Motley Fool Money - Liz Ann Sonders on the Rolling Recession

Episode Date: January 13, 2024

Well capitalized companies are taking higher interest rates in stride.The zombies will have more trouble standing up. Liz Ann Sonders is the Chief Investment Strategist at Charles Schwab. Deidre Woollard caught up with Sonders to discuss: - Why investors should pay attention to the S&P 600. - Cracks in consumer spending. - The year of efficiency, part two. - A major tailwind for the economy. Host: Deidre Woollard Guest: Liz Ann Sonders Producer: Ricky Mulvey Engineers: Tim Sparks, Chace Przylepa Learn more about your ad choices. Visit megaphone.fm/adchoices

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The headlines are always payrolls and then the unemployment rate. But more often than not, the details under the surface of those two headlines tell a better story than just those headlines. And alongside the uptick in wage growth was actually another move down in hours worked. I'm Mary Long, and that's Liz Ann Saunders, chief investment strategist at Charles Schwab. Deirdre Willard caught up with Saunders. to go beyond the economic headlines. They discuss holiday spending and the ascent of buy now, pay later, the rise of part-time work,

and why investors should be careful when drawing conclusions from past averages. Well, let's start by looking a little bit back at 2023 and sort of just a quick thing about what surprised you most about the year. Well, coming into the year, there was a decent amount of momentum associated with what's called the average stock. you know, equal weight doing fairly well relative to cap weight. And we had expected that to persist a bit more into the year. And I think the, really what, what prompted what became an incredibly concentrated market with rightly so, all the attention on the Magnificent Seven and just how dominant

they became, that really started in mid-March, not coincidentally at the same timing as the banking crisis. And I think that that initially just fueled an interest. in the mega cap companies that had strong balance sheets that weren't going to be at the mercy of any significant problems in the financial system, which that didn't become a contagious event, of course. And then it was, I guess, exacerbated by all of the interest in AI.

So it was that that concentration kicked in in such rapid fashion and persisted throughout the year was the biggest market surprise, obviously geopolitics these days, the, you know, Israel Hamas war was the biggest external surprise. So it sounds like what we saw was really that run to safety and then really the start of generative AI kind of fueling that, that rise of the magnificence about, is that correct?

Yes. And, you know, it's not uncommon for cap-witted indexes to be biased up the cap spectrum in a relatively small handful of names. the problem arises when the rest of the market, the rest of an index like the S&P is significantly underperforming. And that was the case end of May into beginning of June, where you not only had the Magnificent Seven accounting for more than all of the year-to-day performance at that point, you had less than 15% of the index outperforming the index itself over the prior 30-day period, 60-day period. So it was the bookends of concentration and really weak breadth and lack of participation that developed the risk associated with concentration. And as the year unfolded,

particularly during the correction phase that we had from late July to October, that you started to see a broadening out and that has continued. And I think that that's a healthier underpinning for the market. So do you see that as one of the ongoing stories, of 2024? I do, but one thing we've been cautioning investors about is in the interest of moving away from just the top five to ten names from a size perspective, you know, there is a lot of interest in moving down the capitalization spectrum into smaller cap areas. I would say don't sacrifice quality.

In an index like the Russell 2000, it still has a decent percent of the combination of non-profitable companies and what are often called zombie companies, companies that don't have the sufficient cash flow to even pay interest on their debt. So I think there's an opportunity to look for interesting ideas and spots within the market that are not just the biggest names, but you definitely don't want to sacrifice quality. And on that note, a lot of people don't realize that even though the Russell 2000 is more commonly used as a benchmark for small caps, there's also the S&P 600. And although not used as commonly as a benchmark, SMP uses a profitability filter in constructing that index.

