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.

LIZ ANN: Welcome back, Kathy. Were you on the road this week?

KATHY: Actually, I was in New York attending some meetings, visiting a few clients, but I have a lot of travel coming up over the next few months. How about you?

LIZ ANN: I do, too. I think I have a little bit of a reprieve still in the next couple of weeks, and then it kicks into crazy-high gear. I'm at that point, and we were just laughing about it before the microphones went live, that people start asking me, "Well, when are you coming to …?" or "What's the date of …?" and I say I'm lucky to know what is tomorrow on my calendar let alone weeks from now. You sorta just … you go where it's in your calendar, and you get on a plane and speak. But yeah, it's kicking back in, I agree. 

Hey, I wanted to get your latest take on one of the clearly biggest issues at play these days. And I think a lot of investors seems to be waiting around for, and that's, of course, the Fed going from the verbal pivot to suggesting they're considering rate cuts to the actual pivot to rate cuts, and pretty much every day it seems like Fed watchers and analysts and economists are making adjustments and positions that are being taken in the futures market around whether or not the Fed's going to start in March. I think I saw that we're down to about a 45% probability, which was about 75% a month ago and even higher prior to that. 

So what is your latest thinking? I know we touched on it in last week's podcast—on not just when you think the Fed starts, but what would be the driver of that in terms of the data.

KATHY: We continue to think that May is the most likely time for the first rate cut. I mean, none of this is carved in stone—and I do see a lot of people now predicting a rate cut in March because, you know, the inflation data continue to show a decline. And I wouldn't rule it out. Inflation data have been declining for a while, and if you look on a three- or six-month rate-of-change basis, we're already pretty close to the Fed's 2% target. But I'm not sure that that's going to change the Fed's decision-making. So far, it hasn't really changed its messaging, and that's what we're kind of waiting to hear. But our expectation is still that May is the more likely time. It gives the Fed more time to make sure that inflation indicators are where they want them to be and stable. It also allows the Fed to start the process of tapering its quantitative tightening program. Now, this is where they've been letting bonds mature without replacing them and shrinking the balance sheet, and they haven't really begun to slow down that pace yet, and that is something that they've been talking about, and I think they prefer to do that before rate cuts begin.

And then there's this bank-term funding program. It expires in March. And although a lot of that loans will continue to be on the books for a while, there's a lot of things for the Fed to evaluate in terms of how the banks are doing. I think that may just mean waiting a little bit longer than March and giving themselves a little bit more time.

LIZ ANN: I also wonder about once they start, whether maybe the process will be either a little slower or more methodical. One of the analogies I've been thinking of is what has historically been said about the Fed during both the hiking cycle and the cutting cycle that they tend to take the escalator up and the elevator down. And I think very clearly what's been different in this cycle is they essentially took the elevator up, given multiple more-than-25-basis-point hikes, 50 even 75, and just wonder whether, just in the interest of making sure that, to use a phrase often used around the Volcker era, that they feel confident in having slayed the inflation dragon, that they might be a little more hesitant to just ramp up the pace of rate cuts, especially if resilience is retained in the backdrop economy and inflation continues to come down. So do you think they'll be more escalator-oriented in this cutting cycle, barring some sort of crisis developing?

KATHY: Yeah, I think that is certainly that is the plan. Let's sort of take a gradual approach to lowering rates as inflation comes down. So the justification is if you look at where real rates are, inflation adjusted, they're pretty high right now. And so there's a case to be made, well, let's get them back to what's a more sustainable level. But as you say, economy is still chugging along pretty well despite the fact that real rates are high. So what's the hurry? You know, it's always the balance of "where do you do more harm than good?" And I think trying to take a more methodical approach like you mentioned would make more sense unless something really goes awry.

LIZ ANN: Well, I'll just assume that probably on nearly, if not all, episodes of this, we're going to have some semblance of a conversation about the Fed and Fed policy. But as you and I are recording this now, of course, we're right in the throes of reporting season for fourth-quarter earnings. And I'll just start with some perspective and overview on what we're seeing in, you know, equity-market land, but I also love your thoughts because of the tie-in, obviously, to the credit markets. 

