NATHAN PETERSON:  Welcome, everybody, to the April 4th Schwab Market Talk event for advisors. My name is Nate Peterson, Director of Derivatives Analysis at the Schwab Center for Financial Research, and I’ll be your moderator today. 

Please remember that the information provided here today is general informational purposes only, and all views and opinions are subject to change without notice in reaction to shifting market conditions. For those who are new to these webcasts, we do them once a month. Regarding today’s format, we’ll start off answering questions and addressing topics that were submitted by our audience in advance during the registration process, and then we’ll start taking live questions. You can submit questions anytime, and while we may have the opportunity to address some alongside the pre-submitted questions, we will have time to answer new questions at the end of the webcast. To ask a question, simply type it into the Q&A box and hit Submit. 

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All right, now let’s get started with today’s event. Our speakers today are Liz Ann Sonders, our Chief Investment Strategist; Kathy Jones, our Chief Fixed Income Strategist; Jeffrey Kleintop, our Chief Global Investment Strategist; and Randy Frederick, who is Schwab’s Managing Director of Trading and Derivatives. 

Thanks to everybody that submitted questions for today. We’re going to start off with some questions about the latest perspective on the banking turmoil, the economy and recession watch, updates on cryptocurrencies, and strategies advisors can consider sharing with clients. 

So let’s start a roundtable discussion to get our latest perspective on a topic that’s on everyone’s mind, and that’s the banking crisis. We’ll kick things off with Liz Ann Sonders. Liz Ann, thanks for joining us today. 

LIZ ANN SONDERS:  Hi, Nate, and welcome everybody. Thanks. 

NATE:  Liz Ann, can you start by giving us your summary take on the recent banking crisis and whether or not you think the potential for contagion still exists?

LIZ ANN:  Sure. So I don’t want to rehash the whole Silicon Valley Bank situation. We wrote a report two weeks ago that’s still posted on schwab.com, called ‘Another One Bites of Dust,’ and it’s a bit of a deep dive. But, clearly, that was a confluence of factors that in many ways made that bank unique in terms of the concentration of the depositors in the VC and Silicon Valley world, the nature of a run on bank being triggered via Twitter, which happens in like, say, Twitter time, and then banking being done on our mobile phones. So that meant the bank run happened at a much more rapid pace. It was lack of interest rate hedging, poor management of the balance sheet, the lack of transactional accounts, and it fed on itself, and here we are.

Now, in the immediate aftermath of the fall of SVB and related Signature Bank, you saw the Fed step in, kind of reach into the toolbox back to the type of emergency funding programs that were established as long ago as the 1930s, and established a new bank funding facility, such that, essentially, SVB’s depositors could be backstopped. 

Now since then, there’s been a lot of controversy and misinformation in terms of is this a de facto guarantee for all deposits, and what are the implications in terms of risk taking on the part of banks? We know that the ability to actually establish that formally would have to go through Congress, and that’s why Secretary Yellen has pushed back on this. 

So at this point, it looks like things are relatively contained. You can see it across metrics of how many banks are going to the combination of the relatively new funding facilities, as well as the traditional bank window. You did see a huge spike in that. I think the data that comes out every Thursday by the Fed as to what the take up is, that’s probably sort of the hot weekly number now that we’re going to pay a lot of attention to search data on things like insurance and FDIC have started to calm down. 

But I really think, though, that this is a broader story of the end of the era of easy money. And this is not just the banking system that’s at the mercy of this, but this era of easy money was one where liquidity was abundant, interest rates were at zero in the case of the US, below Zero and other places, and it not only fueled some of what we’re seeing in the banking system, but zombie companies and startups. And so I think this whole notion of… to quote Warren Buffett, as we always like to do, of the liquidity tide going out, you see swimming naked. Yes, SVB was a naked swimmer, but I think there are some other naked swimmers here that go beyond just the banking system. And I think we’re just starting to be in the meat of that, not so much dislocation, but the inevitable impact of an aggressive Fed hiking cycle like we’ve been in for the past year. 

NATE:  Got it. Let’s get Kathy’s take on this, as well. Welcome, Kathy. 

KATHY JONES:  Hi, everybody. Hi, Nate. Thanks for having me. 

NATE:  Okay, Kathy, how has the Fed’s policy been affected by this disruption we’ve seen with banking? And, more specifically, why is there such a big gap between what the Fed is conveying in regards of their policy and what the market is pricing in? How do you think this gets reconciled? 

KATHY:  Yeah, so Liz Ann sort of ran through the macroprudential regulatory tools that the Fed put into place, along with the strategy to backstop things and calm down the market. So I don’t think from a long-term perspective, this changes what the Fed does in terms of those tools, and, in fact, it probably makes them more permanent tools that the Fed will use. But the goal of the Fed was to use tools to address the banking problems and different tools to address inflation and the economic policy. And they proved that by hiking rates, even though we were in the midst of this turmoil. 

But I think the longer term implications, as Liz Ann mentioned, is this is what happens when money gets tight. You start to see where the cracks are, things break, but the next phase is tighter credit policy. So we’ll probably see banks, particularly the small- and medium-sized banks that need to hold on to more capital will be more reluctant to lend. And so as we move forward, that tightens up credit conditions, it tends to slow the economy. 
And it doesn’t mean we’ll see another crisis, but it does mean the implications are that it’s slower growth and eventually lower inflation down the road. 

Of course, it remains to be seen whether we’re through the worst of it or if something else happens. But I think the divergence between where the market is pricing the path of Fed Funds Rate, and where the Fed is indicating it’s going based on the dot plot, this has been a phenomenon we’ve seen on and off since the Fed started tightening, and it accounts for all the volatility at the short end of the yield curve. So we’ve seen the highest volatility in two-year notes since the great financial crisis in 2009. I think it’s just a reflection of this divergence of opinion. And the market is telling you the Fed will have to cut rates eventually because the economy’s going to slow down and they’re near the end of their hiking cycle, and they’ll have to reverse course second half of the year. The Fed is trying to follow this hike and hold process that they put in place. 