So you automatically start, and I'm not suggesting buy an index fund based that, but if you're a stock picker and you maybe typically start with an index as a source, just know you're getting a higher quality profile in the S&P 600 because of that profitability filter. Thinking also about the thing that everybody wanted to talk about last year, and of course continues on with this year is interest rates. We've heard so much about the soft landing versus the recession. And in a report that you had, you came out with this different take of the rolling recession concept, I think is very smart. Can you explain what that is and how it might play out? Sure. And it's not really a formal, you know, financial markets textbook term that has a lovely definition like a definition of a recession from the NBER. But I think it is the most apt way to think about this unique cycle. And no one wants to rehash the last three and a half years, but we do have to go back to the stimulus era of the early part of the pandemic when you had both massive monitoring.

fiscal kicking in at the same time. Well, what that had the effect of doing was obviously boosting demand, and it pulled the economy very quickly out of what was a very short-lived but painful recession, but it was also at a time where the services side of not just the U.S. economy, but the global economy was effectively shut down. So all of that stimulus and the demand associated with it got funneled into the goods side of the economy. And it didn't just happen in terms of where economic growth resided, it happened in inflation data as well. The initial surge in inflation was very goods oriented. But fast forward to the more recent period, you've seen goods inflation go to goods disinflation to now in many categories goods deflation and many

of the goods categories within the economy like housing, housing related, manufacturing, a lot of consumer oriented goods that were big beneficiaries of the stay-at-home lockdown phase of the pandemic, those have had their own recessions, in fact, fairly deep recessions in some cases. But more recently, you've had the later pent-up demand revenge spending on the services side. It is also woven its way into services categories of inflation later. Inherently, many of those categories are stickier in nature like many of the shelter components. So we are starting to see disinflation there, but it's happening at a much later point in time and a bit slower. And you've had some weakening on the services side of the economy, but not to the degree that you saw on the good side.

So when I think looking forward, best case scenario is not really a traditional soft landing because that ship already sailed for many of those parts of the economy that have had hard landings. it's that we continue to see some roll through, meaning if and when services and related the labor market gets hit that you've got offsetting stability and or maybe even recoveries underway in areas that have already taken their hit. So I've sometimes been criticized for using rolling recessions as a term, fine, that's fair. But the reality is that is what has happened. You know, what term you want to use to describe it, that's personal choice. But that's that, is what has happened. And it's just, it's a very unique cycle for lots of reasons. And it's, I think they, visually, it's the best way to think about this whole recession, simplistic

recession versus soft landing debate, which I think misses the important nuances of this cycle. Yeah, absolutely. And I'm sort of fascinated by that goods and services thing that we saw play out last year. Things like travel, the so-called revenge travel is still going on. But what are you looking for with regard to the consumer? I mean, the holidays, the holidays were good. It seems like the spending numbers were strong. What are you looking for for this year? Yeah, I don't, holiday spending was fairly strong, clearly biased toward online versus in store. And then you had some underlying things that probably bear watching, like not much of an increase in credit card use for spending, but a huge surge in buy now, pay later. And that makes sense for the user of a

system like that because the fees are less, the rates are less. But when you look at the background conditions for the consumer, particularly if you look at various sort of income segments or net worth segments, you have, for the most part, seen a full drain of excess savings for those lower income cohorts. And that suggests that we do have some segment of consumers that are arguably a bit tapped out. Savings rate is down. The excess savings isn't there. Obviously, things like increased credit card use, which has been significant, notwithstanding the shift recently to buy now, pay later, you know, brings with it incredible interest costs. And then you add in the return of student loan payments. You've started to see auto delinquencies pick up broadly, but particularly

for subprime down the income spectrum. You're seeing the same thing in credit card delinquencies. So there are some cracks that have started to form, maybe not in the aggregate for the consumer, but where the health still exists is more up the income net worth weight spectrum. But even there, you have started to see a rolling over in things like luxury goods. So I think we're probably at the tail end of an environment where consumer spending was much stronger than a lot of people thought it would be, particularly given that consumer confidence has been so weak. So we've been in this weird environment, what they're saying is pretty dour, but what they're

doing is in stark contrast to that. I think we may be now at a point where we're going to notice more frugality, even if inflation continues to come down, which is obviously a particular benefit to those on the lower end of the income spectrum, because that just acts as a much more direct kind of tax on lower income consumers. But I think that excess saving story is largely in the rearview mirror now. But it's interesting, too, thinking about, you talked about jobs and wage growth and how that factors in. So you're looking at delinquencies, you're looking at how the consumer is saving or not saving. What else are you looking at to sort of judge where we're at right now? So wage growth continues to be strong. And there's nothing wrong with that. We all want people

to be employed and make, you know, decent wages. The rub, of course, is as it relates to Fed policy. And I think that that was one of the clouds that maybe came on to the horizon with the most recent jobs report for December is you saw that uptick in wages. And there's that potential connection point to inflation and maybe provided the Fed some discomfort that they maybe have a little bit more to go in terms of bringing inflation down to or near their target. But in addition, also as part of the monthly jobs report, which the headlines are always payrolls and then the unemployment rate. But more often than not, the details under the surface of those two headlines tell a better story than just those headlines. And alongside the uptick in wage growth was actually another move down in hours worked.

