KATHY JONES: I'm Kathy Jones.

LIZ ANN SONDERS: And I'm Liz Ann Sonders.

KATHY: And this is On Investing, an original podcast from Charles Schwab. Each week, we analyze what's happening in the markets and discuss how it might affect your investments.

So hello, Liz Ann. We're back again this week, and we've got a lot of inflation data that have been released and a pretty meaningful market reaction, both equities and in bonds. We got the Consumer Price Index and the Producer Price Index this week. So what did you make of both the PPI and CPI data with regards to equities?

LIZ ANN: Yeah, so clearly the CPI release was cheered to a much more significant degree by the equity market, and that's in part because of what happened in your world with the decline in bonds. PPI was, on the surface anyway, pretty benign, fairly mild, actually slightly lower than expectations. The only blemish in PPI, which is maybe why, after initial reaction, stocks sold off again, was the airfares component within PPI, which does feed directly into the Fed's preferred measure of inflation, the Personal Consumption Expenditures index, the PCE index. So that was just about the only blemish in the PPI data, but the Consumer Price Index was better than expected, meaning less inflation, even though was an uptick in year-over-year terms, still in somewhat benign territory. It didn't really move the needle, in terms of what the Fed is likely to do at the January meeting, but you did see some economists as well as Fed chatterboxes move assumptions of when the Fed would next cut from maybe July or September into the June period of time, but a lot of action in the bond side of things.

So what were your thoughts both in terms of PPI and CPI and how the bond market reacted and your thoughts on Fed policy in light of this?

KATHY: Well, bond market obviously liked the CPI number quite a bit. The PPI number, the producer prices were kind of in line with expectations, so not too surprising, as you mentioned. But the consumer price number was good in terms of relative to expectations. So being up 0.2% for the core number was a relief. I think there had been some concerns that it would be higher than that. And that does bring the kind of year-over-year pace down a little bit below 3% for the CPI. And that, again, that print was a relief. I think a lot of the reaction in the market was just because positioning was offsides. A lot of people prepared for a bad inflation number, at least one that confirmed that we're not making any progress and getting news that maybe there's a little bit of progress being made was such a relief, it caused people to turn around their expectations on a dime. Having said that, I'm a little concerned that we're just veering from one end of the spectrum to another in terms of how we are looking at what the Fed's reaction function is. So on the one hand, the market completely pricing out any possibility of rate cuts or just maybe one rate cut by the end of the year, then jumping into, "Oh well, maybe they'll cut in June."

So it's a little bit of an overreaction. I don't think the Fed wants to react quite so quickly to one-off numbers. They want to see trends. They want to make sure things are sustainable in the right direction. And we still have a pretty solid labor market and a solid growth rate in the economy and lot of uncertainties on the horizon in terms of policy. So I don't think the Fed is as likely to jump on this number as the bond market was.

The bond market has had a run now, you know, sold off and yields rising really sharply for quite some time. So it's not too surprising that once we got a little bit of good news, there was a good size rally in the market. Whether it's sustained or not, you know, it's going to depend on subsequent data. But at least for now, a little bit of relief coming in through the bond market, I think, to the rest of the markets, particularly to the risk asset markets.

So one of the things we do have to watch for is what the impact of these fires in California might be on inflation. I mean, besides the human loss and disaster, one of the things that we'll be watching for is how does it affect prices from rebuilding? So used car prices are likely to start to rise. They were down in the current month. I would expect the next couple of months because California is such a big state, and this area affected so many people. A lot of cars have gotten destroyed. So the logic would be that people go out and buy used cars because they absolutely need the transportation. So we could see that factor reverse. Could have an impact on food prices, could have an impact down the road on construction materials, things like that, anything housing related, because demand presumably would pick up. So that's something we need to keep an eye on, but that's going to play out over a relatively extended period of time, I would guess.

