LIZ ANN SONDERS: I'm Liz Ann Sonders.

KATHY JONES: And I'm Kathy Jones.

LIZ ANN: 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.

KATHY: The format of today's show is a little bit different from the typical episode. Instead of looking at the week behind us and the week ahead, we'll be focusing on our market outlook for next year, 2024. And where we typically just focus on stocks and fixed income in this podcast, we'll be bringing in our Schwab colleagues to discuss the international economy, some municipal bonds, corporate bonds, and the outlook in Washington.

LIZ ANN: Yeah, Kathy, we've done these sorts of outlooks for many years. And for the past four or five years, we've done them in podcast form as well as part of Mark Riepe's podcast, Financial Decoder. And we know they are always among the most popular episodes of the year. I want to start out by saying you can find the full in-depth written versions of all of our market outlook reports complete with charts and graphs at Schwab.com/Learn.

So we've got a lot of ground to cover today. So we're going to start with equities and the overall U.S. economy. And I've enlisted my colleague Kevin Gordon to join me in that discussion. And after that, I'm going to turn it back to you, Kathy, to get the fixed income outlook with your team.

KATHY: Thanks, Liz Ann. After we share our overall fixed-income outlook, I know you're going to be speaking with Jeffrey Kleintop, our chief global strategist, about the international economy. And then finally, last but certainly not least, I'm going to be talking with Mike Townsend, our managing director of legislative and regulatory affairs, about the very interesting outlook in Washington for 2024.

LIZ ANN: Yeah, thanks, Kathy. Looking forward to that. And I'm happy to welcome Kevin Gordon to the show for the first time. And I expect you'll be hearing from him again soon on this show. And I'm guessing many of you already know Kevin. He is my research associate. I really think of him as my right arm in many ways. And he works with me in providing analysis on the economy and the market for Schwab's clients. He helps develop deep-dive projects as well as content for Schwab's public website, internal business partners, social media outlets. He is a frequent guest on CNBC, Yahoo Finance, Bloomberg TV, CBS News, and has been quoted in The New York Times, Forbes, Market Watch, CNN, The Wall Street Journal, and Bloomberg.

So Kevin, thanks for being here today.

KEVIN GORDON: Thanks for having me. Good to be on.

LIZ ANN: So Kevin and I are going to do a high-level summary of our 2024 outlook, which was the first out of the blocks to publish. And probably the best way to do that on this podcast, much as I would love for our audience to hear you and I riff and go back and forth and go off on tangents. We are limited in time and people want to hear all of our outlooks, not just what you and I think. So why don't I take the economic outlook part of it, and then I'll toss it to you for the market-related outlook. Does that work for you?

KEVIN: That sounds great to me.

LIZ ANN: All right, so as a reminder, there's a lot more detail in our written report. So this is just a high-level overview of some of what I think are the key points. So I mentioned I'll touch on the economy and want remind everybody that we've been using the terminology rolling recessions for quite some time to describe this very unique cycle given the pandemic and the nature of it and how spread out over time both strength and weakness has been across various economic segments and the rolling-recession thesis in particular is about areas like manufacturing, housing, housing-related, many consumer-oriented areas that have already experienced recession level weakness. They've had hard landings, and the biggest hits have been felt specifically in housing and manufacturing. You've also seen recession-like declines in things like consumer confidence or consumer sentiment, CEO confidence, although neither consumption nor corporate earnings have taken a commensurate hit.

So it's another example of what has been a unique aspect to this cycle where at times the attitudinal-type surveys, the soft economic data has looked a bit more dire than the actual hard-economic data. But specific to the rolling recessions, during the compression phase for those segments, manufacturing, housing, et cetera, there was and continues to be offsetting strength in services, although even services, of course, haven't been fully immune to the cycle. Any hits have been much more wild, and looking ahead to 2024, we view the best-case scenario as a continued roll-through with any subsequent possible hard-landing-level weakness in services, ideally, obviously being offset by some recovery in the already-hit segments.

But we dissected the economy a bit further in the report. One of the things that we wanted to highlight was this concept of long and variable lags to quote Milton Friedman. And we do not believe that the economy has yet passed the so-called "expiration date" on those lags. So one of the things we looked at was the leading economic index, or the LEI, which has now declined for 19 consecutive months. And such steep declines have typically only occurred during recessions. But the details around an index like that are important, especially when you're trying to figure out, "OK, have we passed the expiration date? Have we gone long enough that the recession signal from the LEI has become a moot point?" And the answer to that is no. Now the distance between peaks in the LEI and recession starts has averaged 11 months over the history of this indicator, but the range has been really wide. It's been from as little as three months to as many as 21 months.

And not only that, where there's also a wide range is in S&P performance during the span of time of declines in the LEI. And what we highlight in the report is it's a great example of, as you know, Kevin, one of my favorite admonitions, which is that "analysis of an average leads to average analysis." Remember that because it's going to come up again. We also looked at the yield curve, the inversion of the yield curve. And although not quite the 19-month span of the LEI's decline, the yield curve has been inverted for more than a year. Now, with the exception of an extremely brief and mild inversion in 1998, all other inversions over the past six decades have had a perfect track record of signaling recessions to come. But like with the LEI, there's both a fairly small sample size in history and a really wide range associated with yield curve inversions and both time span and equity market returns. And it makes me think again of "analysis of an average leads to average analysis." That's why we got to put things like historic ranges in context. Now, we recently received a number of questions about whether the recent steepening of the yield curve means recession risk is waning. And the reality is that steepenings are generally signs of easier monetary policy conditions ahead, often, of course, in response to recessions. And I've been using a weather analogy in that the yield curve inversions tend to be the recession watch, while steepenings can often be the recession warning. So keep that in mind. Also, a lot of focus obviously on the Fed. We talked about inflation or wrote about inflation having trended down this year. Obviously more work needs to be done since the various indicators or inflation metrics that the Fed looks at are not down to their stated 2%-ish target.

