind of jumped in and out of the strength bucket at times, for somewhat obvious reasons.
But usually when you had tech doing well, you also had communication services doing well, consumer discretionary doing well, that is not the case this year. I think consumer discretionary is the worst or one of the worst performing sectors year-to-date. Tech is kind of middle of the road, but comm services is in second place. And I think that's reflective of more dispersion among the Magnificent 7. In fact, what's kind of interesting is that the middle of the alphabet is doing well, the ends of the alphabet are not. So of the Magnificent 7, you've got Meta, Microsoft, and Nvidia are all outperforming the S&P 500® this year. So that's kind of the middle of the alphabet. Then you've got the three A's, actually Alphabet, which is Google, Amazon, and Apple. And then at the other end of the alphabet, you have Tesla all doing, in the case of Apple and Tesla doing quite poorly, but all four underperforming.
And that is just reflective of, I think, investors trying to newer opportunities. You're seeing that down in the small-cap space as well. There's a lot of brewing interest, especially among retail traders in areas like quantum computing and power generation, especially nuclear. And I think that's reflective of the fact that we have a cohort that tends to be more active in nature looking for opportunities that is not just set in their Magnificent 7 ways, that they are looking for other opportunities, trying to find forward-looking narratives that maybe are still possibly connected to the whole AI infrastructure, but in a little bit different way.
Our focus, as you know, continues to be that you still want to stay up in quality, and I think that especially applies if you're looking for opportunities down the cap spectrum, because that's where you do still have a lot of non-profitable stocks, zombie companies that don't have sufficient cashflow even to pay interest on their debt.
So I think bringing in that quality is really important in small caps. I don't want to say that you don't have to focus on quality when you go into the larger cap areas, but maybe don't need to have as much of an emphasis because in a rally mode, you also get factors like momentum and high beta that have been doing well, maybe at the expense of protective factors like low volatility, which did really well during the down phase. So still generally an up in quality, but in particular that applies for anyone moving down the cap spectrum and looking for ideas.
KATHY: Yeah, I don't think it surprises me that people are looking for other opportunities since you just get a little bit of a break in that trend and people are suddenly, "Oh, there goes my performance," right? So maybe this is a return to something that should be maybe more normal.
LIZ ANN: Yeah, I mean, correlations are coming down, which is, all else equal, good for stock pickers, good for active managers. When you have correlations through the roof, it becomes really difficult to differentiate. Everything's either going up or down. So I think that that lower correlation, to the extent it lasts, does provide opportunities for those stock pickers out there.
KATHY: We'll see who the investing geniuses are and who the people who are riding the trend, right? Always a distinction.
LIZ ANN: Yep, always, always.
KATHY: Yeah. But I think that's kind of exciting from my point of view and I'm not an equity person. So take everything I say when it comes to equities with a grain of salt, but it is a lot more interesting to watch the market when there's underlying dynamics that you can sort of follow rather than just this wave that's moving. so one area I've been interested in for a long time, well, for a while is the whole CRISPR[1] technology and the biotech area. And it seems to kind of gone under the radar because of AI, but it strikes me that it's just a, I have a nephew who's a doctor who's doing research in that area and just a lot of exciting life-changing things happening there, and I never see a headline about it. I'm always watching, and I never hardly ever see headlines about it. So I'm hoping maybe we get more exciting stuff that bubbles up.
LIZ ANN: Yeah, I think the whole biotech, biomedical… I was in Salt Lake City last week on business and did an event where there were several biotech biomedical startup entrepreneurs there and just talking about how amazed we are going to be with what comes down the pike and in some cases also aided by artificial intelligence. So it is really exciting, but you're right, it tends that whole industry tends to fly a little bit more under the radar than more traditional tech.
KATHY: Right.
Speaking of talking about markets, why don't you tell us about our guest this week?
