MARK RIEPE: I’m Mark Riepe, and this is Financial Decoder, an original podcast from Charles Schwab. It’s a show about financial decisions and the cognitive and emotional biases that can cloud our judgment.
Last December we did a bonus episode where we did not feature a deep dive into a particular financial decision and the biases that can trip us up when making that decision. Instead, we featured four of Schwab’s top analysts, and I asked them to spend about ten minutes each telling us how they expected 2021 to playout in their particular areas of expertise.
It was one of our most popular episodes, and so I’m going to commit a decision-making bias by assuming if we do a similar episode again it will be just as popular.
All of my guests have been on the show before, so you’ll be hearing some familiar voices.
First, we’ll hear from Liz Ann Sonders, our chief investment strategist. Liz Ann is a keynote speaker at numerous industry conferences, and she is regularly quoted in financial publications including The Wall Street Journal, The New York Times, Barron’s, and the Financial Times.
She appears as a regular guest on CNBC, Bloomberg, CNN, Yahoo! Finance, and Fox Business News. In addition, Liz Ann has been named “Best Market Strategist” by Kiplinger’s Personal Finance and Barron’s has named her to its “100 Most Influential Women in Finance” list.
Liz Ann, you’ve been on the show a couple times before. Thanks for coming back.
LIZ ANN SONDERS: Oh, my pleasure. It’s always a great conversation. Thanks for having me again, Mark.
MARK: We’re talking today about your mid-year outlook. Let’s start with the U.S. economy. The GDP numbers from the first quarter, they were terrific. The job market numbers—while I guess you could say were below analysts’ expectations, they were still impressive. What does the future hold for the economy? Are we going to be seeing a return to, you know, what some are calling the roaring twenties or maybe a boom and then things kind of settle down to more of a baseline normal set of growth, or are we setting ourselves up for more of a boom-and-bust scenario?
LIZ ANN: So at this stage, I put myself in that middle camp. In fact, in the mid-year outlook, I use the boom start to three different scenarios, broad scenarios— boom-boom, which would be the roaring twenties, boom-settle, or boom-bust—and at this point, I’m in the boom-settle. And there are reasons at this stage why I think the boom-boom or the roaring twenties may be a bit of a stretch, largely because if we truly were to be in a rapidly accelerating growth environment beyond just the second quarter, which is unquestionably going to be strong, we already know and are getting more than just hints from the Fed that they would probably shorten the timeframe between now and when they start to tighten monetary policy, either via the balance sheet or short-term interest rates, and that could put a damper on a boom type of scenario. And let’s hope, of course, that there isn’t the boom-bust scenario, either driven by the virus or some sort of exogenous shock, or a Fed that maybe make some sort of monetary policy mistake. But I think a lot of the conditions that established what was a relatively low-growth environment before the pandemic probably will reassert themselves. I am optimistic about the investment side of the economy maybe picking up some steam relative to the consumer side of the economy, at least after we satiate some of this pent-up services demand that we’re seeing in earnest right now.
MARK: Liz Ann, you mentioned the possibility of a monetary policy mistake, and we get a lot of questions from clients about the money supply and its huge rate of increase over the last few years. That growth rate, it’s still high, but it’s dropped sharply. What’s behind that and what impact will it have?
LIZ ANN: So there’s a lot of factors behind it. The drop in the money supply is a function, actually, more of monetary policy, but not in the manner that you think. It’s not because the Fed has yet started to raise interest rates or tapered its balance sheet, but what’s going on inside the system. There’s been a dearth of lending, both on the supply side and the demand side. Obviously, much of the fiscal stimulus, at least via direct payments into the hands of households, as well as businesses, are in the rear-view mirror. So we’ve already seen from a peak, during the worst part of the pandemic, I should say, of about 27% year-over-year growth in M2 money supply, and that’s been haircut by about 10 percentage points. But something to be mindful of, because when you go into significant tightening mode, both on monetary policy and fiscal policy, that’s when you tend to run into at least more volatile stock market activity, if not a higher likelihood of some sort of, you know, full-blown correction or something worse. And I think that, not so much tightening, but the pullback and money supply growth, I think, is a factor, not the factor behind some of the recent volatility, weakness, and leadership shifts that we’ve seen in the market.
MARK: When leaders at the Fed speak publicly, they’re often talking about the importance of the labor market and how that’s turning out when they decide what kind of policy decisions to make. Why has that taken center stage, how is the labor market doing, and what’s the connection between the labor market and inflation, because, as you know, we get a lot of questions about inflation, as well?
LIZ ANN: Sure. Well, there are always connections between the labor market and inflation. I think that’s a key reason why the Fed has the dual mandate around what they in formal literature define as price stability and full employment. So there is always that connection. There’s this perception, probably accurate, in the last couple of cycles that there’s less of a formal connection between those two, relative to, say, the 1970s, where you had that period of really outsized growth and inflation driven by what, ultimately, became what is often called the wage-price spiral. And that was a function of wages going up—you know, workers demanding higher wages because the cost of living, the cost of goods was going up—companies opting to pass along those higher costs, and that, you know, spiraled back to consumers paying more, therefore, demanding higher wages.