All that said, enough disinflation is in the pipeline that we do believe that the July rate hike might've been the last in the cycle. So one of the things we want to look at is what does that potentially mean for the economy and market in 2024? And you can look at an average of what the S&P has done in the aftermath of a final rate hike, and you can even make a conclusion based on what the average has looked like. But importantly, that does not convey the right message for many reasons we already touched on. The range in performance has been extraordinarily wide. In fact, six months after final rate hikes, historically, the S&P was down as much as 18% and up as much as 20%. A year after, the range was even wider from down 28% to up 32%. And also, the span of time between the final rate hike and subsequent first cut was also quite wide.

So just be really careful—to our listeners out there—about if you hear something, "Well, the typical market behavior, the typical or average path for the market after the Fed is done, is X. The range is wide; the sample size is small. So with that tying in of a key facet of the economy into market performance, what else, Kevin, did you want to highlight on the market outlook part of our report?

KEVIN: Well, if I was to think about really one picture or one chart or kind of one theme that is at the center of the outlook and what we think about when it comes to the market, it's probably the relationship between bond yields and stock prices. And there are so many different ways you could talk about this and how it wraps into both our outlook on the economy, but also in the market. And the primary way of looking at this is now noting for past couple of years, you've had fits and starts, but for the most part, if you look over the long term, you know, 100 days or 200 days, that relationship has turned negative, meaning every time bond yields have gone up, stock prices have suffered a bit, and it's not a perfect, you know, every single day this happens, you're going to get the opposite move. But that's important to us because that was really the dominant theme from the mid-'60s, really up until the mid-'90s, when you had what, Liz Ann, you and I have written about and talked about, calling it sort of the temperamental era, when inflation was more of an issue, not as much growth. So bond yields going up at the time, it was more because you had worries about inflation getting out of the bag again, and just inflation volatility in general, being more of a risk. That shifted when you got into the late '90s, early 2000s, up until the pandemic really, when that relationship flipped positive.

So every time bond yields were moving up, it was for the so-called, you know, "good" reasons of growth improving. So the reason I talk about that is because if you, if you believe that we've seen, or we're at the peak in yields. And that bond yields are now starting to roll over, given that extreme negative correlation, that provides a support to the stock market. It's not going to happen in perpetuity, but for the most part, when you look at that relationship, it's a better environment for stocks moving forward. But the counter to that is given this move that you've seen in yields this year, there has to be a digestion phase for a lot of companies.

So moving forward, what you're probably going to see as long as yields stay elevated and stay off the zero bound, which is our expectation, the rate structure and the interest rate picture has just changed for a lot of companies. They're now having to deal with rates that they haven't seen in many years. For some companies that are younger, maybe it's just rates that they haven't ever seen. So to us, it's more about maybe 2024 being a little bit of a transition period, or a transition phase, where companies are going to have to start dealing with just a higher-rate picture and maybe not a weaker earnings environment, but having to rely more on earnings themselves to kind of lift you and lift your actual stock price, whether it's on an individual company basis, whether it's on an industry or a sector basis. And that really leads to what I think has been the dominant story for '23, probably going to be a, you know, continue into '24, which is that evaluation. And there are so many different ways that it's come into focus, but one of the ways I think about it is small caps being so undervalued this year in terms of their P/E ratios or price-to-sales ratios, whatever metric you want to pick, getting crushed relative to large caps. And that being the reason for a lot of analysts and a lot of strategists saying, "Well, that just means that they're poised to outperform." But as you always remind investors, valuation is a pretty terrible market-timing tool, especially in the near term, if you're looking just a year out.

There's really no relationship going back in history. So I don't want to use that as just a reason to say, "Yeah, we have a better outlook on small caps." But if you believe in the thesis that you were just talking about of rolling recessions and maybe turning into rolling recoveries at some point in 2024, I think that the market backdrop for that is something along the lines of less bifurcation and kind of everything coming more back into sync, meaning you don't have this really strong split between, you know, the mega-cap high flyers this year and then the rest of the market.

So you know, the Magnificent Seven and then the so-called 493, the rest of the market that just kind of got left out of the rally. There's a little bit more, I think, ground for small caps to kind of take that leadership baton, but the overarching focus is on quality. And we've really, you know, pounded the table on this over the past year, year and a half. And I know that the term "quality" gets thrown around a lot, but you really have to think about what are the qualities that are a little bit sort of dear these days. It's real revenue growth, "real" meaning inflation-adjusted revenue growth, not being as strong. And then interest coverage ratios sort of suffering a little bit for parts of the market again that are not used to this higher-interest-rate backdrop. So if you screen for those looking for companies with lots of cash on the balance sheet, looking for companies that have really high and maybe rising interest coverage ratios, you can find that in the small-cap universe. Admittedly, it's a little bit tougher than finding it maybe in the large-cap universe.

But I think that's going to be a key support moving into next year, especially because you have what we called and referred to in the report as this bigger swing factor for small caps. If you look at something like the Russell 2000, which is the proxy for small caps broadly in the market, the earnings growth estimate for this year is somewhere around down 10%, which is pretty rough. But then you look to next year and estimates are pointing upwards of 20, close to 30%.

And a lot of that is just year-over-year comparisons swinging back in that direction. But if you do believe that at some point we go through some more economic pain next year, you know, at the point of sort of max economic pain in a cycle, that's kind of the time where small caps really start to shine and really start to outperform. So it's not going to be perfect, I don't think, because this cycle has been incredibly unique, you know, as you mentioned. But I do think that acts as a support for areas of the market that got left behind this year.

And the one thing that I'll maybe end on, and we ended on it in the report, and it's come a lot more into focus over the past couple of days, is just the breadth picture. The underlying breadth of the market itself, a risk that we had pointed out being as cap-weighted indexes continue to do better this year, cap-weighted, if you want to use the S&P as a proxy, breadth had actually started to deteriorate in the second half of the year. That summer rally kind of proved to be a head fake, and then we really set back kind of in that October, early November timeframe, but that has started to improve a little bit. And now you're getting a little bit of a brighter picture, especially if you look at something like the percentage of companies within the S&P trading above their 200-day moving average. And in fact, that's the visual that we sort of ended the market discussion on in the report. But I think that picture is going to be really important because what you don't want to have is a setup like you had in late 2021 where cap-weighted indexes were moving higher, but breadth under the surface continued to deteriorate. That was sort of a sign that, you know, the market's legs were kind of losing strength and growing thinner. And then, you know, the bottom, as we know, kind of fell out in 2022. You had a lot more weakness rise up to the surface. I don't think we get a, you know, a similar situation like that, but I think that's the risk worth watching as we go into 2024, especially because some metrics of investor optimism and investor enthusiasm have kind of come back, not into euphoric territory, but at least, you know, in that kind of exuberant, excited territory.