LIZ ANN: Sure, Cameron Dawson is Chief Investment Officer of NewEdge Wealth. She spearheads the development of NewEdge's investment themes, strategies, and market views while collaborating with the firm's advisors and clients. And before joining NewEdge Wealth, Cameron served as Chief Market Strategist at Fieldpoint Private Securities and as a Senior Equity Analyst at Bank of America. She is renowned for her insightful and distinctive financial commentary and frequently appears on Bloomberg, CNBC, Fox Business, and other media outlets. Cameron is a Chartered Financial Analyst and a former board member of the CFA® Society of Orlando. And she has been recognized with numerous industry awards, including Institutional Investor RIA Intel CIO of the Year for 2024.
LIZ ANN: So Cameron, thanks so much for being here.
CAMERON: Thank you so much for having me. Happy to be here.
LIZ ANN: Cameron, let's start a big picture. I often, the way I approach when I do client events or if I do videos, I start more on the economy and then kind of hone in on more market specific stuff. So let me start there. Just give us your general sense of the lay of the land in terms of where we are and yet again a unique portion of this cycle. Maybe your thoughts on whether recession risk is off the table or something that we need to continue to keep on our radar.
CAMERON: Yeah, in order to avoid using probably the most overused word that we're hearing lately, is uncertainty.
LIZ ANN: Uncertainty.
CAMERON: Exactly. We decided to call this period that we are in "The Summer of Mud" and the idea being that you're in this muddy environment that lacks clarity on so many different levels. So muddiness comes from really the start being on the policy side of things, meaning that we've had relief from tariff headlines, but we really still don't know two major things: A, where the tariffs are even going to settle out as we're going through all these negotiations and what the economic impact will be, meaning that we have been calling this period "the space between" inspired by Dave Matthews Band, the idea between you start with the initial shock of tariff headlines, and then the eventual impact to the economic data, we're in this in-between space, and that in-between space is just by definition muddy.
So you're getting data that is conflicting across the board. Take something like if you look at the Purchasing Managers' Indexes, PMIs, you look at the prices-paid line in PMIs, they've all been skyrocketing, but you look at CPI, the Consumer Price Index, or PPI, the Producer Price Index, and they've been coming in and surprising to the downside.
A lot of this is simply because of how long it takes things to work through the system, through supply chains and inventories. And so what we think in this muddy environment is that it translates to a few things. One, the data is just simply not going to tell you a clear story. So if you're waiting for a clear story, you're going to be waiting a long time. And who's waiting for a clear story more than anybody? It's the Fed. The Fed is telling us that they're waiting for clarity. And like, well, that's probably the scarcest asset in this economy, which means that the Fed is likely to continue to sit on their hands and that Fed pricing is going to continue to be whipsawed by incoming data. But we're of the mindset that the Fed's recalibration period, those nice-to-have cuts where we can get policy back closer to neutral, that period is over, that in order for them to deliver more policy easing, that you're going to have to see a more meaningful deterioration in the data, mostly in the employment data.
But again, that's very lagging as well. And then when it starts to translate into markets, we think that that muddiness comes in the form of higher volatility, sideways choppy ranges, really not making much progress towards this kind of straight up-and-to-the right line that we had been in over the course of '23 and '24. And that you are driven by things more like positioning than actual real fundamentals, which I'm sure we'll dive into.
LIZ ANN: Yeah, and let me pull on a couple of threads that you mentioned. You mentioned the PMI data, which for our listeners that don't know what that means, Purchasing Managers Indexes. So you get that both from S&P Global. We get it also from Institute for Supply Management, the ISM data. I want to also relate what we've seen recently in the PMI data to what you also mentioned, the CPI and PPI, which again, for our listeners, Consumer Price Index, Producer Price Index.
You have seen some interesting things in the PMIs with the most recent ISM services index dropping below that 50 demarcation line between expansion and contraction. And not just in the PMI data, but in a lot of the regional Fed data, you're seeing upward pressure from a prices-paid perspective. Yet we've had these recent fairly benign CPI and PPI readings on inflation.
It sounds like you're in the same camp that I'm in, which is, we can't suggest based on that data that that "nothing to see here, turns out all the concern about inflation with regard to tariffs is not going to come to fruition, that this is still ahead of us." So I guess the issue is since prices paid are going up, how are companies going to navigate through this to your very important point of "We don't know what the rules of the game are. We don't really know what the playing field looks like," but I have to think that we're not going to see something terribly unique relative to history, and that companies are going to try to pass on some of these costs. We may just not have yet seen it fully in the numbers.