You know, we’ll see where the dynamic goes. I tend to think that the market is pricing in a more realistic scenario of slower growth, lower inflation in the second half of the year, and some rate cuts. But, again, until the Fed kind of comes around to that view or the market adjusts to the Fed’s view, expect a huge amount of volatility to continue at the short end of the yield curve. 

NATE:  Got it. And let’s go ahead and bring Jeff into the fold on this, as well, and get his global perspective. Welcome, Jeff. 

JEFF KLEINTOP:  Thanks. Great to be here. 

NATE:  Jeff, headlines around bank stress. They appear to be relatively more quiet, at least over the last week or so. But how do you think central banks are assessing this environment given what we’ve seen going on with the banks and especially in light of that stubborn inflation data that we’ve been seeing? 

JEFF:  Yeah. Well, I don’t know, and they don’t know either. I mean, Australia paused their rate hikes today. Norway said it was done in January, paused for a couple of meetings, only to have to hike rates by 50 basis points last month. So I’m listening to central bankers and the reaction to all of this, but I’m recognizing that they’re guessing, too, and it’s still very early. The just announced OPEC production cut suggests more headline inflation pressure in the near term, helping to create waves of inflation. I just wrote about waves of inflation and where we’ve seen them in the past and what that meant… you can find out on schwab.com… and that could keep central banks from declaring victory in the near term in their battle against inflation. But that rise in oil prices if it’s sustained could be a headwind for tech stocks and other long duration equities. But if we look out to later in the year, with consumer incomes tightly stretched, if fuel prices hold their gains, it may have a deflationary impact, as it slows growth, as consumers have to shift consumption away from other things to afford higher prices at the pump. 

So it’s sort of a mixed effect we have energy prices go up, to the extent that it’s near term inflationary on the headline, maybe longer term deflationary on the core. It depends on what you’re watching. I think central banks are watching both and maybe even reacting differently to them. I think, certainly, a rise in energy has different impacts on different economies. 

So for the time being seems like we’re peaking out here in terms of rate hikes. We’ve maybe got a little bit more to go by the European Central Bank. We will hear about some tweaks from the Bank of Japan perhaps this summer. But for the most part, they are maybe going on spring break, let’s call it. 

NATE:  Okay. All right. And so you think the central banks outside of the US are done raising rates? 

JEFF:  Yeah, I mean, I think that was… yeah, that was the takeaway, is that I think they are probably pausing at this point. I mean, I think there’s… certainly, the tentacles of all this banking issues seem to be a little less intense for Europe and for Japan than in the US for a variety of different reasons, but, nevertheless, you know, we’ve still got to a point where global growth is slow. We are in a bit of a global recession here, and, you know, that’s what they’re reacting to more so than necessarily bank stress. 

NATE:  Great. Thank you. And Jeff, I’m going to stay on that topic of the economy there and just ask you what kind of indicators or data are you monitoring to help kind of gauge the state of the global economy in terms of that recession watch? Do you think the odds are increasing or decreasing, and what are you looking at to kind of give you that indication? 

JEFF:  Yeah, you know, we’ve called a global recession since I think August or September of last year. And the recession has so far been in manufacturing and trade, while services and construction and retail have been growing. And even now as signs of firming in manufacturing have started to show up globally, it may be that these other industries begin to soften. There are plenty of real-time data points to follow to monitor this, but I think the most important thing is what Liz Ann pointed out at the beginning, and that’s the weekly in the US and monthly outside the US bank business lending data to gauge how much lending slows in response to these banking issues. Lending is critical to growth, especially in services and areas like construction that have been holding up. When we talk about tightening of lending standards, what we mean is higher interest rates of smaller loans being approved and requested and demands for more capital. And so as this tightening continues in the aftermath of the US bank closures, we might see it show up in a lower amount of overall lending. Again, lending drives growth. In Europe, the potential for tighter lending standards is somewhat offset by the fact that European bank standards were already as tight going into the banking stress of March as they were back in the 2020 recession and the 2011 European debt crisis. They were already braced for a recession starting last year. So any fallout may differ across countries, it might be a little less intense given there’s less of an abrupt shift towards tightening in Europe or Asia versus maybe what we see in the US. 

NATE:  Got it. Okay, let’s keep it on the theme of the economy, bring it back to the US, and I’m going to go back to Liz Ann here. Liz Ann, you know, that that discussion around whether we’re going to hit a recession or whether there’s going to be a soft landing, that debate seems to be still on the table. And, you know, we’ve seen strength in, you know, some of the services sector, the labor markets, and we’ve also seen weakness within housing and manufacturing. And you’ve been calling for the current cycle to be a rolling recession. Is that likely to persist in light of what’s been going on with the banks? 

LIZ ANN:  Right, and I think most people are familiar with the term of rolling recessions. It’s somewhat self-explanatory, in that unlike maybe a COVID 2020 recession or even the global financial crisis, where basically the bottom fell out all at once, and it hit most segments, sectors of the economy in a relatively condensed period of time. This is one that’s rolled through the economy, and that’s just the unique nature of the pandemic, where the initial surge and demand fueled by all the stimulus back in 2020 was forced to be funneled into the goods side of the economy because there was just no access to services. We then subsequently saw contractions in many of those goods-oriented areas, in consumer electronics, other consumer retail goods, a lot of the stay-at-home areas, not to mention housing and housing-related. That was the initial pop and inflation. We’re now since in disinflation on the goods side and in contraction in many of those areas in terms of the overall economy, but we’ve had that offsetting strength in services. Now, services is a larger employer in the United States. That helps to explain, to some degree, the relative resilience in the labor market. So it’s rolled through.

To me, best case scenario was never really soft landing in a traditional sense, but a continuation of the roll through, such that if you got to a point of some pent-down demand on services and weakness there, that you would maybe start to see some stabilization in some of those other areas. 