LIZ ANN: Awesome, thanks, Kevin. So let me just wrap a bow around all of this and do just a quick thirty-second summary. So we've highlighted rolling recessions, think that type rolling cycle continues into 2024, the hope being that we have rolling recoveries, but there is still recession risk. The Fed at some point could pivot to rate cuts, but probably not without some economic pain between now and then to provide that green light for cutting.

From a market perspective, we think there should be less concentration than was the case last year, but in 2023, it was a story of all multiple expansion without earnings. I think 2024, you're going to need to see earnings do a little more heavy lifting, particularly given some valuation issues. We continue to be more factor focused. Think there are opportunities down the cap spectrum, but don't sacrifice quality. Stay up in quality, even if you're going down cap spectrum. So avoid the kind of junky companies. And as always, near-term, short-term volatility will very likely be driven by possible swings in sentiment.

So that's a wrap on our outlook for the U.S. economy and market. And again, if you want to do a deeper dive and see our written commentary and many additional visuals, take a look at the written commentary on Schwab.com/Learn.

Now, Kathy, I'm turning it over to you for the fixed-income outlook.

KATHY: Thanks, Liz Ann. On the fixed-income side, it has also been a challenging year to come up with a forecast, just because this has been a unique cycle, as you mentioned. I mean, every year is challenging to come up with a forecast, but I think this one has been especially challenging. And I've been making quite a few revisions along the way as the bond market keeps making these big last-minute moves.

But in general, our thesis really didn't change from earlier in the year, and that is we do expect yields to continue to move lower in 2024 as the economy slows and the Fed eventually shifts to cutting rates. But there are a couple of cautions for investors that we have. The first is that it's likely to be a bit of a rocky road. The market has made a practice of running ahead of the Fed over the past year, anticipating rate cuts, only to have to backtrack when they didn't occur. Now it's not unusual for the market to try to anticipate policy moves, but so far in this cycle, there have been a lot of false starts. And that's creating a lot of volatility. Another factor is this volatility is really likely to persist because of the uncertainty about the Fed's reaction function. You know, in past cycles, the Fed might have already been cutting rates as inflation has come down.

But this time there's a real reluctance to shift policy until members of the Fed are confident that inflation is heading towards that 2% target. And demonstrably they are not 100% confident about that. And so they're looking more backwards than forward. And that is a very big shift, and that has created a lot of volatility in the market. And I think that push-pull is likely to continue into 2024. Nonetheless, we do think yields will fall, and a couple of basic reasons: Inflation is falling. The Fed's preferred or benchmark measure of inflation,  the core PCE. That's the personal consumption expenditure deflator, which is a mouthful, but that's core PCE. That's the one that they forecast, the one that they watch. That latest reading is down to 3% overall, and for the core 3.5%—that's down by half from where it was just a year ago. But I think more importantly, there have been eight consecutive monthly readings of core PCE at 0.3% or below. That brings the three- and six-month run rate down towards that 2, 2.5% region, which is where the Fed is aiming. So inflation is a key driver of yields, and we think that downtrend will continue.

Also, we're looking at softer economic growth due to those lags from the rate hikes that we've seen. They're not really fully discounted, I think, in terms of the economic data. And we still have very high real rates. If we look at the Treasury yield curve—that is, in rates after inflation expectations—bank lending has tightened up a lot. The global economy is soft. We may even see rate cuts in Europe before we see them in the U.S.

And the Fed is still tightening. Even if they keep rates where they are, which is our forecast for a while, as inflation falls, that means that real rates continue to stay high. And the Fed is still doing quantitative tightening—that is, letting its balance sheet decline. So you put all those things together, and there's still some tightening in the pipeline, which we think will have an effect on economic growth and inflation.

So our forecast for the Fed is we expect to see two to three rate cuts in 2024, probably starting mid-year. Now that lags the consensus, but the direction of travel looks lower from here. We're lagging the consensus simply because we're reflecting what we're hearing from the Fed about their reluctance to cut too early in this cycle. Now, historically, when we go beyond just short-term rates, which the Fed influences the most, and look at longer-term rates, 10-year yields have historically fallen in the six to 12 months around the peak in the fed funds rate. So we are seeing that pattern play out right now if the last rate hike was earlier this year. And we think that will continue to influence yields on the downside. Again, volatility, though, likely to stay pretty high because of this uncertainty about the Fed's reaction function.

The wide range in yields has largely been due to the market's inability to figure out what the Fed will do and when they'll do it. So I do think we will see a lot of comments and reaction to those comments from Fed officials as we transition from a steady policy to easing, but it won't be probably an easy transition. So given all the uncertainty about the timing of rate cuts, we did some scenario analysis, and I would encourage the listeners to read the report if you're interested in these scenarios. We decided to lay out three cases.

So one is our base case of three rate cuts of 25 basis points starting mid-year. The second is a scenario where we hit a recession. And the third is a scenario in which inflation reignites and the Fed has to hike one more time. So I'm not going to walk through all the details of this, but the upshot is that returns in fixed income for commonly used strategies like one-to-five-year barbells and ladders, one-to-ten-year barbells and ladders, were all positive in our projections to varying degrees. But when we do the analysis, it looks like because we have such high starting yield levels, and those … that coupon income that you get from fixed income is starting out at high levels.

That provides some cushion against some of the volatility that we could see in price change. And that's very different from where we were a while ago when we had low-to-zero interest rates. And then we looked also at, well, what would it take to get a negative return in fixed income? And remember, total return consists of the income you earn, plus or minus the change in price. And what we found is that rates would have to rise by as much as 100 basis points, and then the negative returns would largely be confined to the long-duration bonds, those with maturities of 10 or 20 or 30 years or greater. And for most investors, we have suggested keeping a benchmark duration right around the aggregate bond index duration, which is around six.

