Liz Ann Sonders: Navigating a New ‘Temperamental Era’ in Markets

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Background

Bio

“Liz Ann Sonders: ‘We Could See Some Inflation Scares,’” The Long View podcast, Morningstar.com, Jan. 6, 2021.

Secular and Cyclical Looks

“What the End of the ‘Great Moderation Era’ Means for Investors: Morning Brief,” by Jared Blikre, news.yahoo.com, March 2, 2023.

“Market Snapshot With Liz Ann Sonders,” video commentary, schwab.com, April 2023.

“Helpless? Recession Risks Abound,” by Liz Ann Sonders and Kevin Gordon, schwab.com, Jan. 23, 2023.

“Expect Volatility, Rolling Recession, but Watch for Contagion, Schwab’s Sonders Says,” by Tracey Longo, fa-mag.com, March 15, 2023.

“Hurts So Good: Jobs Picture Stays Mixed,” by Liz Ann Sonders and Kevin Gordon, schwab.com, Jan. 9, 2023.

“Schwab’s Sonders Says Bear Market Hasn’t Yet Hit Bottom,” by Tracey Longo, fa-mag.com, Feb. 7, 2023.

Inflation and the Fed

“U.S. Stock Market ‘Pretty Expensive’ as Investors Parse Inflation Report in Choppy Trade,” by Christine Idzelis, marketwatch.com, April 12, 2023.

“Mixed (Inflation) Signals,” by Liz Ann Sonders and Kevin Gordon, schwab.com, April 17, 2023.

“Market Perspective: Searching for Spring,” by Liz Ann Sonders, Kathy Jones, and Jeffrey Kleintop, advisorperspectives.com, Feb. 19, 2023.

“Schwab Market Perspective: Top of the Rate Cycle,” by Liz Ann Sonder, Kathy Jones, and Jeffrey Kleintop, schwab.com, April 14, 2023.

“Under Pressure: Fed Hikes in Face of Bank Turmoil,” by Liz Ann Sonders, schwab.com, March 22, 2023.

Credit Risk and Real Estate

Senior Loan Officer Opinion Survey on Bank Lending Practices

“A Recession Seems ‘Somewhat Unavoidable’ as Tighter Credit Conditions Reveal More Zombies of the Easy-Money Era, Schwab Strategist Liz Ann Sonders Says,” by Phil Rosen, businessinsider.in, April 7, 2023.

“The US Housing Market Is in Recession—and the Pandemic Has Created a Unique Economic Headache, Elite Strategist Liz Ann Sonders Says,” by Theron Mohamed, markets.businessinsider.com, March 8, 2023.

Stocks and Earnings

“The Price You Pay: A Look at Equity Valuations,” by Liz Ann Sonders and Kevin Gordon, schwab.com, Feb. 21, 2023.

“This Indicator Clearly Shows Where Wall Street’s Top Money Managers Expect Stocks to Head Next,” by Sean Williams, Nasdaq.com, April 14, 2023.

Growth vs. Value and Asset Allocation

“Mysterious Ways: Growth vs. Value Debate,” by Liz Ann Sonders, schwab.com, May 1, 2023.

“Elevation: Largest Stocks to Market’s Rescue?” by Liz Ann Sonders and Kevin Gordon, schwab.com, April 3, 2023.

Transcript

Jeff Ptak: Welcome everyone. We’re so pleased to have you joining our live recording of the The Long View podcast. I’m Jeff Ptak and this is my colleague, Christine Benz. We’re the co-hosts of The Long View. And we’re just overjoyed to be joined today by Liz Ann Sonders, of Charles Schwab.

Liz Ann, welcome to the Morningstar Investment Conference, and welcome again to The Long View podcast. Thank you very much.

Liz Ann Sonders: Thanks for having me.

Ptak: We’re thrilled to have you again, and we’re looking forward to this conversation. We’ll launch into the conversation in just a moment here, but just a quick administrative item. We’re going to chat for about 45 minutes or so, and then, as with the previous session, we’re going to open it up to you all. So, we would encourage you to submit your questions just as you did in Professor Damodaran’s session via the chat applet in the MIC app. And we have a moderator here who’s collecting those questions. We’ll curate them and ask them in the last 15 minutes of today’s session.

But before we do that, I thought we would have a chat, and we thought the logical place to start off—we’ll widen the aperture and talk about the secular outlook. This is an area you’ve spent a lot of time thinking about writing on, speaking of. You’ve said “the great moderation” era, as you put it, is over, so maybe you can talk about, first of all, what you mean by the great moderation era, and also why you think it’s coming to an end?

Sonders: Obviously I did not coin the term. I think it was Larry Summers who did, and it stuck. There’s slight differences in terms of how people define the beginning of it. But, in general, it covers the period from very late ‘90s to essentially the pandemic, and it’s often characterized as a period of disinflation for the most part. But I think of it more broadly than that, and I’ve often used the acronym GEL—everything was gelling at that time—and the GEL stands for goods, energy, and labor, because there was abundant and cheap access to all three of those. In large part the case of goods and labor due to China’s entrance into the world trading order, with the WTO, which was in 2001, globalization, the shale and fracking revolution in the United States that made us essentially energy independent. And it was at this disinflationary environment for much of that period. It also is why, for almost the entirety of that period, save for a brief time in ‘08, you had an inverse relationship, or a positive relationship between bond yields and stock prices. Or an inverse relationship—bond yields, when they were going up, typically it was not because of an inflation problem. It was because growth was improving. Stocks did fairly well.