Now with credit tightening… and by the way, and Kathy… I believe Kathy mentioned… this even before the failure of SVB and some of the alarming concerns about the banking system, you had seen credit conditions tighten quite dramatically, both on the commercial industrial and the consumer side. So that was underway anyway. It’s hard to suggest that this points the needle more toward easier credit conditions, which does suggest that we do roll into a more traditional recession. 

And by the way, at this point in the cycle, for people coming out and saying, ‘Well, maybe we’ll avoid it this time, it’s different this time,’ be it relative to the yield curve or the decline in leading indicators, that’s somewhat normal at this point in this cycle where people say, ‘All right, it looks like it’s starting to deteriorate, but maybe we can manage a soft landing.’ More often than not, you get a recession. And I think with things like the steep inversion of the yield curve recently and an 11-month decline in the leading indicators, coupled with the tightening and lending standards, I think, eventually, this will be declared a more formal recession by the NBER. 

NATE:  Got it. Okay, let’s pivot over to the stock and bond market. And for that, we’re going to bring in Randy Frederick to talk about how the markets have been reacting. Randy, thanks for joining us today. 

RANDY FREDERICK:  Thanks, Nate. Great to be here. 

NATE:  Randy, can you talk about how the various concerns, whether it’s Fed policy all the way to the banking crisis, has affected the stock market volatility so far here in 2023? 

RANDY:  Surprisingly, it hasn’t affected it all that much. If you look at the long-term average of the VIX, which goes… of course, the volatility index goes all the way back to 1993, the average is somewhere right around 20 Year-to-date, it’s averaging about 21. So really not too far out of line with just historical averages. You know, we did see a very brief spike up to about 30 back on March 13th, sort of when this banking crisis first hit, but it really only took a few days for it to come back down. And, in fact, right now, we’re about one point above the year-to-date low. So not really anything to say, that people are panicked. Even when the Silicon Valley failure first happened, the VIX spike, you know, up to 30 isn’t really what you would typically call panic level. The way I’ve studied the VIX over many years that you really have to get to about 40 before you actually would call it a panic, I would just call it sort of elevated anxiety. 

Now, granted you know, the speed that which the volatility came back down is directly to proportional to how quickly the Fed, the FDIC, and the Treasury sort of stepped in to sort of stave off this crisis. As you recall, the Silicon Valley thing blew up on a Friday afternoon, and by Sunday before the overnight futures opened, they had already announced that they were going to have the new lending facility, that they were going to backstop the deposits and things like that. So they took very quick action rather than sort of letting it blow up as we saw back in 2008. Not that it would have been that big, but certainly things could have gotten worse than they did. 

You know, as far as Fed policy goes, I mean, it’s a pretty similar story. Everyone knows. I think that we’ve had about nine interest rate hikes in this cycle, and the total of that being about 4-3/4%. And, yet, even if you go back to the S&P 500’s low so far, which was back in mid-October down a little bit more than 25%, this has been the shallowest bear market we’ve had since 1966. That goes back a heck of a long way. 

You know, and, again, going back to the VIX the bear market that we’re in has now lasted for about 15 months, and the average for the VIX over that entire time is only about 25. So, again, just a few points above the long-term average. Now, we did see a spike up to about 39, so we almost got to that panic level back when this thing first hit way back in February of last year. But this is the only bear market so far out of four that we’ve had since the VIX has existed, where we’ve not yet seen a spike above 40. And, again, that’s kind of the level where panic actually sets in. 

NATE:  Got it. Okay, let’s turn to Liz Ann in regards to stocks here. Liz Ann, you know, the S&P put together a 7% gain here in the first quarter. There’s some strategists, although, that still are a little bit cautious and think we potentially could retest the lows back in October. What signs are you looking for that help you to confirm that the worst is behind us? 

LIZ ANN:  Let me get to the middle part of that first, which is whether the market is going to retest the October low. I suppose what might not thrill people is for me to be honest and say I don’t know. I will say back at that point, and we put some of this in our 2023 outlook, which we put together at the end of November, that there were some positive signs that developed around that October 12th low in the case of the S&P 500, distinctly better than what was the case when the S&P first had its kind of woosh low in mid-June. That was an environment where the indexes hit a new low, but there was even more ugliness still under the surface. Then we had that mid-June to mid-August rally that, rightly so, in our opinion, the Fed pushed back on and said, ‘We’re not pivoting any time soon.’ Market sold off again. The S&P took out its mid-June low and went pretty decently below it, but under the surface you were seeing less deterioration. So that was considered a positive divergence in technical terms. 

Fast forward to the early part of this year, we saw the rally kick in. I think the January rally, where you went down the quality spectrum. Again, you saw a relift again in things like the meme stocks. I think that had a lot to do with short covering more so than this mean reversion. 

Lately, we’ve seen a little bit of improvement in breadth, but what’s also been happening is the reason why we’ve had a strong start to the year in the case of cap-weighted indexes like the S&P and the NASDAQ, is because money has gone back into these very large, not really just tech, but kind of tech-oriented, the mega cap names. In fact, the 10 largest stocks in the S&P account for more than 90% of the rally this year. 

So I think there’s been this move into this safety, perceived or otherwise, into maybe the more cash-rich-type of companies in this era of uncertainty. Under the surface, what you’re seeing in terms of leadership, maybe most notably, financials doing quite poorly, I think does reflect what’s going on in the broader economy. 

So I think we have… I think be really careful about not really chasing and let FOMO get in the way of jamming yourself way into these larger cap names, the sort of… those, you know, big five, big eight are back up to near recent highs in terms of the weight that they have in the S&P 500. I still think you want to focus on quality and screen for quality fundamentals, and be careful about not letting yourself get overly concentrated in these names that have a lot of fundamental support, cash generation, things like that, for the most part, stronger balance sheets. But I think that there could be a period again where you see some downward pressure there in favor of, call it the average stock or equal-weight indexes. 

NATE:  Got it. Yeah, thanks for covering that because we did have a question about whether that outperformance within mega cap tech and growth will continue. It’s certainly been substantial so far this year. 