So our projection for the low end of 10-year yields would be in the 3.5 to 4% region in our base-case scenario. So far I've really been talking about Treasuries and interest-rate outlook, but the bond market is huge, and there are lots of different kinds of bonds, and credit quality is a really important component of analyzing the market. And we're going to get into this more with my colleagues, Collin Martin and Cooper Howard, but I think from a high level, I just emphasize that our point of view is that we really prefer to stay up in credit quality. There is a risk of a further slowdown in the economy, possibly a recession, and that's not the time in the cycle that it really makes sense to take a lot of credit risk. So we do prefer staying in the higher-quality bonds—like investment-grade corporate and municipal bonds, Treasuries, other government-backed securities—and avoiding the real risky parts of the market.

And to expand on all of that, on the credit side, I'm going to bring in my colleague, Collin Martin.

Collin is a director and fixed income strategist here on my team at the Schwab Center for Financial Research. He holds a Chartered Financial Analyst designation and provides analysis and education about fixed income for our Schwab clients.

Collin's a frequent guest on Bloomberg TV, and he's also widely quoted in the various financial publications, including The Wall Street Journal, MarketWatch, and Reuters.

And he's our first returning guest on the podcast. So welcome back, Collin.

COLLIN MARTIN: Hi Kathy, thank you for having me back.

KATHY: Yeah, it's great. So nothing I like better than an opportunity to talk fixed income.

So I'm going to start with the corporate bond market, which is a taxable bond market, which is really your major focus of attention, your area of expertise. So can you tell us just quickly—give us a recap of 2023 in the corporate bond market. What happened, and did anything surprise you?

COLLIN: Well, here we are now in early December, and returns are generally positive. And that's been the case for a lot of fixed-income investments this year, but admittedly we were a bit cautious coming into the year. And what surprised us is how well some of the riskiest or more aggressive parts of the bond market have performed.

And part of the reason is if we go back to what our outlook was coming into 2023, we saw a lot of things that were a bit concerning to us. The inverted yield curve, the aggressive pace of rate hikes and what that means for corporate borrowing costs. If you're a corporation and you need to refinance or you're looking to issue new debt, it was very expensive, and it's very expensive now. We thought that would weigh on sentiment a little bit. It really didn't.

And then finally, if you look at what's happening with bank lending standards, usually when banks are tightening their lending standards as they have over the past number of quarters, usually that has a negative impact on corporations. You tend to see their values decline a little bit as spreads rise. And spreads are the extra yield that we as investors get for assuming the risk of those types of riskier investments, and none of that really happened this year. So it was a little bit surprising to us that corporate bonds, specifically the riskiest parts of the corporate bond market, performed so well this year. It's a good thing for investors of course, but it surprised us a little bit.

KATHY: Yeah, I'd have to agree. This rally in risk assets this year was really very surprising given the tightening by the Fed and other central banks around the world. I think that's got to stand out as a real surprise.

So given that, what do you think about 2024? Do we expect more outperformance from corporate bonds, especially the riskier segments of the market?

COLLIN: We don't expect outperformance of corporate bonds. And when I say outperformance, I'm talking specifically relative to Treasuries, the highest-quality fixed income investments that are generally out there. We think positive total returns are likely, but we don't know if we're going to see that same outperformance this year. And a key reason for that is valuation and those spread levels that I alluded to earlier.

So again, when we as investors are considering different types of bond investments, what matters is the amount of extra yield we're receiving. And if you look pretty much across the board, whether it's investment-grade corporate bonds or high-yield corporate bonds, also called junk bonds, the extra yield or spread that we get is near the lows of the year and really over the past 18 months or so. And given that, we're just not being too compensated too well.

KATHY: So Collin, I'm going to interrupt you there just for a second. For our listeners who aren't as familiar with the corporate bond market, could you explain what the difference is between investment-grade and high-yield and how those—you know, we refer to them various names and various ratings—can you just kind of give us a quick one-minute breakdown of how that works?

COLLIN: Yeah, it's a great question, Kathy. I get too excited and I kind of gloss over some of those details that I know people would like to hear about.

So when you look at the different types of corporate bonds, they're all issued by corporations, and the credit rating is a rating of the credit worthiness of the issuer. And when you look at the credit rating spectrum, which starts as high as AAA and then it goes to AA and single A, it keeps going down that spectrum. And then once you get to a certain threshold—so if we use Standard & Poor's rating spectrum as a guide right here—if you go from BBB-rated bonds and above, that's still considered investment-grade. When you get to BB and below, that's high-yield. And one little interesting point about high-yield—so high-yield bonds, they're not necessarily defined by the yields they offer, but they're defined by those credit ratings. And then they offer those higher yields because the credit worthiness of those issuers tend to be a little bit lower. So investors demand slightly higher spreads and yields as a compensation for the greater risks.

KATHY: So what I'm hearing is AAA to BBB is investment-grade. And below BBB—BB and below, all the way to D default—is what we call junk bonds or sub-investment-grade or high-yield. Great.

So let's just take a little bit more of a deep dive here. What is it that looks to us attractive or well-priced in the market versus what looks a little riskier, and what should an investor who wants to take a little bit of risk consider?

COLLIN: Well, so one of the areas we like the most right now is investment-grade corporate bonds. So going back to that spectrum we discussed before, that's BBB and above. And when you look at the investment-grade market, about half of the market is rated BBB, so that lowest rung of that spectrum. But we still think that market is attractive for two reasons.

The first is just the level of yields they provide. Now I highlighted that spread, the extra yield we get by investing in investment-grade corporate bonds, is relatively low, but if our slightly cautious outlook comes to fruition, we're not too worried that we're going to see the prices of investment-grade corporate bonds fall too sharply, if at all, because they have those investment-grade credit ratings for a reason. So if growth does slow, we think that their more stable cashflows and stronger balance sheets should allow them to really navigate a challenging environment, should that happen. So we're focusing more on just the actual yields they offer. While there could be a little bit of volatility over the next six to 12 months, we like those yields for long-term investors.

Now if we go down to that other spectrum, high-yield corporate bonds, we are a little bit more cautious there because we think the rise in borrowing costs should continue to eat into their profit margins and really affect their ability to continue to remain current on their interest payments and ability to refinance debt as it comes due. So we're a little bit cautious there, but that doesn't mean you can't consider them because if you look at the absolute yields they offer, they're really high. If you look at the high-yield bond market, you can get yields of around 8.5% or more, and that gives you a bit of a buffer should prices fall a little bit where if you're holding for 12 months or longer, you'll be earning those income payments to again help serve as a buffer to a degree.

