Schwab’s Sonders: 5 Gloomy Economic Trends Advisors Should Watch

What You Need to Know

Late-cycle alarms ringing now include ongoing concerns about inflation and how the Federal Reserve will react.
Thus far, there are more differences than similarities between the inflation of today and 1970s-style stagflation.
Advisors and their clients should keep a close eye on the correlation between bond yields and stock prices.

“There are some late-cycle alarms that have been ringing lately,” including ongoing concerns about inflation and how the Federal Reserve will react, Liz Ann Sonders, chief investment strategist at Charles Schwab & Co., said Tuesday during the virtual Schwab Impact conference.

She has been pondering lately whether the COVID-19 pandemic-driven recession has “been a traditional recession in the sense that it launched a new economic cycle, or might it be more aptly thought of as a war that interrupted an ongoing economic cycle” — or maybe it’s “something different altogether,” she told viewers.

Below are a few of the main things that advisors and their clients are or should be concerned about now, according to Sonders.

1. Ongoing inflation leading to stagflation.

“The key question is whether COVID’s toxic brew and its impact on global supply chains is a setup for 1970s-style stagflation,” according to Sonders. But, thus far, “there are more differences than similarities,” she said.

After all, she explained, the “purest definition of stagflation includes high and rising unemployment — clearly, in contrast to today’s extremely tight labor market, while productivity is much stronger today as well.”

Meanwhile, “secular forces tend to shift and create either a prevailing inflationary or deflationary backdrop,” she said. But she said: “Psychology also comes into play when the psyche of workers and companies change and each decides they can use their power to demand higher wages [and] pass on higher costs persistently. That’s when the so-called wage-price spiral kicks in.”

Not all inflation is the same, she went on to explain. “There are two broad categories of inflation. Procyclical inflation occurs when stronger economic activity drives prices up. Countercyclical inflation occurs when high prices drag economic activity down.

“I think a risk is that we have shifted from procyclical to countercyclical inflation. And, for now, we have moved from an age of abundance to an age of scarcity. Interdependencies, low inventories across global supply chains have created a pretty fragile system that’s become more vulnerable to shocks and their ripple effects, including the global energy crisis.”

2. The Fed’s reaction to ongoing inflation.

What remains to be seen is what the Fed’s reaction will be, according to Sonders. “We all know that central banks’ policy tools can do little to ease bottlenecks in the global supply chain but a risk is that the Fed will have to tighten policy more quickly than anticipated to quell demand,” she warned.

However, she pointed to a potential, “more benign scenario” also: that “high prices cure high prices with lower demand; in other words, might inflation protect us from the Fed before the Fed feels it has to protect us from inflation?”

When it comes to Fed policy, “there may be no precise or mechanical link between” quantitative easing (QE) and asset prices but “clearly the Fed’s ongoing promise of liquidity has had important psychological impacts,” she said. “This is why concerns about the coming tapering remain front and center for equity investors.”

3. Market drawdowns.

“The reality… is that the growth rate of liquidity peaked in February,” Sonders said. “Not coincidentally, many of the market’s more significant drawdowns began at that inflection point — certainly among the speculation-fueled nontraditional market pockets.”

Meanwhile, there has “been lots of chatter about how resilient the market has been this year,” she noted. “But a look under the hood is revealing. More than 90% of the S&P and Nasdaq has had at least a 10% drawdown at some point this year, with the average being minus 18% for the S&P and, get this, a whopping 38% for the Nasdaq.”

Rotational corrections are “certainly preferred over swift, index-level corrections and that benign scenario could persist.” But she said: “I wouldn’t be surprised if the indexes at some point play some catch-down.”

“We all know the market is not cheap, although the surge in the denominator” of price-to-earnings ratios has “done yeoman’s work of bringing multiples down from last year’s surge,” she said.

4. Whether the market is in a bubble.

Of late, Sonders has often been asked “whether the market is in a bubble,” she said. “Bubbles we know form when enough people shift their investment thesis from ‘will I make money by holding this security, this asset class and receiving its profits?’ to ‘will I be able to find someone to buy this security or asset class at a higher price?’” she explained.

That “certainly applies to many of the speculation-fueled pockets but perhaps not yet to the broader market,” she said.

5. Ongoing volatility.

“So what’s an investor to do? First, keep a close eye on the correlation between bond yields and stock prices,” Sonders suggested.

Also, “given ongoing extreme volatility in sector leadership, we’ve been suggesting focusing more on factors than sectors or traditional style buckets, with a sharp eye on quality,” she said.

For three decades starting in the 1960s, yields and stock prices moved inversely, she pointed out. “For the two decades since, the bursting of the housing and tech bubble, yields and stock prices moved together. Recently, the correlation inverted for a short stand. A more sustained inverse correlation could send the message that we’ve been through the secular period of higher inflation.”

Meanwhile, “rapid-fire rotations also offer the time-tested benefit of rebalancing, a strategy we’ve been suggesting for investors,” she said. Advisors and their clients should “consider volatility-based vs. calendar-based rebalancing, in the interest of adding into weakness and trimming into strength,” which she called a “more subtle form of buy low, sell high.”