I'll avoid going really precise with some of the numbers that have come out because, of course, when you're in earnings season, it's a moving target on a day-to-day basis, and as of this, we're still not even at 100 of the S&P 500® companies having reported. And we get the start of some of the high profile, big, techie kind of companies, the start of stocks included in the so-called Magnificent Seven. I'd say based on the traditional metrics that tend to be in focus, the earnings season has been OK so far. And in particular, the beat rate so far is about 80%, meaning 80% of companies that have reported within the S&P have beaten estimates. Now that said, that is down from where we have been in the last couple of quarters and has been trending down so far in this earnings season. Just a couple of days ago, you were at about, I think, an 86% beat rate. And also the percent by which companies so far have beaten estimates has dropped to below average. But what we also get in earnings season is not just the bottom line, which is earnings per share, but top-line revenue growth. And there, the beat rate, the percent by which companies have beat, are both pretty meaningfully below average. And the other, I think, important metric is what has happened to estimates in the past few months. Three months ago, at the end of October, which was obviously prior to reporting season, the expectation was for low double-digit growth year-over-year for the fourth quarter. And that's down now to about 4% expectation. And it hasn't just been concentrated in the fourth quarter. Every quarter in calendar year 2024 has seen estimates come down more significantly for the first quarter or two. And that's just the nature of analysts being a little nearer term in making adjustments because of the less precise guidance in general that they're getting from companies.

But the effect of lower estimates is that the multiple on the S&P has gone up. So before earnings season, the market was trading at about 18 and change, less than 19 on forward earnings. And because we're losing some lift in the forward earnings, that multiple has jumped up to 20. What's interesting though is maybe no surprise, the Magnificent Seven are more expensive than the overall index in aggregate. They're trading at a multiple of 30 times. But the net is that if you X out the Magnificent Seven, the S&P's multiple drops down to a more reasonable 17. Magnificent Seven is where a hefty portion of the earnings growth is concentrated. So I think as has been the case in the last few quarters, I think not just overall earnings season is key, but what we hear from the Magnificent Seven companies and many related to that, not just about the fourth quarter, but what their outlook is for calendar year 2024. So what are you seeing in credit land and the health of companies both up and down the size spectrum? 

KATHY: You know, it's interesting because in corporate-bond land, everything looks rosy right now. So demand for corporate bonds is really strong—everywhere from, you know, the higher investment-grade bonds to high yield. And that has brought the yield spread between corporate bonds and Treasuries of comparable maturities, you know, well below average now, even a three-year low for some of the bonds. And I guess that's an optimism that earnings will continue to be good, and if the Fed cuts rates that's going to help the economy, you know, this Goldilocks scenario. I think people forget that Goldilocks got complacent, remember, fell asleep and got chased away by the bears. So I wonder if we're not just a little bit too complacent in corporate-bond land right now in terms of pricing in a perfect scenario. 

We still think they're good hold for people looking for income, especially investment-grade corporate bonds. We do think you'll earn the coupon this year and without too much trouble, but we do expect some more volatility. And right now, the valuations are pretty optimistic, and maybe that's just the equity folks leaking over into the corporate bond market.

LIZ ANN: Kathy, you touched on the somewhat narrow differential between investment grade and junk, or high yields. And there's an interesting comparison that happens in, just in general with corporations, but tied into equity world and where maybe earnings have been surprising on the upside and why cash flow has been a leadership factor.