Now, there are differences from the 1970s, of course, not least being macro forces like globalization, which was less rampant at that point. It was much more of a closed economy. You had much greater unionization. You had much weaker levels of productivity. The good news is, looking at the current environment, we have much stronger productivity growth. We’ve had the benefit of globalization, in terms of supply of labor, keeping wage costs fairly low. We’ve been of the view that the Phillips Curve, the relationship between wages and inflation, has not been forever broken. There were just extenuating factors as to why it just didn’t work as well as it has. And I think especially now, given where we’re seeing some big upward pressure in certain parts of the economy, in certain industries, certain types of jobs, where there is either a skills gap or just a labor supply problem on big spikes in wages.
Now, what we don’t know yet is whether that’s a one-time adjustment, where in order to attract talent, you bump up the minimum wage to a higher level, or whether it becomes more of that spiral, where it feeds on itself and it becomes a consistent increase in prices and wages, as opposed to a one-time adjustment. And we’re of the view right now that … to use the Fed’s word, that this inflation spike that we are seeing is rooted mostly in short- to medium-term factors and that it, ultimately, will prove transitory.
Now, the definition of transitory, at least in the Oxford Dictionary, is “not permanent.” By that definition, you could define the ’70s era as transitory—it’s just a question of the semantics around timeframe. But looking at the sustainability of wage increases, whether they’re one time in nature and whether the whole psychology around inflation kicks in, because when it … when it really gets to the type of environment like the ’70s, there is that psychological component, too. So, in particular, in this environment, it’s key to look at that connectivity between wages and inflation.
The last thing I would say, though, is what’s interesting about the past year or so is that the Fed has made important adjustments to both its inflation and employment mandates. On the inflation side, they went from 2% for PCE inflation, their preferred measure, to being a target, which basically meant, historically, they would potentially preemptively change monetary policy if you were approaching that target. Now they’re view it as an average. They actually are willing to let it and are actually desiring to let it overshoot to offset how much time it spent under that target. So it’s more of an average. It’s almost like the Fed has gone from driving its car via the windshield to driving it via the rear-view mirror. They are less outlook-based and more outcome-based. And then the adjustment they made to the labor market was not just a decline in the unemployment rate to whatever the cycle full employment would be as that’s defined, but they’re also looking for quality and breadth associated with the improvement in the labor market. So they don’t want to just see it concentrated, say, in higher-income segments of the economy. They want to see it spread.
So it’s an interesting past year or so because of those less-than-subtle changes to both of their mandates, which means the connectivity is a bit different than what we’ve seen in the past.
MARK: Let’s move on to the stock market, and one of the metrics that you highlighted in your report is called real earnings yield. I suspect that’s less familiar to a lot of our listeners. What does that mean, why is it important, and what is it telling you right now about the stock market over the next year or so?
LIZ ANN: Yeah, Mark, and you’re right that it’s probably not as common evaluation metrics as many investors are familiar with, the more common ones being things like your traditional P/E ratio. What the earnings yield is, and I’ll get to the real part in a minute, is … mathematically, it’s simply the inverse of the P/E ratio. So instead of P divided by E, or price divided by earnings, you’re doing earnings divided by price. And the way I describe it is a P/E ratio on an index like the S&P or on an individual stock is really a way to look at valuation within an asset class or within a sector. So you can compare the P/E of, say, a stock to other stocks in that sector, or to the market overall, maybe to its own past history. Whereas the E divided by P, or the earnings yield, is a valuation metric that helps you across asset classes, and, basically, it’s a way to compare, you know, a stock or an index to yield instruments, say, on the fixed income side. So it’s an across-asset-class valuation metric, as opposed to a within-asset-class valuation metric like a P/E. And with anything that you apply that real label to, you’re simply subtracting the inflation rate from the earnings yield.
Until this recent spike in inflation, the real earnings yield was positive, and that, actually … that was one valuation metric that suggested the stock market was pretty inexpensive relative to either corporate bonds or Treasuries. But now courtesy of that spike in inflation, and you’re now subtracting a higher number than the earnings yield, bringing the real earnings yield pretty deep into negative territory, about one of the most extreme negative readings that we’ve seen in decades. And that has, historically, been accompanied by weaker stock market performance.
The key is how short-lived this is. If this is, indeed, a very short-term spike in inflation and that eases in short order, then we could quickly revert back to a more positive real earnings yield, but it’s something to keep on the radar, given that in the past, it has meant weaker stock market performance.
MARK: Liz Ann, as we are recording this, the stock market, or at least the U.S. stock market, is near an all-time high, and whenever that happens, we always get questions about investor sentiment and whether there’s too much euphoria. One way of measuring that is margin debt. What does that look like right now and what is it telling you?
LIZ ANN: So margin debt is … it is a valuable metric among many to judge investor sentiment, and it would be within that category of behavioral measures of investor sentiment. So if you think about investor sentiment, there are attitudinal measures, things like the American Association of Individual Investors Survey that’s done on a weekly basis asking their members, “Are you bullish or are you bearish?” There are other attitudinal measures like Investor’s Intelligence, which just measures what the newsletter writers are writing about. That’s an attitudinal measure, you’re pretty much just asking investors for their opinions. And then there are behavioral measures, things like the put-call ratio in the options market. It’s actually tracking what investors are doing to gauge their level of optimism or pessimism. And margin debt would be one of those because it shows the change in willingness to take on debt in order to make investment decisions.
