Warsh's Hawkish Turn: What It May Mean for Investors

COLLIN MARTIN: I'm Collin Martin.

LIZ ANN SONDERS: And I'm Liz Ann Sonders.

COLLIN: 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.

LIZ ANN: Hi, Collin. Nice to … well, I'm only seeing you. It's nice for me to see you. It's, I'm sure, nice for our listeners to hear you. So last time we spoke we were gearing up for Fed Chair Kevin Warsh's speech at the Jackson Hole confab that happens every year. We weren't able to really discuss it because our taping was in advance of that, but now that we've all had time to digest his speech and, of course, so have the markets, what is your reaction, Collin? What do think investors should maybe expect from the Fed at least in the near term, call it the rest of this year?

COLLIN: Yeah, in the near term, you know, the likelihood of a rate hike has increased, from the comments that Warsh gave us, and we're seeing that in the bond market as well. We look at the fed funds futures market to get an idea of how investors across the globe are kind of positioning themselves for what the Fed may or may not do and the likelihood, the implied probability, of a hike has increased. We're seeing that in Treasury yields. The two-year Treasury yield has touched 4.4%, up pretty sharply over the past few weeks. Much of the movement came from Warsh being more clear about what his view and stance of the economy is. And being more hawkish than expected. He was more hawkish than I expected. I think he was a little bit more hawkish than a lot of investors probably expected. He stressed that the economy was in pretty good shape. He said he was impressed by how it's performed. He commented that the labor market is stable. Importantly, he said that financial conditions don't appear to be very restrictive. Now, financial conditions don't necessarily equal the fed funds rate or monetary policy, but it certainly plays a role there. And he's saying financial conditions are not very restrictive right now. And he focused a lot on inflation. And this is really where the hawkishness comes from.

He singled out that inflation's just too high. And he didn't take comfort necessarily in some of the softer readings we got in June and July, and he focused instead on the underlying trends that we've seen lately. Specifically, he called out the large share of the components of the PCE, the Personal Consumption Expenditures basket, that are rising above 3% year-over-year, and he kind of gave us a few benchmarks for what that looks like. Currently about 54% of the components are rising above 3% annually, versus 77% at the peak of the inflation boom we've seen. But more importantly, you know, that number was just 32% in the two decades leading up to the pandemic. So underlying trends are still very much there.

And then he also confirmed that the PCE is the Fed's target. And PCE's too high. The headline number was 3.7% on a year over-year-basis, as of its most recent reading. And core, which strips out volatile food and energy prices, was 3.3%. So just too high. And given, you know, that framing by Fed Chair Warsh, I'd say the risk of a hike has increased. I do think economic data still matters, though. I think the way he framed it gives Warsh some optionality to see how, you know, the jobs report that we get later this week plays out or how inflation that we'll get next week before the next meeting plays out. But I think that the bar for a hike is probably a little bit lower than it was prior to the speech. And it seems like Warsh might be on board with more of the officials who are leaning towards a hike.

One final point, Liz Ann, that I'd bring up is something that Warsh said that … not that I worry, but I wonder if it boxes him in a little bit. And there was a line in the speech where he said that "Market prices show confidence that we," 'we' meaning the committee, "will deliver price stability." And he said, "I can assure you they're right." So he's saying that the markets believe the committee will deliver price stability. So either that means they might need to hike to deliver that, or if they don't hike, it shows that the decisions made by the Fed over the past few months were the right decisions.

And he kind of went out of his way to maybe diss the Fed a little bit prior to him joining and talk about mistakes that were made. And so if he doesn't hike, it's almost suggesting that they made the right decisions before I came in, even though I've chosen to kind of call them out publicly. So I worry a little bit that he boxes himself in. I do think they're data dependent. We'll see how the next few readings of the labor market, inflation play out. But the bar for a hike, I believe, is a lot lower than it was just a week ago.

Now with that, Liz Ann, we've seen some movements in the stock market over the past week or so. We see stocks generally down a little bit. How did they react to the comments? And do you think the more hawkish pivot and the potential for future rate hikes, did that play a role in any of the stock market movements?

