Q&A with Schwab investment pros: What’s ahead for 2019 markets?

Submitted by Marc.Jones on July 17, 2019
Panel of Schwab investment professionals

Four Schwab investment professionals recently got together to discuss the state of the economy, the likely direction of interest rates, and how investors should be positioned. Here’s what they had to say.

Panelists: 
Liz Ann Sonders
Chief Investment Strategist for Charles Schwab & Co. Inc.

Brett Wander
Chief Investment Officer of Fixed Income for Charles Schwab Investment Management, Inc.

Kathy Jones
Chief Fixed Income Strategist for Schwab Center for Financial Research

Omar Aguilar
Chief Investment Officer of Equities and Multi-Asset Strategies for Charles Schwab Investment Management, Inc.
 

Q: Is the U.S. economy headed for a recession?

Liz Ann Sonders: Well, I can say with 100% certainty that we will get a recession because we always do when the cycle ends. I think trade is probably the most important needle-mover as to the timing. But I will say upfront that, if we are heading into a recession, I think it has already started. Recessions are not two quarters in a row of negative GDP. That’s never been the definition. There are historic proof points to that. The ’01 recession didn’t have back-to-back down quarters, but it was ultimately declared a recession.  

The bureau that dates recessions, the NBER [National Bureau of Economic Research] looks at what are the four coincident economic indicators: personal income, payrolls, industrial production, and wholesale-retail sales. With the exception of wholesale-retail sales, which have ticked back up, the others are in downtrends. When the NBER dates recessions, they don’t say it started at the moment they conclude you’re in one. They go back to the peak in the cycle. If we’re on that glide path, then the peak was probably sometime in the first quarter.

We’ve seen a rollover in consumer confidence that hasn’t yet been reflected in most of the traditional metrics around consumer spending. But what was hoped for was that we would kick in a capex-led part of the cycle stimulated by corporate tax cuts. Unfortunately, when you announce corporate tax cuts and then start a trade war three months later, it had a little bit of an offset in terms of business confidence. And you’ve now had back-to-back, year-over-year declines in capital spending. Historically, about two-thirds of the time that’s happened, you’re actually in a recession, not heading into a recession. To me, it’s just hard to envision a scenario, absent a comprehensive trade deal, that we reignite corporate animal spirits sufficiently enough to kick in that capex-led part of the cycle.

Q: Is the yield curve a cause or a symptom, and how concerned should people be?

Kathy Jones: It’s both a cause and a symptom. I think everyone knows that an inverted yield curve is a pretty solid indicator of recession 12 to 18 months later. The problem is, there’s a long and variable lag time. What causes an inverted yield curve, typically, is the Fed has raised short-term rates, and then long-term rates start to fall in anticipation of slower growth and lower inflation. 

Subsequent to that, as the yield curve is inverting, you start to see banks pull back on lending. That’s partly because it’s less profitable because their cost of funding is higher than what they’re going to earn on funding. But it’s also because they’re looking forward and saying, “Well, the economy is softening. We’re going to start being more cautious, and maybe raise lending standards.”

What’s unique about this cycle is we’ve had the yield curve invert, but the lending officer survey is not indicating that banks are tightening credit, nor are financial conditions very tight. We’re getting kind of conflicting signals. 

So, right now, I’d be a little bit more on the fence than Liz Ann. I’m sure a recession is coming, but we don’t have all the indicators falling into place that would say it’s imminent.

Q: What role do you see the Federal Reserve playing in the coming months?

Brett Wander: We’re in a pretty extraordinary time Fed-wise. If you recall, it was only in December when the Fed was talking about two possible rate hikes this year. So we’ve gone from two rate hikes at the beginning of the year to the potential for a rate cut. What was even more extraordinary to me was how little the people in the marketplace—financial pundits and the Fed—were even talking about the possibility of a rate cut back in December. 

Over the course of the past few months, the number of rate cuts priced into the marketplace went from one to two, possibly even three, and the Fed has said nothing to refute what the market is pricing in. By saying nothing, they’re kind of implicitly acquiescing to what the market is stating.  

Keep in mind what the Fed dreads more than anything else: Number one would be a protracted recession, or worse, deflation—a spiraling economic downturn. They also want to do everything possible to ensure stability in the financial markets. And the worst case for them would be if there’s market instability that they are blamed for. The Fed doesn’t want to have the market price in one thing and then do something else. In 80 of the last 80 Fed meetings, the Fed has done exactly what was priced into the marketplace. 

Q: How should investors be positioned in the equity market at this time?

Liz Ann Sonders: I’ll go back to the latter part of 2017, when we made the first of what became a series of changes from a tactical recommendation perspective to reflect our views that we were moving into a later cycle and the risks associated with that. We took U.S. equities down from an overweight to neutral, which basically meant telling our investors to stay at their normal long-term strategic allocations.  