I have been talking about the transition I think we are heading into being something that looks a little more like the 30 years prior to the great moderation, from the late ‘60s to the late ‘90s. I’m not going to suggest that my terminology for it is going to become the name like it did with Larry Summers. But I’ve been calling it the temperamental era, and it was an environment of not permanently higher inflation, but more inflation volatility, more geopolitical volatility, more economic volatility, actually shorter cycles. And, as a result, more recessions but sharper growth periods on the upside in between. It’s not necessarily a much tougher investing environment. It’s just a different investing environment than even somebody with a 25-year history of investing has gotten used to.

Christine Benz: What would prove we’ve exited one era and entered another as opposed to say, traveling through different parts of a typical expansion/contraction cycle? What are you looking for to confirm that it’s a more durable secular shift?

Sonders: Some of it would be that that bond-yield stock price relationship, because in the temperamental era, up until the late ‘90s, bond yields more often than not were moving based on inflation. So, in the moves up typically in yields, it was a sign of inflation being let out of the bag again, negative for the equity market. Vice versa on the way down. And then we had that opposite situation for the 22 or 23 years. So that might be the one quantifiable metric that you could point to. The rest of it, it’s not so much anecdotal, but it’s a little bit more of a qualitative assessment of whether the conditions, not that have led to this high inflation are likely to persist, but are we more subject to supply shocks in this sort of new world we live in, given, not deglobalization, but regionalization as well as maybe shifting thoughts around diversification of supply chain and going from a just-in-time mentality to a just-in-case kind of mentality.

I think much like was the case in the late ‘90s, where you’d transitioned to that great moderation era, I think we’re in that transition, which means you’re going to see a lot of choppiness and not necessarily concrete signs that this is happening. But I think that the changing nature of global relationships and supply chain and geopolitical instability and uncertainty suggests that the era we’re entering into is not a great moderation era.

And I also don’t think that central bank’s inclination, at least near term, is to go back to the zero-bound or the negative-bound. I think, for now for a while probably, I hope, anyway, that that ship has sailed.

Ptak: What are the implications of if we are in fact in this more temperamental period, as you describe, the implications on business investment and the way investors allocate capital to those businesses?

Sonders: I’m actually beyond the near term, fairly optimistic about the investment side of the U.S. and global economy. There’s been such grave underinvestment in the case of the U.S. and infrastructure and structures. So, I think the next cycle on the upside may have more of an investment-driven CapEx supply chain bias to it. At the expense of discretionary consumption, and I think that’s a more optimistic outlook for the economy than the one that’s built on 71% discretionary consumption, especially one like the prior cycle where discretionary consumption was a driver but it was driven by an excessive amount of debt, particularly mortgage debt.

I’m actually quite optimistic about the investment side of the economy. I just think that we’re likely to have more normal cycles. This, quite frankly, is a bit of a normal cycle. What preceded it, and what led us to this wasn’t terribly normal, but growth heated up. We got inflation. The Fed stepped in. They tightened monetary policy until something breaks. Liquidity tide goes out, and now we’ve got the return of the risk-free rate, which means the era of the absence of price discovery, and the era of capital misallocation hopefully is in the rearview, and fundamentals are reconnecting to prices. It’s why equal weight is playing on a more level playing field now, with cap weight, and why active has been given a shot again relative to passive.

I think there are good things about the changes that have come about here.

Benz: Many in the audience, no doubt, are being asked where we are in the economic cycle currently. You recently said that most of the recession dominoes have fallen. Can you explain what you mean? And, also whether that leads you to conclude that we’ve already entered a recession perhaps?

Sonders: I think parts of the economy already have. We’ve been using the term rolling recession, or rolling recessions, to describe the unique nature of this cycle. And it goes all the way back to the spring of 2020, when we had the COVID recession, we were in lockdown mode, massive stimulus kicked in, causing a surge in demand. But all that demand, fueled by stimulus, was forced to be funneled into the good side of the economy, because services were shut down. That launched the economy out of the recession, but it was highly goods-concentrated inclusive of things like housing and housing related. That’s also where the breeding ground of inflation began, exacerbated by the supply chain problems. But fast forward to today. We’ve seen the good side of the economy absolutely go into recession territory. Housing, housing related, the factory sector, a lot of the stay-at-home-oriented goods components of the economy were in disinflation for most of those segments within metrics like CPI. But we’ve had the offsetting and later strength by services. Services is a larger employer. It has explained until very recently the strength in the labor market.

So, when I think about recession versus no recession, I do ultimately think we’ll get an officially declared recession. But the NBER, they’re way after the fact. Could we be in one? Yeah, if the factors at the NBER gauges to judge, not just, we’re in one. But when did it start?