CAMERON: Yeah, I think that that's the critical point is that who bears the burden of these higher tariffs because when you see the headlines of how much tariff revenue is getting raised, that's not coming from nowhere. It's coming from somewhere. Somewhere is paying this effective tax. And there seems to be a heuristic rolling around where people are thinking it could be a third, a third, a third.
A third, the exporter, so the people who are manufacturing the goods that are then being shipped into the U.S., then the companies are drawing a third, and then maybe a third goes overall to the consumer. But there's really no real data to suggest that that is going to be how this burden is being shared. And so it's really people kind of sticking their finger up into the wind and going, "Well, maybe this could be how it works out." And the reality is that we also have all these inventory dynamics where companies that anticipated the tariffs had bought a lot of inventory going into the beginning of the year pulled forward a lot of that and now are burning off this lower-cost inventory than what they would be buying today. And what that means is that they're trying to wait as long as they can to pass on price increases to consumers. And this is the last important point, which is that we think that consumers are less able to absorb higher prices today than they were back in 2020 and 2021.
Because in 2020, 2021, you had big increases in disposable income really driven by transfer payments. So you had all that fiscal stimulus, the checks to people's mailboxes that helped support the ability to absorb higher prices to pay for all these costs increases that were happening. Wage growth was also running at a much higher pace. You had excess savings that were built up during the pandemic that helped cushion the blow as well.
LIZ ANN: And finance costs being so low.
CAMERON: And finance… it's a really important point is that for the consumer with your classic Econ 101, those with the highest marginal propensity to consume, so not your highest-income consumers, but those that spend the majority of their paychecks, that financing costs really do matter for them. And the end result of all of that is that as we look at the consumer today, we say they just have less ability to absorb higher prices. They're hitting a wall which suggests that companies might have more trouble passing on price increases compared to 2020 and 2021, which then suggests that maybe we should be watching corporate margins really closely because that's where we could see the biggest impact.
And so the question is, are there then enough technology changes in corporate margins that could suggest that we could at least hold steady? I would contrast it to what we see within the current consensus forecast for margins, which is that you see them getting to new record highs in 2025 and 2026. So the market has a very optimistic view about corporate margins. And for good reason, they've been in an uptrend for the last, let's call it 40 years, but that was a 40 years of globalization and finding lower costs production at every turn. So I think that that probably is that key fulcrum point of "we don't know how margins will fare during this environment," which then drives EPS growth, earnings per share growth, for S&P 500® and will certainly drive where we think that the equity market can go.
LIZ ANN: Let me expand on the earnings outlook because as you well know, this has been also a unique period in the sense that we had much better than expected first quarter earnings, almost double what was expected at the start of the quarter. Yet there's been no extrapolation of that strong growth into the remaining three quarters of this year. I know part of that is just a lot of companies just withdrew guidance altogether, not to the same degree, but similar in trend as we saw in the 2020 period when companies just said, "We're not going to try to give guidance to the cents per share, two and three quarters out in a global pandemic with everything shut down."
A little bit different, a kind of uncertainty right now and not to that same degree in terms of withdrawn guidance, but it appears that analysts, when left a little bit more to their own devices, their bias has been to lower estimates, which makes even valuation analysis difficult because you have the moving target of the numerator in the price and the moving target of the denominator in the earnings. So do you think, how much confidence do you have in that mid-to-high single-digit consensus for 2025 given how, we'll use the word again, "uncertain." And by the way, you said muddy as your chosen word. I've been using unstable.
CAMERON: Oh, I like that.
LIZ ANN: So a different un-word, which I think that also has a different meaning. So what are your thoughts on the earnings outlook? Could it be the case that now yet again analysts have just set the bar too low, and you have that beat potential or have they been right in not doing any extrapolation of Q1?
CAMERON: I think it's really interesting that you've actually been seeing earnings estimates cuts since July of last year and that the equity market is effectively flat since July. It's up a couple percentage points. We've been calling this the Talking Heads market, "The Road to Nowhere." And that this is, it's a great reminder that earnings estimates really do matter. So that's kind of the teeing up of why even have this discussion. I think that there could still be further downside to earnings estimates as we progress through 2025 simply because you do have, you came into the year with a really high bar for where margins could go and that continues to be kind of the big open question mark.