LIZ ANN: Unfortunately, speaking of the devastating fires and of course, our hearts are with everybody that was impacted, we did want to take the opportunity this week to talk about how some natural disasters can have real financial impacts on the markets. I live in

Florida a good chunk of the year, and we've experienced some pretty serious hurricane disasters in the last couple of years, and I don't think that's going away anytime soon, and it is important to assess not just the very short-term impacts but maybe longer-term impacts. So I think this is an important topic. It's a timely topic. So Kathy, tell us about our guest today.

KATHY: Sure. Joining me now is my colleague Cooper Howard. Cooper holds the Chartered Financial Analyst designation. He's a director at the Schwab Center for Financial Research. He's on my team. And he's our expert on the municipal bond market which is really important for a lot of our individual investors. He's been quoted in many financial publications, The New York Times, Bloomberg, Bond Buyer, and CNBC. 

So Cooper, thank you so much for being here today.

COOPER HOWARD: Thank you so much for having me, Kathy.

KATHY: We're here to talk about climate shocks and the impact on the municipal bond market. Obviously, timely topic because of the devastating fires in California. And we do want to acknowledge the human impact here. But we have you on to talk about the financial aspects of it and how it might affect the municipal bond market. So why don't we jump in here and just say, are California municipal bonds at risk due to the wildfires?

COOPER: You know, that's a great starting point. And obviously, there are more important things going on than what's happening in the municipal bond market. And we're fully cognizant of that. However, our job is fixed income strategists. So I want to look through the lens of a municipal bond strategist and kind of see what's going on in that. And I think a good starting point, I go back to the quote that Peter Lynch, the famous investor, had, and it's "know what you own."

And so I think that there are many different credits potentially related to this. And I want to take a minute to funnel out, if you will. Start at the very narrow end of the funnel and then move out to potentially what could be the risk to the broader municipal bond market. Now, the immediate risk or kind of near-term risk is to those issuers that are going to be directly impacted by the wildfires.

For example, there are utility districts in the area. The largest utility district in the area is the Los Angeles Department of Water and Power. Now, they have two different types of bonds that are outstanding. They have bonds that are related to the power system, and they have bonds that are related to the water system. And the potential risk to the two types of bonds is a little bit different. I'll start with the potential risk to the power system.

And in California, California is relatively unique in the sense that if a utility's equipment is found to have been the cause or the start of a wildfire, then that utility may be financially responsible for the wildfire itself, even if there isn't negligence associated with their equipment. So the potential risk to those types of bonds is that if they are found liable for the fires, then they'd be financially responsible for it. Now, how big of a financial hit will that be to them? That's a big question that we ultimately don't know at this point. So we don't know what the cause of the wildfires are. So we don't want to speculate on that. It's also going to be dependent upon what liquidity do they have on hand? What insurance premiums do they have available to them for situations like this? So there are a lot of unknowns in that.

We are seeing a little bit of a market reaction already to where those bonds have traded down in price, up in yield. So that's one side of it. The other side of it is the water bonds. And the potential risk there is that it could be related to lawsuits related to the Palisades Reservoir being offline. And there's a group of homeowners in that area that could potentially file a class action lawsuit because there wasn't enough water that's available. Now, that's the very narrow end of the funnel. If we zoom the funnel out a little bit further, then it would be issuers in the area as well. Those could be things that receive revenues based off of usage fees around the area. For example, LAX, the airport in the area, if there is a decline, a long-term decline in usage, then maybe that would be a potential impact to their revenues. It doesn't appear at this point that it's that big of an impact to them.

And then if we take a further step back and look at what is the impact to the state. Now the state has a very progressive tax structure. The top 1% of earners, they account for about 40% to 50% of state income tax revenues. Now at this point, only 1% of LA County has burned. It's obviously very devastating. But where most of the wildfires are occurring are in areas with homes and businesses of variable and sometimes significant value. So these are higher-income earners that contribute a large portion to the state's overall tax revenues. They've been granted an extension to file their income taxes, Kathy. So this delay in receiving income taxes could ultimately flow through to the state and have a little bit of an impact. I don't think that there's going to be that large of a credit impact because the state has been building up its financial reserves and is in a relatively good financial position, and they can probably offset some of the temporary declines in revenues if they have to.