And so that's a sign of. of what is also unique in this cycle. This notion of labor hoarding is very valid. Companies are hanging on to their labor. They're more hesitant to put out large layoffs. But ours works reflect whether it's an interest in protecting margins or just a demand side of the economy story. I think that tells a story of a little more economic weakness

than you might pick up if you only, focused on the headline beat of payrolls or the lack of any move up in the unemployment rate. The other thing I'd say about payrolls and the unemployment rate is payrolls comes from the establishment survey that the Bureau of Labor Statistics does. That counts businesses. And every month, they have something called the birth, death adjustment. It's just a, it's not the birth and death of people. It's the estimated birth and death of businesses. and they tend to overestimate births and underestimate deaths when you're in a slowing economy. For the 216,000 payroll jobs created per that survey that we got last Friday for the December jobs report,

I think it was 110,000 of that was driven by these birth death assumptions. That's probably outsized. And it's one of the reasons why every month, in 2023, with the exception of July, has been revised down. We don't know whether December will be revised down because we won't get that until the January jobs report, which doesn't come until February, but also the household survey, which is a survey of people. That's where the unemployment rate is generated from. That saw a decline of 683,000 jobs. You also had a similar, I think, it was $657,000 decrease in the overall labor force.

The fact that those two offset each other is why the unemployment rate didn't go up. However, that's the unemployment rate staying steady for the wrong reasons, a decline in the labor force and a huge decline in jobs. It's also the case that more than all of the job declines, the household survey job declines, were full-time. The only job gains per the household survey were part-time. And so that's another kind of underlying message of some weakness, some cracks, that if you only listen to the headline of 216 versus 170 consensus and still low 3.7% unemployment rate, you'd say, why, everything's hunky-dory. The details are a bit more cloudy, if not dower, in some cases.

Yeah, good reminder to look at those revised numbers, because I think those don't get reported the same way that the originals do. They do not. And it really matters. In fact, in a recent report that I wrote that was just posted a couple of days ago on the December jobs report, it was called mixed signals. It's on Schwab.com, the public site. You know, talked about, as an example, what happens when you're sort of in the moment heading into a recession. So I used the period from mid-2006 to kind of, or late-2006 to the end of 2008. And what's interesting is if you go back and you look at, say, a chart of what monthly payrolls were in that period leading into and during, you know, the financial crisis, they, what you would see now if you pulled up a chart is the data post all the revisions. So what I did in this report is I put a comparative bar chart together where for each month, the first bar was what was initially reported versus what ultimately we know was happening based on all the revisions that the BLS does.

And the net is that over the period of time we looked at, at the time, you would have thought one million jobs were created, which is part of the reason why even into the first half of 2008, look at a lot of headlines, newspaper headlines, magazine headlines, research report headlines that were saying, yeah, there's stuff going on with housing, but no recession risks because job growth is so strong. Well, during that period, at the time, we thought a million jobs have been created over that span of time, when in fact, post-revision's 2.2 million jobs were lost. So context is really important. Again, I'll just remind you that if you go back through any kind of typical charting service and you look at a chart of payrolls or any other economic

data point that is subject to revision, what you're seeing is the post revision numbers, which at that time, you didn't have those. Right. That's not what people were reacting to. Right. Right. And by the way, this, you know, I know I often sound like Debbie Downer when talking about recession or rolling recessions.