Now, of course, there's other things that companies can pull on. We've seen companies start to reduce headcount in some ways. We've also seen them really do a lot of share buybacks, which can help the EPS line. So there's different ways that they can navigate around this. And we've often quipped that "Never bet against the great American might of margin expansion." They'll find a way. It's like in Jurassic Park, "Nature will find a way."
So we do think that maybe there's room for further downside only because it doesn't that reflect the degree of estimate cuts that we've seen on things like the GDP line, where GDP estimates have been cut a lot. But there's one interesting flavor that's happening within the earnings estimate revisions, which is that you can break down between the Russell 1000 Value and the Russell 1000 Growth index. And it's a good reminder, Russell 1000 Growth is about 55% coming from the Mag 7. So all those big, ultra-growing companies have are really the main driver of the Russell 1000 Growth. And what you see is that those earnings estimates have actually been stable, and all the earnings estimate cuts have been in the value portion of the indices. And it's interesting that that has been the flavor of the market over the course of the last two and a half years because over the last two and a half years we've had above-trend economic growth.
And if you were to ask me, if you give me one piece of data and just said, "GDP growth is going to be above trend, do you want value over growth? And that's all the data that you're going to get." I'd usually say, "Well, give me some value," because it's cyclical and they benefit from this higher growth environment. But the reality is that the higher growth environment, the benefits of it have not accrued to the value names. You continue to see these estimate cuts and that it's growth that does so much better. And so if we continue to be in an environment that these growth estimates are holding up better than value, be prepared that this is going to be a concentrated market again. We're going to be back to this top-heavy market. We're going to be back to talking about how the Mag 7 is really the only driver of returns and EPS growth because other areas of the market are just getting their estimates cut. And I don't know what the catalyst is to see that turn in the other direction where value earnings can do better. But until you see them do better, I don't think that value can sustainably outperform growth. It can outperform growth over short periods of time, but it's likely ephemeral moments that fade.
LIZ ANN: Let's talk a little bit more market-specific and not just the equity market, but maybe I'll start the question with the unique set of circumstances that unfolded in the immediate aftermath of the April 2nd announcement of reciprocal tariffs, where you saw that crescendo further move down in the equity market. But that came at the same time you had a couple of days spike in bond yields, which means bond prices down, the dollar was tanking. So for at least a week there, and I think undoubtedly it was a trigger for the de-escalation that kicked in a week later, you had our markets and our currency behaving like what you see in emerging markets, not in the biggest economy in the world with generally mature and stable and liquid markets.
So do you agree that it was that combination of forces that sent a message, "Whoa, you need to de-escalate," but the ongoing concern is we saw that maybe as a sign of the peril potentially of losing some foreign demand for areas like US Treasuries. If we are really on a path to improving the trade deficit, which seems to be the goal of the administration, that means fewer dollars going out into the world. We run a capital-account surplus, less demand for Treasuries, even on the equity side of things.
So that is such a hot topic right now, especially in the context of the budget deficit, which regardless of what version of the One Big, Beautiful Bill gets through, if it does, we're talking about a significant increase in deficit. So wrap that all together, your thoughts on the trade deficit and foreign demand. I think last I saw foreigners owned a third of our Treasury market and about 20% of our equity market. So where do you sit in that sort of heated debate right now as to whether we're seeing an unfolding buyer strike by foreign entities on US securities?
CAMERON: I think that that is a risk that we highlighted in our outlook and one that we continue to come back to is what is the risk of a de-anchoring of the long end of the yield curve? And we've been calling this the idea of the "zoo steepener." So usually you have a, you can have a bull steepener or a bear steepener.
A bull steepener in the yield curve is driven by yields falling, meaning that the short end of the yield curve, the two year is falling. So it's a bull market because the bond price is going up. Bond math is so fun. Then you get the bear steepener where the yields are rising at the long end, and you have this dynamic where bond prices are falling. So you call it a bear steepener.
