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: Well, hi, Kathy. So one thing I know on our team we've certainly been talking a lot about and writing a lot about is that this cycle is very different. It's I've often said it's, you know, one big orange compared to history's apples and lots of cross currents and bifurcations and data that doesn't always tell a similar story. And it makes it just a bit more difficult to make sense of how things are going in the economic cycle, where we are in the markets. We've both been around a long time. You've certainly seen maybe one more cycle than I have over the years. So how do you think of this cycle as it compares to those in the past? And do you think at some point we return to whatever we define as normal, or are we in maybe a different era?

KATHY: Yeah, you know, I'm not sure any cycle is normal, so to speak, because the economic circumstance has changed. But as we've talked about, it certainly is very different because of the pandemic, right? It was, you know, shut things down, open them up, and see what happens. And that's not kind of what we think of as a normal business cycle when, you know, you overheat, and then the Fed tightens, and then you slow down and all that. This was like, bam, you know, all of a sudden.

With supply shortages and all that kind of strange stuff. So I think it has been extremely difficult for economists and strategists and even central bankers to try and figure out where we're going and what we're doing at any point in time. Everybody sort of admitted that. 

From a fixed income point of view, there are a couple of really interesting aspects of this cycle, though. One is that despite the rise in inflation, inflation expectations never got as high as you might have thought. So short-term expectations kind of moved up with actual inflation, but long-term inflation expectations really didn't move up very much at all, you know, what the Fed likes to call "well anchored." And so the market sort of saw through, I think, part of that inflation that was indeed due to supply shocks and was indeed transitory despite that word being a pejorative these days. The market really did see through that and did, I think, have faith that the Fed would address it and that it would correct. So that's remarkable, but the outcome was we had that inverted yield curve for like two years, right? Very unusual to have it for that length of time and then to not have a recession that accompanied it. So really a strange cycle from that point of view, and I think everybody in the market should be kind of humble about what they got right and what they got wrong because there's a good chance if you got somethings right, it was luck. If you got some things wrong …

LIZ ANN: Although I would apply that to every cycle. Yeah.

KATHY: True, true. But I think this one especially stood out from that point of view. You could declare victory for about 10 minutes, and then the whole thing would change again. So from my perspective, that was unusual. And the other unusual part of this cycle from a fixed income point of view is that credit spreads stayed very, very tight. So we never really saw, outside of just momentary blips, kind of the expectation that we'd see huge defaults in the corporate bond market or problems of that sort. Now maybe that's because we did have such a robust fiscal response. That was certainly an unusual aspect of this. But you would have expected, and we certainly expected, lower-credit-quality companies to run into trouble, but they really hung in there. The financing was available, and as we kind of look forward now, it doesn't look like we're going to go through that default cycle that you would normally associate with a full cycle in the economy. So really unusual. And one for the one for the record books, I think. PhDs are going to be writing about this forever. But that, to me, from the bond market, that's what stands out for me. But what about you, Liz Ann?

LIZ ANN: Yeah, I'm glad you mentioned the inversion of the yield curve because a common question I've been getting in this cycle, particularly more recently, is the air quotes "failure of the yield curve to accurately forecast, at least not yet anyway, a recession." And that ties into leading indicators, which have been moving down for about 30 months right now, and it has not led to broad-based weakness in the economy.

And they're related in the sense that, of the LEI, which is the Leading Economic Index, the most widely watched index of leading indicators put out by the Conference Board on a monthly basis, there's 10 components to it. And the yield curve is one of those components. They have another financial component that is the Leading Credit Index that looks at things like spreads. And then the S&P 500® is the third of the three financial components. But the other issue with the LEI is that the other seven components, which are of the economic variety, tend to be more manufacturing biased. Now, that's not some fault of the folks at the Conference Board not understanding that services is a larger driver of our economy. They know that. It's just in the normal sort of course of a business cycle, you see weakness often show up first in those financial indicators and inversion of the yield curve weakness in the stock market. You then see it show up in the economic data points within manufacturing new orders, and then it eventually moves into weakness in services. And to your point about the massive fiscal response, it sort of elongated the timespan or maybe erased the spread of weakness from manufacturing to services. There just has been enough stimulus and enough support in the economy from the labor market as well to keep services afloat, even though we actually did have recessions in areas like manufacturing and housing and housing-related. And arguably, if you use the ISM Manufacturing Index as a proxy for manufacturing, we haven't pulled out of that recession yet. We're still in contraction mode. So I think that's another way to think about how this cycle is different.