So you don't need to avoid high-yield bonds, but we're certainly telling any investors and our clients at Schwab that we expect volatility. So if you are considering high-yield bonds, be ready to ride out those ups and downs to earn those higher yields that they offer.

KATHY: This has been great, Collin. The message I'm getting is that there's some pretty attractive yields offered in the corporate bond area, but you do have to be a little bit careful about where you take the risk.

Thanks for being here today.

COLLIN: Thanks for having me again, Kathy.

KATHY: Joining me next is Cooper Howard. He's a director of fixed income strategy for the Schwab Center for Financial Research. He's an expert on fixed income markets, especially the municipal bond market, which is important to a lot of individual investors. And he's been quoted in several financial publications, including The New York Times, Bloomberg, and The Bond Buyer.

Cooper, thanks for talking with me today on the podcast. Why don't we start out with just an overview of your expectations for the municipal bond market in 2024.

COOPER: Yeah, thanks for having me, Kathy. We think that it's going to be a relatively positive year for municipal bonds next year. And it really boils down to two reasons. The first are high yields. So if you look at the average municipal bond, it yields about 3.7%. While on the surface, that may not seem attractive relative to a corporate bond or a Treasury bond of similar maturity, it's because most municipal bonds are exempt from federal income taxes and then potentially other income taxes like state income taxes. So if that bond were to be fully taxable for an investor in a high-tax state like New York or California, Kathy, that would be above 7%. So we think that that's relatively attractive today.

The second reason we think that municipal bonds will be an area of opportunity next year is because of strong credit quality. If you look at the Bloomberg Municipal Bond Index, the amount of AA- and AAA-rated bonds, which are the top two credit qualities, it's the highest proportion of those types of bonds going all the way back to 2008.

KATHY: Well, you had me there at 7% on the highest yield there. So that does sound pretty attractive. Can you tell me what some of the potential potholes might be along the way? We've talked about a rocky road this year for fixed income. What do you see as some of the risks that investors should watch out for?

COOPER: Yeah, so the municipal bond is going to navigate across that rocky road, and we think that it's going to be a bumpy ride for investors. There are a couple reasons for that. One is that although our expectation is that yields will likely move lower next year, there is the potential for rates to reverse and increase. So that would be a negative for the municipal bond market. The second headwind is that yields relative to Treasuries are low compared to historical averages. Although we think that they are attractive on an absolute basis, that's a headwind looking at a relative basis. The other reasons are that COVID stimulus is starting to wind down. Many state and local governments are in a strong financial position, but navigating that headwind has the potential for creating some volatility. And then finally, although we're a long way out from the election, I do think that could be a potential area of concern for the municipal bond market. Now, what is actually said on the campaign trail may not come to fruition as actual law, but it does create the potential for headline risks and some potential volatility there as well.

KATHY: Well, it's true. We do know that politics can have a big influence on the muni bond market because public policy involves taxation, and taxation and spending are a big factor for local governments and state governments. So tell us now about some of the opportunities you see in the muni bond market for next year.

COOPER: Yeah, so one area of opportunity is not staying too short in duration. Duration is a measure of interest rate sensitivity. But what we found is that many investors have been sitting on cash for too long. We think that it makes sense to extend out a little bit, lock in those attractive yields, because if yields do move lower, then that captures some of the potential for a price increase on that. The second thing that we do think to make sense is to stay up in credit quality and focus on issuers that tend to have revenue streams that aren't too volatile or subject to current economic risks. So that would be focusing on more AA- and AAA-rated bonds compared to focusing on BBB-rated bonds. If you are navigating into a little bit lower-rated bonds on the investment grade spectrum, we do so selectively on that regard.

KATHY: That's great, Cooper. Thanks for the information. It's consistent with our "up in credit quality, but looking for positive returns" outlook for fixed income. Thanks for coming on the show.

COOPER: Of course, thank you for having me, Kathy.

KATHY: So that's where we stand with the fixed income outlook for 2024. I'm going to pass it back over to you, Liz Ann.

LIZ ANN: Thanks, Kathy. And I am looking forward to having a conversation with our colleague Jeffrey Kleintop on the international outlook for 2024.

Jeff is Schwab's chief global strategist and one of our managing directors. Cited in The Wall Street Journal as one of "Wall Street's best and brightest," Jeff frequently appears on CNBC, Bloomberg TV, and CNN. And he's also frequently quoted in The Wall Street Journal, Barron's, and the Financial Times. So welcome to the podcast, Jeff. 

JEFFREY KLEINTOP: Thanks, Liz Ann. Thanks for having me on. Great to be with you. 

LIZ ANN: So it's obviously outlook time for all of us. And as we look forward to what 2024 may hold for investors, what's the overall theme for the year that comes to mind for you when thinking about the global markets and economy? 

JEFF: You know, although we're accustomed to defining investment environments in calendar-year terms, I don't think 2024 is going to fit that approach very well. It may be a turning point for policy rates and earnings growth, but that may not be easy to identify in real time. Investors may have to step back a little bit and see the bigger picture and look beyond the noise and the volatility. 

In fact, I'm reminded of that scene in the movie Ferris Bueller's Day Off that features Ferris' best friend, Cameron, focusing more and more closely at the child in one of Seurat's paintings until he just sees dots and he loses perspective. In the commentary on the DVD, director John Hughes said the closer he looks at the child, the less he sees, as the face kind of disintegrates into a chaotic jumble of pointillist dots.  

Often the closer we get to something, the more complicated and noisy and chaotic it seems. And I think focusing too closely, or too near term, on specific developments in the economy, on the markets, or politics in 2024 can risk missing that bigger picture and broader trend. 

So the bigger picture I see for 2024 is of a shallow—I guess I call it a U-shaped recovery in global economic and earnings growth rather than the V-shape seen in the past two global recessions. If the global economy experienced a sort of, I don't know, soft landing in 2023 with growth for much of the Group of Seven countries like Canada and France and Germany and Italy and Japan and the U.K. kind of stalling—not really contracting much—then it's also probably a soft recovery that gets slowly underway during 2024, with growth rebounding only modestly and unevenly throughout the year. 

