Bullish corporate earnings forecasts for 2018 could very well be individual investors’ biggest source of trip-ups, Charles Schwab’s chief investment strategist Liz Ann Sonders tells ThinkAdvisor in an interview.
“Curb your enthusiasm” and do not count on highly optimistic 2018 earnings growth expectations to necessarily continue into 2019 and 2020, warns Sonders, a popular industry keynote speaker and frequent commentator on CNBC, Fox Business News and CNN.
Equity investors’ “biggest mistakes” occur when they bet wrong based on the corporate earnings outlook, says Sonders. She has been with Schwab since 2000, when the firm acquired U.S. Trust, which she joined a year earlier as a managing director and member of its Investment Policy Committee. (Schwab sold U.S. Trust to Bank of America in 2007.)
The country’s largest publicly traded investment services firm since 2015, Schwab had $3.48 trillion in client assets under management as of the end of January.
For the year ahead, Sonders predicts more market corrections, higher inflation and tighter monetary policy. In the interview, she argues that the Federal Reserve will raise interest rates more frequently in 2018, even in the face of higher market volatility and pullbacks.
Long term, her biggest worry is the federal deficit, and she explains what the government must do to substantially reduce it — or suffer the inevitable consequences.
ThinkAdvisor recently talked with Sonders, on the phone from Florida, where she was visiting Schwab’s Naples office. She discussed a disturbing cause of last month’s market correction — among others — but why she sees such upsets as “healthy” for investors. The strategist also elaborated on the three market sectors she believes will outperform this year as well as the three she pegs to underperform. Here are excerpts from our conversation:
What’s your outlook for corporate earnings this year?
Last October, earnings estimates for 2018 year-over-year were about 11% [growth]. Now it’s 19.2%. We’ve never had such a sharp acceleration. And that’s largely courtesy of the tax cut. The concern I have is that if analysts or investors establish a permanently higher plateau of expectation and extrapolate, and assume that kind of growth for 2019 and 2020, there could be disappointment.
I think investors make their biggest mistakes when it comes to tying together corporate earnings’ fundamentals and what the stock market is doing. I tell investors: “If your level of enthusiasm just ramped up because we’re approaching 20% earnings growth, you may want to curb that enthusiasm because at some point, the market is going to sniff out the eventual turn.”
In January, you said that you wouldn’t mind seeing “some healthy pullbacks” in the market. Please elaborate.
That’s because in January, we started to see the market look melt-up-like. If melt-ups continue to go on, they tend to be followed by meltdowns, much like what happened in 2000. In contrast, when the market is moving with fundamentals, has a normal pace of pullbacks or corrections and sentiment is in check, it’s a better long-term environment.
Do you foresee further corrections this year?
I think we could have more bouts like [the February correction] as we see some of the money and vehicles that have been tied to volatility’s staying suppressed forced [now] to unwind as we move back into what is a more normal environment. The lack of volatility was an exception. The return of volatility is more the rule.
Are you saying that corrections, net-net, are a positive for the market?
Yes. They’re painful, but they remind investors that markets don’t go up forever. I think that’s something healthy. And [corrections] also may be [showing] a change in character [in the market] and be a further indication that we’re later in this cycle.
What’s significantly different about the economy and stock market now vs. a year ago?
We’re in the later stages of the economic cycle with a pickup in inflation and are likely to get tighter monetary policy and more market volatility.
What are the risks of current monetary policy?
Several things have been unique about this cycle. One: We had the fed taking interest rates to zero. Then it started the quantitative-easing programs — never done before. Now the Fed is starting to unwind its securities holdings of $4.5 trillion. We’re backing away from that unprecedented stimulus.
What could all that mean to the market in the future?
We’ve gone from one uncharted territory into a different kind of uncharted territory. Most past episodes of volatility, late-cycle corrections and then a bear market — which we’ll get eventually — have been caused by tighter monetary policy. It looks different this time because we’ve never come off zero interest rates, and we’ve never shrunk a $4.5 trillion balance sheet.
Do you see a bubble about to burst or a meltdown on the horizon?
I don’t think we have a broad bubble that could take down the entire global financial system, a la the tech or the housing bubbles. There are some mini bubbles, however. But they don’t have massive leverage tied into them, and the counterparty [default] risk is nowhere as significant as in the tech or the housing bubbles. These aren’t going to cause trouble like a spike in volatility.
What approach do you expect from Fed Chair Jerome Powell this year?
If the Fed shocks anybody, then they just haven’t been paying attention. I think he’s going to maintain not just a lot of what Janet Yellen put in place but Ben Bernanke too, which is that transparency will stay high.
Can you talk specifics?
I believe that the Fed is going to raise interest rates at a more steady pace than has been the case in the last couple of years because the data will [likely] warrant it — growth going up at a higher trajectory, the output gap having closed, the labor market tightened sufficiently so that we’re now getting wage growth.
Why didn’t Yellen and Bernanke raise rates more often?
For the last eight years or so, the Fed [policy was] that if there was any kind of volatility or turmoil, they didn’t want it to morph into an economic problem. So they stepped off the brake pretty quickly.
And for this year?
I don’t think we’ll see that as much. The Fed is going to be more tolerant of higher volatility in both the equity and fixed income markets and also more tolerant of more frequent pullbacks. I think they see themselves on a path where rate hikes are going to be a bit more frequent than has been the case [in the recent past].