Let’s turn over to Jeff. Jeff, international equities have been outperforming, and that’s continued to be the case. And if you look at European banks, they’ve outperformed US banks by 10 percentage points, and that’s even with, you know, what had occurred with Credit Suisse. Why do you think that’s going on? 

JEFF:  Yeah, some of this gets back to what Liz Ann just talked about with regard to screening for quality characteristics. You’ll find more of those like low price-to-cash flow companies, higher quality companies outside the US’s Benchmarks. Remember, investors didn’t want those for a long time. They wanted companies… didn’t care if you had earnings, just growing very rapidly, maybe with a lot of that growth out in the future. That’s certainly changed now, big regime change, and that’s favoring international equities this cycle. 

Referring to the banks, though, it’s actually 12 percentage points now. There are big differences here. Unlike the sudden end to SVB tied to investment losses as rates climbed in 2022, Credit Suisse’s problems were a whole different animal. They dated back to earlier years, back in 2019 to 2021. The SEC had delayed the annual report due to cash flow statement questions about 2019, I think it was, in 2020, and then the multi-billion-dollar hit linked to Archegos Capital Management in 2021. So it have been struggling to restructure and get its business back on track under new leadership. It wasn’t just related to, you know, interest rates rising. I would say that the stress did probably increase around the banking issues in the US, but I don’t think it was signaling a contagion to other European banks given that its troubles were unique and not new.

In Europe, capital buffers have really improved and stress tests had been strengthened. You know, despite Silicon Valley Bank being the sixteenth largest bank in the US, with assets equivalent to almost 1% of GDP, it wasn’t subject to the Fed’s stress test or 100% liquidity coverage ratio. The European banking authority, in contrast, is undertaking stress tests on nearly all banks in Europe, all the way down to just 30 billion euros in assets. So much more oversight and liquidity there. And, finally, I’ll add the European banks have had little exposure to commercial real estate, which is becoming a problem for lenders, given high vacancy rates. In fact, it’s only 7% of lending in Europe versus US regional banks have near 40% of their lending to commercial real estate. 

And so as you point out, this has shown up in performance, with European banks outperforming US banks by 12 percentage points so far this year… or I should say, financials, I guess, banks even more so within financials. And we can see this more broadly in international markets outperforming US stocks again this year as they did last year. 

NATE:  Got it. Okay, let’s bring Kathy into the mix. Kathy, there’s been some concerns out there about the potential for this credit crunch. A lot of headlines have been going on about that. Are you seeing any evidence of that within the corporate bond market? 

KATHY:  Well, in the corporate bond market we’ve seen sort of fits and starts, which would indicate some concerns more in the high-yield market than in the investment-grade market. So when the SVB banking situation hit, spreads widened for both investment-grade and for high-yield, and the markets kind of froze up, there really wasn’t a lot of activity. Now spreads have come back to pretty much, you know, average, normal levels. Investment-grade market has had some issuance come back, and, in fact, after a couple of days issuance started to boom. So when we look at the capital market side, we’re not seeing it on the corporate bond sector. In the high-yield side, you’re not seeing much in the way of issuance. Spreads have widened. They have come back down. So performance-wise, they’re doing okay because rates have come down. 

But I would think that if stress shows up, it’s two places. It’s the bank loan market, which hasn’t been performing well. And then, of course, the high-yield market, that’s where you start to see the strains on credit. So far, you know, bank loans not doing so well, but that will play out over time, I think, as credit tightens up there. That’s less visible to most investors because they’re usually just in bank loan funds. But in the high-yield market, right now, you would look at it on the surface and say, ‘Gee, it doesn’t look too bad,’ which it doesn’t, but there’s just not much issuance going on, so we don’t know what the market’s appetite for it is. 

So bottom line is whether it’s a credit crunch or just, you know, a credit contraction, which I think is more likely that we start to just see credit tighten up, the cost of it going up, access to it getting more difficult, starting to see hints of it, but nothing too severe at this stage of the game. 

NATE:  Okay. And, Kathy, I got a follow up question, and that’s in regards to some of the weakness we’re seeing in the commercial real estate sector. And if we talk about the municipal bond market, is there a concern there regarding municipalities and states? 

KATHY:  Well, not in the short run. Usually, these sorts of events, even when you get an economic downturn that’s more severe and broad-based, it usually takes two to three years to actually filter through to the budgets of state and local government. And right now, state and local government budgets are in really good shape. And I would say it depends on the municipality and it depends on where the funding tends to come from. So if you are in a local municipality where most of the funding comes from property taxes, sales taxes, other… and fixed revenue streams, probably not a big impact. But then you go to other places, obviously, much more dependent on, say, the big warehouses and office buildings, and those issues where usage goes down yet you would see revenue flows go down. 

So at the state level, in some GOs we might see it, depending on how big an impact it has. But, again, it’s kind of a slow moving issue rather than a quick issue. And it would really be specific to a given area rather than kind of a general muni market problem. 

NATE:  Got it. Okay, thank you for that. And let’s pivot over to cryptocurrencies. And for that we’ll bring in Randy, Schwab’s cryptocurrency expert, Randy, as a result of the banking turmoil that we’ve seen, cryptocurrencies have performed really well recently. What’s your take on that and do you feel like that outperformance can continue? 

RANDY FREDERICK:  Well, obviously, a banking crisis creates concern about safety, and to somewhat lesser extent, you know, the value of money. And for much the same reason that you oftentimes see gold prices go up when people get concerned about money, you see now the same sort of thing happening in Bitcoin and really even some of the other cryptocurrencies. But for many years, despite, I would call it, dubious proof that gold is really the only true currency and it’s the one you need if there’s a major crisis, it’s not easy to transact business in gold, and many of those same sort of characteristics have been ascribed to Bitcoin, again, I think with even more dubious proof that it’s a good inflation hedge. And, historically, that hasn’t really turned out to be the to be reality. But the fact that people believe it is, those two have a tendency to move together. In fact, if you look at the charts of Bitcoin and gold just really since March 10th, they are remarkably similar, I mean, just running almost perfectly with each other. But on the other hand, if you look at them long term, they’ve been very, very different. 