And when did it end? If at its payrolls, industrial production, personal income and business sales, if we decelerate in those with IP already having rolled over—payrolls have decelerated, they’re still strong in level terms—but if we were to decelerate to recession conditions, it’s certainly possible that the NBER when dating the start, they go back to the peak in the aggregate data. But I don’t think that matters really all that much. I just think best-case scenario is not so much soft landing in a traditional sense, but that if weakness rolls into the services side of the economy and hits the labor market even more, which quite frankly, is something the Fed wants to see—it’s a bit of a feature of what the Fed’s doing here, not a bug. But maybe we have stabilization in those other areas. In fact, housing is starting to show some signs of life. But I do think, especially with what’s going on in the banking system and credit conditions, that we’re already in recession territory, pre-SVB. It’s probably going to start to hit services and the labor market.

The other last thing I’d say about the labor market that’s unique, is this has been top-down in its initial deterioration, not bottom-up. And what I mean by that is normally when layoff announcements start to kick in in higher gear, it tends to be concentrated down the wage spectrum and nonmanagerial, nonsupervisory people, it’s completely topsy-turvy this time. I heard somebody say actually on a podcast that it’s getting rid of some of the surplus elite. I thought it was kind of a rough way to say it. So that’s unique and that helps to explain why you haven’t seen an immediate lift until recently in unemployment insurance claims.

Because a lot of these folks either got severance, so they’re not eligible for it; had enough prior income that they didn’t need to rush to the office. But now it’s starting to work its way in terms of breadth into those areas.

It also helps to explain why there’s a big difference between average measures of wages and median measures of wages. So average hourly earnings has actually been heading down. But median measures are still fairly high, and that’s simply because if you take a bunch of larger numbers out of an average, it lowers the average. When you’re measuring it in median turns like the Atlanta fed does that it’s not picked, so it’s mixed ship that’s also, not wreaking havoc with the wage data, but you need to understand to know why we’re seeing such mixed signals.

Ptak: It sounds like the job market certainly isn’t a great barometer for understanding whether or not we are in the midst of or heading toward a recession for the various reasons you mentioned.

Sonders: Claims are up 30 or 35% from their low, the average going into recessions of a lift and claims from a trough is only 20%. When I hear people say there’s no way it could possibly be a recession with a 3.5% unemployment rate. It’s the most lagging economic indicator. Just look at a long-term chart of the unemployment rate; put recession bars in. Unemployment rate is always near its low at the start of recessions. It’s not that a rising unemployment rate brings on a recession. It’s a recession brings on an eventual rise in the unemployment rate. So, trying to gauge what’s going on in the economy, you want to look at the leading indicators, not a lagging indicator. And the leading indicators have sunk like a stone for 15 months.

Benz: We want to bring the market into the discussion. Your research has found that bear markets typically arrive at the actual start of a recession or slightly precede it, whereas the National Bureau of Economic Research, which you referenced, announces a recession start on a lag. So, we’ve already gotten a bear market, but no recession call from NBER. Have we already had our bear market? Was 2022 our bear market?

Sonders: That’s sort of another way of asking is the mid-October low, the low. I don’t know. Can I just stop there? Is that a sufficient answer? No, I know. But that’s the honest answer, and everybody should answer that way. I have no idea.

And, by the way, trying to time tops and bottoms with precision, that’s just gambling on moments in time. And it’s not what I know or you know, or an investor knows that matters—meaning about the future. It’s what we do along the way, so frankly I wouldn’t be surprised either way. It certainly wouldn’t surprise me if the market retested the low to the extent that a recession isn’t already underway. If the October low holds, and a recession either doesn’t start at all, or starts later than the timing of us sitting here—and not that there aren’t always firsts—but it would be the first time that the bottom happened before the recession began.

Not before the NBER makes its call, and that’s what people seem to forget—the order of things, to use, it’s actually the 2007 to 2010 cycle, because the bear markets started in October of ‘07. We knew eventually that the recession started in December of ‘07, the NBER told us it was a recession in December of ‘08. And then simultaneously said, “And by the way, it started 12 months ago,” which I think at that point everyone’s like, “Well, duh!” And then the recession ended … Well, the bear market ended in March of 2009. The recession ended of June of 2009. But we didn’t know that until October of 2010. So that’s just how things unfold, and I can’t tell you how many times I’ve talked to investors that say, “But if you do think it’s a recession, why wouldn’t I just wait until I know there is one, and I know it’s over and when.” You missed probably a big chunk of the next bull market.

Ptak: I did want to ask you about whether you see any parallels between the current conditions and what we saw in the early 1980s? The bear markets, as you’ve noted, they often conclude around the time a recession ends, but there have been exceptions like the early 1980s. The recession ended in the summer of ‘80, but the market didn’t emerge from its bear market until August of ‘82, reason being the economy entered a second recession. And so, do you foresee that as a possibility for us?

Sonders: I hope not. In fact, I think that when people think about the playbook that Powell is going off of, it’s not really the inflation playbook of the ‘70s per se, because the drivers of inflation in the 1970s were quite different relative to the drivers of the current bout of inflation. So, he’s not looking at the underlying conditions. What he’s trying to I think avoid is the Arthur Burns mistake of 2, could argue, maybe even 3 times, of hanging the mission-accomplished banner after tightening policy inflation came down. “Our job is done, we can loosen policy. Oops inflation out of the bag again. We did it again. Mission accomplished. Boom!” And that’s what led to Paul Volcker having to come in and pull Paul Volcker, bringing on the back-to back recessions.

