Are You Prepared for the Markets’ ‘Temperamental Era’?

On this episode of The Long View, Charles Schwab strategist Liz Ann Sonders shares her thoughts on the Federal Reserve, recession risk, and inflation.

Here are a few excerpts from Sonders’ conversation with Morningstar’s Christine Benz and Jeff Ptak.

Have We Already Had Our Bear Market?

Benz: We want to bring the market into the discussion. Your research has found that bear markets typically arrive at the actual start of a recession or slightly precede it, whereas the National Bureau of Economic Research, which you referenced, announces a recession start on a lag. So, we’ve already gotten a bear market, but no recession call from NBER. Have we already had our bear market? Was 2022 our bear market?

Sonders: That’s sort of another way of asking is the mid-October low, the low. I don’t know. Can I just stop there? Is that a sufficient answer? No, I know. But that’s the honest answer, and everybody should answer that way. I have no idea.

And, by the way, trying to time tops and bottoms with precision, that’s just gambling on moments in time. And it’s not what I know or you know, or an investor knows that matters—meaning about the future. It’s what we do along the way, so frankly I wouldn’t be surprised either way. It certainly wouldn’t surprise me if the market retested the low to the extent that a recession isn’t already underway. If the October low holds, and a recession either doesn’t start at all, or starts later than the timing of us sitting here—and not that there aren’t always firsts—but it would be the first time that the bottom happened before the recession began.

Not before the NBER makes its call, and that’s what people seem to forget—the order of things. To use the 2007 to 2010 cycle, the bear markets started in October ‘07. We knew eventually that the recession started in December ‘07, the NBER told us it was a recession in December ’08. And then simultaneously said, “And by the way, it started 12 months ago,” which I think at that point everyone’s like, “Well, duh!” And then the recession ended … well, the bear market ended in March 2009. The recession ended June 2009. But we didn’t know that until October 2010. So, that’s just how things unfold, and I can’t tell you how many times I’ve talked to investors who say, “But if you do think it’s a recession, why wouldn’t I just wait until I know there is one, and I know it’s over and when.” You probably missed a big chunk of the next bull market.

Market Parallels to the 1980s

Ptak: I did want to ask you about whether you see any parallels between the current conditions and what we saw in the early 1980s? The bear markets, as you’ve noted, they often conclude around the time a recession ends, but there have been exceptions like the early 1980s. The recession ended in the summer of ‘80, but the market didn’t emerge from its bear market until August ‘82, reason being the economy entered a second recession. And so, do you foresee that as a possibility for us?

Sonders: I hope not. In fact, I think that when people think about the playbook that Powell is going off of, it’s not really the inflation playbook of the ‘70s per se, because the drivers of inflation in the 1970s were quite different relative to the drivers of the current bout of inflation. So, he’s not looking at the underlying conditions. What he’s trying to I think avoid is the Arthur Burns mistake of two, could argue maybe even three times, of hanging the mission-accomplished banner after tightening policy and inflation came down. “Our job is done, we can loosen policy. Oops, inflation out of the bag again. We did it again. Mission accomplished. Boom!” And that’s what led to Paul Volcker having to come in, bringing on the back-to back recessions.

I think that’s very much what Powell is trying to avoid, which is why he’s been so forceful in pressing this idea of yes, the pause is soonish, terminal rate is soonish, but we are going to stay there. And that’s I think the disconnect that there’s sort of three narratives out there right now. The one the Fed is giving us, the one that the bond market is suggesting, and then what the equity market is doing. And they’re all not going to be right permanently.

I think the inclination, anyway, is for the Fed to see this fight to the end. If anything, recession, I’ve heard, with sort of a bullish tinge, well, recession is not till 2024, and I think that’s a more bearish case. A recession right now, or one that’s already underway, that’s the more bullish case, because if there is one consistent kind of cure for an inflation problem, it’s a recession. I think, sooner rather than later, is actually better from a market perspective.

Inflation and the ‘Temperamental Era’

Benz: You just mentioned inflation, Liz Ann, and we’ll hear from Treasury Secretary Larry Summers first thing tomorrow morning.

Sonders: Yes, ask him if he likes my temperamental era.

Benz: We will. But Summers has warned that it takes longer to quash inflation than you think. Do the data support that assertion?

Sonders: Well, generally, Fed officials have said that fighting deflation is a little bit tougher, only because it’s a proverbial halt on activity. If you as a consumer, an investor, or a debtor, think prices are going down more, rates are going down more, it sort of halts activity. So, in theory, central banks usually say that deflation is a tougher battle to win, particularly if it’s entrenched—the Japan situation. And inflation is easy; you just raise rates. I think it’s letting inflation not only get out of the bag but get to a 40-year high.