So question is, of course, is that trend over? Well, I think it is for now. I mean, that doesn’t mean we think things can’t flare up a little bit more, but I do think that at the moment it is, and partially because of the easing of the anxieties in the banking sector. But I think there’s also a bigger difference, or a bigger component here, and that is the anxieties have actually been rising in the cryptocurrency markets. And that has a lot to do with sort of this new regulatory crackdown that we’ve been seeing that’s taking place. And it’s been hitting two of the biggest players out there, Binance and Coinbase. 

NATE:  Yeah, Randy, actually, we did get some questions on that. Can you expand on those rising, you know anxiety that’s going on with crypto, specifically, with Binance, and the enforcement action against Coinbase for violating investor protection laws and not registering with the SEC for their staking products? 

RANDY:  Right. So just since about March 23rd, which is just, you know, not hardly even two weeks ago, shares of Coinbase have fallen about 25%. Now, the reason I mention Coinbase is not only are they under investigation, but also it’s the only publicly-traded of all of the crypto exchanges. So the SEC said, ‘Hey, you’re going to be facing some security charges.’ So what they get is this official declaration that’s called a Wells Notice. Most people are kind of familiar with that term. And it says that, as you just mentioned, that Coinbase is in violation of investor protection laws and that their coin staking product, which has not been registered with the SEC. 

Now ‘staking’ is kind of an odd term. If you’re not into the crypto industry or familiar with it, you may not know what that means, so let me cover it. So when you stake a product, essentially the exchange or the blockchain, or in some cases, it’s both, pays rewards for people who are willing to hold their coins in a wallet for a fixed period of time. Well, if you think about that, that sounds an awful lot like paying interest on a fixed income product, owning a bond, owning a CD, something like that. It is, in fact, it’s very similar. And the SEC then considers this to be a security. And so then that means that they have to be registered. It means that the exchanges are required to provide adequate risk disclosure documents to their clients. And, of course, none of that’s been going on. Coinbase, as I said, is currently the only publicly-traded crypto exchange, but a privately-held rival, which is a pretty big exchange, as well, known by the name of Kraken, they settled some charges on these exact same allegations not too long ago, and they paid a $30 million fine, which isn’t a whole lot, but, more importantly, they had to agree to stop offering those staking products, so they can’t do that anymore. 

The other one, I think, is probably even more important, and that’s because it involves the biggest exchange, and that is the crackdown by the CFTC, which is the Commodity Futures Trading Commission, on Binance. Binance is not publicly traded. Its CEO, Changpeng Zhao, known by the initials CZ, and is pretty well known, and they’re being charged with running an unlicensed derivatives exchange. Binance… I mean, the magnitude here is hard to overstate. Binance is the world’s largest marketplace in Bitcoin trading, in NFTs, non-fungible tokens, digital wallets, custody service, token issuance, and even crypto venture capital. They’re the biggest in all of those. In fact, you know, the thing about crypto that’s always fascinating to me is that those who are real proponents of it often talk about the fact that it’s decentralized, but that’s really not the case at all. And I’ve said this many times, it’s not decentralized, it’s decentralized away from a central bank, but it’s recentralized in a much more risky entity. And, in fact, on any given week, Binance is responsible for nearly 70% of all global cryptocurrency trading. So they are just massive in size. I mean, that is far, far bigger than FTX ever was, and that’s about 10 times the size of Coinbase. So we’re talking about some pretty big players here. Now, most of the CFTC’s concerns relate to charges that Binance was actively, even as they were telling the regulators something different, actively helping their biggest clients avoid oversight and avoid regulatory detection.

So here’s the thing, the bottom line is basically that, you know, whether these exchanges are publicly-traded or whether they’re privately-held, crypto investors, for the most part, right now, are simply running out of places where they can go, where they can trade and avoid significant regulatory scrutiny. And, inherently, that raises the systemic risk of the entire industry. 

NATE:  Got it. Thanks for covering that, Randy. Okay, let’s bring in and condense some of this discussion and talk about some of the actions our advisors can potentially take. And I’ll start with Liz Ann. Liz Ann, what are some of the most important takeaways for advisors given the current environment? 

LIZ ANN:  So as many advisors know, we went to… about a year ago, a little more than a year ago, we went to a sector neutral approach feeling like the better way to approach investing within the equity market for equity-oriented investors is to take more of a factor-based approach. We’ve been doing a lot more work on factors, meaning, characteristics. And you could look at a combination of growth and value factors and put together a portfolio or come up with ideas. It really transcends the whole overweight/underweight, monolithic approach to sectors. And that’s particularly important given this transition through this most aggressive tightening cycle in more than 40 years to a very different environment from a liquidity perspective, from an interest rate perspective, and just felt like that was one way to approach things. We’ve also been saying that to the extent you have a rebalancing program that is more calendar-based, maybe consider rebalancing to be more volatility-based or portfolio-based, your portfolio telling you when to adjust allocations across and within asset classes, take advantage of that volatility to do what we know are supposed to, as I often say is, you know, ad low/trim high. So those would be two really important takeaways.

The third one, only because there’s… I find there’s too much simplicity around the growth versus value debate discussion, and there should be a more nuanced conversation about that because the characteristics of growth and value can often be very different than either our preconceived notion of what is a growth stock or what is a value stock, or even what sits in the indexes. One example of that is S&P has growth and value indexes. They do the rebalancing in mid-December. Russell does not do theirs until June. And on December 19th, when S&P did, its rebalancing, this is just an example, but S&P pure growth, those are stocks that only exist in growth, where in their regular growth and value indexes there can be overlap, but in pure growth, on December 18th, all eight of the MegaCap-8, the FANG+ names we’re all familiar with, all eight were in pure growth, which means that was the only index they sat in. On December 19th, seven out of the eight moved out of pure growth, and four of the seven actually were in both growth and value. Only one was left in pure growth, that was Apple. And as a result, tech went from being 37% of that index to 13% of that index, with energy and healthcare above in terms of weight. 