Because a lot of the larger companies, in fact, I think 18 out of the 20 largest companies—and the two that are excluded are two financials where you don't do the same kind of analysis on things like cash flow—but they earn significantly more interest on their cash holdings than they pay on their debt because so many companies, particularly those that had the wherewithal and the strength to term out their debt means that they're paying interest on debt, if they have debt, that is fairly low, and obviously the interest that they're earning on their cash has continued to grow for the most part, notwithstanding some ups and downs in longer-term yields. So I think that's been something that hasn't been discussed as much as I think it should. It's often tied into questions about "Is the economy less interest-rate sensitive than it's been in the past?" And that's one way to answer it in terms of healthier corporations that, even if they took on debt, they might have done it for legitimate reasons, taking advantage of what was an incredibly low-rate environment and now are earning much higher interest on, in many cases, the hoards of cash that they're holding.

KATHY: Yeah, that's a great point, and it is a big differentiator between the higher-credit-quality bonds and the lower-credit-quality bonds where, you know, we are seeing higher, by definition, higher leverage rates, you know, much more in the way of borrowing and more exposure to the interest rate cycle. But right now, the market's not displaying a huge price differentiation or yield differentiation, at least not as much as we might expect given where we are in the cycle. 

So that's where things stand this week.

Now let's talk about next week. And believe it or not, we're almost to February. So by our next episode, January will be in the rear-view mirror. What's on your radar for next week, Liz Ann?

LIZ ANN: Well, we get another couple of regional Fed reports, and it's nice to get the full package on them so you can get a sense of maybe what's happening more broadly, some home-price-related information. You've got consumer confidence coming out, and it'll be interesting to see whether it corroborates the big move up in consumer sentiment. What's interesting is consumer sentiment, which is put out by University of Michigan, tends to key more off of what's going on in inflation, where consumer confidence tends to key more off on what's going on in the labor market. And that explains at times why there can be a differential between the two. So it'll be interesting to see what that one shows. There's a Fed meeting, which we don't anticipate anything in terms of a to-do on their part, but as always, the statement's interesting, the press conferences are always interesting. We've got the ISM data that is coming out. We had the S&P version of it that showed a bit of an uptick, so we'll have to see whether the ISM Purchasing Managers Indexes again corroborate that. And then we've got jobs, jobs report at the end of the week, which these days are always headline grabbing. How about you?

KATHY: Yeah, same. I don't expect much at the Fed meeting this time around. Everyone's focused on March as the next big meeting. And, of course, the employment data, always important. And since it's part of the dual mandate, and it's been a big driver of expectations, I would expect that that'll be pretty important. Also, watching some of the other central bank meetings around the world. So far, the news has been pretty quiet, but at some stage, the European Central Bank is likely to start easing policy because the economy there, particularly in Germany, has been pretty soft. So that's going to be interesting to see how soon and how fast they move. And on the other hand, we have the Bank of Japan that's talking about raising rates sometime this spring, but they keep kind of pushing that back. So we'll be watching to see if there's any indication there that they have changed their mind and are ready to finally move after, well, the last rate hike was in 2007, I think. So it's been a long time.

Also, you know, as we've mentioned in the past, it's an election year, and there's just a continual flood of news about that and what's happening in Congress with the new speaker. Congress just avoided another government shutdown, and we'll have our colleague Mike Townsend on again soon to talk about the implications of all that. But in the meantime, make sure you stay subscribed to Mike's podcast, WashingtonWise. You can find it in any podcast app or at Schwab.com/WashingtonWise.

LIZ ANN: And with that, I hope we don't often have to end on the subject of the election. But with that, we're going to wrap it up for today. As always to our listeners, thank you for tuning in, and be sure to follow us for free in your favorite podcast app. And if you've enjoyed this episode, tell a friend about the show.

KATHY: And if you want to keep up with the charts and data we post in real time, you can follow us both on Twitter (or X) or LinkedIn. I'm @KathyJones—that's Kathy with a K on Twitter and LinkedIn.

LIZ ANN: And I'm @LizAnnSonders, and that's S-O-N-D-E-R-S.

KATHY: On next week's episode, my colleague Cooper Howard and I will be speaking with Jane Ridley, who is a senior director and the local government sector leader in the U.S. Public Finance Government Group at S&P Global. That is the rating agency. So stay tuned for that conversation.

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