So the combination of those two, both bull and a bear at the same time, effectively says you're in an environment that looks like the end of last year, where the Fed's cutting rates by 100 basis points at the front end of the curve, but the back end of the curve is going up by 100 basis points. And that is an environment that suggests that the bond market has a certain degree of consternation about inflation stickiness, potentially, meaning that the Fed isn't serious about tamping it down or has consternation about the deficit and the degree of supply that's going to be issued into the bond market. And the question would be is that, let's say we hear from the Fed and let's say they start talking about, "Yes, we can do rate cuts." How does the long end of the bond market respond? And I think that the risk is that the long end of the bond market continues to creep higher and move higher even as the Fed cuts rates.
And we're not of the camp that they're going to do that soon. But if they did, we think that you could see that that press higher. And the reason that's a problem is because there's a dynamic within the idea that if the Fed's cutting rates, you're hoping that there will be interest-rate relief on the economy, meaning that the Fed cuts rates, the cost of financing goes down. You can see more investment. You can see more cyclical activity. The problem is a lot of cyclical activity is actually priced on the long end of the curve.
Think about the housing market, the mortgage market. So if the Fed cuts rates and the long end goes up, that actually hurts housing activity and demand even further, and that puts pressure down on the cyclical economy. Then there's a funny dynamic that happens at the front end of the curve, which is that if you see the Fed cut interest rates, remember that we have record money market cash balances, and that the majority of the spending in the US is coming from the highest-income consumers that are sitting on the majority of this cash balance that have been enjoying very high rates.
So we actually think that rate cuts for that consumer are net restrictive, which is such a through-the-looking-glass, totally upside down. But if you're sitting on big cash balances that we're earning 5% and now they're only earning 3%, that is less money in your pocket.
So we actually think that this dynamic of a "zoo steepener" is on net a restrictive policy move, which is so weird and unique and topsy turvy. One last thing to point out is you talked about the dollar, and I think the dollar and its relationship to yields is so fascinating right now. Usually you would expect in a world where the Fed is tighter than the rest of the other central banks that the dollar would be stronger. Interest rate differentials, it's what drives the dollar in some ways.
But we've been in this environment that despite the rebound we've seen in equities and some of the stability we've seen in bond prices, that the dollar continues to weaken and weaken and weaken, which suggests to your question as to "Is there at the margin less demand for dollars because of less trade flows, which means less current account deficit, means less capital account surplus," you will go on down the line. And I think that we should all raise an eyebrow at the DXY breaking down below 98, even as you were seeing equity markets remain resilient. And so that would suggest to me that maybe at the margin, there is less demand for dollars in the world. And that suggests that we have to have these discussions about bigger tectonic shifts that are happening with capital flows.
But we've been often saying that the hardest thing as an investment analyst is determining the difference between a counter-trend move and the start of a tectonic shift. They look the same at the start.
LIZ ANN: So two things that I wanted to mention about that. It sounds like you're somewhat in our same camp as it relates to, you know, foreign demand for Treasuries, as an example of dollar-denominated securities. We haven't been of the view that we're going to see some mass scale dumping of Treasuries by foreign entities, frankly. China's been diversifying away from heavyweight dollars for a dozen years now, so that's not a new story. They would be aiming the gun squarely at their own foot if they just suddenly started… But if you lose some of the power represented by the price insensitive buyer, by default, that puts a little bit more power in the hands of the price sensitive buyer. Now we've been in this calmer yield environment for a little bit time right now, but I'm guessing you're also in that same camp?
CAMERON: Yeah, yeah, I think that that's the… it's the biggest question. Markets happen at the margin. And so if you lose even a little bit of that marginal buyer who is looking at their allocations and saying, "Well, it was for the last 15 years, US or bust" that you are starting to say, "Well, maybe at the margin, I should diversify a little bit more."
That would suggest that then you could see that upward pressure on yields, mostly at the long end where there already is concern about the degree of supply. We had good 10 and 30 year auctions this week, but there could be some concern there. And then as well as that downward pressure on the dollar.