Is such tolerance a good thing?
Yes. It’s another sign that we’re in late cycle.
Why do you think the February correction occurred?
The correction was a bit more complicated than just that the market was overdue for a correction. I think investor sentiment had much to do with it, in addition to all the volatility and market-structure technical stuff. By January, we were starting to rack up records for longevity without pain. Then, boy, were we smacked with it in February, especially with that one unbelievably bungee-jump day that some were saying was like a little flash crash.
What else contributed to the correction?
It was exacerbated by a technical issue regarding one exchange-traded note in particular that was an inverse volatility index. The price of that ETN went down by the same percentage that the VIX [volatility index] went up. So on the day the VIX jumped by about 100%, you lost [nearly] 100% of your money in this ETN.
Please discuss the change in the investor sentiment component.
Up until last fall, clients were waiting for the other shoe to drop. But then it was like somebody flipped a switch, and the sentiment was more of what you typically see in a bull market.
What did it mean to your investment strategy?
That was one of the things that started to concern me and a reason why we got more cautious about U.S. equities at the end of the summer: We started to see that turn in sentiment. From last fall till January, we went to record-breaking optimism in many cases. That alone was a trigger for us to say that we probably have some bouts of volatility coming and maybe the first correction in a while.
What’s your forecast for inflation this year?
We recently hit an inflection point in inflation, which is starting to become elevated. For the first time in this entire expansion, normal GDP growth is higher than the unemployment rate, which is an interesting phenomenon. But we don’t think inflation is going to run away — we’re not worried about stagflation.
What do you anticipate for the bond market, then?
Our fixed income group says that we’ve probably entered into what could be termed a bond bear market, though those markets are nowhere near as grisly as equity bear markets. Interest rates are rising; and when they do, bond prices go down. But at the end of the period of rising rates, you can still have positive return on certain fixed income instruments.
So fixed income investors shouldn’t panic?
This isn’t Armageddon. Even in the worst bond bear markets, you don’t have losses like a drop of 20%, as you do in the stock market, because you‘ve got that coupon, that income stream.
You said at a speaking engagement a few weeks ago that your biggest long-term concern is public and private debt, which continues to grow, and that “the problem can’t be solved by tax increases and budget cuts alone” but would require entitlement reform. How big is the total debt?
It’s massive, about 340% of GDP. Federal government debt is between 75% and 100% of GDP. The numbers are huge; and with the deficit now expanding, that means we’re going to be adding to the debt at an increasing pace. But this doesn’t represent some moment-in-time crisis and that three years from now, say, we’ll have a crash.
What’s the significance, then?
During eras where credit market debt has been rising sharply, as it has recently, it’s been an impediment to economic growth, with the need to finance debt crowding out the ability for the economy to grow more organically. Now the government is going to be spending more to finance its debt as opposed to spending on more productive things.
Will the debt bubble burst?
It [already] has burst, in 2008, when we had the global financial crisis that [also] unleashed a simmering crisis that really wasn’t addressed then. The only component that was addressed was household debt. So corporations didn’t have to go through a massive deleveraging cycle like they did after the 2000 bubble. Government simply levered up even more to pull ourselves out of the hole.
Seems like the issue of entitlements keep getting pushed further into the future.
It’s the ultimate can-kick down the road.
But you’ve said that reducing entitlements would go far to solve the debt problem?
Of course, but try to convince politicians on either side of the aisle to focus on that when they’re dealing with, in some cases, a two-year election cycle — not to mention that the public doesn’t have this at the highest level of their priority spectrum. So [politicians] just continue to kick the can down the road.
What could repercussions be later on? We’re going to run into bigger and bigger debt problems down the road. About the only “solution” is that you inflate your way out of debt. I don’t think the Fed or the Treasury wants to establish that on purpose. But at this stage, given the weight of entitlements, if you add the future debt associated with unfunded entitlements, you’re talking about 700%-900% of GDP, according to economists’ consensus. For now, though, politicians would say it’s not a problem for us to deal with in the near term.
What sectors do you think will do well this year?
We’ve had the same three Outperform ratings and Underperform ratings for a while now. None of them were changed in advance of the correction or after it. We have Outperform ratings on technology, financials and health care. Technology will be the biggest beneficiary of what we expect to be a pretty long capital spending cycle in the aftermath of tax reform. The financials story is rising interest rates, rising net interest margin; plus, financials had become so unloved for so long after the financial crisis that they became, sort of, a value story.
And health care?
We like health care because, with all the government uncertainty about the Affordable Care Act, the stocks got really cheap. They were still growth companies but had value-like multiples.
What sectors do you expect to underperform? Utilities, telecom and real estate investment trusts [REITs], which [in 2016] got their own classification. The main reason we have Underperform ratings on these is that because investors have been in a desperate hunt for anything that generates yield, they chased these higher-yielding sectors — and prices went up, and there was no longer value. These three are classic value sectors that didn’t have value anymore because the stocks were too expensive.
You were a regular panelist and a guest host of “Wall Street Week with Louis Rukeyser” on PBS TV (1978-1995). It was an excellent show.
I always say it was a kinder, gentler and, arguably, much better era of television than what we have today. [Guests] were [given time] to answer questions in full sentences. The show wasn’t about bombast and hyperbole — like so much of what exists in financial media now.
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