A Crystal Ball Reading on the U.S. Economy with the Chief Investment Strategist of Charles Schwab, Liz Ann Sonders.
Liz Ann Sonders is one of the most respected investment strategists on Wall Street, with over three decades at the top of her game. On August 19, 2019, I asked her to peer into her crystal ball on what the rest of the year, and 2020, have in store for equities, and what Main Street investors should be doing to both profit and protect themselves.
Natalie Pace: Let’s start off with your crystal ball for 2019 and 2020.
Liz Ann Sonders: My crystal ball is cloudy these days.It’s a tricky landscape. We continue to think that we are late in the cycle. The manufacturing economy is quite weak, on the verge of a recession. The global manufacturing economy is arguably in a recession. So far, it has not transferred over to the services or the consumer side to a significant degree. That’s what is important to watch as we head into the latter part of the year.
NP: Are you concerned about the weakness in manufacturing causing a downturn in the stock market?
LAS: Right now, the weakness is concentrated in manufacturing. We had that a couple of years ago, which didn’t bring the overall economy down with it. You can have manufacturing only recessions. If we don’t see a lift from here, either driven from lower interest rates by the Fed or a trade deal, and manufacturing continues to weaken and it starts to filter into the consumer side, then the risk of a recession goes up. Current conditions do not suggest that. But we have to understand how the manufacturing weakness historically can morph into broader economic weakness. That is why manufacturing indicators are leading indicators. They tend to weaken first, before the consumer side of the economy.
NP: This year is projected to grow 2.1% compared to 2.8% last year. That is far below the 3% or higher GDP that is needed to pay for the tax cuts. What happened?
LAS: Tax cuts were put in place on the corporate side to stimulate capital spending. We were hoping to see business spending take over from consumer spending. Then, a few months after the tax cuts, the trade war was launched. That caused business confidence to come to a screeching halt. That offsetting force is the reason why we’ve seen the economy slow. In this environment of uncertainty, where a Tweet can change the landscape, businesses are basically saying, “We’re going to keep our powder dry here.”
NP: The White House Tweets boast about all of the money we’re making on the tariffs. However, aren’t tariffs simply a tax on businesses and consumers that flows into the government coffers?
LAS: We pay the tariffs. Tariffs on Chinese goods are basically taxes that U.S. companies that are importing goods from China have to pay. As tariffs persist or increase, companies basically have decisions to make. Yes, they can adjust their supply chain and move manufacturing from China to Vietnam or Indonesia, but that can’t be done on a dime. That’s a longer process. In the short term, companies can eat the higher cost in their profit margins, or pass on some or all of the higher costs to consumers, or some combination of both.
NP: Businesses have weighed in en masse against the tariffs. However, Main Street doesn’t seem too concerned, at least not yet.
LAS: This next round of tariffs – which were supposed to kick in on September 1st, some of which were delayed until September 15th – are much more heavily weighted toward consumer goods. That’s why you’ve seen some consumer goods companies, like Wal-Mart (which just had great earnings), say that they are going to pass at least some of those higher costs onto consumers. In the beginning of the trade war, it was a bit more esoteric. There wasn’t as much understanding about how tariffs work. Now it’s starting to hit home.
NP: Are we seeing any negative impact from tariffs on corporate earnings?
LAS: Deere & Co. last week reported negative earnings which was very much tied to trade. More and more, companies on earnings conference calls are starting to quantify the impact that tariffs have had and likely will have. The landscape has definitely changed.
NP: Analysts point out that the French should make wine, not the English – that each area has natural strengths and weaknesses, which should be played to for the benefit of all. However, the pendulum has swung from globalization to nationalism and protectionism.
LAS: There is nothing perfect about the way our world works. There are flaws and hopefully things we can try to adjust. What has happened over the last decades is that the United States has moved away from traditional manufacturing and toward the intellectual side, in areas like artificial intelligence, robotics and new-age manufacturing. We’ve become more of a services-oriented economy. We’ve outsourced some of the traditional manufacturing to other places where it can be done more cheaply. Again, this is not a perfect system. However, globalization, and the competition that comes from globalization, has kept inflation very much in check around the globe. If we continue down this path toward protectionism and nationalism that potentially has implications for inflation.
NP: What’s the bottom line on tariffs? Are they good or bad?
LAS: Trade wars are not easy to win. Everybody involved gets hurt. What we are seeing is the impact on psyche, the impact on animal spirits. That’s happening. That’s not just perspective.
NP: Our concerns have been deflation for so long that inflation is just not on the radar. Are you concerned about inflation?
LAS: I’m always at least as intrigued by the story no one is telling as the story that everyone is telling.The story everyone is telling right now is that inflation is dead and buried forever. I can’t help but to play Devil’s Advocate in my own head and think, “If this very pat consensus turns out not to be true, what could be the factors that cause a surprise away from that consensus?” Deglobalization/protectionism could be one of those forces. We don’t see [inflation] now. I don’t think we see it in the near-term.