I think that’s very much what Powell is trying to avoid, which is why he’s been so forceful in pressing this idea of yes, the pause is soonish, terminal rate is soonish, but we are going to stay there. And that’s I think the disconnect that there’s sort of three narratives out there right now. The one the Fed is giving us, the one that the bond market is suggesting, and then what the equity market is doing. And they’re all not going to be right permanently.

I think the inclination, anyway, is for the Fed to see this fight to the end. If anything, recession, I’ve heard, with sort of a bullish tinge, well, recession is not till 2024, and I think that’s a more bearish case. A recession right now, or one that’s already underway, that’s the more bullish case, because if there is one consistent kind of cure for an inflation problem, it’s a recession. I think, sooner rather than later, is actually better from a market perspective.

Benz: You just mentioned inflation, Liz Ann, and we’ll hear from Treasury Secretary Larry Summers first thing tomorrow morning.

Sonders: Yes, ask him if he likes my temperamental era.

Benz: We will. But Summers has warned that it takes longer to quash inflation than you think. Do the data support that assertion?

Sonders: Well generally Fed officials have said that fighting deflation is a little bit tougher, only because it’s a proverbial halt on activity. If you as a consumer, an investor, or a debtor, thinks prices are going down more, rates are going down more, it sort of halts activity. So, in theory, central banks usually say that deflation is a tougher battle to win, particularly if it’s entrenched—the Japan situation. And inflation is easy; you just raise rates. I think it’s letting inflation not only get out of the bag but get to a 40-year high.

Then obviously it becomes a little bit more difficult. And the Fed and Powell, they can see that they probably stayed on the zero-bound too long and waited a bit too long to start shrinking the balance sheet, but it is what it is. We’re here now, and there’s nothing we can do about what wasn’t done, or what should have been done. It’s all the counterfactual. But I think that that’s front and center, is tackling this problem. It takes a little bit longer when it bursts to a 40-year high.

Ptak: Real wage growth is edge positive after being negative for two years, I think. Do you think that’s a positive economic development? Does it back up the Fed’s point that inflation is yet to be subdued?

Sonders: I think that the whole nominal versus real is always important, especially in a high inflation environment. You’ve got to always look at data in both nominal and real terms. But I think we’re now at the point of the tell in terms of how much was wage growth, pricing power tied to just the nominal inflation getting to a 40-year high. And whether as disinflation continues, fingers crossed, whether we start to see that chip away at whether there’s actual pricing power. And you’re starting to hear it every day now, especially in earnings season,

with, we are trying to maintain prices but unit sales are down a ton. You’ve seen companies, biased toward hanging onto employees and keeping their wage the same, but hours worked have come down quite a bit. So, I think the real story is a little more nuanced, and I think you’ll see maybe a decent amount of stability in nominal wages. And then just the math changes if we continue to see disinflation.

What I do not think we have had in this cycle is anything resembling the kind of wage price spiral that characterized the 1970s. I already mentioned that I think the drivers were different, and that’s a key difference between that era and now.

Benz: Headline inflation appears to be easing, but not core CPI. So, I’m hoping you can explain the difference between those two things. I’m guessing many in the audience will know, but we can go over that and also discuss whether a decline in headline inflation will be enough to convince the Fed to back off its aggressive stance.

Sonders: Headline and core are just a differential; core is excluding food and energy, and the original idea of doing that is not because anyone thought we don’t heat our homes or drive cars or eat food. It’s just that those are much more volatile components, that not only are often driven by factors that are noneconomic and out of central bank’s hands, but would, if monetary policy keyed off that, would be counter to what would help. If you’ve got a real economic problem that comes with food prices spiking because of a major drought or a war, you’re going to raise rates? That can’t deal with the supply side of things, and that’s a big part of the conundrum that central banks have dealt with in this environment. But what’s interesting about the most recent inflation report, is there was a lot of concern about headline coming down a lot. But, uh-oh, core is still sticky on the high side. And when I see some of the headlines, I think, did you not look at what happened?

And I put it on Twitter every time the inflation data is reported. The biggest month-over-month decline by category in the most recent month was gasoline and other energy. That’s good. But so therefore, X food and energy. Again, it’s the whole average thing. You don’t have the benefit that accrued to headline of those lower energy prices. It wasn’t that a bunch of these other core things spiked. It was just a big drop in certain energy prices flattered the headline but didn’t flatter the core.

It’s also important to know that CPI is what we all focus on. It’s what consumers are generally familiar with. It’s not the Fed’s preferred measure. Theirs is PCE, and the biggest difference between the two are the shelter components, and the shelter components collectively represent 43% of core CPI and the biggest portion of that is owner’s equivalent rent.

And it’s a really funky, imputed calculation of asking homeowners, if you were renting your house to someone, what would they pay? First of all, homeowners have no freaking clue what that number is. It’s just a complete guess. It’s biased depending on their own perceptions, or where they live, or what they think they know about what’s going on in the world. It’s not really connected, and even the rent of primary residents, which is an actual calculation, if you ask somebody who leased their apartment a year ago, what rent? They’d say that number. But you asked somebody who leased it a week ago, and it’s going to be a completely different number. So, it’s inherently lagged data. But it’s 43%, of course. It’s a much lower percent. The housing component is much lower in PCE, and now the Fed has got this core services ex housing. It’s kind of throwing darts at what metric. But there’s a lot to understand about these calculations.