I think one of the problems with people who look at margin debt, and I see this too often, is they look at the growth in margin debt, whether they just do a number of dollars of margin debt out there, or some sort of percentage change year-over-year, or a number of months rolling percent change, but they look at that in isolation. If they see a spike, they say, “Uh-oh, this is a big potential contrarian signal because margin debt has been growing so rapidly.” You have to look at it in conjunction with appreciation in the stock market.
In the past, when margin debt has been moving up in line with the pace of appreciation of, say, the S&P 500®, it’s actually not a contrarian leading indicator of impending doom.
It tends to be more of a coincident indicator reflecting that margins got up at about the same pace that the stock market has appreciated. It’s periods where the growth in margin debt starts to move significantly higher than the appreciation in the stock market. And that has been happening recently, not to yet an extreme degree, but the fact that we’ve now seen a rolling over, and we’re starting to see a retreat in margin debt in conjunction with the recent weakness in the stock market, that is a bit of a checkmark in the risk column, and that’s only in the last a week or so. That is even a change since I published the mid-year outlook a couple of weeks ago. So certainly something to keep a close eye on
MARK: Investor sentiment is, obviously, important, but the sentiment of companies also matters because they’re making big investments of their company’s money in the future. What is the mood of CEOs these days?
LIZ ANN: Well, the mood is actually somewhat off the charts to a level in terms of CEO confidence, which is a monthly reading higher than it’s ever been in the past. And that is somewhat, obviously, reflecting the unbelievable surge we’ve seen in the economy off the pandemic lows of this year, not just the third quarter of last year, where we saw that significant, more than 30% annualized growth for GDP off what was an equivalent decline in the opposite direction, the quarter before, but more directly tied to CEO confidence would be the surge we’re still in the midst of in terms of corporate earnings growth. So using the S&P as a proxy in terms of earnings growth, we nudged back into positive territory, slightly positive territory, in the fourth quarter of last year after just an epic implosion in earnings mid-year, and then heading into the first quarter, expectations were that we were going to see 25% year-over-year growth in earnings in the first quarter. When all was said and done, at the end of the first quarter reporting season, it was more than double that, at 52% year-over-year, and estimates for the second quarter are now at about 63% year-over-year.
So CEO confidence is reflecting that surge in earnings, which, in theory, anyway, or maybe not in theory, on paper, or based on perception, that would seem to be a phenomenal backdrop for the stock market, and it has. But we have to remember that the stock market is a leading indicator—it’s a leading indicator both in terms of earning, as well as overall economic activity. And, in fact, if you look at the history of periods of very lofty CEO confidence in the past, the highest zone of CEO confidence, which we are currently in now, has actually been accompanied by the weaker returns for the stock market, not dire negative territory, but the weakest if you kind of zone CEO confidence.
And that’s similar to, I think, one of the underlying factors behind high CEO confidence, which is the kind of robust earnings growth we’re seeing. And although the stock market, historically, has had its worst performance when earnings are down more than 25%, you know, recession-type conditions, the second-worst performance is actually when earnings are up more than 20%. The best performance, interestingly, has come when earnings are down between 25 and about 5, kind of that initial launch point out of a recession. That’s when you get, generally, the biggest move from the stock market, as it anticipates the coming turn in earnings. Once you’re in the midst of it, the market, for the most part, has priced maybe not all of that in, but a lot of it in.
So we might have another season here where companies do dramatically better than that 63 expectation, and that could continue to be a tailwind behind stocks. But simply looking at things like CEO confidence being off the charts isn’t automatically a positive for the stock market, especially when the market has already reflected a lot of that, given the 90% appreciation since March of 2020.
MARK: All right, Liz Ann, last question. What does this all mean for people’s portfolios? How should they go about constructing the portfolio?
LIZ ANN: Well, the first part of the answer here would be an answer I would give at any point in time, having nothing specifically to do with the current COVID environment or the unique period from a stock market perspective or policy perspective, and that is to have a plan, to have a long-term investing plan that is tied to your time horizon, your risk tolerance, the connection between those two, the difference between your financial risk tolerance and your emotional risk tolerance, which can sometimes be, unfortunately, a pretty yawning gap, your income needs, past experiences, etc., etc. And then, more specific to the recent period of time, given some of the risks that I’ve talked about, sentiment-related risks, a bit of complacency, if not outright speculative froth, certainly, in some pockets of the market, the fact that we’re in the process of exiting the recovery phase of the move out of the recession into the expansion phase, where, basically, you either go to above-trend growth or you take out the prior high in GDP—there’s lots of ways to define going from recovery to expansion—and then some of the other factors like the valuation risk, margin debt, CEO confidence, you add all those up and it’s suggestive of maybe a choppier period in the market and some rising risks at this point in the cycle.
What you don’t have to do is make wholesale changes. Given my view on the market, which I don’t ever attempt to time the market, or your own perspective, there are more subtle things that investors can do to sort of stay in gear with the market without having to make a market call that then suggests an all-in or all-out decision. I think one of the big mistakes that investors make is they think that to be successful, it’s a function of what they know or who they listened to that claims they know what the future is going to hold in terms of the market. What makes an investor successful is what they do regardless of what happens in the market. So there are certain strategies you can employ, from maybe a bit more frequent rebalancing, to more diversification, making sure you’re not putting all your eggs in one basket, make sure you’ve got that blend across and within asset classes. You can certainly do things like, you know, stop-loss policies or certain techniques that some investors can apply inside the options market to maybe hedge some risks.