Then obviously it becomes a little bit more difficult. And the Fed and Powell, they can see that they probably stayed on the zero-bound too long and waited a bit too long to start shrinking the balance sheet, but it is what it is. We’re here now, and there’s nothing we can do about what wasn’t done, or what should have been done. It’s all the counterfactual. But I think that’s front and center, tackling this problem. It takes a little bit longer when it bursts to a 40-year high.

Is Real Wage Growth a Positive Economic Development?

Ptak: Real wage growth is edge positive after being negative for two years. Do you think that’s a positive economic development? Does it back up the Fed’s point that inflation is yet to be subdued?

Sonders: I think that the whole nominal versus real is always important, especially in a high-inflation environment. You’ve got to always look at data in both nominal and real terms. But I think we’re now at the point of the tell in terms of how much was wage growth, pricing power tied to just the nominal inflation getting to a 40-year high. And whether as disinflation continues, fingers crossed, whether we start to see that chip away at whether there’s actual pricing power. And you’re starting to hear it every day now, especially in earnings season, “We are trying to maintain prices but unit sales are down a ton.” You’ve seen companies biased toward hanging on to employees and keeping their wage the same, but hours worked have come down quite a bit. So, I think the real story is a little more nuanced, and I think you’ll see maybe a decent amount of stability in nominal wages. And then just the math changes if we continue to see disinflation.

What I do not think we have had in this cycle is anything resembling the kind of wage price spiral that characterized the 1970s. I already mentioned that I think the drivers were different, and that’s a key difference between that era and now.

What Is the Difference Between Headline Inflation and Core CPI?

Benz: Headline inflation appears to be easing, but not core CPI. So, I’m hoping you can explain the difference between those two things. I’m guessing many in the audience will know, but we can go over that and also discuss whether a decline in headline inflation will be enough to convince the Fed to back off its aggressive stance.

Sonders: Headline and core are just a differential; core is excluding food and energy, and the original idea of doing that is not because anyone thought we don’t heat our homes or drive cars or eat food. It’s just that those are much more volatile components, that not only are often driven by factors that are noneconomic and out of central banks’ hands, but if monetary policy keyed off that, would be counter to what would help. If you’ve got a real economic problem that comes with food prices spiking because of a major drought or a war, you’re going to raise rates? That can’t deal with the supply side of things, and that’s a big part of the conundrum that central banks have dealt with in this environment. But what’s interesting about the most recent inflation report, is there was a lot of concern about headline coming down a lot. But, uh-oh, core is still sticky on the high side. And when I see some of the headlines, I think, did you not look at what happened?

And I put it on Twitter every time the inflation data is reported. The biggest month-over-month decline by category in the most recent month was gasoline and other energy. That’s good. But so therefore, excluding food and energy. Again, it’s the whole average thing. You don’t have the benefit that accrued to headline of those lower energy prices. It wasn’t that a bunch of these other core things spiked. It was just a big drop in certain energy prices flattered the headline but didn’t flatter the core.

It’s also important to know that CPI is what we all focus on. It’s what consumers are generally familiar with. It’s not the Fed’s preferred measure. Theirs is PCE [Personal Consumption Expenditures Price Index], and the biggest difference between the two are the shelter components, and the shelter components collectively represent 43% of core CPI, and the biggest portion of that is owners’ equivalent rent.

And it’s a really funky, imputed calculation of asking homeowners, “If you were renting your house to someone, what would they pay?” First of all, homeowners have no freaking clue what that number is. It’s just a complete guess. It’s biased depending on their own perceptions, or where they live, or what they think they know about what’s going on in the world. It’s not really connected, and even the rent of primary residents, which is an actual calculation, if you ask somebody who leased their apartment a year ago, what rent? They’d say that number. But you asked somebody who leased it a week ago, and it’s going to be a completely different number. So, it’s inherently lagged data. But it’s 43%, of course. It’s a much lower percent. The housing component is much lower in PCE, and now the Fed has got this core services excluding housing. It’s kind of throwing darts at what metric. But there’s a lot to understand about these calculations.

And there’s big differences between. It’s also the case that everyone’s inflation is different. I also think it’s hysterical every time the numbers come out. And I’m a geek, and I’m focused on the month-over-month changes. They go in, and they say, “Am I paying more for a dozen eggs than I was a year ago?” Yeah. But if you don’t drive a car and you’re not renting? My parents are still alive. They’re in their mid-80s and early 90s, and they live in senior living. Thank God for all of you—we took my dad’s car keys and car away from him two years ago. He’ll be 93. We pay for their senior living, so they don’t have any housing costs. Their meals are paid for. They don’t drive anymore. They have no inflation. But somebody who drives every day and is buying food at the grocery store and is paying rent, their inflation … So, inflation is a very personal thing, too, and we generalize with all these statistics.