RANDY FREDERICK: Thank you for joining us for Schwab’s Quarterly Update, where we share insights and perspectives on the economy and the markets.
Well, it’s only taken 8½ years, but the persistent skepticism about this bull market finally seems to be giving way to some broad market optimism. But is that such a good thing? Schwab’s Chief Investment Strategist Liz Ann Sonders gives us her take on whether or not this supports a bullish perspective, or whether a more cautious approach may finally be warranted.
LIZ ANN SONDERS: Looking at traditional investor sentiment indexes, it’s clear the number of skeptical investors has dwindled as equities continue to hit all-time highs. This in and of itself may actually present a risk for the market as complacency is clearly evident. In a surprise to many, stocks have defied the chaos emanating from Washington, although the dollar has been hit partly as a result.
But there could be a pickup in volatility after this period of relative calm, especially given the debt ceiling fight that looms after Labor Day, as well as the Fed’s initiation of the shrinking of its balance sheet, which is a form of tightening monetary policy. That said, we have been making the point for months that strong U.S. and global equity markets are a function of extremely healthy fundamentals— including decent economic growth, low inflation, ample global liquidity and the surge over the past year in corporate earnings.
Let’s start with the U.S. economy. After an upward revision to an initially reported very weak first quarter, second quarter growth was a respectable 2.6%, while the Atlanta Fed’s GDPNow forecast has 4% for the third quarter. That forecast will ebb and flow of course, but clearly the weakness in the first quarter did not persist.
Other than the significant drop in regulatory pressures, the pick-up in growth can’t be much-credited to the Trump administration given the lack of traction on most of its pro-growth policy proposals. The diminishing regulatory burden has been under-appreciated and is increasingly referenced by small businesses in particular as one basis for their optimism.
Another effect of the rebirth of animal spirits, which accompanied the election, was on the spread between so-called soft and hard economic data. Soft data are confidence and survey-based ... in other words, they are subjective readings on the economy. Hard data are objective and quantifiable economic data.
As we’ve been highlighting for several months, it was our view that the record-wide spread of better soft data relative to hard data was unlikely to persist, and that the spread would narrow by the soft data catching down to the hard data vs. the other way around. This is precisely what has been occurring recently as the bloom has come off the rose of anticipation given the chaotic atmosphere in Washington. An implication of the post-election surge in animal spirits was an economic expectations bar, which arguably was set too high.
Related to that, the U.S. Citi Economic Surprise Index took a dramatic plunge from its post-election high. Not so much because the actual data was weak in an absolute sense, but because the expectations bar was set too high.
Remember, this index measures how data is coming in relative to expectations. But perhaps because of political chaos, the expectations bar was lowered significantly; and recently, economic data has been generally besting expectations, especially on the jobs, unemployment and wages front. This ties in to a mantra of mine as it relates to economic data and the stock market. It’s often the case that better or worse matters more than good or bad.
Now, a byproduct of better economic data has been stronger corporate earnings growth. After a four-consecutive-quarter profits recession, which ended in last year’s second quarter, earnings have rebounded smartly— in large part due to the rebound in the energy sector. In the current earnings season, during which companies have reported second quarter top- and bottom-line growth, the results have been quite strong. Not only did a very low percentage of companies guide down estimates ahead of reporting season, but the earnings and revenue “beat rates” have both been strong—73% and 69%, respectively.
Now earnings, of course, are only half of the valuation equation, prices being the other. But lately, earnings growth has been greater than market appreciation. As you know, when the denominator (the E in the case of a P/E) is growing faster than the numerator, the P/E will move down, which has been the case recently. Now, valuations still remain stretched, but as long as earnings continue to power ahead, it should serve as a tailwind behind the stock market.
RANDY: Liz Ann’s comments helped highlight the risk/reward balance at the moment.
As you’ve just heard, some investors are feeling pretty good right now. But too much optimism can create risks of its own. Schwab’s Chief Global Investment Strategist Jeff Kleintop gives us his thoughts on some market bubbles we should be looking out for—and some ideas on how to avoid them.