So there are strategies that can be employed that don’t mean you have to try to time the market—and when is the next 10% correction is going to be, when the next bear market is going to be—that allows you to continue to participate on the upside, but make sure you’re not taking an undue amount of risk, either by lack of diversification, a lack of rebalancing, or succumbing to, and I used the two most common example these days, either, you know, FOMO, fear of missing out, or the newer one that the young folks are using, you know, HODL, H-O-D-L, hold on for dear life. And I think, importantly, concluded my mid-year outlook by saying neither FOMO nor HODL are investment strategies. So keep that in mind, as well, especially given how much hype there is around certain segments of the market these days.
MARK: Definitely good advice. Liz Ann Sonders is Schwab’s chief investment strategist. Liz Ann, thanks for talking to me today.
LIZ ANN: Nice to be here, Mark. Thanks for having me.
MARK: Now I’m joined by Jeffrey Kleintop. Jeff is Schwab’s chief global strategist. Cited in The Wall Street Journal as one of “Wall Street’s best and brightest,” Jeff frequently appears on CNBC, Bloomberg TV, and CNN. He’s also quoted frequently in The Wall Street Journal, Barron’s, and the Financial Times.
Jeff, nice to have you back on the podcast.
JEFFREY KLEINTOP: Thanks for having me, Mark. It’s great to be with you.
MARK: Jeff, the most interesting line from your mid-year outlook, or at least most interesting to me, was “The recovery is now over.” What do you mean by that?
JEFF: Well, the recovery is over, but that’s actually good news. During the first half of this year, the world economy seems to have rebounded back above its pre-pandemic peak, transitioning from the recovery phase to the start of a new economic expansion. Now, of course, some countries and businesses and families have not fully recovered from the pandemic-led recession, but, overall, global GDP fully recovered by the end of the first quarter. And this continued economic expansion in the second quarter is now lifting output above its pre-pandemic high. And this was the sharpest economic V in history, with its deep recession and rapid recovery both contained within just five quarters.
The expansion continues now with the consensus forecast for global GDP growth of 6% for this year. And that’s supported by a lot of powerful factors, like the global vaccine rollout, of course, expanded fiscal stimulus, and the anticipation of a demand snap back as a lot of restrictions that are still lingering are eased. And if we get this 6% growth rate, and I think that’s likely, it will be the fastest pace of growth for the global economy seen in nearly 50 years. We’ve got to go back to 1973 to see a year of global growth that’s this strong.
So, Mark, despite calls for more stimulus to aid the recovery, the recovery is over, and a new economic expansion is now underway.
MARK: So let’s talk a little bit about that new expansion, that new phase, if you will. Which markets stand to gain the most from entering into this new phase?
JEFF: For stocks, this new economic cycle has meant stock market leadership has passed from the U.S. to Europe this year, as we forecast in our 2021 global outlook published late last year, which we entitled “New Cycle, New Leadership.” The MSCI Euro Index, which tracks stocks in the Eurozone, has delivered a total return of 18% in U.S. dollar terms, while the S&P 500 index has posted just 13.8% year-to-date through yesterday, June 15th.
Now, if we look back to when the new cycle really got underway, since the beginning of November, when hopes for COVID-19 vaccines began to boost confidence in the recovery, Eurozone stocks have returned 48%, compared with just 31% for U.S. stocks. International stock markets, especially in Europe, have a higher share of stocks in more economically sensitive sectors, like industrials and energy, and those are two of the best performing sectors this year, than the U.S. stock market, which is more in tech and healthcare, which have actually lagged the overall market this year. And this combination of stronger earnings growth and lower valuations and more cyclical stocks has helped propel Europe stock market this year.
But these aren’t the only reasons. I’ve written a lot and even talked on your podcast in the past about how Europe stocks were likely to return to outperformance with this new cycle after lagging behind the U.S. in the 2010s. So I won’t go into all the reasons we’ve been calling for this to take place, but I will point out that the Eurozone has outperformed even though their vaccination programs lagged those in the United States. And now Europe is finally ending restrictive lockdowns and unleashing pent-up consumer demand, and they’re continuing ramped-up bond buying by the European Central Bank and nearing the rollout of Europe’s largest ever fiscal stimulus program. And all of that should aid growth heading into the second half of this year. And that may mean that the peak in Eurozone economic momentum may not come until much later this year, unlike other major economies, like the U.S., where growth may have peaked in the second quarter of this year, or China, where it probably peaked in the fourth quarter of last year. And this suggests that Europe’s growth still has some way to go before peaking and that Eurozone stocks could still deliver further gains, even after outperforming in the first half of the year.
MARK: Jeff, we like to think about the international markets, we like to, you know, divide them up, if you will, between developed markets and emerging markets, and in past economic calamities, it was really the emerging markets that got hurt the worst. Did that play out this time?