Now, global stocks may react with heightened volatility to that, to the seemingly chaotic data points as parts of the global economy move in different directions and a broader stabilization and recovery may only be visible over time. But on the positive side, patient investors in global stocks with an eye on the big picture might benefit despite this uneven path as markets discount better growth ahead supported by rate cuts among major central banks. 

LIZ ANN: Well, I specifically love the Ferris Bueller reference because that's one of my all-time favorite movies. I think it's just absolutely brilliant. So for the rare person out there who hasn't seen it, you got to put it on your list. 

Now not to rehash the past year, but when we were all doing our outlooks last year for 2023, in yours, you had forecast what you called a cardboard box recession. So I guess a natural question as we head into 2024 is, do you see a cardboard box recovery next year? 

JEFF: Yeah, you rightly called this a rolling recession. The part that was weak in 2023, kind of rolling down, was manufacturing and trade. I call that the "global cardboard box recession," again, because the downturn was concentrated in manufacturing and trade, things that tend to go in a cardboard box. And it was evidenced in 2023 by falling factory output, trade volumes were weak, even demand for corrugated fiberboard, which is what most cardboard boxes are made out of, was very weak. 

And it lasted the whole year. In fact, the November reading for the Global Manufacturing Purchasing Managers Index, the PMI, marked the 15th straight month below 50, that level that divides growth from contraction. And that's the longest stretch in history, tied with the downturn that ended two decades ago, back in 2002. So of course, the downturn is nowhere as deep as most of the past manufacturing downturns, but its extended duration is unique in making a recession, I guess in duration, if not in depth. And unfortunately, declining new orders indicate that production weakness might extend into the early months of 2024, furthering the record duration of the recession before it begins to firm up as inventories are further drawn down and demand stabilizes. Economies that are more manufacturing and trade exposed have been among the weakest, like Germany. Germany is likely contracted in three of 2023's four quarters. And economies that are more services focused, like France and even the U.S., have fared better than that. 

So I'd say yes, a modest cardboard box recovery might be in store in 2024. Manufacturing economies might begin to improve while more service-based economies slow down. We have seen the services PMI on a global basis edge down to 50.4 in October. We don't have the November reading yet. While the latest reading still indicates modest growth, it's come down steadily from the peak of 55.3 in April, so really highlighting that decelerating trend in this rolling recession moving maybe towards services. 

The 2024 forecasts from the OECD, that's the Organization for Economic Cooperation Development—I know you know that big global economic think tank—was just published last week, and it reflects these trends reversing. 

Germany's GDP is expected to accelerate out of recession in 2024, though still remaining fairly weak on a sort of relative to average, while growth in France is expected to actually slow down—that more service-based economy. And so the different trajectories of the manufacturing and services sectors adds to the noise in the individual data points we might see in 2024, again, making the big picture a real challenge for investors to stay focused on. 

The biggest economy outside the G7, I'll just mention lastly, is China, of course. And that's also likely struggling with growth in 2024. Recent stimulus may provide a floor from which stabilization can build, but the recovery is uneven, and investors may need to get used to slower growth for longer in China due to a weak property market, the past buildup of debt, and just the law of large numbers. 

LIZ ANN: Let's narrow the focus a little bit and talk about the labor market. You know, we've had some economic weakness in 2023 in the U.S., and the labor market so far has been relatively resilient. So what are your thoughts on the global labor market in the year ahead? 

JEFF: I think it's going to be noisy, just like the manufacturing and services data. Even as the weakest sector of the global economy, manufacturing, might show some signs of improvement next year, the strength in the labor market may actually weaken. And there's a clear and intuitive relationship between borrowing costs and job growth. But the length of the lag between higher costs and weaker demand for workers really varies, varies a lot overseas, and I think is more likely to be felt in 2024. 

The weakening of the labor market next year could be signaled in things like the manufacturing employment PMI, where they survey manufacturers, and that number's really rolled over. The manufacturing number for employment has really come down, and that tends to lead job growth in Europe by about six to 12 months. And evidence is emerging that the labor market is actually cooling in some of the coolest economies in Europe. 

For example, in Germany, unemployment rose for the 10th month in a row in November, pushing the unemployment rate up to 5.9%. That's nearly a full percentage point above where it bottomed at 5.0 in the post-pandemic environment. 

And we have at least one month of job losses in most G7 economies, and not just Germany, but the U.K., Canada, Italy, Japan as well. Now, France reports employment on a quarterly basis rather than a monthly basis, and their latest number for the third quarter was for a gain of 0.1% in employment. But I bet one of those months was negative in there and could be on the cusp of joining other countries in reporting just a broader trend of weaker employment for 2024. 

LIZ ANN: All right, so what about inflation? Obviously, it's been an obsession for central bankers and investors everywhere. What is your outlook as it relates to global trends in inflation? 

JEFF: Well, one of the benefits of a sluggish economy, particularly in Europe, is that it's really helped to bring down inflation, right? Inflation is now at 2.4% in Europe in November. That's down from 10% a year ago and very close to the European Central Bank's target of 2%. 

The PMI Input Price Index has provided a near perfect six-month leading indicator of the trend and level of inflation in Europe, and it does so in a lot of other countries as well. It really does a great job of forecasting where prices are going to go, right? What are companies paying for their inputs? They usually pass that on to consumers. And that's suggesting the level of inflation is probably going to stabilize at around 2% in Europe in early 2024. This decline, coupled with a stagnant economy in Europe, really opens the door for rate cuts next year. 

But importantly, much of the impact of 2023's rate hikes has yet to be felt. The rise in interest rates in Europe as ECB hiked its policy rate from zero to 450 basis points hasn't really tightened European household budgets. You'd think it would have, but it really hasn't yet. The share of income going to interest payments has actually fallen over the past year, and it's done so for three reasons. 

One—this is unique to Europe and much of the world. Fixed-rate mortgages weren't really a thing until we got to the very low interest rates from the second half of the 2010s. For example, Spain—you had more than 90% of mortgages were adjustable-rate mortgages in 2015. That's now down to below 25%, replaced by fixed-rate mortgages. So they termed out those mortgages. They're not feeling the initial impact of that rise in rates for much of what's going on in Europe. 