LIZ ANN: Yeah, so you're right, Collin. And those were … particularly your final points were super interesting, and I agree with everything that you said. Before I get to the stock market reaction, I also got such a chuckle at how Warsh started this speech with a discussion about two different kinds of hikes: the more intense kind of hike where it's more of a technical climb and then your meandering kind of hike. And I don't think that that was by mistake or coincidental.

COLLIN: Yeah, I mean, so maybe, you know, did everything I just say, does that matter less than the fact that he opened the speech talking about hikes? You know, was that a little nugget in there?

LIZ ANN: Yeah, I think it was a nugget, and I wonder whether he had a little bit of a smirk on when he was working on the beginning of that speech. So I thought that that was well done. It kind of showed the human side of Chair Warsh. So yes, we did see some weakness in the equity market as we're taping this, notwithstanding some strength today. But I think it's also important to look under the surface of an index like the S&P 500® at how sector performance has arrayed in the aftermath of that speech. And to me it's not terribly surprising at the high end of the ranking, perhaps no surprise, is the energy sector. And that's tied less of course to what Warsh talked about at Jackson Hole and more to the pick back up in in oil prices given re-escalations in the Iran war. But second to that was the healthcare sector.

So a little bit of a move toward defense in the aftermath of his speech. And then on the other end of the spectrum, the underperforming areas have been industrials and technology. In the case of technology, it's generally considered one of those long-duration segments of the equity market. And when you face higher interest rates, higher yields in this case, it tends to put downward pressure on those longer-duration segments of the equity market. And industrials is also a function of some of the concerns about the build-out of AI, the investments in data centers.

We're in political season now. And fortunately, you and I never really have to go there, other than if we have Mike Townsend, our colleague, on. There is so much backlash right now on data centers. It's really become a political hot-button issue. That plus re-escalation of the trade war and much more front-and-center discussion about tariffs, all else equal, I think, put some pressure on industrials, which has been the worst-performing sector over that period since Jackson Hole.

You know, back to the hiking fun that Warsh had at the beginning of the speech. I think there was an important message in there. And I'm increasingly getting questions about how the equity market behaves in a tightening cycle. And it obviously varies because it is not just what the Fed is doing with rates that impacts the market. There are myriad things that impact the stock market on a day-to-day, week-to-week, month-to-month basis. And it's hard to really segment out a precise driver absent all the other drivers for the market.

But if we go back in time and look at all rate-hiking cycles in the post-World War II period of time. So it's an ample array of data. And you just look at the percentage change in the S&P 500 from the point of the initial hike out the first year, all first hikes, the average performance for the S&P in that one-year subsequent period is about 4.5%. But interestingly, if you break out the cycles between slow cycles and fast cycles, slow would mean cycles where the Fed is maybe taking the escalator up, they're not necessarily hiking at every meeting, they're a bit more methodical throughout the course of the cycle.

Those slow tightening cycles, the market's one-year performance has been 10.5%. On the other hand, if they are fast tightening cycles, they're moving at every meeting. They might have even more than your normal 25-basis-point move up. The average performance has been down a bit more than 3.5%. What may be also interesting … and by the way, Kevin and I are writing about this next week, so keep an eye on our X feeds and Schwab.com because we're going to do a full look at tightening cycles historically. But there's also something called a non-cycle, which is sometimes if they do a one and done or maybe just a two and done, it doesn't turn into an elongated cycle. Maybe no surprise there. Those have had the best subsequent performance, actually up about 11.5%. So speed is a factor.

There's so much focus these days, as you well know, Collin, on the level, you know, what is some sort of trigger, psychological or otherwise? I get the question all the time, "OK, Liz Ann, what matters to you as it relates to implications for the stock market? Was going through 4.75% on the 10-year it? What if we get close to 5%?" And it's kind of common to use these round numbers. And I do think it comes into play in terms of psychology, and it can be a volatility driver in the short term. But ultimately, it's less about level, more about not just speed, which we already talked about, but the why behind what the Fed is doing. You know, are they chasing a runaway inflation problem? Are they just trying to ease maybe overheating economic growth? So there's also lots of different reasons behind what the Fed is doing, but it also brings up a more secular discussion about which we've been writing for quite a few years now, and that is the end of the so-called Great Moderation Era. And this is where the world in which you live day-to-day and the world in which I live day-to-day really combine together to represent implications for individual investors.