JEFF KLEINTOP: As I travel around the country, the questions I am getting from investors have changed from earlier this year. From worries that things are going wrong like the amount of student loan debt, or the Brexit vote or even tensions with North Korea to worries that things may be going too well now with stocks at all-time highs, earnings at records and unemployment very, very low.
When people worry that things are too good to last, they worry about bubbles.
I mean, bubbles are trouble for investors, right. And that’s why we are always on bubble watch. Fortunately, the current candidates don’t seem to fit the classic bubble profile and may pose less potential damage to the broader markets and the economy if they were to reverse.
Now it’s true sometimes bubbles are only seen in hindsight. But bubbles with potentially damaging impact on the broader markets and economy tend to have some similar characteristics that may enable us to spot them before they burst.
As you can see in this chart, these past bubbles, like the dotcom stocks of the NASDAQ or housing stocks, inflated around 1,000% over approximately 10 years before bursting, cutting prices by more than half in the following two years. This happened with oil prices and precious metals, too. That 10-year buildup is important to how embedded the bubble becomes in the markets and economy when it bursts.
Potential bubble candidates, like crypto-currencies such as bitcoin, or internet-retailing stocks, or even central bank assets, none of them seem to fit the classic profile of a potentially damaging bubble to the broader markets with ripple effects across the economy and markets. Either they haven’t inflated enough—or they did so over a much shorter time period—like bitcoin, for example. But now that doesn’t mean they don’t pose risks to investors, and they could create volatility if they were to pullback sharply. But they don’t fit the classic profile of a bubble.
But volatility is still important here, and when it comes to managing risk, global investors have the return of a benefit they haven’t seen in 20 years.
Bull markets can be found in the stock markets around the world right now. But I like to say, the bulls aren’t running in a herd. Their movements are less correlated with each other than we’ve seen any time since the 1990s. And that means diversification has made a big comeback.
And this is a big deal. For some investors, this may be the first time since they started investing that they’ve seen this kind of environment.
For the past 20 years, global diversification nearly disappeared. Stocks all tended to move together. We saw high correlations as stocks moved in sync. You know, stocks around the world fell together when we had that U.S.-led dotcom and housing bubble burst, and in between, as international sales grew to exceeded domestic sales, companies’ fates became more tied to what was going on in the global economy, and not just what was taking place inside their own borders.
Fortunately for investors, that’s changed now. This chart shows that, measured statistically, the correlation between the world’s stock markets has returned to the average level that prevailed throughout the 1970s, the 80s, and for much of the 1990s. Those levels were the golden years for diversification and a smoother path to financial goals.
The driver of these lower correlations seems to be the lower correlations among the sectors that drive these countries’ stock markets. For example, energy stocks have been a wild ride in recent years, along with the ups and downs in oil prices. Tech stocks have kind of moved higher through it all, and financial stocks have been very tightly tied to what’s been going on with interest rates. So these divergent trends, as long as they remain in place across sectors, well, countries should diverge in performance, too.
And the return of diversification across stock markets really has the potential to cushion a pullback in globally diversified portfolios without hampering long-term returns. A key benefit investors haven’t seen in 20 years.
International stocks outperformed U.S. stocks in the first half of 2017. The greater diversification these markets now offer is another reason to check to see if you have the right amount of exposure to non-U.S. stocks in your portfolio.
RANDY: As Jeff points out, while a small correction would not be surprising, diversification should help lessen the impact.
So far we’ve talked about domestic equities and global correlations, but when the Fed is tightening credit, the bond market should not be overlooked. Schwab’s Chief Fixed Income Strategist Kathy Jones talks about how strong performance all across the bond market may be creating some risks of its own.
KATHY JONES: The fixed income markets have performed quite well year to date, even though the Federal Reserve has raised short-term interest rates twice this year. Bonds, which tend to be influenced more by prospects for growth and inflation than the Fed’s rate moves, are benefiting from a drop in inflation.
Every major category of bonds that we track has posted positive returns as a result of the income generated, plus price appreciation. In fact, the riskiest asset classes, like hig-yield and emerging-market bonds, have produced the strongest returns.
After such a strong rally, we’re somewhat cautious as we look forward. Some of the factors that have been positive for the bond market appear to be fading. Inflation looks like it is stabilizing and beginning to turn slightly higher, and the Federal Reserve is likely to start the process of reducing its balance sheet this fall.