The other thing I've been talking a lot about and been getting a lot of questions about at client events is obviously the recent geopolitical turmoil and the possible impact on the market. And we often see, as we did as you and I are taping this, there was the missile attacks from Iran to Israel, and it did cause weakness in the market and at least a little mini spike in volatility. Wouldn't surprise to see a bit more of that, but as we've all written, including our colleague Jeff Kleintop, these geopolitical crises and events tend to have a somewhat short-lived impact on the market through things like volatility spikes and short-term weakness, but until or unless it turns into something much more protracted and gets through in a more sustainable way, the energy markets, if oil installations are taken out, then it can have a longer lasting impact on either the economy or the market, but it's premature to make that declaration at this point. But that's certainly been top of mind, being on the road this week and getting a lot of questions from clients on that note.

KATHY: Yeah, unfortunately those geopolitical events are just very difficult to maneuver around if you're trying to be tactical in a portfolio. They're so unexpected. Typically, as we pointed out, they don't have a long-lasting impact, but you never know when there's one that does, right? And so it's a hard one. We did see, during some of those spikes in volatility, Treasuries rally as the safe haven, the dollar bounce up as a safe haven. And that's really kind of interesting too because the dollar is now in an interesting position because we are a major producer of oil in the world and an exporter. And so what happens in the Middle East not only affects us through the import channel, but through the export channel as well, and of course, inflation, etc., at least on a headline basis. So it's an interesting situation in this cycle that wasn't necessarily true in other times when we'd had these Middle East tensions. So it remains to be seen just how it's going to play out. But oil prices have been falling for quite some time. It looks like they were set to go even lower. And then we had this volatility. But I don't know how the dollar and oil prices … is the dollar now a petro currency? Partly a petro currency? Does have that impact or not? So definitely another interesting aspect as we go along that's relatively new. 

LIZ ANN: Well, according to clients that I spoke to at an event last night, I got a few comments, not so much questions, on the dollar. And there were a few of the folks, I know you hear from, of "The dollar is imminently losing its reserve currency status." And you and I always tend to pose the question back, "And what do you think is replacing it?" And there's not generally a quick or cogent answer to that. I did get, believe it or not, I got the Bitcoin answer last night to that question. I thought, "Really? We're back to that?"

KATHY: That's interesting. You know, my position has been that it will take a lot for the dollar to lose its reserve status. And the truth is, as people have been talking about this over the last several years, the use of the dollar has grown in the global economy, has become even more dominant in the global economy. So the facts on the ground, which often don't matter when people kind of engage in this sort of speculation, but the facts on the ground are that it's just not happening. And as you point out, there's just not a lot of alternatives that would make sense right now. But you know, never say never. Things can happen longer term. I think I'll probably be retired by the time, you know, the dollar is no longer the world's reserve currency. So that will that'll be your question, not mine. 

LIZ ANN: OK, well, I don't know that I'm that far behind you, but sure, I'll tackle it. You know, I guess I have a question for you. I have a feeling your answer is probably the same as what swirls around in my head. Let's just assume that the conflicts becomes much worse, and you do see a feeder in a more sustainable way through the energy market, maybe through other commodity channels, and it causes a turn higher in inflation, maybe just at the headline level, but sometimes it can feed into core inflation. Of course, you add to it things like the port strikes, possibility of much higher tariffs, and it is a recipe for potentially higher inflation. 

Part of the reason why the Fed has always operated with core inflation as half of their dual mandate is because there's volatility associated with things like energy and food prices that is sort of out of control of monetary policy, and they don't want to pull those levers if that's the driver. But what do you think the Fed's reaction function would be if, God forbid, we saw kind of the triple whammy of geopolitical escalation, feeder through energy prices, higher tariffs, and maybe a more protracted port strike than what we're hoping for at this point?

KATHY: I think that that puts them in a really bad spot because all of those things are kind of like a one-time inflation shock that then translates into slower growth down the road. But they have to deal with both sides of that problem, right? They have to deal with the inflation shock, and then they have to deal with the slower growth. And so it really puts them in a bad spot. I can only guess that the initial reaction to something like that would be to probably pause the rate cutting, wait and see how things play out, and then figure out which side of the equation is more meaningful for the economy. Is it inflation? If it's a one-time shock and it starts to ebb, then maybe they don't need to do too much more, which would likely be the case in those situations. 