So, I completely agree with you. This is not about all of a sudden people boycotting US assets. And in fact, Bank of America published some really interesting data back a couple of weeks ago that showed foreign flows into equities and fixed income. And into equity funds, foreign flows actually are running at a near record pace in 2025. So people haven't stopped wanting to buy great American companies.
Where they have seen significant declines in flows has been in fixed income. And fixed income has almost completely stalled. And that is the concern.
LIZ ANN: So you mean bond funds.
CAMERON: Bond funds….
LIZ ANN: …being purchased by foreigners. Yeah.
CAMERON: Yeah, which just suggests that people are starting to have this question mark of "Is US debt, on a currency-adjusted basis, as attractive as it was?" And look, if you are having discussions about potentially shaking up the entire economic world order of the last 40 years, these decisions by asset allocators take a lot of time. It's not an overnight decision and it could suggest that we could be in for a bigger tectonic shift. But again, it's really hard knowing the difference between counter-trend moves that are short term and these… the start of something much larger.
LIZ ANN: Yeah, I want to close in a minute with your thoughts, because I thought you had a great way of phrasing your thoughts on international outperformance this year, international diversification. But I want to go back to one of the things you said earlier in this conversation with regard to the money sitting in money market funds and how that's been to the benefit of upper-end getting that very juicy yield. Would you also apply that… so, in the period before the Fed embarked on the aggressive tightening campaign in 2022, you had the 0% interest rate backdrop. We touched on that as it related to easy and cheap financing.
But we also know that many corporations, particularly larger corporations, had taken advantage of that backdrop and termed out their debt, such that even in the tightening cycle, many companies were earning more interest on their cash than they were paying interest on their debt.
So I like the way you said "A decline in interest rates might not serve the same purpose as in the past as it relates to spending and that pool of money and money markets." Do you think that, should we also be thinking in those terms as it relates to the corporate side of things, particularly large companies that aren't sitting on a lot of debt and they've been banking some of that interest on the cash?
CAMERON: Yeah, 100%. So this whole dynamic of the construction of the US balance sheets from corporates and households was the central part of our thesis as to why we didn't think we would get a recession in '23 or '24. And we were actually calling it the "strange landing." So instead of having a hard or soft landing, calling it this idea of it being very strange, it's inspired by Robert Heinlein's Stranger in a Strange Land.
And the whole idea behind it is that COVID distorted so many different things, relationships between data, but one of the most important distortions was balance sheets. And balance sheets that were able to be termed out, whether it was people getting a 2% 30-year mortgage or corporations being able to do 30-year bonds at a percentage of half. Remember the 10-year Treasury yield hit 0.5% in June of 2020.
So there was huge opportunity to be able to refinance debt. And if you look at the high-yield issuance in 2020 and 2021, over two thirds of it came just for refinancing. So people locking in lower rates. So we've been in this dynamic where for the first time ever, according to Bureau of Economic Analysis data, for the first time ever, you actually saw net interest expense fall as the Fed was raising rates.
That meant as the Fed was raising rates, you saw the net interest expense, meaning the interest that you pay on your debt minus the interest that you earn on your cash, that that actually was falling, meaning people were benefiting more from interest rates going up than they were getting hurt from seeing their cost of debt go up. And so what's interesting is that, if we get real wonky, what we say is that the second derivative of that has turned, so it's starting to go down less and that you're actually almost at the point where net interest expenses starting to rise again because the Fed is cutting rates, so that's hurting the cash portion, but people are now having to refinance some of that debt. The average maturity of high-yield bonds is five years, 2020, it's now 2025. It starts to kick into higher gear in 2026 and 2027. So we do think that when we talk about this idea of long and variable lags, we think that the lags are longer and more variable because the Fed effectively, through 10 plus years of quantitative easing of suppressing long run interest rates, they effectively immunized the US economy to short-term interest rate moves. Not immunized, or desensitized maybe is the better word.
And so because of that, the Fed's policy rates that focus just on the front end of the curve just have less impact than they did in prior cycles, which is why I think so many people were led astray in '23 and '24 of saying, "No, of course we should have a recession, look what the Fed just did." But companies and households looked around and said, "No, this is actually kind of great." And so that's how we get this above-trend growth. So I do think that eventually these high rates will weigh on the economy. We would say it's kind of like the Led Zeppelin song, "Your Time is Gonna Come."