That plan has been laid out and communicated, so it shouldn’t be too disruptive to the markets, but it is a form of tightening in monetary policy. The Fed will no longer be reinvesting the principle and interest on the maturing bonds it holds, which is a way to take away some of the stimulus that it was providing over the past seven years. That could result in some increase in bond yields as private investors will need to take the Fed’s place when new Treasuries are issued. Our analysis indicates the process should have a modest impact on the bond market, perhaps only about 15 to 20 basis points per year. But it’s still a form of tightening in monetary policy.
We also expect the Fed to raise short-term interest rates one more time this year—probably at the December meeting. However, the markets aren’t necessarily priced for tighter monetary policy. Instead, the probability of an increase in the fed funds rate by December, as implied by futures market prices, is only about 40%. In the past, the market’s expectations have been more accurate than the Fed’s, but we don’t think it’s smart to be complacent about the potential for rate hikes.
The key factor to watch will be inflation, which has drifted lower this year and is under the Fed’s 2% target. Unless it drops much more, we don’t think it will stop the Fed from raising rates. After all, the Fed’s been raising rates since 2015 even while inflation was below 2%, and even after several rate hikes, the current fed funds rate is still below the level of inflation. That means “real” interest rates are negative. That might have been an appropriate level in the wake of the financial crisis and recession, but now the economy is in much better shape, so the Fed appears anxious to return to a more normal level.
Also, the unemployment rate is falling, wages are gradually picking up, the dollar has fallen by about 7%, and financial conditions are still quite easy, meaning businesses and individuals seeking loans can get them easily at relatively low rates. Those conditions are good for economic growth and usually lead to a rise in inflation down the road, because it raises demand at a time when there isn’t much excess capacity in the economy.
We still look for 10-year Treasury yields to stay in the 2.0% to 2.5% range for the rest of the year, with yields likely to move up towards the upper end of that range. In other parts of the market, we’re concerned that risk premiums have declined. That is, the extra yield an investor gets to buy corporate bonds compared to Treasury bonds, of similar maturity, has fallen. That’s also true in other parts of the fixed income market, like municipal bonds and foreign bonds. Those can still be great investments in a diversified portfolio, but investors should be aware of the risks they are taking to get that extra yield.
We continue to think it best to limit the average duration in a bond portfolio to the intermediate term, which means about three to seven years for Treasuries and investment-grade corporate bonds and about three to 10 years for municipal bonds. We also think it makes sense to be sure your bond portfolio is well diversified and not too heavily weighted to riskier parts of the market.
RANDY: Well, there certainly are plenty of things to keep an eye on in the fixed income markets, but bond investors can still benefit … if they have a plan.
Well, activities in Washington have certainly kept things interesting since the election, but there are a few issues whose urgency far outweighs the rest. Schwab’s Vice President of Legislative & Regulatory Affairs Mike Townsend will close us out with his discussion of today’s most pressing political issues.
MIKE TOWNSEND: Today I want to cut through the noise coming out of Washington to give you an update on four key issues that investors should be aware of as we head into the fall.
First up is the issue with the highest likelihood of directly affecting the market in the coming weeks—the debt ceiling.
After being suspended for all of 2016, the debt ceiling returned in March. Since then, the Treasury Department has been employing what it calls “extraordinary measures”— a series of steps it takes to ensure the United States does not default on its debts. But those steps are finite, and the time is rapidly approaching when they will run out.
Treasury Secretary Steven Mnuchin wrote a letter to Congress in late July urging lawmakers to act by September 29. He stopped short of saying that the Treasury would run out of cash to pay its bills by that date, but he’ll have to provide Congress with a drop-dead date for action very soon. That date is likely to fall somewhere in the first half of October.
Raising the debt ceiling used to be routine and non-controversial— but not anymore. In recent years, it has become one of the thorniest political battles Congress has to face. The uncertainty about if and when Congress will act is likely to increase market volatility. In 2011, when Congress went to the very edge of default before raising the debt ceiling, one credit-rating agency downgraded the U.S. debt rating, and the S&P 500 dropped 13% in the week before a last-minute deal was reached. It took a couple of months for the index to recover.