So if you’re going to take more of a passive approach and think growth and value from an index perspective, you better know what you’re buying at the index level because there can be dramatic differences even in just the six-month span between when Russell and when S&P does its rebalancing. So those would be three that I think get right to the heart of navigating within the equity market. 

NATE:  Great, thanks. And let’s turn it over to Jeff. Jeff we’ve seen the international outperformance that’s continued. What do you think is driving that outperformance and what are you watching to determine whether this will continue or not? 

JEFF:  Yeah, I’ve been talking about international outperformance for a while now and continue to bang that drum. Look, this year has been instructive. The market had to shift from fears of recession in January, to overheating inflation worries in February, to concerns over a financial crisis in March. And that drove a lot of volatility in sector leadership changes during the first quarter. But one trend through that noise has been that each month this year, international stocks have outperformed US stocks. They’re now ahead by nearly 3%, just looking at my screen here, adding to their outperformance last year. And that could continue in April and the second quarter, with earnings growth in Q1, as it gets reported here in the coming weeks, expected to be up 6% from a year ago in Europe, that’s for the STOXX 600 Index, versus down 5% in the US for the S&P 500. 

Also, European banks aren’t as exposed to the risks. I talked about that a little bit. They got more capital, hedged interest rate exposure, less exposure to commercial real estate. And international valuations are still much lower even after a year of outperformance. The forward PE for EAFE, for the developed international benchmark, is 12.6 versus about 17.4, I think, for the S&P 500. 

Also, positioning can drive performance. Across the industry, investors are still pouring money into bond funds out of stocks, but we’ve started to see positive flows into international stock funds over the last six weeks. Really since mid-February, we’ve started to see inflows into international funds, despite the ongoing outflows from stock funds, in general. Investors have generally been light on international in their allocations, and so the flows could have a long way to go if they’re relocating. 

A risk to that ongoing outperformance by international stocks is if we see a return to a liquidity-driven bull market of the last cycle if central banks, let’s say, cut aggressively back towards zero, since there are fewer of those types of long duration, low quality stocks in the international benchmarks. They’re more focused on quality characteristics, and that’s one of the reasons why they’ve been outperforming. 

So, yeah, I see that outperformance continuing here, although, you know, perhaps by maybe a lesser margin here or maybe some volatility around that as we see some shifts in in the outlook for central bank activity. 

NATE:  Great, thank you. And we’ll turn to Kathy. Kathy regarding bonds, some of the short-term yields are still relatively high. Should advisors still be suggesting clients add duration to the portfolio? 

KATHY:  Well, as you know, we’ve been advocating adding duration for quite some time, and really 10-year treasury yields peaked back at 4.35 late last year. So yields have been falling for quite some time, and with the inverted yield curve it gets harder, obviously, to convince people that it’s a good idea to move out in duration because they’re getting more in short-term than they would in intermediate- or long-term. But the nature of the cycle is such that once you’ve hit the peak and you start to roll over, and certainly by the time you’re into inverted yield curve, you should be adding duration because you’ve got to lock in some of those intermediate- to long-term yields for the future. 

And I know it’s a difficult conversation that you have with clients, like, ‘Why should I… if I’m getting 4-1/2% in a very short-term money market fund, why should I be buying intermediate-term bond at 3-1/2 or at 4?’ But the argument is that you control your cash flows into the future when you lock in that yield for the next, say, five years or so. And, of course, you get the benefit of a more stable long-term portfolio because you get the benefit of diversification from bonds. 

So, yeah, you know, we’re going to see some volatility here and I think we are going to see some ups and downs, but we still like adding duration, particularly if you’re under benchmark, whatever that is. If you’re using the ag for a benchmark, it’s around 6.70-and-change. We’d at least want to be at benchmark duration on average in portfolios because we think that we’re on the other side of the cycle, the downside of the cycle, and there might be times when yields pop up, but you’re going want to have to, you know, lock in some of that. 

The second part of that, though, is to stay up in credit quality. As we’ve talked about, the risk to the economy, potential credit crunch, all those issues that happen late cycle when the Fed has been tightening, and it’s been tightening for one year, and we’re starting to see those cracks just right as you would expect that the lag time. So we would extend duration, but we’d stay on higher credit quality bonds to do it because of those risks that are going to come out as we get to the next phase of this cycle. 

NATE:  Great. Thanks, Kathy. And we are getting a lot of live Q&A and that’s what we’re doing right now. If you guys do have questions, just go ahead and submit one into the Q&A field there.

Kathy, I’m going to stay with you because I’ve got a couple questions here on concerns around the debt ceiling and whether there’s any risk to US treasuries as a result. And, you know, what would happen if we get a government shutdown and we default? 

KATHY:  Okay, those are a whole bunch of different scenarios. So, you know, Mike Townsend, as you know, our Washington expert, continues to believe that we will get a last minute deal on the debt ceiling just because that’s kind of how the politics play out. And so his… you know, and I certainly hope he’s right with that optimistic view. It really doesn’t benefit anybody to have a showdown that gets worse or a potential risk of default. 

The second thing is that… so the treasury has exhausted a lot of it’s, you know, possible tools to use to stay under the debt ceiling. The crunch time is believed to be sometime this summer when they just really can’t make it work anymore. And so we have seen higher volatility in T-bills maturing in that timeframe, July-August-ish because of the uncertainty of banks. Institutions that hold short-term T-bills don’t want to hold them during that timeframe just in case there’s some deferred payment or something else. You know, a default we don’t believe is going to happen. I still think that it’s much more likely that some sort of agreement is reached. 

Obviously, a default is a devastating thing, but we went through something very similar in 2011, and what we ended up with… and back in the ‘90’s, we had the government shutdown, if you’ll recall. So what happened in 2011, ironically, was that there was a safe haven bid into long-term treasuries when we had that risk of default, when we did get downgraded by S&P, Standard & Poor’s. 