JEFF: No, they actually fared better economically. But emerging market stocks have actually lagged so far this year. While we believe European stocks can outperform this year and have been recommending an overweight relative to U.S. stocks, we have not done so for emerging markets, but that isn’t due to worries about a crisis. You know, in the past global recessions, emerging markets suffered crises, which led to deeper economic declines than we saw in developed markets. And they often saw their currencies plunge, which also contributed to poor investment performance. But this recession, which was tied to a health crisis rather than a financial crisis, has been different. Emerging market economies suffered less in 2020 than their developed counterparts and are expected to experience more rapid growth in this year, 2021. Their currencies have also fared well—the MSCI Emerging Markets Currency Index hit a new all-time high in late May.
The best performing asset class last year was emerging market stocks. But as I mentioned, this year they’ve lagged, rising only about 7% so far this year through yesterday, the 15th. And this is due to a few factors, I think. One, China’s pace of growth peaking late last year and slowing this year was a factor. Second, concerns about higher inflation, possibly leading to tighter monetary policy, was an issue, as well. And then, of course, the dollar has been positive during the first half of the year. And that acts as a drag.
Now, in the second half conditions for emerging markets may improve. We’ve got solid relative economic growth and stimulus in Europe. Europe is the emerging markets’ biggest customer. Also, it’s worth remembering that emerging market countries engaged in much lower levels of fiscal and monetary stimulus than developed nations. And that may have avoided sowing seeds that can lead to potential future financial problems. So they may have an opportunity for catch up in the second half, Mark.
MARK: Investors, obviously, seem to be looking past, you know, case counts or, you know, COVID case counts, positive test results, percentage of population that’s been vaccinated. Is that optimism still warranted or, you know, is the virus still really behind us?
JEFF: Well, the COVID-19 vaccine rollout has worked, but it’s had a bumpy start in most countries. After logistics were worked out and production was ramped up, the pace of vaccinations increased and kind of aligned with the path to recovery that we outlined in our 2021 global outlook, and the markets have been satisfied with that. Major countries, including China, are on track to have more than 50% of their populations vaccinated this summer, so that’s good news. But on the negative side, the potential for new variants, and the fact that antibodies do wane over time, may mean that this winter we could see yet another wave of infection. And aid by developed countries may be needed for low-income countries to prevent unvaccinated areas from evolving new variants.
Now, currently the vaccines are proving to be effective against severe cases and appear to provide protection from variants, reducing hospitalizations and the need for lockdowns. In the absence of variants that escape vaccines, we could face fewer economically impactful lockdowns, even in the face of another winter virus wave.
MARK: In our last episode, we talked about inflation. And one thing we didn’t really talk too much about, because I knew you were going to be on this episode, was this issue of supply bottlenecks, particularly given how interconnected global trade is and connecting different economies. Why does that matter when thinking about the future of inflation?
JEFF: Yeah, bottlenecks have been a big factor. You know, as the economic reopening broadens, raw materials and component shortages seem to be improving and lessening the price pressures. In fact, congestion at the ports of Los Angeles and Long Beach, the most congested in the world, have improved considerably. I’ve been counting the number of container ships at anchor waiting to be unloaded. And, remember, these things have cargos like semiconductors that are needed to get to automakers so that they can ramp up those production lines and get those cars out there. We’ve seen used car prices soar and shortages of new cars on lots leading to higher prices because they just can’t get the components. But to get back to the point, I’ve been counting the number of container ships at anchor waiting to be unloaded in San Pedro Bay. That was more than 40 in the first quarter, when it took over a month to unload those ships, while manufacturers waited for those critical inputs. Then it was down to 30 ships in late April, about 20 in late May, and I counted around 10 each day in the past week. It’s never zero. So this is a vast improvement, and it suggests that more products like semiconductors are getting to manufacturers and easing those supply shortages, taking some of the pressure off prices. And prices of raw materials, like lumber and iron ore and copper, have pulled back from the highs of early May, as China began an administrative crackdown on commodity markets.
Now, combined, these factors could moderate the pace of gains in inflation by late summer, just in time for the annual meeting of the world’s central bankers in Jackson Hole, Wyoming. If these early signs continue to signal a deceleration of the upsurge in price pressures for manufacturers, then the risk of market worries over the pace of the rebounding consumer inflation might soon begin to lessen.
MARK: Thanks, Jeff. Given all of that kind of background foundational information. What’s your strategy, what are you telling investors to think about as they invest their global portfolios?
JEFF: Well, I’ve got three takeaways.
First, as the new global economic cycle moves into its next phase, European countries are only now starting to ease their restrictions on economic activity, just as Europe’s largest-ever stimulus plan is about to be deployed. And that suggests Eurozone growth still has some way to go before peaking, and that Eurozone stocks can still deliver further gains even after outperforming in the first half of the year.
Second, a risk to the expansion is the prevalence of COVID-19 variants and the presence of antibodies waning over time, which may mean yet another wave of infections in the late fall or winter. And this is still the most important factor for the expansion in the economy and earnings that drive markets.
And, third, a potential positive is that the signs signal a deceleration in some of the upsurge in price pressures here in the second half of the year. And that may lessen concerns over the risk of premature policy tightening by central banks that weighed on emerging market stocks in the first half of the year. And that may allow them to catch up with the performance of developed markets here in the second half.