So the Great Moderation Era, which went from the late 1990s up until the 2022 spike in inflation driven by the pandemic. And I think it was Ben Bernanke that coined the term "Great Moderation." And there were lots of forces driving what was a fairly moderate backdrop during that secular span, not least being that there was not a lot of inflation volatility, not elevated concern about inflation igniting, generally a disinflationary backdrop, in large part courtesy of major globalization, China joining the WTO, World Trade Organization, in 2001 and flooding the world with cheap and abundant access to goods and labor. We had the energy revolution in the United States with fracking and shale giving us the ability to move to a, you know, a net energy exporter. So all of those things conspired to make the interest rate backdrop relatively benign, but maybe most important the correlation between the 10-year Treasury yield, which is the most relevant yield for the equity market, and stock prices was positive in that environment, other than an exception in the 2008 financial crisis period when oil spiked, when bond yields were moving higher, typically stocks were moving higher too, because the yield was keying more off the growth side of the equation, less off the inflation side of the equation.

So if yields are moving up because growth is improving without the attendant concern about a risk of inflation, that's nirvana for equities and vice versa when yields were coming down. But if you go back to the 30-plus years that predated that, mid-to-late '60s to the late 1990s, we coined the term "Temperamental Era" a few years ago to describe that. That was a period of heightened inflation volatility. That's not the same thing as saying inflation was high in perpetuity for that 30-plus-year period of time, but much more volatility, inflation, more economic volatility, shorter cycles, more frequent recessions. Interestingly though, the growth phases were higher on the upside, more uncertainty with regard to monetary policy, supply shocks, geopolitical crises, and for much of that 30-plus-year period of time, bond yields and stock prices moved in the opposite direction because typically in that environment when bond yields were moving higher, it was often because inflation had reaccelerated or was viewed as being let out of the bag again, negative for the equity market and vice versa.

And more recently we've been back in negative correlation territory again between the 10-year yield and stocks. And I do believe it may mark a secular change, not necessarily back to what exactly was happening in the Temperamental Era. I think there's a lot of differences, particularly between now and the 1970s, but it is a different backdrop for investors, because, just to remind investors that don't live, eat, and breathe this every day like you and I do, when bond yields are going up, bond prices are going down, and vice versa.

So the relationship between stock prices and bond prices, they moved positively relative to one another in that Temperamental Era, making it at least on paper a bit more difficult through a simple diversification scheme like 60/40 to get that diversification. That was not the case in the Great Moderation Era. That gave rise to the whole notion of a 60/40 type portfolio because of the offset of prices moving in the opposite direction. So we'll continue to write about that. As I mentioned, we're going to be talking about or writing it next week about Fed rate-hiking cycles. So it's not just the level, it's the speed, whether it's orderly or not, and ultimately it's the why behind what yields are doing that historically has defined how the stock market behaves.

COLLIN: Let's talk about that a little bit. So I look forward to reading that article. That'll be good because I agree that level and change … well, they're different things, and that can matter along with speed. You know, when I look at the level of interest rates, and this whether it's for the economy as a whole or for companies and businesses, you know, there doesn't appear to be too much restriction, I'd say. You know, it doesn't seem like the level of borrowing costs … well, one, it's not scaring away corporate borrowers right now, certainly not tech and hyperscalers, but issuance across the board's very high. And I think a key reason for that is what the borrowing costs are relative to what we're seeing, again, whether it's the economy or with corporate earnings. I mean, nominal growth in the second quarter was 6.2% year-over-year. So well above, you know, borrowing costs for our government.

And when you look at corporations, you know … and you and I, we both look at this, Liz Ann, it's not just S&P 500 earnings, but it's, you know, corporate profits from the GDP report. And we got that last week. And I think on a quarter-over-quarter basis, I think pre-tax profits were up 9%, and I think 22%. We get that from the Bureau of Economic Analysis. So if corporate profits are growing 22% year-over-year, and you're an investment-grade corporation who can borrow at 5%, I would say that the level of borrowing costs isn't phasing them too much.