And they'd have to address the likelihood of a much weaker economy and higher unemployment by cutting rates down the road. But my guess is that it would just be a very cautious pause to say, "OK, we need to see how this plays out." This has been, after the experience of the cycle, a very cautious Fed, I think, trying to maintain kind of a balance. They're in a good spot right now, but if things kind of blow up, literally and figuratively, then they have to probably go back to cautious mode would be my guess. But you know, fighting a commodity inflation shock or a tariff-driven commodity-type shock with rate hikes just sets us up for a deeper downturn down the road, and it probably doesn't accomplish much on the inflation front because it's not a demand-driven problem. So that's probably how they'd look at it, but it definitely would be a big problem.

So Liz Ann, last time we talked was a week ago, and a lot has happened. Anything you want to add from after the last week or so's information.

LIZ ANN: Yeah, I think because we now, notwithstanding some of what we just talked about and your thoughts on what the Fed reaction function would be, but we have spent a lot of time recently, given that we've moved into the easing part of the cycle, looking at past full Fed cycles and market behavior. And part of the reason why we put together a detailed table showing all 14 full cycles, meaning the hiking part of the cycle, pause part of the cycle, and then a cutting part of the cycle going back the entire history of the S&P 500, is I was reading and hearing so many comments like, "Well, typically the market does …" and then fill in the blank. And I bristle at that because we've only had 14 full Fed cycles in the history of the Fed/S&P 500. The founding of the modern Fed predates the S&P, but not by much. So you can track those and cover the full history of the S&P 500. 

Fourteen is not a very large sample size. And the ranges of outcomes, whether it was what the market did during the hiking part of the cycle or the pause part of the cycle or the cutting part of the cycle, the range of outcomes was so significant that the averages are almost meaningless. They don't tell you a heck of a lot because the range around it. So when you have a small sample size and a wide range, it always makes me think of the, you know, "analysis of an average can lead to average analysis." And but one of the interesting things that you can see when you look back at history is the best performance historically for the stock market in the six months following an initial rate cut in the cycle was the cycle that started in 1974. And once the Fed moved from hiking to cutting, within six months after the initial cut, stock market was up almost 40%. The interesting thing is, though, is that what that followed during the pause period, the period immediately prior to that, was a decline in the market of 27%. So it was the strongest performance once the Fed started cutting, but part of the reason for that is just how weak the performance was leading into the first cut. So you did have a bit of a boomerang. 

And leaving aside this cycle, because the pause period in this cycle actually was the strongest in history, but leaving this cycle aside, because it's not finished yet, the weakest performance once the Fed started cutting in the history of these 14 past cycles was when the Fed started cutting in 2007. We know the reason why the Fed started cutting and how bad it became, so it's no surprise to see that the market weakened. But interestingly, the period immediately prior to that, the pause period, was actually the strongest in history. So another boomerang just in the opposite direction. So as we've often said, it's not just the what, meaning "Are they cutting?" It's the why. What are they combating? And that comes into play in terms of market behavior. I think the use of the word "typical" does not really paint the full picture because there's such a range of outcomes and it's a function of what else is going on in the economy and inflation and longer-term interest rates, but also the why behind what the Fed is doing. So I just wanted to share some of those data points.

KATHY: Yeah, and I think we probably should link to that article in the show notes so that people can take a look at it. We've looked at sort of a similar analysis just during various rate-cutting cycles, what has been the performance of the bond market in actual fact. And generally, not surprisingly, generally the bond market, as defined by the Bloomberg Aggregate Bond Index, which is for people who aren't familiar with that, it's an index that tracks the investment grade and government securities in the market. So it'll have Treasuries, mortgage-backed securities, some of the federal agency paper, along with investment-grade corporate bonds. And so it's kind of considered similar to the S&P 500 for the bond market when you're tracking. 

And generally performs pretty well—there were a few cycles in which there were minor decline in total return. And the reason for that is that it was generally the back half of a bull market already. And so, similar to your examples, you'd already had a bull market and there wasn't much left to go. But it's a little more straightforward when you come to the fixed income market when the Fed is easing. It usually has been good news for the bond market. And it usually didn't matter whether it was a fast-moving cycle with many rate adjustments or a slow-moving cycle.

Neither one produced significantly different kind of results. Your story about the stock market in '74, though, that cycle does remind me: When I was young, we had a neighbor who had made a whole lot of money in the stock market. And we lived in an area where people didn't usually invest in the stock market. And he sort of stood out as this guy who had some magic formula for making money. And everyone was very jealous.