And there’s big differences between. It’s also the case that everyone’s inflation is different. I also think it’s hysterical every time the numbers come out. And I’m a geek, and I’m focused on the month-over-month changes. They go in, and they say, “Am I paying more for a dozen eggs than I was a year ago?” Yeah. But if you don’t drive a car and you’re not renting. My parents are still alive. They’re in their mid-80s and early 90s, and they live in senior living. Thank God for all of you—we took my dad’s car keys and car away from him two years ago. He’ll be 93. We pay for their senior living, so they don’t have any housing costs. Their meals are paid for. They don’t drive anymore. They have no inflation. But somebody who drives every day and is buying food at the grocery store and is paying rent, their inflation … So, inflation is a very personal thing, too, and we generalize with all these statistics.

Ptak: The bond market and in the Fed don’t seem to be on the same page by many measures and so the question for you is what risks does that pose to capital markets, the economy? Does it continue to put a chill and bond issuance, for instance. What’s your take?

Sonders: I think the bond market is often said as being more rational than the equity market in terms of what you can infer by that. The only rub, and I just had a conversation about this with my colleague, Oliver Renick, who was our lead anchor on TD Ameritrade network, about the fact that there’s also a lot more speculation, institutional trading that goes on in the bond market, even in the Treasury market, which throws a wrinkle into what has historically been this idea that the bond market is rationally giving a picture of what’s going on with inflation, with the economy, and the equity market because it’s always been biased by short-term traders. And now the speculation is, that’s why you see the move index as a measure of bond market volatility has skyrocketed relative to equity market volatility. So, you have to take that into consideration. But to the extent that the bond market is right, and the fed-funds futures market is right, that a pivot to cuts will come sooner than what the Fed is suggesting, and the equity market until very recently, whistling past that, that’s that sort of triple disconnect that doesn’t seem to make a lot of sense. It’s certainly possible that the Fed might have to start cutting rates in the latter part of this year, but not if everything stays the way it is.

This idea that fighting a 40-year high in inflation, if inflation is still well above the Fed’s target, if we don’t see economic-growth deterioration, and we don’t see a hit to the labor market, and the Fed’s going to go against their promise that they want to stay at the terminal rate, why? Talk about credibility loss if they did that. I think a Fed pivoting to actual rate cuts could come, but only if either much more economic deterioration, clear recession attendant with weaker labor market, maybe and/or much more stress in the banking system than what we’re seeing right now. Even if we continue to see disinflation, and let’s say you get to a sub-three-handle on PCE, if all else was equal, that might justify pause. But that doesn’t justify cuts. That would be pulling an Arthur Byrns, which I think the Fed definitely doesn’t want to do.

If I want to put my bullish hat on with regard to the equity market, maybe it’s the case that the equity market is pricing in or voting for a near-term recession. Let’s just get a recession. It will be mild. The Fed will pivot to rate cuts and then we’ll be off to the races again. So, either that or the equity market just somehow thinks the Fed’s going to pivot, but without the attendant conditions it would suggest a need to pivot.

Benz: Why isn’t Fed tightening slowed down the services sector where the bulk of jobs can be found the way it has the goods sector?

Sonders: Well, we’re not as indebted as we have been in the past, including even on the housing side. So, we didn’t have adjustable-rate mortgages like the last cycle. A lot of people either locked in or refinance to lower mortgage rates. Until recently you had not seen an aggressive increase in things like credit card debt. It’s just not as interest-sensitive. An economy plus the hiring binge occurred much later in the cycle. We’re still in the revenge-services buying on the part of the consumer. I don’t want to say it’s getting exhausted, but the whole excess savings thesis is just getting a little bit long.

If we continued the same trajectory of consumption as we’ve been in, that trillion dollars or so of excess savings is basically gone by the second half of the year. And that assumes there might not be a reason or a desire on the part of some consumers to say, “The labor market is starting to look a little worse. Maybe I’ll just keep some of this actually in savings.” And it is also the case that if you break the excess savings into income quartiles or quintiles, most of it is up the net-worth spectrum, down below that, it’s getting a little … But we’re just not as interest-sensitive an economy, and that’s why it’s had the hit in areas like housing, and where there was debt, the interest-sensitive. But it hasn’t hit the broader economy, because more broadly balance sheets were just healthier coming into this cycle with less debt, certainly relative to the ‘07/’09 cycle.

Ptak: I wanted to jump ahead to credit and lending standards. Before I do that, just a quick reminder to our audience in about 15 minutes’ time we will begin answering questions that you’ve submitted via the MIC app, so we would again encourage you if you have questions, use the applet. You can submit them to our moderator, and he will ask them of us in about 15 minutes’ time.

Until then, maybe to jump to credit risk and lending standards. I’m curious whether by the measures that you track credit has gotten tighter for small businesses since Silicon Valley and Signature Bank fell?

Sonders: Probably the most comprehensive data that is formal in nature as the SLOOS—Senior Loan Officer Opinion Survey. That’s only done quarterly. The most recent release was in February, and it’s called the Q1 but that’s because it was released in the middle of Q1. But it really only goes through the latter part of last year, maybe a little bit. It doesn’t cover anything post-SVB. That credit conditions both on the consumer side as well as C&I loans were well in recession territory even then. I don’t think it’s a stretch to think that they got tighter in the aftermath of SVB. I think the next release from the Fed is May 8, but the Fed does see this about a week or so before, so coming into the May 3 FOMC meeting they will have that data. I don’t know that that sways them off what is likely to be 25-basis-point hike. They’ve essentially been telegraphing that, but it could work its way into the press conference and commentary around credit conditions, because he will certainly be asked about that.