To be perfectly honest, we're going to get a recession, you know, an officially declared recession by the NBR. That's how cycles end. It's always going to happen. We never know when. I think the economy cracking a little bit more here sooner rather than later would actually be better from a market backdrop perspective and maybe even from an economic perspective, because that would allow the Fed to not just be in pause mode, which they're in now, but actually be able to look at loosening policy. And I think the market is right now a little bit sort of over skis in terms of expecting five or six rate cuts this year, including the first one coming as soon as March. I think maybe that's a little aggressive. But more weakness sooner rather than later, I think,

would keep the weakness more constrained. I think would be better for the economy from a Fed policy perspective and probably a better backdrop for the stock market. Yeah, absolutely. Because I think that that happens where we wait and Fed waits until it gets bad enough and then all of a sudden it's rate cut, rate cut, rate cut. So what you're saying it sounds like is take a little bit. bit of the pressure up and have a more gradual approach. Correct. Yeah, that makes a lot of sense. I want to talk about something else that gets a lot of headlines, which is the yield curve inversion. I think it's hard to make sense of, you know, there's a lot of headlines about it, but what is it and what might be signaling right now? So when the yield curve inverse,

so the normal relationship between shorter term interest rates, say the three-month treasury bill or a two-year treasury versus longer-term interest rates, normally there is a positive spread. So short-term interest rates are lower, long-term interest rates are higher, reflecting that if you're going to commit your money out for a longer duration, you want to be compensated for that. That allows the financial system, the banking system, to sort of borrow at low rates and lend out at higher rates. So that provides fuel for what the financial system does, which is provide credit, and help businesses, et cetera, et cetera. So that's the normal relationship.

An inversion comes when it's the opposite, where short-term interest rates are now higher than long-term interest rates. And it can happen for a variety of reasons with a different kind of ordering and timing. But in this case, obviously, we saw the Fed embark on a very aggressive tightening cycle, so they were dramatically raising short-term interest rates

to the point where they went above long-term interest rates. and that was reflecting the inflation problem with which we're still dealing in the most aggressive cycle in 40 years. So the yield curve inverted about, I think it's about 13 months ago. And it has had a pretty strong track record of, I don't want to say forecasting recessions, but being a precursor to recessions, especially because of the impact it has on banks and the financial system and credit availability. The lead time between a yield curve inversion and when recessions have occurred historically, I think the average is something in the, I don't know, 13 months or so, but the range is really, really wide. It's another example of when you don't have a large sample size and you

have a really wide range. It always makes me think of the old adage analysis. of an average can lead to average analysis. So the real net is if you look at the range, we're not past the so-called expiration date based on history in terms of what they call the long and variable lags of a tighter monetary policy cycle that causes an inversion of the yield curve. We're not well past anything that has happened historically

whereby one can say, all right, well, the yield curve didn't work this time. it was a false signal. Maybe we get there, but I don't think we're there yet. Interesting. So we talked a little bit earlier about the magnificent seven and really that sort of path that sort of led 2023. Looking forward to with AI, what continues to happen,

what kind of questions are you asking about the biggest gainers last year? Well, I think 2024 could still be a year. very focused on AI, but I think what we might be starting to see is a shift in interest away from just call it the providers, the creators, the semiconductor area, the sort of gears of AI to the users of AI, which of course that spans just about any industry, any sector, where companies are finding they can adopt AI, use AI, whether it's for efficiency or productivity or, you know, growing their business in other areas. To me, that's, I think, should be at least as much of a focus this year on just who are the providers of and creators of the engines of AI.

Now, who are the effective users of AI? And again, that's across the special. of industries and sectors. Last year was sort of, you know, Mark Zuckerberg called it the year of efficiency. And we saw a lot of companies being more efficient, showing that they were cost cutting. You know, do you think that that is something that's going to continue this year as well? I do. I think, you know, margin production, I think will continue to be a pretty powerful force. And so far so good because estimates for 2024 have been quite resilient.

And in part, it's because companies have been focused on protecting margins in an environment where, you know, unit demand has been coming down. The cost structure has been hefty, particularly on the labor side. And that's part of the reasons why, you know, a metric like hours worked shows that weakness, even if wage growth or layoffs have not. So it's another example of to see how companies. companies have been protecting margins, you do have to, you know, peel at least one layer back from the onion to see how they're doing it absent solely via the typical labor market part of the cycle

where you have, you know, mass layoffs and you see a pretty sharp increase in the unemployment rate. That has not been a characteristic, at least not yet, of this cycle. But companies have found ways to keep margins at a relatively healthy level. some of it is through what they're doing and cutting hours. Other has to do with investments that they're making in efficiency and productivity, inclusive of AI. And there's definitely this need to cut corporate debt. That was a big theme last year. So what are some of the impacts now, especially as money has become more expensive? So for well-capitalized companies, even many that on the books have a decent amount of debt, it's not really a problem. In fact, a lot