Second—higher rates caused them to pay down a lot of their debt. They dropped overall debt levels in the Eurozone. So that was a plus in helping them offset the impact of higher rates. 

And third—income rose just as fast as debt costs did. In fact, Eurostat shows wages rose 4.6% during the past year. And that's slightly ahead of the 4.5% rise in policy interest rates. So all that kind of helped offset and actually made household budgets better off than they were, even before rate hikes started. But the bad news, of course, is that as we look out to 2024—well, wages probably won't rise as fast as they did in 2023, and some of that variable-rate debt and new debt will reflect those higher rates, which means it's likely that household budgets will be tighter than they were in 2023, in a lagged response to those higher interest rates. 

Now, a partial offset may be that the drop in inflation in the Eurozone to their target may allow the ECB to begin to reverse those rate hikes as soon as the second quarter of next year, easing some of the potential impact on households and helping to slowly improve the economic momentum throughout the year. But we've still got a year of headwinds ahead of us as we finally feel the impact of those rate hikes we experienced in 2023. 

You know, Liz Ann, there's a lot more I could say about the interest rate outlook next year, including potential rate hikes by the Bank of Japan. But you know what? I'll leave that discussion to those who want to go to Schwab.com and check out the 2024 global economic outlook. 

LIZ ANN: Ah, the tease. Good for you. Well, this has been great. But before I let you go, based on your overall global outlook, just give us a couple of takeaways for investors. What do you think investors should specifically keep their eye on as it relates to their own investments? 

JEFF: Sure. Well, real quick, because I neglected to mention this so far—geopolitics, including the ongoing wars, are likely to remain a source of market volatility. But despite their unimaginable human toll, these developments have had only a marginal impact on most markets around the world in 2023, consistent with the long history of these types of events. And obviously geopolitical developments are difficult to forecast. They may again take a backseat to the economic outlook as the main driver in 2024. 

So overall, we don't expect a V-shaped economic recovery, nor do we expect an inverted V-shape to the path for interest rates. So we continue to favor quality companies with strong cashflow. Stocks with low price-to-cashflow ratios, more heavily represented in the MSCI EAFE Index, may continue to outperform in 2024. These stocks can be found at all sectors, but they're more concentrated in areas like financials and energy, for example. 

The overall economic and earnings picture might be sluggish for much of next year. And that could mean stock prices are more determined by moves in the price-to-earnings ratio than earnings themselves as investors try to figure out what the right valuation multiple is in an environment of higher discount rates and uncertainty over the timing and pace of an earnings rebound. 

International stock valuations, I think, are already braced for a challenging 2024. You've got the price-to-earnings ratio for the EAFE Index 15% below its 10-year average, and many Japanese stocks have price-to-book ratios below one. So valuations could begin to lift on clarity around rate cuts and as the economy firms later in the year. And as with the economic picture, maybe looking too closely at the performance of just a handful of stocks can keep investors from seeing the bigger picture of international outperformance. 

You know, as the global economy transitions to a new economic cycle, markets are experiencing new leadership. In 2023, the average international stock outpaced the average U.S. stock through the end of November. If fact, the EAFE Equal Weighted Index has outperformed the S&P 500 Equal Weighted Index by nearly 5% so far this year, adding to the 15 percentage points of outperformance since the bear market ended in 2021. 

Let me wrap up by saying on emerging-market stocks, I'm a little less enthusiastic. I've written a lot about China lately. My recent report on China is entitled "Is China Investable?" Check that out. We've also talked a bit about India. India just reported a booming third quarter GDP of 7.6% growth. But India stocks are expensive, perhaps already pressing in high expectations. So again, a little bit less excited by emerging-market stocks than developed-market stocks for 2024, just as I was for this past year. 

LIZ ANN: Well Jeff, thank you for taking us on a little trip around the world. Make sure you all check out the written version of Jeff's report. But also, thanks for being here today. Thanks for joining our podcast. 

JEFF: My pleasure. As always, thanks for having me on. 

LIZ ANN: All right, so now we've covered the U.S. outlook, the international outlook, Kathy and her team and the fixed income outlook. So now let's take a look, courtesy of Mike Townsend, at the outlook for Washington, which is always interesting.

KATHY: That's right, Liz Ann. I'm happy to bring in Mike Townsend who we had on the show just a few weeks ago. Mike is our managing director of legislative and regulatory affairs at Schwab and our chief Washington strategist. Mike has nearly 30 years of Washington experience, and he's also the host of Schwab's WashingtonWise podcast. If you haven't listened to it, you really should. It's a great podcast. So be sure to search your podcast app for WashingtonWise, all one word, if you don't follow it already. Thanks for joining us today, Mike.

MIKE TOWNSEND: Great to be with you, Kathy.

KATHY: Mike, there's more than a few things going on in Washington these days. So I wanted to get your outlook for 2024, but I think we first need to call on your 30 years of experience in the nation's capital and ask, was this the craziest year you've seen yet?

MIKE: You know, Kathy, I think it was. I mean, think about some of the things that have happened in Washington this year. We started off the year with 15 votes just to elect a speaker of the House. Ten months later, that speaker was ousted by a vote of his colleagues, the first time that has happened in history. And then we had 22 days of limbo while the House tried to find someone, anyone who could be elected as the next speaker. We had a debt ceiling fight that brought us to the precipice of default. We so far have had had two last-minute deals to avoid a government shutdown, and just last week the House voted to expel one of its own members for just the sixth time in history. So I'd say it's been pretty crazy.

But you know what there hasn't been much of? Actual legislation. Outside of the debt ceiling deal, it's hard to think of any really significant bill that Congress passed this year that has had any real impact on the markets. And as I've been traveling around the country talking to investors, particularly this fall, there's just a lot of frustration that Congress isn't doing much that matters. It seems to a lot of people like it's just a daily circus here in the nation's capital, and honestly, they're not wrong. There was a recent poll that put the approval rating of Congress at 13%. And I'm not sure I have found any of the 13% who actually approve of Congress right now. So it's certainly been a crazy year.

KATHY: Yeah, I'll have to agree. I haven't met anybody who would be included in that 13% that I know personally. So let's look forward now. Maybe 2024 will be a more productive year. I assume the first thing you'll be watching next year is whether Congress can avoid a government shutdown. What's the timing of the next round of this fight? And what do you think the prospects are for getting government funding legislation through Congress?