At the beginning of 2018, we also went to an overweight in large caps and an underweight in small caps. We wanted to reflect caution but weren’t ready to throw in the towel with a neutral rating. But we felt pretty confident in the likely outperformance of large caps versus small caps.

In August, we neutralized our sector recommendations too. We took technology and financials down from outperform to neutral, and we raised REITs and utilities up from underperform to neutral, leaving only health care as an outperform and only telecom services as an underperform. We were basically suggesting it’s not the right environment to make outsized major sector bets. Prior to the change, we had had three outperform ratings, three underperform ratings, and the rest were neutral. 

If you look at the periods from the peak in 2018 and the 10% correction to the peak again in September and the 20% correction to the peak in April and the 7% to 10% correction, each subsequent kind of roundtrip has led to more defensive leadership. I think that’s somewhat typical at this point in the cycle. My one concern, and something that our sector analyst and I have been talking about, is there’s been so much of an interest in the more defensive areas, and in places where investors can find yield, that you may be looking at a bit of a lack of value in those traditionally valued areas.

Omar Aguilar: What we have continued to talk to investors about is that it’s good to evaluate where you are and to look at your risk parameters. This is an opportunity for you to rebalance your strategy, because you now most likely have more equities than fixed income because we have had a huge rise in the market.

I always tell people that the best thing is to diversify, especially when you think about the fact that we’re in a global market. Investing outside of the U.S. usually provides a larger breadth of opportunities that will give you better risk-adjusted returns. Over the last 10 years, the U.S. had led the markets. However, out of the top 50 stocks that have had the best returns year after year, on average, 75% of those have been non-U.S. companies. 

And, while the indexes themselves tend to be heavily weighted toward Japan and Europe, which have struggled economically in the last decade, the actual investment opportunity is still there for diversification. Twelve years ago, emerging markets represented only 3% of the global capitalization of the entire world. Today, they are 13%. So when you think about the impact of international, it’s more than what you may think, and the opportunities for diversification have not changed. 

The average allocation that most U.S. investors have in international assets is 15%. Most people think that at least doubling that should be the right norm. If you go by global market capitalization, you’re talking about 50%. When you look at the risk-adjusted returns, given the fact that it’s more expensive to trade international assets, you have to think about the currencies and other components. Yes, maybe 50% is too much for a lot of people, but 15% is definitely very low.

The biggest driver of the decision to potentially increase international allocations today has to be the U.S. dollar. The dollar has been a significant headwind for international investing for a decade. Now, we seem to be heading into an easing cycle, where the Fed is expected to reduce rates. That should actually put pressure on the dollar, potentially giving more opportunities to international investing. 

Q: What about bonds? Where is the right spot to be on the yield curve?

Kathy Jones: I don’t think there’s one right spot—there rarely is. Our thought is to have some short-term and some intermediate-term. I know a lot of our clients will say, “Well, why not have just short-term bonds because I get paid more in a one-year or a two-year note right now than I can get in everything else, so why take the duration risk?” 

There are two reasons. One is that, if the panel is correct, the next move by the Fed is a cut, which means you would be reinvesting at lower and lower rates, so you’re not locking in anything. Having some 7- to 10-year maturities, as low as they are, would allow you to lock something in for the future. 

Second, it’s for diversification, particularly in Treasuries. One of the things people often don’t realize is that if the stock market goes into a bear market or even a correction, Treasuries are generally your best diversifier. They tend to do better than all other fixed income asset classes when the stock market goes down. If you’ve got a one-year T-bill, it will stay there and hold its value, but it’s not going to appreciate, because the Fed is going to be cutting and you’re going to be reinvesting at lower rates. Even a five-year Treasury has tended to appreciate in past cycles anywhere from 5% to 15%, or even 20%.

For those two reasons, we think you should have some duration in the portfolio, but it should be really high quality.

Q: Every financial website seems to have an article about how to get higher yields. What are some of things to think about when chasing yields?

Brett Wander: How to maximize yield is one of the most dreaded questions I could possibly receive. Most importantly, it’s the wrong question to ask, because it implies that higher-yielding strategies are better than lower-yielding strategies.  

There’s an expression that was coined by a Wall Street commentator a long time ago that went something like this: “More money has been lost reaching for yield than at the point of a gun.” That really encapsulates how insidious the yield trap can be. Typically, when investors reach for yield, they’re doing so in the credit, or non-Treasury, markets. Point of fact: If this were 10 years ago and you said, “Hey, I need a 5% yield,” you could do so with Treasuries. If you went back five years ago, perhaps you could get a 5% yield with investment-grade corporate bonds. They’re not quite as safe as Treasuries, but they’re doing OK. Today, if you had to have a 5% yield, you would probably have to go into the high-yield market, which would mean taking on a lot more credit risk.

Does it make sense to keep taking on increasing risk that is correlated with the equity markets because of fixating on a yield target? I think such a strategy is probably one of the biggest mistakes an investor could make.

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