LIZ ANN: Correct. And then that's really important because there's so much focus on these levels, but you're absolutely right, Collin. You got to actually look at what the impact it's having, and are we seeing constraints in terms of the availability and/or willingness to borrow? And certainly as it relates to the AI build-out story, the answer so far is a no. And the one thing I will say about strong earnings growth, and it's so good to see that National Income and Product Accounts version of corporate profits, which comes out with GDP that you mentioned, as strong as it is, because that's a much broader measure of corporate profits than what we get out of S&P. The market tends to focus on S&P profits, but that's just a … you know, that's 500 companies. NIPA-based profits is thousands of companies, and it's large and small and those that trade in the public markets and private companies. And we had a divergence last year where S&P profits were strong, but you were actually in negative territory for NIPA-based profits. And to see that reacceleration tells you that this is a broad economic story, not just one tied to a theme like the tech sector or the AI build-out. So that was good news.

COLLIN: Let me build on that also. I love hearing these things from you because I have questions. So I'm sure our listeners have questions, too. So AI is clearly a theme. The data build-out, I know that I'm seeing that with corporate-bond issuance. We got, you know, really big numbers from the Nvidia earnings report, not just from an actual quarter, but I think expectations. But there's a lot of questions these days about, you know, data centers in the U.S., and this has become a bipartisan issue where what … you know if we go back, I don't know, a year, two years, you know, it was kind of celebrated. "Look at all this." But now there's a lot of pushback. And what started as, you know, a small, I think, movement is spreading across the country, about the idea of, you know, "not in my backyard." Or what are the risks to these build-outs? That that's probably a story for another day, but what kind of risk does that pose if we were to see a slowdown in that build-out?

LIZ ANN: I think it's a risk that we do have to monitor. And it is extraordinary how much this has built just over the last several months. It really started with … back in May, which is a college commencement address season of the year, and how viral some of these speeches went where a commencement speaker mentioned data centers or even just AI and got loud, loud boos from students. So this started as something that was a groundswell of frustration and … some of it may be related to data center build-outs, but it was probably more concern about AI and the disruption of the labor force, whether that was a legitimate concern or just a concern about the near future, or an obvious concern as you're graduating college and what job opportunities are, but then it became much more of a political hot-button issue. And to your point, the NIMBY, "not in my backyard."

And but there's other constraints here, too, that I think we need to be mindful of. That is one of them. But just the surge in the cost of memory, because AI data centers just … they demand a growing share of the world's supply. So I think those supply-oriented constraints are coming into play. In the meantime, though, Nvidia's report was phenomenal.

They continue to invest in other companies so that it kind of, you know, keeps the circle going. And what was also good about Nvidia, say, in contrast to Samsung's report a month or so ago, or maybe even longer than that, Nvidia beat not just the sell-side consensus, which are the published consensus expectations of analysts covering their stock, but also what is often the much higher buy-side expectations bar. And that that gave support to the story that this is an ongoing force. But I do worry about some of those supply constraints, inflation within AI.

And the other thing, too, is that we recently got the update to second-quarter GDP, and one other thing I wanted to point out as it relates to the AI spending boom, the capex boom, is non-residential fixed investment, which is the line item in GDP representing business capital spending, that has had very strong growth. Two quarters ago it was double-digit. I think this past quarter it was about 8.5%. A big chunk of that spending is on imports, where you saw the line item for imports up, I believe, 12% or 13% for the second quarter. So that's a very big number.

The problem is that our export number growth rate was lower. And the way the math works in GDP is, because as a country we import more than we export, the trade line item actually is a subtractor from GDP. And, in particular, if imports are growing much at a much sharper rate than exports, it actually acts as a drag on GDP. So you had this boom in business capital spending. You had the boom in imports associated with that, but that trade piece actually acted as about a 1% drag on GDP. So just wanted to explain that in the in the numbers as it relates to just the math associated with GDP.

COLLIN: Well, I think, Liz Ann, we can look forward to hearing more about these build-outs, the pros and cons, not just in the weeks but in the months to come, maybe even years. So we'll be hearing about that.

But let's focus more short-term now. We do have a long weekend coming up, so we have a holiday-shortened week next week, but what will you be looking at, and what can investors be paying attention to next week?