But we do have other measures on an interim basis, some of which are soft data in the sense that it’s survey-based like NFIB, credit conditions. They’ve all deteriorated pretty markedly, and you’ve also got data that comes out weekly by the Dallas Fed and the New York Fed, all of which point in the same direction of tightening credit conditions. And now that we not only have the information from the larger banks, which quarterly data was actually fine for the first quarter, but of course the crisis didn’t really erupt until the middle part of March, so you only had two weeks of trouble in the quarterly data. We now see who’s going to be left standing, and who’s really in trouble. But clearly the impact is going to be felt by the small and regional banks because of deposit outflows. The fact that they’ve had loan books on the other side of deposits, but a much greater bias in those loan books to the commercial real estate side of things and there’s lot of focus on the next shoe to drop and I don’t have a contrarian view on that—it is. It’s just maybe not the best descriptor of shoe to drop, because it’s probably not a moment-in-time thing like with the mortgage crisis, where there’s the blowup September moment. It’s probably more of a grind, but it clearly will have more of an impact down into the small and regional banks because they represent about 80% of commercial real estate-lending relative to obviously much lower for the larger banks.

Benz: In your most recent quarterly market outlook, you and your colleagues Kathy Jones and Jeffrey Klein Top wrote, “We are only starting to wring out the excesses of easy money and ample liquidity.” What are the most obvious excesses yet to be rung out? Is it private credit?

Sonders: In the aftermath of SVB, there’s obviously been acute focus on the B, but not maybe as much focus on the SV, and I don’t mean specifically Silicon Valley regionally, and what that represents. But as a moniker for the broader environment of startups and zombie companies and nonprofitable areas—just what was given support in an environment of ample liquidity and free money, and that bred capital misallocation, and inability to do price discovery.

I think that’s just starting to unwind. So, when I think about … We all love to quote Warren Buffett, but the liquidity tide going out, you see a swimming naked. Yeah, SVB was clearly a naked swimmer, but I think there are more. And it’s why you’ve seen this flip-flop in terms of layoff announcements top down. Again, I can’t remember who said it, but the demise of the we’re getting rid of the surplus elite and I think that’s part and parcel of this return of the risk-free rate and liquidity that is—the tide has gone out. But I think it’s much like the fallout of commercial real estate. I think it’s more of a grind. We’ll see a pickup in bankruptcies. More of a grind than a moment-in-time bottom falls out.

Ptak: Housing is in a weird place. Mortgage rates have risen, yet supply is scarce, and so that seems to have mitigated some of the price declines. In fact, I think the medium home sales price didn’t fall until relatively recently. What do you think’s going to bring the housing market back into a state approaching equilibrium where affordability isn’t the issue that it seems to be right now?

Sonders: Housing affordability really is a three-legged stool. There’s three main components of housing affordability. Obviously home prices, income, and then mortgage rates. And for a while there all three of the legs were knocked out from under the stool. You had the spike in mortgage rates. You had income going down, particularly real income courtesy of inflation, and you had home prices that were incredibly elevated. You’re right, Jeff, to point out that home prices haven’t compressed much at all. Home sales, the combination of existing and new-home sales, I think peak to trough down around 40% this cycle. That’s not the 50 in change that was the case in ‘06, ‘07. But when people say, well, home prices are only down a couple percent, how can you call it recession? Home sales are down 40%. I think that’s probably in anybody’s thinking of what might define a housing recession.

I’m not sure that prices are going to collapse because of the supply/demand imbalance. It is the case, and this more is a tie into potential problems for certain type of operators and banks, but the supply of multifamily homes coming on the market this year is massive, like a record.

So, we’ll start to ease some of the supply constraints on the multifamily side. But there’s a way to go to solve some of those constraints on this single-family-home side of things. So, it’s also the case that with this recovery we’ve started to see in housing—we’ve seen the NHB Housing Market Index lift up off the bottom, the latest data has generally been a turn back higher, sales have picked back up. Even saw a little bit of an uptick in certain regions and prices.

I’m not suggesting it’s going to be a short-lived rally but a lot of this housing data goes back decades and decades, so you can take a long view, every time you’ve been in a Fed-hiking cycle and housing has struggled, which it always does, when the market, the overall market, the housing market has in its sights the pause, the terminal rate—OK, they’re almost done—housing has always rallied. In soft landings, it continues to; in recessions, it rolls back over, so maybe you’d think of it at the other way. Keep an eye on housing because it may be kind of a tell on recession risk. If this is just an attempt at a rally, a last gasp before the next let down. All that, said, this is not a weight in any way, shape, or form, either, for the banking system or housing.

Benz: We want to go back to the stock market and earnings. You’ve noted that the spread between the S&P’s earnings yield, and the three-month Treasury yield recently went negative for the first time since 2001. How could that not be bearish for stocks?