Right now, there is no clear path forward for Congress. Secretary Mnuchin has called for a “clean” debt ceiling bill—an increase without any other policy measures attached to it. But many Congressional Republicans will only support an increase that is coupled with spending cuts or other policy issues, something that Democrats strongly oppose. It is likely that a coalition of moderate Republicans and Democrats will have to work together to get a debt ceiling increase through the Congress.
Ultimately, we remain optimistic that Congress will get the job done—after all, they always have before. The United States has never defaulted on its debts. But expect some anxious days for the markets as the deadline approaches this fall.
While the debt ceiling deals with how much the government can borrow, the second key issue to watch is how much the government will spend. The government’s fiscal year ends on September 30. If Congress hasn’t allocated funds to keep the government going by then, there would be a government shutdown on October 1.
The battle over spending is always a tough one, and this year is no different. But despite some tweets earlier this year from President Trump that seemed to welcome the possibility of shutting down the government, there does not seem to be much appetite on Capitol Hill for doing so. Since Republicans control the agenda in Washington, they worry that they will get all the blame if there is a shutdown.
As the September 30 deadline approaches, look for Congress to do what it has done so many times in recent years— pass a temporary agreement that funds government operations for a short time, perhaps through the end of the year. That will buy Congress additional time to continue negotiations without having a government shutdown.
The third issue is tax reform. It’s moved to the top of the agenda for the White House. But tax reform remains far from a sure thing. There’s a reason the tax code hasn’t been reformed since 1986—it’s hard. Really hard. Tax reform is as politically complex an issue as there is in Washington.
Republican leaders from the House and Senate have been meeting for weeks with top officials from the White House to develop a plan they can all agree to, but there still hasn’t been a draft bill produced. In fact, nothing has been produced beyond a series of principles. We know generally that Republicans want to lower tax rates for both individuals and corporations, and eliminate both the estate tax and the Alternative Minimum Tax. But how to pay for big tax cuts without increasing the federal deficit—that’s going to be a very difficult question.
Moreover, there are literally hundreds of trade-offs that will have to be made as the bill is developed. For example, Republicans have said they want to keep the deductions for mortgage interest and charitable contributions. But there are hundreds of other deductions and credits in the tax code that will have to be addressed, and each one has a constituency and a champion ready to defend it.
This is going to be an enormously complicated debate, and despite optimistic predictions from some in Washington that tax reform can be completed by October or November, count me as skeptical that tax reform will happen before the end of the year. Don’t be surprised if this issue is pushed into 2018. I also doubt that Congress can pass sweeping, comprehensive tax reform. Lawmakers may start out with that as their goal, but a possible fallback position is to pass something less ambitious, like a corporate tax cut that could attract bipartisan support.
Finally, any discussion of what’s happening in Washington these days has to include a mention of health care reform. As we all know, repealing and replacing the Affordable Care Act has been a Republican priority for seven years and was a key campaign promise of President Trump. But Congress has nothing to show for months of debate over what should replace the law.
Despite pressure from the White House to give it another try, Republican leaders in Congress appear to have moved on from health care reform for the time being. But it’s likely to come back this fall. There are real issues with the Affordable Care Act that need to be addressed—most notably the fact that insurers have been pulling out of the exchanges, leaving Americans in some locations with one or even zero options for purchasing insurance.
There are bipartisan groups on both sides of Capitol Hill trying to work out a smaller bill that will provide some temporary fixes, but no formal agreements have been reached yet. Still, we think some kind of health care bill will need to be done this fall to address these problems. If and when health care legislation moves forward this fall, it probably won’t have a huge market impact, but it merits watching if you are invested in the health care sector.
RANDY: Liz Ann, Jeff, Kathy and Mike have covered a lot of ground today, and hopefully they’ve given you a sense, not only of where the next bout of volatility might come from in the near term, but also that there’s plenty of reasons for optimism, in the longer term.
Don’t forget, you can view our weekly Market Snapshots at Schwab.com/Insights. And, if you have any comments or questions about anything we covered today, you can always pick up the phone and give us a call.