LIZ ANN: I'm the biggest Led Zeppelin fan on the planet.
CAMERON: No way, I didn't know that.
LIZ ANN: So you are preaching to the Zeppelin choir here. I love any of those references. So well done.
CAMERON: Thank you, thank you. So I do think eventually your time is going to come, but it's taking a heck of a lot longer than people are expecting and mostly the Fed expecting as well.
LIZ ANN: All right, one final question before we wrap it up. I want to ask about diversification. Maybe that's a good way to wrap up thinking about, "OK, how should we think about portfolio construction in these, here we go again, uncertain times." But you had wrote in a recent note, "For the past 15 years, being internationally diversified has meant always having to say you're sorry but this year you can say 'you're welcome.'" So I thought that was a great way to phrase it because, man, things can turn on a dime as they sure did. And you're right. And we deal with it all the time. Investors saying to us, maybe until this year, "Why would I have any money anywhere other than the US equity market?" or maybe specifically the Magnificent 7 or the AI stocks. But again, things can turn on a dime. So how are you thinking about not just international diversification, but how to think about portfolio construction in this unique period of time.
CAMERON: Yeah, we think that that investors should be at least neutral and because of 15 years of underperformance of international versus the US, meaning neutral international stocks, because of 15 years of underperformance, most people are structurally underweight international. Now, it has to come with the huge caveat that US economic dynamism, mostly corporate earnings power dynamism is just that much better. I would much rather buy a great tech company with huge gross margins and massive free cash flow yield than some old stodgy European industrial company with teeny tiny margins and no desire to return capital to shareholders. So any day I'd prefer those higher-quality companies.
However, you cannot ignore things like positioning and valuation. And when things get so skewed, or positioning gets so lopsided and valuation gets so discounted as it did to start this year, we think that like peak American exceptionalism, that narrative peaked effectively right before the inauguration, that you were at these valuation extremes that weren't sustainable. And we always say, "Valuation is not a catalyst," but then the catalyst comes with something like the weaker dollar.
So we do think that again, it's the idea of making sure you're neutral. There's opportunities to find higher quality, attractively valued names within markets outside of just large-cap growth, but you have to be very selective. And if you think of having a budget for fees and taxes for active management, of all places to spend that budget on active management, it would be within international markets where you just have less concentration and you have more asymmetric information and just more dispersion between the winners and the losers.
The other important part of it when it comes to portfolio construction is just recognizing that, as we talked earlier, the equity market has been kind of sideways for the last nine months or so. Effectively, we've gone up, we've gone down, and we're kind of back to where we began. And it's a great argument for having things in the portfolio that are diversified, meaning that they derive the return stream from things outside of just equity beta. And so that's where, for a lot of our clients, we build in alternative portfolios where the returns coming from these kinds of investments are less correlated and that they've been able to generate high single-digit, low double-digit returns, even in an environment where equity markets go effectively sideways.
So an example of that is that we looked at our portfolios and we said "We think investors are probably under-invested in infrastructure." Infrastructure is not exciting when you have a NASDAQ that's comping every year at 20% year after year after year. But if you can give me high single-digit, low double-digit returns that are less sensitive to equity markets, kind of would take that all day long in this environment. So we've been making efforts to get higher exposure to some of those non-traditional 60-40 areas because we think that this environment is one that will have lower returns and more rotations, more volatility, more chop. So it's great to have those ballasts built into portfolios.
LIZ ANN: So Cameron Dawson's many, many, many, words of wisdom on a lot of topics. This has been great. Thank you so much for joining us. I really enjoyed our conversation. I'm a fan and happy to have you on our little pod here.
CAMERON: Well, I'm a fan right back. Thank you so much for having me.
KATHY: OK, looking ahead to next week, we do have the FOMC meeting, that is the Federal Reserve's Open Market Committee meeting, and I'm sure we'll be both watching that closely. What else is on your radar for next week, Liz Ann?