of, well, capitalized companies with generally strong balance sheets, took advantage of incredibly low interest rates, you know, the ZERP era of 0% interest rates, you know, the 10-year got down to a half a percent. A lot of companies took advantage of that. They might have borrowed, but typically it wasn't because they needed to borrow the fund their operations. They might have borrowed to pay a dividend or to buy back stock, or they termed out their debt, which is why we've seen so much resilience in the corporate sector in the face of an aggressive, you know, 40-year record aggressive cycle on the part of the Fed. And frankly, a lot of consumers did something similar. The massive shift from adjustable rate mortgages to fixed-rate mortgages

meant that this huge surge in interest rates did not bite as quickly, to the same degree, on the corporate sector, on much of the consumer sector. Now, on the corporate sector, that's exclusive of the weaker companies, the zombie companies that do have debt coming due. They have to roll over that debt at now much higher interest rates. And many of those zombie companies, even with lower interest rates that they've been paying on their debt, don't have the cash flows. So I think the hurt point is still to come for those weaker companies.

You know, zombie companies were really sort of propped up or allowed to stay afloat courtesy of zero interest rate policy. But I think the bills, you know, literally and figuratively will be coming due. Now, in my mind, it doesn't represent some moment in time the bottom falls out because every company has a different maturation schedule. It's sort of a rolling problem over time, but it's part of the reason where we're saying you want to stay up in quality when going down the cap spectrum and avoid those non-profitable zombie type companies. About the only segment that could have probably done a better job of lengthening duration, you know, terming out debt if you want to use it as the government sector. That's where the world of hurt is significant in terms of

increase interest that's being paid on debt. They didn't do it. But corporations and certainly homeowners did. That doesn't mean we no longer have any impact of rising interest rates. There are still our long and variable lags and there still will be an impact. But it's been muted because of what many smart companies and smart individuals did when the going was good in terms of very low, both short-term and long-term interest rates. So that has muted the impact. which is a good thing. Interesting. So as we wrap up here, you called yourself Debbie Downer earlier.

I don't think that's true at all. But what are you optimistic about? I'm a realist. Realism is good. So what are you at least real, maybe slightly optimistic about for this year? Well, some of it we touched on, which is, I don't want to say just AI specifically, but I think what we are shifting toward is an economic backdrop that is more investment driven and less discretionary consumption driven. In fact, we've already seen it. You know, GDP as a data

point is very lagging in nature. It's also subject to revisions. But what you get when you look at initially released GDP figures, but also the details within, and then you look at, you know, kind of subsequent revised data, one of the interesting things that we've seen over the past year is About a year ago, when we initially got, I think it was for fourth quarter, 2022 GDP, consumer spending represented more than 71% of the economy. The most recent data that we got for the third quarter, we won't get fourth quarter GDP for another week or so. But the data we have for the third quarter, which has already had one revision, now has consumer spending down to 68% of GDP,

and it's the investment side that has picked up. And that doesn't mean that CAPX is booming now, will boom imminently. We're in an uncertain time, especially for things like CAPX, between geopolitics and just labor market uncertainty and recession uncertainty, not to mention election uncertainty.

I don't think this is, an environment where companies are likely to really kick in a CAP-X cycle other than in areas that they deem really important and strategic. But when I think beyond the next couple of quarters, I think this is going to be more of an investment-driven economy. And that, I think that's a better backdrop for growth. I think it's a better backdrop for the employment situation, especially when you have not maybe this most recent cycle, but in past cycles, when consumption was growing so significantly as a share of the economy and it was happening off the back of debt. I think more of an investment-driven economy, both on the non-residential side, which is the terminology used within GDP, which basically

means business capital spending and the residential investment side. And then also weaving in government with public-private partnerships associated with infrastructure spending and CAPEX that has that bridge into public sector spending. I'm very optimistic about the investment side of our economy. Fantastic. Lysanne Saunders, thank you so much for your time today. My pleasure. Thanks for having me. As always, people on the program may have interests in the stocks they talk about. And The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Mary Long. Thanks for listening. We'll see you tomorrow.