MARK: Jeffrey Kleintop is Schwab’s chief global investment strategist. Jeff, thanks for being here today.
JEFF: My pleasure. Thanks for having me, Mark.
MARK: Now let’s turn to the fixed income markets, and there’s no one better to speak on that topic than Kathy Jones. Kathy is Schwab’s chief fixed income strategist.
Kathy has analyzed global bond, foreign currency, and commodity markets extensively throughout her career as an investment analyst and strategist, working with both institutional and individual clients.
She makes regular broadcast appearances on CNBC, Yahoo Finance, and Bloomberg TV, and is often quoted by The Wall Street Journal, The New York Times, Financial Times, and Reuters.
Kathy, it’s been an interesting year in the bond market. Could you describe the rollercoaster ride that the bond markets have been on between January and June?
KATHY JONES: Yeah, Mark, it really has been an interesting year so far, one that’s really defied consensus expectations, both in terms of rising and falling rates. So we came into the year, yields were low—10-year Treasury yields were below 1% because the economy was still struggling to get off the ground after the pandemic. But then when vaccine distribution ramped up faster than expected, and the fiscal stimulus package was much larger than anticipated, yields started to rise pretty quickly. And so by the end of the first quarter, the last trading day of March, 10-year Treasury yields actually rose to 1.74%, but then they’ve been falling ever since even though inflation has been rising pretty sharply since then. And now we’re looking at 10-year Treasuries around 1.5% or even below.
I think there are a couple of reasons that explain the recent drop in rates. One is just positioning. A lot of investors were on the wrong side of the market coming into the year. They got on the wrong side before yields peaked, and they’ve had to scramble to get out or just throw in the towel.
But there are some fundamental reasons, as well. One is that there’ve been a couple of disappointing employment reports. Not bad—by most normal standards they would be quite healthy, quite strong—but in this case we’ve expected employment to bounce back quickly as the economy opened up. And they’ve been a little bit below expectations. So since we know that the Fed is really focused on employment, that’s signals that the Fed might keep short-term interest rates lower for longer until employment bounces back more quickly.
The second is inflation readings, although they’re very high, that was anticipated, and we might have already seen the peak in the rising expectations. So much of the increase in prices we’ve seen are in areas that have been really related to the pandemic. So used cars and trucks, airfares, clothing, things that fell very sharply in price during the pandemic and now have bounced back very quickly, and there are some shortages. And these increases really aren’t likely to be repeated month after month.
And then, finally, foreign investors have come back into the market. Even after hedging against currency risk, U.S. Treasury yields are now high relative to yields in other major developed markets, and that makes them attractive to foreign investors. So we’ve seen some of that foreign capital come back in, as well.
MARK: Kathy, your outlook for the rest of the year is that long-term rates are going to be going higher, but short-term rates are going to stay low. Let’s talk about the long-term rates first. What are the forces that are driving them up?
KATHY: Well, I think that it comes down to economic growth. I think the market may be underestimating the rebound in economic growth in the second half of the year. As I mentioned before, the employment numbers have been a little bit disappointing, but we think when schools reopen to full-time in-person learning that that’s going to give us an uptick in job growth. So there’s still 800,000 state and local education jobs that haven’t come back to pre-pandemic levels, and those jobs are likely to show up in the August and September employment reports. And then you add in parents who might’ve had to drop out of the workforce or cut back their hours sharply because of the lack of childcare, and you can add that to the payrolls in the fall, as well. Also, on the spending side, you know, the savings rate is high, consumers have spending power, and we think that they’ll continue to increase their spending as time goes by. And then global trade is rebounding as the rest of the world reopens and gets their economies back on track, and that contributes to growth, as well. And then, finally, we have both fiscal policy and monetary policy are really set to boost economic growth. So we think that’s all consistent with rising long-term rates.
MARK: I’m going to go back to this issue of, you know, the economy really growing. Why are current rates inconsistent with the level of growth that we’re seeing?
KATHY: Well, the main reason is that real rates, those adjusted for inflation, are steeply negative. So inflation expectations, if you look at what the market is pricing in for the next few years, is around 2.5% or so, but nominal yields are about 1% lower. So that difference means you have a negative real rate. And that usually only occurs when the economy is really in a depressed state like in the depths of a recession. And that’s not where we are today and nor where we expect to be anytime soon.
So this conflict between the economy and real rates can be resolved in a couple of ways: Either inflation expectations can come down, or nominal yields can rise, or both. I think there’s a good chance they sort of meet in the middle right around 2%.
MARK: Kathy, earlier you mentioned the fiscal stimulus that’s been pumped into the economy. There’s more, a lot more that’s coming if the Biden administration has its way. How does that connect with the story around rising rates?
KATHY: To the extent that fiscal policy is providing a boost to the economy, it should lift economic growth. You know, the American Rescue Plan is providing a lot of funding to state and local governments, which saw their revenues fall steeply during the pandemic. In addition, a lot of the fiscal stimulus is directed towards lower income households, where there’s a tendency for those people to spend more rather than to save more. And that tends to boost consumption, and that boosts economic growth, and with stronger growth, you tend to get higher interest rates. But it isn’t necessarily the case of rising budget deficits that push rates up. The link between budget deficits and inflation or rising interest rates hasn’t been strong for decades. So the impact is more one of lifting demand and overall economic activity.