And so bottom line is people still see the US Treasury market as a safe haven, even when there’s a risk of default. So I wouldn’t necessarily run out of the treasury market or worry about that. I don’t think that there’s a loss of faith in the market as we can see the way yields are trending right now. But, again, it just adds to the volatility at the short end of the yield curve. 

NATE:  Got it. Okay. Let’s turn to Liz Ann. Liz Ann, you had mentioned the outperformance there within the large cap names year-to-date. We’ve got a question here about small- and mid-cap. Do you think the tightening lending standards are going to be impacting the small and mid-caps this year? 

LIZ ANN:  So I’ll, I’ll go back to something I touched on when I was talking about takeaways, things like growth versus value in sectors. Be really careful about monolithic approaches. To say, ‘Do you like small caps?’ Well, what small caps? You know, Russell 2000 is the most common benchmark for small caps, again, 2,000-ish stocks. That’s a lot of stocks. About a third of which, by the way, are zombie companies, companies that simply don’t have the cash flow to meet the interest on debt. And those were the types of companies that were supported by the ample liquidity ZIRP environment. And it’s the unwinding there that is filtered into things like the banking system, but as I mentioned, I think that broadens from here. So I think there’s a lot of lower quality stocks in an index like that.

A lot of people don’t realize is that the S&P 600 is also a small cap benchmark. It doesn’t happen to be a benchmark utilized as much by institutions, but they have a quality and a profitability filter. As a result, it’s a much, much smaller share of things like zombie companies. So the one thing I’d say is if you want to start at the index level with a base of what to screen for, that might be a better starting point than the Russell 2000. 

But beyond that, you still have to look for, I think, the factors that are most important right now, which is strength of balance sheet. In other words, lower on the debt end of the spectrum, higher on the cash flow. As Jeff touched on, outside the United States, shorter duration companies that have the here and now cash flows and earnings. It’s not total addressable market way out into the future long duration type companies. Interest coverage, cash position. In an environment where earnings estimates continue to go south, certainly for the first half of this year, you want to look for stocks that have either those positive revisions or once we get into earning season positive surprises. So that factor-based approach, you can also apply on the small cap side, but the little kind of tidbit of a tip or advice is make sure you at least have a start point that weeds out a lot of those really low on the quality spectrum companies. 

NATE:  Got it. And, Liz Ann, I’m going to stick with you because we are getting a couple of questions here just in regards to potential earnings contraction into being more important than the short-term rates. And you know, with this talk about a potential for a recession, do you have any anticipation that we’ll see a contraction within EPS and that the price earnings ratio on the S&P will come back down to a more historical standard? 

LIZ ANN:  Well, we have been seeing a contraction in earnings. If you look at overall S&P earnings, they were down in the fourth quarter ex energy, which has been, at least last year, was the big earnings power driver for the S&P. Ex energy, the fourth quarter was the third quarter in a row of negative year-over-year change in earnings. Now, the consensus expectation for overall S&P for Q1 and Q2 is down again. So it would be three quarters in a row, assuming that consensus is accurate, about mid-single-digit territory of a decline year-over-year in Q1 and Q2. But then the consensus has a lift back into mild positive territory in the third quarter and back into double-digit growth territory in the fourth quarter. I think that’s a bit of a stretch. It wouldn’t surprise me if at some point we get to a calendar year or even a rolling four quarter decline relative to 2022’s numbers. 

I think part of the reason why there’s been more of a… call it a short duration focus on the part of analysts where they typically wait to adjust the next quarter or two of their estimates until you’re in the current quarter’s earning season, where they at least get some of that guidance and perspective from companies. But in an environment where companies are providing less precise guidance, not quite as bad as it was during the worst part of the pandemic when a record percentage of companies just withdrew guidance altogether, there’s still a lack of that concrete guidance, and that’s leaving analysts somewhat to their own devices, and, therefore, they’re taking a shorter term approach to adjusting numbers. So I think the path of least resistance is still down for the E, which all else equal, no movement in the P, which means there’s upward pressure on PEs, all else equal.

Now, inflation has been coming down. If it continues to come down, that puts less of that downward pressure on multiples, which really defined the first half of last year, when with what was expected coming from the Fed and a 40-year high in inflation, that put massive downward pressure on multiples to a point at the lows that multiples looked pretty decent, but now they’re seeing some upward pressure because of that decline in the denominator. I think we need to see some stabilization in forward earnings to be able to do more compelling valuation analysis. 

NATE:  Great. Thank, Liz Ann. And we’re getting several questions here about the dollar. So let me bring in Kathy for this one. Kathy, a lot of concern basically about the dollar potentially being devalued. And, you know, with what’s going on with China, is there any potential that the dollar loses its status as the world reserve currency? 

KATHY:  Yeah, this has really been going around a lot, and I think that some of the stories have been picked up by the more mainstream media. Typically, this is something that comes up periodically for those who are advocating switching into, you know, alternatives like gold or Bitcoin or whatever. But has gone mainstream, and that’s because we’ve seen a handful of trades done in Chinese yuan for oil between a handful of emerging market countries. And some of this has to do with Russia’s position and some of it has to do with politics. And so it’s created the idea that perhaps the dollar will be displaced as the medium of exchange for oil, other commodities, and more broadly in the global economy. 

But let’s step back a minute and look at what’s happening. So the dollar had a 10-year bull market, 11-year bull market. It moved up 1.4 times against a broad index of major trading partners. So it’s had a decade long bull market. It’s pulled back a little bit since we started to see interest rates come down in the US relative to elsewhere, typical sort of cyclical activity when you’ve had a big move based on interest rate differentials, relative growth, and enthusiasm for US stocks, and now it’s a rolling over and it’s come down a bit. But it’s hasn’t even broken its long-term uptrend line. So a lot of the rhetoric seems really overdone based on what’s actually happening. 