NP: Globalization has also kept the interest rates on our rather substantial $22.46 trillion public debt quite low…
LAS: For now, we’ve had no problem attracting investors to our Treasuries. We’re in an environment where $16 trillion of global debt has negative yields. Even though our yields are low, relative to negative yields in much of the rest of the world, it’s a pretty good bargain. At some point, that’s not going to continue.
NP: So, does the recent rate cut of the Federal Fund rate have you concerned that we’ll move closer to that negative yield range, where the appetite for our Treasuries might abate?
LAS: I hope we’re not in an environment where we are going to see negative rates here in the United States. What has been proven by having $16 trillion in negative yielding debt is that taking rates negative did not solve the economic problems in those regions. There was this idea that it would help pull these economies out of deflation, if you disincentivized hoarding money. But the exact opposite happened. It actually cemented the deflationary mindset and didn’t solve their economic woes. This idea that ever-lower interest rates is the elixir for what ails us, it’s just not the case. I certainly hope that we don’t feel that we need to go down that same path. It’s been a failed experiment globally… so far any way.
NP: Interest rate cuts helped bonds to keep nest eggs buoyant in the last two recessions. We’re starting out so low this time, at 2%, compared to 4.75% in June 2007 and 6.50% in June of 2000. Should Main Street investors rethink the safe side of their portfolio?
LAS: We continue to think that you want to stay pretty defensive by using treasuries as a diversifier. In the equity market, be defensive. This is not a time to get out over your skis and take on a lot of risk.
NP: The Feds have been pointing out that 50% of the investment grade bonds are at the lowest rung – just above junk bond status. Are bonds carrying more risk than Main Street realizes?
LAS: [Investment grade fixed income] is a risk that we’ve been pointing out. If there is any area within markets that you can attach the bubble label to, it would be that. There is a heavy shift toward a large percentage of the so-called investment grade that are down in the triple B, the lowest rung. If things deteriorate, and you move into junk status, that can cause a lot of problems. This highly indebted, weak component of the corporate sphere will mark the end of this cycle in some way. But we don’t think it represents something akin to what happened to housing in 2007.
NP: Do you have any other tips for navigating your nest egg through the late stage of this business cycle?
LAS: For two years we’ve had an overweight to large cap and an underweight to small cap. A record high percentage of small cap companies don’t have profits. Many are zombie companies, where they just don’t have the cash flow to pay debt. They’ve been feeding out of the trough of low interest rates to survive. In a normal interest rate environment, they would never survive.
NP: We’re both big fans of rebalancing. Will you explain why this is such a key part of a sound investment strategy?
LAS: Rebalancing should always be part of a disciplined strategy. Think about the old mantra of “Buy low, sell high.” We all know as investors we’re supposed to do this. Unfortunately, when left to our own devices, we often do the opposite. The stock market is the only market where when things go on sale, we tend to run in the opposite direction. We seem to be more enthusiastic buyers when things are expensive. If Neiman Marcus had a 50% off sale that might be more intriguing to me than if they had a 50% markup.
What investors need to think about is that rebalancing does two very important things. It forces us to do what we know we’re supposed to do, which is to buy low, sell high, or add low, trim high. If you have a big move up in domestic equities and
[your exposure]
goes from 45% of your portfolio to 55% of your portfolio, your portfolio is telling you it’s time to do something. It puts investors on the right side of the trade.
It also means that you don’t have to worry about short-term market timing. We should never think about our portfolio as get in/get out, all or nothing. That is a losing strategy. The data has proven it for decades.
NP: Any last words of wisdom?
LAS: This entire bull market, until about a year and a half ago, didn’t get any respect. Everybody was skeptical about why it was moving up and when the next shoe was going to drop. In January 2018, it was like somebody flipped a switch. I’ve seen these bursts of optimism. I saw it then. I saw it again in September of last year, and started to see it again in both April of this year and July.
Sentiment is a contrarian indicator. At extremes of optimism, the market has historically done quite poorly, and at extremes of pessimism, quite the opposite. It’s not every single day that we look at it. But at extremes over the long term, it is an extremely valuable indicator. So, watch how sentiment shifts.
If you’d like to listen to my entire 25-minute interview with Liz Ann Sonders, go to BlogTalkRadio.com/NataliePace.
More About Liz Ann Sonders
Liz Ann Sonders analyzes and interprets the economy and markets on behalf of Schwab’s clients. She is a regular guest and guest host on many CNBC programs, as well as on Bloomberg TV & Radio, CNN, Fox Business News, Nightly Business Report, PBS NewsHour, Yahoo! Finance and TheStreet.com. Liz Ann is also regularly quoted in financial publications including The Wall Street Journal, The New York Times, Barron’s, Financial Times, Market Watch and Associated Press articles.