MARK: Let’s talk a little bit about the short end of the yield curve. What’s keeping rates so low? Is that just solely because of the Fed? And if that’s correct, what’s the Fed’s angle? Why do they prefer to keep rates low right now?
KATHY: Well, it is the Fed. That’s a primary reason short-term interest rates are low. Keeping rates low or near zero is one of the tools they have to support the economy in a downturn. So with very low interest rates, it makes it easier for households and businesses to borrow, and that leads to more investment and spending.
It’s also a signal that when the Fed sets interest rates near zero and indicates they’re going to keep them there for a while, that tends to dampen yields across the yield curve. So if you’re looking for a car loan or a home mortgage, rates stay low, and that encourages more borrowing and more spending. And then for companies, it keeps access to capital and low interest rates, that encourages hiring and investing.
MARK: Given that outlook, or at least given that interest rate outlook, what kind of strategies should investors be pursuing?
KATHY: Well, since we expect yields to rise, we do want to take advantage of that potential for an increase in intermediate- to longer-term rates without getting caught up in a serious price drop. So to mitigate the risk of rising rates, we suggest keeping the average duration on fixed income investments low. In other words, if you normally invest in mostly long-term bonds, you might want to add some short-term bonds to lower your average interest rate exposure. A bond ladder can be a good way to do this since you spread the bond maturities out over time and dollar-cost average into higher rates. It tends to work well when the yield curve is steep because it means reinvesting maturing bonds into higher-yielding bonds.
Now, in terms of other types of bonds, this is an environment that’s typically positive for taking some credit risk. If you have expansive fiscal policy, easy monetary policy, the economy should do well. That makes corporate and municipal bonds look good. The downside is that valuations are already pretty high in those markets. In other words, yields relative to Treasuries are already low. So some of that good news is already priced into the market.
At the end of the day, we usually say diversify. And I think that more than in most time periods, this is a really important factor to consider because there’s so much has been changing, so many unexpected twists and turns in the market. It really makes sense to be well-diversified.
MARK: Kathy Jones is Schwab’s chief fixed income strategist. Kathy, thanks for joining me today.
KATHY: Thanks for having me, Mark.
MARK: Let’s wrap up this episode with the Washington outlook from Mike Townsend, our chief Washington strategist. Mike has nearly 30 years of Washington experience, and he’s also the host of Schwab’s WashingtonWise Investor podcast. Be sure to search your podcast app for “WashingtonWise” if you don’t already subscribe.
Mike, welcome back to the podcast. It’s been a while since you’ve been here.
MIKE TOWNSEND: Well, thanks so much, Mark. It’s great to join you.
MARK: Now that the new chair of the SEC has settled in, what are his priorities that matter most to investors?
MIKE: Well, Mark, I’ve got my eyes on three issues—equity market structure, cryptocurrency, and public company disclosure.
So, first, earlier this month, Chairman Gary Gensler announced a wide-ranging overhaul of the structure of the equity markets. He pointed out that it’s been 16 years since the SEC approved major market structure changes, and technology has changed a lot since then. He also said that the ongoing retail trading frenzy in so-called meme stocks—we’re talking about like GameStop Corporation, AMC Entertainment, the movie theater chain—those situations have brought to the fore a number of issues with our markets. He said, in particular, he’s concerned that nearly half of all trades are executed somewhere other than on the public exchanges, like NASDAQ or the New York Stock Exchange, and that there’s less transparency and less certainty about whether investors are getting the best execution on those trades. He also talked about whether there are conflicts of interest inside the market plumbing where there can be financial incentives for brokers to send their customer orders to a particular trading venue, and that may or may not be best for the investor. He’s also expressed concerns both publicly and behind the scenes about the gamification of stock trading, where behavioral prompts and other incentives to trade could be pushing unsophisticated investors into making poor decisions. And he’s also said that he’s interested in speeding up settlement times so that trades are settled the next day or even the same day as they’re executed, rather than the two days it takes under the current system. So the chairman has asked the SEC staff to prepare a set of recommendations for possible rule changes to address some of those issues.
Second, cryptocurrency, obviously, becoming more and more familiar to investors. But the SEC is really worried that cryptocurrencies are too volatile for retail investors, and that there just are not the investor protections in that space that are part of the equity markets or the bond markets. And the SEC, itself, has been pretty hostile to cryptocurrency as an investment option for retail investors. Cryptocurrency fans have been hoping that Gensler’s arrival at the SEC would herald a change in that attitude and might even mean that the SEC would approve the launch of the first ever Bitcoin exchange-traded fund. But on June 16th, the SEC again deferred any decision on a Bitcoin ETF, and, instead, asked for public comments on the issue.
Then the third thing I’m watching is public company disclosure. The SEC recently requested public input on how to improve public company disclosure on climate change risk, and they received hundreds of substantive comments. SEC’s climate disclosure rules haven’t been updated since 2010, and there’s broad agreement that investors need more robust disclosure in that area. The goal is to try to make it useful to investors by making it easy to understand, and, really importantly, comparable across companies and sectors. So companies and asset managers, investment advisors, they’ve all agreed that it would be helpful if that information was standardized, not just here in the US, but globally.