MIKE: Yeah, Kathy, the most recent deal, which was crafted right before Thanksgiving, set up this kind of unusual two-tier deadline. So five major federal agencies representing about 20% of the total budget are funded through January 19th, and the rest of the government is funded through February 2nd. So once Congress returns to Washington in January after the holiday break, lawmakers are going to be staring at those two deadlines right out of the gate.

House Speaker Mike Johnson has said that the House won't pass any more temporary extensions of funding. At the same time, there is absolutely zero chance that the House and Senate are going to agree to the 12 appropriations bills that fund all government agencies between now and early February. So I think the risk of a government shutdown is quite high. Now, will that matter much to the markets? Probably not. Historically, government shutdowns have not been big market movers. In fact, the S&P 500® has actually gone up in the last five shutdowns, which probably tells you everything you need to know about how the markets feel about Washington since the market has gone up the last five times that the government has literally been closed.

But the length of a government shutdown does matter. And if we have one that lasts three, four, five weeks, then the impact on the overall economy starts to become real, not to mention the opinion of foreign investors and rating agencies on the trustworthiness of the United States, given the level of dysfunction right now. So I do think the risk of a shutdown is high and that there are some potential negative impacts. Again, I'm not sure that the market is going to overreact to that though.

KATHY: Well, I guess we'll have to wait and see on that one. Moving beyond a possible shutdown, what are some of the other key issues in Washington that you think investors should be keeping an eye on in 2024?

MIKE: You know, whenever there's a divided Congress, regulatory agencies tend to get very busy, definitely no exception this year. Next year, we are expecting the SEC to move to finalize a number of controversial rule proposals that can have some serious impact on investors in the market. There's one that will require public companies to share more with investors about the risks they face from climate change. That's really controversial. There's a series of proposals to overhaul equity market structure which would really impact how retail trading works. There is a rule proposal to strengthen mutual fund liquidity risk management, which will affect mutual funds. There's one to expand rules for how firms custody assets. And there's one to expand and better define the use of analytics when providing investment advice to an investor. So those are just a few examples of really a long list of rule proposals that we're going to be watching in 2024 to see how they play out and figure out the real-world implications for investors.

I'll also mention a couple of issues that I know investors are interested in right now: cryptocurrency and artificial intelligence. Both are getting a lot of attention on Capitol Hill. In both cases, Congress is looking to put some regulatory parameters in place. For crypto, it's about defining which cryptocurrencies are commodities, which are securities, putting some investor protections in place and creating a kind of regulatory framework for the crypto industry. And with AI, particularly given the explosion this year and use of these natural language processors like ChatGPT, there's a sense on Capitol Hill that some guardrails are going to need to be put in place. Both of these are really complicated issues, but these are two areas I'll definitely be watching in 2024.

Finally, I would say that the really big issue looming out there won't come to fruition until the following year because it's 2025 when the 2017 tax cuts are all set to expire. That includes lower income tax rates, the corporate rate, higher standard deduction, and probably most importantly from a financial-planning perspective, the estate tax, which would see the exemption amount cut nearly in half if it is not extended past 2025. So not a next-year issue but certainly one that really matters to investors that will have to be resolved the following year.

KATHY: Well, that's a long list of regulatory issues that we need to keep an eye on. But Mike, we've been avoiding the elephant in the room: the 2024 election. That likely will dominate the calendar. What are the big takeaways for investors right now?

MIKE: Well, obviously the presidential race is going to take up a lot of the oxygen over the next 12 months. Certainly appears we're headed for a rematch between President Biden and former President Trump. Though, I think there are a lot of questions surrounding both candidates that will persist in the months ahead. And whether it's President Biden's age or former President Trump's legal issues, which are going to unfold right alongside the primary season. So I certainly expect there will be some twists and turns as the race unfolds.

I focus a lot of my energy on watching the battle for control of the House and the Senate. You know, at the end of the day, the balance of power on Capitol Hill probably has a more direct impact on the policies that could affect investors and the market than the White House. In the Senate, Democrats have a 51-49 majority. There are 23 Democratic senators up for reelection and just 11 Republican senators. So I think there's a real advantage for Republicans. Among those Democrat seats on the ballot are the three red states that have a Democrat senator, Montana, Ohio, and West Virginia. Those will be really challenging for Democrats to hold onto. And with moderate Democrat Joe Manchin recently announcing that he won't run for reelection in West Virginia, that tilts that seat heavily toward a Republican win. So I think Republicans are favored to capture control of the Senate next November. Interestingly, though, I think there's a decent chance that Democrats can flip control of the House. Republicans only have a four-seat majority in the House. There are plenty of opportunities for Democrats to pick up the handful of seats that they need to take the majority. I think the battle for the House is going to be really close. If that plays out that way, we'd have a split Congress again in 2025, just split in the opposite way it is now. And that would mean that the tension and the partisanship and the challenges to getting anything done would probably continue for the next couple of years.

Generally, the market doesn't mind some gridlock in Washington, but keep in mind that we will have some huge issues looming after the election, including another debt ceiling battle and that battle over taxes that I mentioned earlier. So the markets will have a lot to keep a close eye on as this election plays out and as we see the result and what it will mean for 2025.

KATHY: Definitely a lot that we'll be watching in 2024, and I'm pretty sure you're going to be a very busy person. So thanks for coming on the podcast.

MIKE: Thank you very much.

LIZ ANN: Woo, Kathy, I know this has been a lot of material for our listeners, but it's also some of our most requested information. So to our listeners, if you've enjoyed this episode, please leave us a rating or review on Apple Podcasts. And remember, check out Schwab.com/Learn to get the full written reports for all of our 2024 market outlooks.

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 at Kathy Jones. That's Kathy with a K on Twitter and LinkedIn.

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

KATHY: Thanks for listening. On next week's episode, I'll be speaking with Dr. Julia Coronado. She's the president and founder of Macropolicy Perspectives. And she's a former economist for the Federal Reserve. So stay tuned for that episode next week.

For important disclosures, see the show notes or Schwab.com/OnInvesting where you'll also find the transcript.