And then he lost quite a bit of it in that downturn in the market. And I remember my father saying, "Well, I was really tempted to jump in, but I figured by 1970, all the opportunities were gone." My father never became an investor in the stock market as a result of that.

LIZ ANN: Well, maybe he had an easier job sleeping at night, I suppose.

KATHY: I don't know, but it reminds me of just how much we're affected by recency bias and how that can stick with us for a long time. 

So now that we talked about cycles and past cycles and the cycle that we are in, what are you looking forward to next week, Liz Ann? What's on your radar?

LIZ ANN: So there are times where economic data points that come out suddenly take on a little bit more importance. You go through eras where economic reports that we all wait with bated breath on then turn into the boring numbers. For a good part of the great moderation era, CPI and PPI were not big market movers. There was not the countdown on CNBC of when the CPI report was going to come out. Obviously, that's different. I think a couple of things coming out next week maybe are taking on a little bit more importance in this backdrop. Consumer credit, I think data on the consumer and what we've already seen, which is some cracks, particularly down the income spectrum, defaults and delinquencies picking up. You even saw it with the consumer confidence readings where confidence was only up for the highest income bracket. All the other income brackets, you saw confidence down. So I think that may have some tells. And also the monthly budget statement comes out. 

I, these days at client events, sometimes almost purposely don't bring up the subject of debt and deficits in the quote, you know, "formal remarks." And when I don't bring that up, the first question I get almost universally is on debt and deficits. So I think getting a sense of where we are in terms of the budget deficit. We also get the NFIB data, National Federation of Independent Business, that has … it's just chock full of great information on the health of small businesses, what their single biggest problem is, whether it's labor quality, inflation has been running as the number one cause for concern, but that always has interesting nuggets. Mortgage applications. 

And then of course, we mentioned CPI and PPI, they come out next week. So those are always important. And both initial and continuing unemployment claims are important leading indicators because we're not seeing significant deterioration in the labor market, some cracks and things like the hiring rate coming down, and we saw downward revisions to payrolls, but as a key leading indicator, I think trends in claims, especially given that it's data we get on a weekly basis, matters. I also think we get the FOMC minutes next week. So you think there might be anything interesting in there? It was probably a pretty interesting meeting.

KATHY: Well, yeah, one would think so. Given that we had the first dissent in I don't know how many years from Bowman, and that they decided on a 50-basis-point instead of a 25-basis-point cut in rates to initiate the cycle. So yeah, I imagine it was a fairly robust conversation. And well, by the time they get in the room, things are kind of decided, but I do think that it should be interesting to get the perspective of the various Fed members on just what they were looking at, what were they watching, what was important to them in this decision. So definitely want to keep an eye on that. So yeah, next week, the CPI and PPI numbers, clearly very important. The minutes of the Fed meeting, clearly very important. And on those budget numbers, I'm going to be really interested to see how things shake out over time.

But the good news is we've had a big jump in productivity and stronger GDP growth. So actually the deficit as a percent of GDP might be turning over a little bit because growth is a little stronger than what we realized. Now that's a nuance that's going to be lost in the bigger picture, but it is kind of worth noting, I think, when we look at those numbers. 

But we're waiting to see what the various central banks make out of what's going on in the global economy as well. We've got a lot of mixed messages out there, and that is affecting the U.S. market to some extent. So a lot to watch, and then we have the port strike and a number of strikes and the devastating flooding and storms in the South that's going to affect likely the employment figures and collecting data on all the numbers as we go forward. So next month's going to be pretty challenging. We won't face it this coming week, but after that, especially if the strikes last, in addition to the weather complications, we're not going to have probably good, clean, clear data for a while.

LIZ ANN: You know, and I'm glad you mentioned the jobs. We probably should have mentioned it, but I'll do it now, that you and I are taping this midweek. At the end of this week, we get the monthly jobs report from Bureau of Labor Statistics. So we're not ignoring it. We just don't have the data as we're taping this.

KATHY: So that's it for us this week. Thanks for listening. As always, you can keep up with us in real time on social media. I'm @KathyJones. That's Kathy with a K on X and LinkedIn. And if you've enjoyed the show, we'd really appreciate it 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.

LIZ ANN: And I'm @LizAnnSonders on X and LinkedIn. If you see me on Facebook or Instagram or WhatsApp, it's not me. It's an imposter. I promise you; I don't have a stock-picking club. So only follow the actual me on X and LinkedIn. And next week, I will be sitting down with Paul Hickey from Bespoke Investment Group. So stay tuned for that one.

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