LIZ ANN: Well, we'll certainly still be digesting the jobs report, as is typically the case. We record this in advance of a Friday jobs report. So that might still be getting digested depending on whether it's an upside surprise or a downside surprise. We also get the National Federation of Independent Businesses. That's a small-business think tank, and they have an overall headline reading on optimism, but there's a lot of subcomponent questions. One that I pay attention to is a question about "What is your single most important problem?" And that has jumped around a bit. Inflation was at the top of the list for a while. You've had taxes at the top of the list because many small businesses, rightly so, weave tariffs into taxes, so they answer it with a collective thought because a tariff is a tax. And quality of labor, so watching how those array.

We also get consumer credit data. That might be increasingly something worth watching, given concerns about at least the lower part of the K-shaped nature of this, the lower-income folks, and where maybe we might start to see some stresses. But probably the biggest numbers out next week are the Consumer Price Index and the Producer Price Index as the next reading on inflation. And those can be important because, unlike the Personal Consumption Expenditures price index, which Kevin Warsh reiterated was the Fed's preferred measure, PPI and CPI can sometimes be reported outside the bounds of expectations because you don't really have the inputs.

Once you get CPI and PPI, you can map that to PCE, which is why PCE doesn't tend to surprise as much relative to the economic consensus. And then we get a couple different versions of inflation expectations. The Fed's version comes out, and then at the end of the week, we get University of Michigan Consumer Sentiment Index, which has as a component of it forward inflation expectations. How about you?

COLLIN: Well, you mentioned the jobs report that we'll get this week, but after the podcast comes out. I do think that's still important. I know inflation is in the crosshairs of the Fed, but the labor market still does matter, and I think surprises matter. So upside surprise would probably make a hike more likely. A downside surprise, and maybe if we got another month of job losses for non-farm payrolls, maybe that, you know, gives the Fed some pause and about hiking into an environment where maybe the labor market's cooling more than they expected. So surprises still matter.

You know, as it relates to the Fed, as you mentioned, PPI and CPI. They'll be very important. I think that the bar for a hike has come down. And I think we have to look for progress. You know, prior to Warsh's speech, I thought, you know, inflation readings that were meeting expectations was probably good enough for them to remain on hold. But now we might need to see better-than-expected, true progress there.

Moving to other parts of the market, next week is the start of the upsized Treasury buyback operation. We've talked about them. Treasury Secretary Scott Bessent has mentioned that they're upsizing the sizes of the so-called liquidity support buyback operations. The current size is two billion. Beginning next week, September 9th, they will be at least 4 billion. It'll be interesting to see what the sizes are because Bessent has told us they're at least 4 billion. You know, so that seems to be the floor. What will that ceiling look like? It'll be interesting to see. I think the signal matters more than the actual operations themselves. So I think we already know what his plans are, but the actual execution and sizings, I do think, will matter.

And then next Friday we get the Fed's Z1 account, the financial accounts of the United States. It gives us a really big-picture look at household balance sheets, corporate balance sheets, kind of just the state of households, the state of businesses. There's a lag, of course, but it is a really good cross-directional asset class, households, businesses, you know, just view the economy. How are they doing? That's something I always pay attention to with regards to the corporate bond market because it breaks out debt growth. Again, not just at, you know, publicly traded companies, but it's much more comprehensive, as well as kind of what their balance sheets look like, liquidity, short-term liquid assets, things like that. So I will be paying attention to that as well.

Liz Ann, I think that's it for this week. As always, thank you all for listening. As a reminder, you can always keep up with us in real time on social media. I'm @CollinMartinCS on both X and LinkedIn. It's Collin with two L's, and the CS is for Charles Schwab.

LIZ ANN: And I'm @LizAnnSonders on X and LinkedIn. Still have lots of imposters, so please make sure you are following the real me. And you can find all of our written reports., those always include lots of great visuals, charts, and graphs and tables. And they can be found at schwab.com/learn. And anything that we write, Collin, you and I, we always post it on our feeds as well. So that's one-stop shopping.

And if you've enjoyed the show, please consider leaving us a review on Apple Podcasts, a rating on Spotify, or feedback wherever you listen. And please tell a friend or more about the show. And we will be back with a new episode next week.

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