KATHY: OK, that's a good rundown on California. And I would note that there's actually another impact of the delayed filing of tax returns in California because we are still in the midst of trying to resolve the debt ceiling issue in Washington. And usually the Treasury has some leeway between when we hit the debt ceiling and when they actually start to run out of money and are unable to do these maneuvers to keep things going. If the tax revenues from California are delayed, then that could mean that we hit the debt ceiling, you know, drop-dead date a little bit earlier. So something just to keep an eye on. I think this happened the last time when California had delayed filing because of the fires in Northern California. So we'll keep an eye on that. But going back to the whole issue of climate shocks. And is this something that muni investors should be concerned about going forward on a broader basis?

COOPER: I wouldn't say that they should be concerned about it, but I would say that they should be cognizant of it. So we know that the number of billion-dollar shocks, or climate shocks, has been increasing. Just last year, 2024, there were 27 billion-dollar climate shocks. If you compare that to the '80s, on average, there was only 3.3 billion-dollar climate shocks on average per year. Fast forward even to the 2010s, and there were only about 13 billion-dollar climate shocks on average per year. So the number of climate shocks has been increasing, and this could be a potential impact to municipal issuers in areas that are prone to those climate shocks. 

Now, to date, no municipal bond issuer has defaulted because of a climate shock. Part of the reason for that is that when a climate shock occurs, and if the president declares a federal disaster, FEMA[1] can come in and provide 75% of the cost in cleanup. And that goes a fairly long way in helping to offset some of the costs that might be borne by that local issuer. Now, the other thing about it is that, oftentimes, there's a little bit of a fiscal boost or an economic boost following a climate shock. Because when individuals rebuild their homes or rebuild structures, there's going to be sales tax that's going to flow through to state and local governments, depending on how they're structured. So I do think that it is something that individual investors should be aware of. But at this point, I don't think that it is a major risk in the municipal bond market.

KATHY: That's great to know. If I'm a muni investor, what steps could I take to mitigate some of the risks associated with these climate shocks?

COOPER: Yeah, so although I don't think that it is a major risk in the muni market, I do think that, again, it is something that investors should be cognizant about. And one of the things that we would suggest is to diversify across issuers among different locations. So we usually recommend, Kathy, at the Schwab Center for Financial Research, to invest in at least 10 different issuers with differing credit risks. Differing credit risks can mean different economic locations.

So for example, if you hold some of your portfolio in Southern California, if you're a California investor, maybe consider diversifying into Northern California or other parts of the state that aren't subject to similar economic risks in the area. For many other investors who aren't in high-tax states like California or New York, I'd suggest looking at bonds from other states. So you can diversify and get away from things like hurricane risk, potential droughts, potential wildfires.

So this is something that climate shocks do impact different parts of the country to varying degrees. But by diversifying across, that can help spread out some of the risk. I think one of the other things that is a potential risk of climate shocks is out-migration. So we've already seen a pretty significant increase in homeowners insurance costs because of climate risks. Now, if those individuals in those areas that tend to be prone to climate shocks start to move away, that's a deteriorating tax base. So that's a negative impact to state and local governments or issuers in that area that derive taxes. So what we would suggest is usually demographics take years to kind of play out. I would suggest focusing on shorter-term bonds or intermediate-term bonds so you can see some of those longer-term demographic issues, potentially avoid some of them somewhat.

KATHY: That's great advice. Thank you. We always talk about diversification. And I think sometimes people think it's only stocks and bonds or, you know, high-yield bonds and investment-grade bonds, but it really has a lot to do with just having different issuers in your portfolio, making sure that you have spread your risk across a number of different issuers and areas. 

So Cooper, I know you've addressed this issue in the past. You had a nice article about it—I think it was nearly a year ago—and you've talked about the topic a number of times.