But then when you get to the question of, you know, will the Chinese yuan or some other currency replace the US dollar’s reserve currency, you have to think about what is required to have a reserve currency. And you need deep and liquid markets that people can invest in, you need a medium of exchange that people believe in, and you need open capital markets. And China does not have any of those things, and particularly it’s got a closed capital account. Money can go in, sometimes it can’t always come out. They control it. They’ve pegged the yuan to the US dollar, so they’ve controlled the currency. But the main thing is even if you wanted to use the yuan as a reserve currency, you would have to have access to government bonds in China, and that’s not an easy thing to pull off. And then 80% of the global transactions, financial transactions, still take place in US dollars. US dollar reserves still are about 60-some-percent of total reserves. Now, that’s down from about 70% 20 years ago. So over 20 years it’s gone down, you know, probably less than 10 percentage points. And that’s with the introduction of the Euro. So you would think that if the dollar is going to be displaced by any other major currency as reserve currency, it would be something like the Euro, because at least you have access to their markets. The problem is Europe’s bond markets are more fragmented because they’re divided between a number of different countries. So, actually, holding securities, liquid securities in Europe is more difficult to do in size than it is in the US. And on and on it goes. 

So when you kind of look at the underlying facts, it would be hard to create a scenario in which the dollar is displaced as the world’s reserve currency anytime soon. There’s a long way to go from where we are today to that in the future. Could the dollar go down on a cyclical basis and continue to go down? Sure, absolutely. Could there be inroads in terms of trading and the transacting and other currencies? Sure. But to go from a small movement to replacing it as a world’s reserve currency when there’s no real evidence that there’s an alternative that’s worth… that would attract the kind of funding… or the funds or investors that you need to have, it’s just not there. 

So, no, we don’t worry about the dollar losing its reserve status anytime soon. We do see a cyclical decline. But particularly some of the stories about, you know, China’s currency replacing the US dollar, it seems to me to reflect a lack of understanding of how reserve currencies function. 

NATE:  Got it. Okay, let’s… sticking with the theme of China, let’s turn to Jeff. Jeff, with the rising tensions between the US and China does your view on the emerging markets change at all? 

JEFF:  Well, emerging markets is driven by China, and China’s economy and stock market is being driven by domestic growth as consumer spending rebounds from the Zero COVID restrictions last year. Tensions won’t change that. And I’m not sure the popular take on tensions increasing between the US and China is all that meaningful as it relates to performance. Certainly, there’s not much his historical correlation between geopolitical tensions and Chinese equities or EM equities, for that matter. Attempts have been made lately to turn the heat down after that balloon incident. No executive order has been released yet on Chinese tech investment. Taiwan’s president came to the US to see the house speaker and not the other way around. This happened in August of last year when Pelosi went to Taiwan. China’s two sessions’ parliamentary meeting in March ended with a clear message they do not have any intention of supplying weapons to Russia as the US had publicly requested. And the US Public Company Accounting Oversight Board issued a statement that the agency received complete access to inspect and investigate Chinese and Hong Kong audit firms during recently concluded programs. So they, basically, are telling us that China is completely compliant with the requirements of the Holding Foreign Company’s Accountable Act, meaning that that stops all Chinese firms from being delisted from US exchanges, which had been set to take place beginning early next year. And so… oh, and I’d also add that China recently brokered a peace deal with Saudi Arabia and Iran, which is in the US’s interest. 

So I’m not sure that theatrics in DC and Beijing reflect the reality on the ground as it pertains to the relationship. I don’t want to suggest things are rosy between the US and China, but maybe different than the brink of war the headlines suggest. Instead, focusing on strong consumer, spending a softer dollar, perhaps, and a policy focusing on stimulating growth rather than reigning it in should help Chinese stocks and all of EM this year. 

NATE:  Great. Thanks Jeff. And I got a real quick separate topic. We’ve got someone asking, ‘What is the total notional value of world derivatives?’ 

JEFF:  Well, according to the Bank for International Settlements, I think the last number was 600-and-some-odd trillion dollars. I’ve seen estimates of over a quadrillion dollars in notional value for derivatives. I don’t think this number matters at all. A notional value really isn’t that important. The market value is going to be quite different. If you had, let’s say, a put on the S&P 500 for a million-dollar portfolio or your notional value is a million, how much is the market value? Well, it depends on what you paid for put, a tiny, tiny fraction of the notional value. So these numbers get thrown around because they’re big, they’re not all that meaningful. 

They are meaningful when markets are moving quickly or when there is counterparty risk among major banks that are counterparties to these contracts, because, in theory, you know, one lines up with the other and they net out, but not if the counterparty fails on one side of that trade. That’s not what we’re talking about with these banking stresses. These are in regional banks, not the big banks that are counterparties to major derivative transactions That did happen in ‘08/’09. That is not happening now. It doesn’t appear to be on the agenda that happened now. So I think it’s a very different environment. The notional value of derivative is not high on my list of things that I’m worried about at the moment. There’s plenty of other things higher than that. 

NATE:  Got it. Okay. Thanks, Jeff. 

And, guys, that’s all the time that we have for today. So to Liz Ann Sonders, Jeffrey Kleintop, Kathy Jones, and Randy Frederick, thanks so much for your time today. And thanks to the audience for joining us and for all your questions. And if you would like to revisit this webcast, we’ll send a follow up email with the repay replay link. 

As a reminder, if you would like to receive one hour of CFP or CIMA continuing education credit, we’ve changed the process for submitting CFP CE credits. Please make sure to enter your CFP ID number in the window that should have popped up on your screen. Schwab will submit your credit to the CFP Board on your behalf. CIMA credit is now self-submitted and directions for submitting can be found in the CIMA widget at the bottom of your screen. You can also download the CFP certificate for your records from the CFP widget below. If you’re watching this replay, just as a reminder, you cannot receive CFP credit. 

And as mentioned at the beginning of this webcast, we hold these events monthly. The next one will be May 2nd, and guests on that call will include Liz Ann Sonders, Kathy Jones, and Jeffrey Kleintop. 

Until then, if you would like to learn more about Schwab’s insights or for other information, please reach out to your Schwab representative. Thanks, again, for your time and have a great day.