So those are the big issues that I’m watching.
MARK: That’s a pretty ambitious agenda, Mike. A lot of complex issues there. What are the odds that investors will be seeing anything concrete approved this year?
MIKE: Yeah, you’re absolutely right. The new chairman has really taken on a lot of big kind of high-profile issues that are really complex and have a lot of moving parts. I think we will see rules proposed later this year on the climate disclosure for public companies. That seems to be on the fastest track, but the regulatory process, even when it’s on a fast track is really, really slow. It’s likely that new rules won’t get finalized until 2022, and then there is likely to be a lengthy transition period before companies have to comply, so definitely could be awhile.
And on something like the market structure initiatives I was talking about, I mean, that is a huge undertaking. It’s going to be controversial and very complicated. So on that one, I expect we’re at the front end of a multi-year review and debate process over any new rules that, you know, fundamentally overhaul the structure of the market. So I think that’s an even longer term product.
MARK: Mike, the Biden administration shortly after taking office was able to score a quick win by getting a COVID relief measure through Congress. But since then the sledding has been tougher. What would the administration like to get through between now and the end of the year?
MIKE: Well, I think the highest priority, of course, is the two big economic proposals that the White House has put forward. That’s the American Jobs Plan, which focuses on infrastructure and climate change, and the American Families Plan, which focuses on social programs like universal pre-kindergarten, a national paid leave program, and a big boost in childcare. Those plans total about $4 trillion in spending, and the White House proposes paying for that spending by increasing taxes on corporations and wealthy individuals. The plans include four big tax proposals. One is to increase the corporate rate from 21% to 28%. The second is to increase the top individual tax rate to 39.6%. The third is to tax capital gains and dividends as ordinary income for filers earning more than a million dollars per year, so the very wealthiest filers. And the fourth is to end the step-up in basis for inherited assets.
But I think, Mark, it’s really important to remember that just because the president proposes something doesn’t mean Congress has to even consider it. It’s Congress that has to turn those ideas into actual legislation, and that means they can take a very different approach than what the president has put out there initially. We’ve definitely been seeing over the last few months how hard it is to get the sausage made inside Congress. There have been lots of negotiations to try to find common ground between Republicans and Democrats, particularly on infrastructure spending. But so far still don’t have an agreement and we don’t even have a draft bill or multiple bills on Capitol Hill yet. There’s also been a lot of pushback on some of the tax proposals, and that pushback is coming not just from Republicans who oppose any tax increases, but also from Democrats, many of whom think the increases proposed by the White House are too extreme. So there’s still a lot of negotiating that still has to happen.
At the same time, there are other issues looming. As it must every year. Congress has to pass the appropriations bills that fund every government agency and every federal program by the start of the fiscal year on October 1st or risk a government shutdown. Another issue that the market is definitely watching is the fact that the debt ceiling returns on July 31st. That’s the cap on how much debt the United States can accumulate without defaulting. At some point late this summer or early this fall, Congress will have to suspend or raise the debt ceiling, and that’s always really controversial. Historically, uncertainty about when or whether Congress will do so has led to market volatility. So that’s something investors need to be on the lookout for later this summer. All in all, definitely shaping up to be a big summer with a lot of big, complicated issues that Congress is wrestling with.
MARK: Mike, let’s wrap up with one more question. It’s really the same question I asked you about the SEC. It’s an ambitious agenda that the Biden Administration has thrown out there. What are the odds that investors will see anything concrete this year?
MIKE: Yeah, I think there’s a very good chance that some kind of infrastructure spending package focused on traditional infrastructure—roads, bridges, tunnels, broadband expansion—something, I think, will pass Congress probably sometime in the fall. Both parties understand we need to spend money to upgrade the nation’s infrastructure. It’s something that’s popular. It’s very visible to voters. So I do think a deal will eventually be reached.
Some of the more progressive parts of the president’s economic plans, I think, have a more difficult path to success. Democrats can use a special set of rules known as the budget reconciliation process to pass economic priorities without any Republican support. Those rules prohibit a filibuster and allow Democrats to pass something with just a simple majority of 51 votes in the Senate. Of course, in order to do that, they have to have something that all 50 Democrats in the Senate can support, and that, in and of itself, has proven to be very tricky.
Probably the piece of this that is of the greatest interest to investors is the simple question of whether their taxes will go up. Right now, it seems like the most likely potential tax increase is taking that top individual rate back to 39.6%. That’s just the one that seems to have pretty much universal support from Democrats on Capitol Hill. There also seems to be support for increase in the corporate tax rate, probably not to the 28% level that the president proposed. There’s a number of Democrats who said a rate of maybe around 25% is the highest that they could support. The president’s proposals to change how capital gains and inherited assets are taxed seem to be much longer shots right now. Democrats have not yet coalesced around those ideas.
The bottom line is that I think some spending and tax proposals have a good chance of passing, but there are likely to be significantly less sweeping than the president’s original proposal.
MARK: Mike Townsend is Schwab’s chief Washington strategist. Mike, thanks for coming by today.
MIKE: Thank you, Mark.
MARK: Thanks for listening to this special episode. If you’d like to learn more about our outlook on the market for the rest of the year, check out our special collection of articles on the Insights tab of schwab.com.
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