Sonders: It’s the last valuation metric to move into market is not cheap territory. Last year, particularly at the beginning stage of the bear market, valuation was off-the-charts bad. It started to improve—that’s what happens in a bear market. But the only metrics that suggested the market was still relatively cheap were those metrics like equity risk premium, or the earnings shield, the inverse of the P/E ratio. It’s a way to look at equity evaluation in the context of the bond market. And because yields were so low it made equities look pretty reasonably valued. That ship is now sailed, which also suggests we’re later in the cycle. That doesn’t mean that valuations, the traditional valuations, are anything resembling cheap. Right now, we have the rub of inflation.

Last year was the key driver down in multiples, particularly the first half of the year when we saw major multiple compression when the market was getting hit. Yet at the same time earnings were still growing. That was just the inflation pressure down on multiples. Now we have less of that inflation pressure down on multiples. Disinflation is starting to become a little bit more of a benefit. But now the e, the forward e, is in decline, which means you’ve got declining e, all else equal, putting upward pressure on multiples; inflation, still putting some downward pressure on multiples, not as acutely as last year, and I think we probably need to see some stabilization and forward earnings. We don’t need to see much better earnings stabilization. What a lot of people don’t realize is the best performance for the equity market, historically … When I ask people, I say, “OK, what do you think the range of earnings is that the equity market has done best?” And people always say, “When earnings are highest.” And then I’ll give the breakpoints and I’ll say, so does the equity market do well when earnings are growing at more than 20%? Yes. It’s actually the second-worst performance when earnings are in this high … The worst is when earnings implode by more than 20%, because, particularly on the way into that implosion and earnings. That’s recession. But the best performance for equities for the S&P has come when S&P earnings are down between negative 20 and negative 5%, and the best performance in that zone is typically the coming-out point. And that’s just the nature of the market. It keys off of better or worse. Better or worse matters, more than good or bad.

By the time earnings are in the above 20% zone, the market is saying, it’s not getting better from here. The next move is the inflection point and down. So, we don’t need to see a huge surge in earnings. We just need to see a stabilization of what I think is still more downward pressure. In particularly, the second half of this year, which miraculously we’re going to have negative growth in Q1 and Q2. Estimates are that earnest growth will be back in positive territory in 3Q. And back double-digit growth in Q4. That to me seems kind of la la Land, especially given what’s going on with credit conditions. So, I think there’s still some downward pressure. But once we start to see stabilization, then I think you can start to better assess valuation, and it certainly looks better than it did a year ago.

Ptak: Why don’t we take a few audience questions, if you don’t mind?

Moderator: If interest rates do stay at an elevated level, what are the investment implications?

Sonders: So again, I think the environment we’re likely transitioning into is one of more inflation, volatility, and probably not returning to anything resembling a 0% interest-rate environment or negative interest-rate environment. I think one of the key implications with the return of the risk-free rate, as I already mentioned—price discovery and the reconnecting of fundamentals to prices. I think we’ve already started to see it, and I think we’ll continue to see it in general.

Not every week, not every day, but equal weight, doing well relative to cap weight and active management, operating on a more level playing field, at least versus passive management, and I think to think broadly, that’s going to be a distinct difference in this more inflation, volatility, rates not going back to the zero-bound environment of price discovery, and reconnection of fundamentals. And I think it also supports factor orientation in equity investing versus monolithic sector calls, or really monolithic growth versus value, which I think there are so many misperceptions about, and so much simplicity around growth versus value.

Ptak: Why don’t you talk about that for a minute? Because I think that’s something that you’ve talked about previously.

Sonders: Yeah, and I think I’m going to write about it again on Monday, barring something that happens that suggests I need to write about something that happens. I think there’s three ways to think about growth and value. There are preconceived notions of what growth and value is and what buckets certain types of stocks fall in. That’s what’s in our head. Then there’s the indexes called growth and value. I’ll get to that in a second, and then there’s the actual characteristics of growth and value. And those latter two things often relate to each other, and the best way I describe this—I used to describe it by going back to October of ‘02, when finally the tech bust bear market ended. And that was an environment where that the S&P was down 57%, the Nasdaq was down 80%, and even worse for the Nasdaq 100. If you were a deep-value investor, but you weren’t beholden to what was in the value indexes, you went into the deeply undervalued tech stocks—ideally, the ones that survived. And that’s where you found deep value. They weren’t all moved into the value indexes, but that’s where the characteristic of deep value was.

But the more recent example, which I think really brings this to light, is what just happened in December. Although Russell growth and value indexes are the more common benchmarks that are used, S&P also has growth and value indexes. Russell has four of them; S&P has four of them. Russell, it’s large, large growth, small growth, large value, small value, 1,000 and 2,000.

S&P has S&P pure growth, S&P growth, S&P pure value, S&P value. If you’re in S&P pure growth, you can also be in value. If you are in S&P regular growth, the same stock could also be in the value index, because there are stocks that have characteristics of both. S&P does their rebalancing in December every year. Russell does it in June.

So, they just rebalanced their four indexes on Dec. 19. On Dec. 18, S&P Pure Growth index had all eight of the mega-cap eight in it. Apple, Microsoft, Google, Amazon, Meta, Facebook, I mean Tesla and Nvidia. I think I got them all. And tech was 37% of S&P pure growth. On Dec. 19, seven of the eight were out of pure growth, three of them actually went into value—regular growth and regular value. Only one was left in pure growth and it was Apple, and as a result, in one day S&P pure growth went from 37% tech to 13% tech. Energy became the number-one sector and healthcare became the number-two sector. And because so much of tech was moved, tech became the second-highest sector in S&P value. Meanwhile, Russell hasn’t done the rebalancing so Russell 1,000 growth is 42% tech. S&P pure growth, it’s gone up a percent, is 14% tech.