LIZ ANN: Well, as you know, because we don't expect any move on rates at this meeting, it still is the case that these press conferences can always have some interesting tidbits. So they offer some, from excitement, even if the announcement is as we expect. But we also have the Consumer Price Index and the Producer Price Index. And you know, it's really hard to judge at this point when we might start seeing the impact of tariffs directly in these numbers. One of the reminders about the CPI, the Consumer Price Index, it's got a heavy shelter component to it. So owner's equivalent rent and other shelter components. And that's actually where there's been some downward pressure. So even if we start to see it embedded in some of the categories within CPI that are directly impacted by tariffs, it could have a broader offset by some of those shelter components.
So I think it's important to sort of fine-tooth comb this inflation data. And I think you're going to start to see from economists more of that breaking out so we can really start to gauge the very specific impact from tariffs on goods and categories that are directly affected by that. And then we also, next week, have retail sales and speaking of housing, some housing data and at the end of next week we have the Leading Economic Index, the LEI, which has turned a little bit lower again. We'll see whether that continues. So that's what's on my radar.
KATHY: Well, I'll be obviously watching that FOMC meeting closely, but they're also the one thing that's I think we're going to get some information on or maybe a few hints on is the Fed's new framework. They've been reviewing their framework for quite some time now, but they're due to give us an update on that. You know, they have the Flexible Average Inflation Targeting, FAIT, for a while, and that was in place because inflation was quite low and undershooting. And instead of saying, "Well, we're just going to stick to 2%," they said, "Well, we wanna average around 2% to make sure we don't slip too low." Well, of course, that's ancient history now and we've been above 2 % for a while. And I think that there is need for a new framework. So much has happened in the last couple of years.
LIZ ANN: So a FAIT accompli?
KATHY: Oh, ouch. I love it. That was good.
LIZ ANN: I'll see myself out.
KATHY: That was good. I'll have to use that. I'm stealing that one.
LIZ ANN: Go ahead, take it.
KATHY: But I think where we're going to end up is maybe some combination of a Taylor rule, which the Fed has incorporated, and some sort of maybe nominal GDP targeting or something like that.
If you're not familiar with it, the Taylor Rule is a monetary policy tool. It was introduced by John Taylor, so it's named after him. And it's meant to help central banks determine how to set short-term interest rates. It uses the Fed funds rate, the target interest rate that the Federal Reserve uses. And it's adjusted for inflation, and something called the output gap. And the output gap tries to measure where the economy is growing relative to its potential. So, in other words, if we're growing below potential, there's room to lower rates. If we're going above potential, might cause inflation, then you'd bring the, you'd bring the Fed, you would tighten monetary policy and raise the Fed funds rate.
It's going to be tricky because they want to give themselves some hard and fast things to stick to, but also enough flexibility around that because the framework is meant to give them room to maneuver when the economy changes. And so many things are changing domestically and globally in the economy. I think that they're really going to try to opt for as much flexibility as they can get. But it's going to be interesting to see because that's going to affect how the Fed operates for a long time to come. So I'm keeping an eye on that.
So that's it for us this week. Thanks for listening. As always, you can keep up with us in real time on social media. We both post regularly on X and LinkedIn. I'm @KathyJones. That's Kathy with a K on X and LinkedIn.
LIZ ANN: And I'm @LizAnnSonders on X and LinkedIn. As I always say, please make sure you're following the real us because we have lots of imposters. You can also read all of our written reports, including all of our mid-year outlook pieces. I think mine was the last to publish along with Kevin. We co-write it and that published earlier in the week. So check all of them out. And our reports and our postings on social media always include lots of charts and graphs and you can find everything at Schwab.com slash learn.
And, of course, if you've enjoyed the show, we'd be so grateful if you would leave us a review on Apple Podcasts, a rating on Spotify, or feedback wherever you listen or tell a friend about the show. Also, I will note that the stock market will be closed one day next week, June 19th, for Juneteenth, and we are taking some time off as well. So we will be back with a new episode in two weeks.
For important disclosures, see the show notes or visit schwab.com/OnInvesting where you can also find the transcript.
[1] Clustered Regularly Interspaced Short Palindromic Repeats, https://en.wikipedia.org/wiki/CRISPR