So we're going to link to your author page in the show notes so that people can find those existing articles. And I believe you've got another one coming out very soon in the next couple of days. So people will be able to monitor the ongoing information that you're providing.

Great to have you on sort of last minute to address this timely issue.

COOPER: Thank you so much, Kathy.

LIZ ANN: So it's that time in our episodes where it's look ahead. Kathy, we have a holiday-shortened week next week. So what is on your radar for the next four-day week or so?

KATHY: Yeah, I love these four-day weeks. 

LIZ ANN: Me too. 

KATHY: I mean, it's so nice to … we get a lot of them in the first half of the year, but I really enjoy them. Economic calendar, a little bit quieter next week. Obviously, we have the inauguration. So whatever news comes out of that, potential wave of executive orders that could be relevant to the markets, we'll certainly be watching for any information on tariffs because that's kind of top of mind in the market.

We also have a number of Fed speakers out. Now, we have the annual rotation of voting members that's occurred, occurs every January. And I'll be paying pretty close attention to where some of the new voters are on this sort of dove-to-hawk spectrum. New voting members are Austan Goolsbee of the Chicago Fed. We know him well. Susan Collins of the Boston Fed, we know her well. she's a familiar face.

The new faces are Musalem and Schmid from St. Louis and Kansas City Feds, respectively. I would assume that they're more likely to be on the hawkish side, but it's going to be interesting to see how they explain their views, what's important to them in terms of setting policy, where they see things going. So we're going to be watching that pretty closely. And then that will be in anticipation of the FOMC meeting at the end of the month, January 28 and 29. So we'll go into the quiet period coming up by the end of the week. What about you, Liz Ann?

LIZ ANN: Well, we get the LEI, which is short for Leading Economic Index. That's put out monthly by the Conference Board. And it may be not garnering as much attention as it has in past cycles because it has been generally declining for a couple of years plus now and obviously has not been a leading indicator of at least a traditional recession. But any kind of significant improvement there, even though it got dismissed as an erroneous indicator for the economy on the downside, I still wouldn't be surprised if there's some cheering at the point where we start to see some meaningful moves higher. So I'll keep an eye on that. 

We get claims—that's a weekly number. We get unemployment claims every week, but some of the recent readings have been quite low. And we'll have to see whether that continues to corroborate what was a very strong most recent jobs report. We get the University of Michigan data out. That's both consumer sentiment, which is another version of consumer confidence that the Conference Board puts out. But we also have within that inflation expectations, so we'll see whether the needle has moved there at all. S&P Global puts out a version of PMIs, which stands for Purchasing Managers Indexes. And those are starting to garner a little bit more attention and getting some traction as key indicators, maybe not quite with the popularity of the ISM, which is the Institute for Supply Management, version of those, but we'll get that collective reading on both the manufacturing and services side of the economy, and then toward the end of the week we get existing home sales. And that's important, especially when you talk about home sales broken out between existing and new. Existing is about 80% of the market. So it does represent a much larger share and therefore is a more important reading on the housing market than just new home sales if you were looking at those in isolation.

So that's it for us this week. Thanks as always for listening. And as always, you can keep up with us in real time on social media. I'm @LizAnnSonders on X and LinkedIn. Not only should you make sure you're following the actual me on X, but also note that I am not on Facebook. I'm not on Instagram. I'm not on WhatsApp. I've had a lot of imposters. So please make sure you are not scammed by those imposters. And you can read all of our written reports including all the charts and graphs at schwab.com/learn.

KATHY: And I'm @KathyJones—that's Kathy with a K—on X and LinkedIn. And if you've enjoyed the show, we'd be really grateful if you'd leave us a review on Apple Podcasts, a rating on Spotify, or feedback wherever you listen. You can also follow us for free in your favorite podcasting app. We'll be back with a new episode next week.

For important disclosures, see the show notes or schwab.com/OnInvesting. 

[1] Federal Emergency Management Agency