My point isn’t so, which index do you buy? But you sure better know when somebody says I like growth. OK, are you talking in general? Are you talking about the characteristic of growth? Are you talking tech, because that’s what the preconceived notion of what is growth. Or are you looking to track an index? Yeah, just any. You’ve got 14% in pure growth. You’ve got 42% in 1,000 growth. And, yeah, financials are the number-one sector in all of the value indexes. But energy is now the number-one sector in S&P pure growth. So, I think investing based on the characteristics of growth and value make all the sense in the world.

And I think you want to look at a combination of both. Just don’t put blinders on as to where … You can find value in areas that you might preconceive as growth areas. Utilities last year got to a level of expensiveness relative to the S&P beyond anything that’s ever happened before. They were more expensive than the S&P in terms of P/E than ever before. That doesn’t make them growth stocks. It just makes them expensive stocks that happen to be housed in value indexes. I always think of the factors of growth and value, and I’m always aware of what’s going on in the indexes, but I think it’s the characteristics that matter.

Moderator: What are your thoughts on the potential U.S. defaults, and what ramifications may have on the current macro environment?

Sonders: I think it’s common wisdom to say that we won’t default. But if there’s one thing that both sides do really well together is kick the can down to the eleventh hour and 59th minute, and given the weakness in tax returns, the pendulum is moving a little closer. A week or so ago, the thinking was, now we hit the limit in June. Now, without anything official from Janet Yellen, they’re thinking maybe you can move the deck chairs a little bit until July.

It’s eerie the similarities between the current environment and 2011, including the full makeup of Washington. And I don’t say that, because … I blame both sides, by the way. I’m an equal-opportunity critic of Washington, especially on this subject, but the least-common makeup of Washington in history is what we have right now, and what we had in 2011. And, unfortunately, I think that the partisanship has not just gotten worse; I think in many ways the extremes of both sides thrive on the chaos and thrive on the Brinkmanship. And so, I fear that maybe we all have too benign a thought that they’ll just … But I still think it’s going to happen. There are the memories of 2011, with not just the threat of default, which I don’t think actually would happen. But S&P’s downgrade of U.S. debt, and about 18% or 19% fall in the S&P. So, I certainly hope we don’t get there, but it’s an even uglier environment now than it was 12 years ago.

Moderator: When do we no longer characterize investments as international or emerging markets based on addresses rather than geopolitical revenue sources?

Sonders: Well, I think to some degree that is done with analysis of multinationals, and I think that’s one of the reasons for what has been for the most part a larger-cap bias. But I think the environment that we’re in right now where it’s not so much deglobalization but Regionalization and many of these sort of factions being formed, I think economic security and geopolitics will come into play to a greater degree in defining where people think their money is best invested or is safe.

That said, about a year ago, we didn’t shift to a non-U.S. bias, but we said we felt we were entering into an environment where having non-U.S. exposure was going to be a beneficial diversifier, and that was a hard sell for a long time. You go in these long multiyear cycles of in the equity market, global equity market, U.S. outperformance, and then and we think we’re on the side where you’re going to see some diversification benefits. That was clearly the case last year and we think it will continue. Our bias is a little more on the developed market side than on the EM side, in large part because of what that question gets to with more geopolitical uncertainty, more of these economic factions forming. I’m not a believer in this whole de-dollarization—dollars not losing its reserve status anytime soon, but there is clearly an attempt to have more transactions done in local currencies. It’s so on the margin relative to the share of global reserves. There’s just no there there in the practicality of what makes the dollar the reserve currency. That said, I think it could lead to weakness in the dollar, which is another reason why you want to make sure you’re not completely biased to the domestic market.

But I think EM is where you’re going to see more of the risks associated with this geopolitical instability than in developed markets, which tend to be more of the U.S. allies.

Ptak: Maybe switching to the 60/40 rule briefly—you talked earlier about the importance of bond-yield stock price correlations, and perhaps that will change compared to what we’ve seen in the past few decades. What implications do you think that has on a tried-and-true portfolio allocation like the 60/40?

Sonders: I think it’s less about OK, if bond prices and stock prices are now moving in the same direction, are we just going to have lots of years that look like last year? Which was sort of Armageddon. I don’t think that’s the case. What I think it suggests is what I already touched on for other reasons, which is active, and I think there’s probably a greater need for adding active into both the equity side of portfolios but also into the fixed-income side of portfolios. I think pure, passive, investing on both sides with permanence, and not moving that around. If we continue in this correlation environment akin to what we had last year, you’re going to struggle with that.

But I think there are ways to get around that by being factor-based on the equity side, not cap- or sector-based or style-based, and being active on the fixed-income side, whether it’s duration calls on the Treasury side or where to be within the corporate market out to higher yield at times into the safety of investment-grade corporate. So, I think there’s ways to get around it, even if the correlation environment is changing.

Ptak: Well, please join me in thanking Liz Ann Sonders for her time and insights today. It’s been a pleasure having you back on The Long View podcast. Thanks again.

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