Jeffrey Kleintop: What to Make of ‘the Cardboard Box Recession’

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Our guest this week is Jeffrey Kleintop. Jeffrey is managing director, chief global investment strategist for Charles Schwab & Co. In his role, Jeffrey analyzes and comments on international markets, trends, and events. You can find Jeffrey’s commentary on social media at @JeffreyKleintop, as well as on Schwab’s site, where a full library of his content is available. Jeffrey is quoted often in national media and has been a regular guest on CNBC and other television outlets. Prior to joining Schwab, Jeffrey served as Chief Market Strategist at LPL Financial. He received his bachelor’s in business from the University of Delaware and his MBA from Pennsylvania State University and is a Chartered Financial Analyst charterholder.

Background

Bio

Twitter

Market Evolution: How to Profit in Today’s Changing Financial Markets, by Jeffrey Kleintop.

Markets and Consumer Confidence

Charles Schwab Weekly Market Outlook

“Gloomy Consumer Confidence May Signal Stock Rally,” by Herbert Lash, Reuters, June 18, 2008.

“Confidence Is Everything: 3 Things May Shake It,” by Jeffrey Kleintop, VettaFi Advisor Perspectives, Aug. 18, 2020.

“Schwab Market Perspective: Different Speeds,” by Liz Ann Sonders, Kathy Jones, Jeffrey Kleintop, VettaFi Advisor Perspectives, June, 20, 2023

Liz Ann Sonders

Kathy Jones

“Kleintop: We’re in for an extended period of market volatility,” CNBC Television.

“Revisiting Short-Duration Stocks,” by Jeffrey Kleintop, Schwab, April 9, 2023.

Cardboard Box Recession

“Mid-Year Outlook: Global Stocks and Economy”, by Jeffrey Kleintop, Schwab, June 5, 2023.

“U.S. Is in a ‘Cardboard Box Recession,’ Says Strategist,” Yahoo Finance, June 13, 2023

“The US Is in a ‘Cardboard Box Recession’ That’s Pointing to a Sharp Fall in Inflation by the End of the Year,” by Jennifer Sor, Markets Insider, June 6, 2023.

Central Banks, Yen Carry Trade, International Markets

“Risk: Hikes May Be Over, But QT Goes On,” by Jeffrey Kleintop, Schwab, Sept. 25, 2023.

“Divergence: Rate Cuts, Pauses, and Hikes,” by Jeffrey Kleintop, Schwab, July 31, 2023.

“Are You Focusing on the Wrong Central Bank?” by Jeffrey Kleintop, Schwab, Feb. 26, 2023.

“Europe Sentiment: So Bad It’s Good,” by Jeffrey Kleintop, Schwab, Sept. 11, 2023.

IMF World Economic Outlook

“China: Contagion or Contained?” by Jeffrey Kleintop, Schwab, Aug. 28, 2023.

Artificial Intelligence

“Investing in Artificial Intelligence (AI),” by Jeffrey Kleintop, VettaFi Advisor Perspectives, Aug. 15, 2023.

Transcript

(Please stay tuned for important disclosure information at the conclusion of this episode.)

Jeff Ptak: Hi, and welcome to The Long View. I’m Jeff Ptak, chief ratings officer for Morningstar Research Services.

Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.

Ptak: Our guest this week is Jeffrey Kleintop. Jeffrey is managing director, chief global investment strategist for Charles Schwab & Co. In his role, Jeffrey analyzes and comments on international markets, trends, and events. You can find Jeffrey’s commentary on social media at @JeffreyKleintop, as well as on Schwab’s site, where a full library of his content is available. Jeffrey is quoted often in national media and has been a regular guest on CNBC and other television outlets. Prior to joining Schwab, Jeffrey served as Chief Market Strategist at LPL Financial. He received his bachelor’s in business from the University of Delaware and his MBA from Pennsylvania State University and is a Chartered Financial Analyst charterholder.

Jeffrey, welcome to The Long View.

Jeffrey Kleintop: Thanks for having me. Longtime listener, first-time guest. So, this is great.

Ptak: Well, we’re thrilled to have you, and thank you so much for listening. We wanted to start out big-picture level. You are getting this firehose of information on a daily basis. We know that you’re very practiced at processing and making sense of that. Not all of us are as practiced at doing that. So, a question with that in mind, when you inevitably have friends and family that come to you and ask you for tips on which economic or market indicators or data points to pay close attention to, what do you tell them? What do you point them to?

Kleintop: I guess I have a reputation as someone who pushes to find the truth in data. Often, I find, in maybe nontraditional measures, I find more comfort in things that just make sense to me. Like the downturn that’s currently indicated in official manufacturing and trade data. Some of that’s kind of abstract. I find comfort looking at the plunging demand for cardboard boxes. I’ve been referring to this as a cardboard box recession because things that are manufactured and shipped tend to go in a box and because demand for corrugated fiberboard, which is what most cardboard boxes are made from, has fallen just like it did in past recession. So, literally, cardboard boxes are in a recession. So, things like that make sense to me. The truth is out there. What was that, The X-Files or something? “The truth is out there.” Meaning, you don’t have to rely on official sources for data. Those are helpful, but you can often find it in things that just make sense. The internet is an amazing tool and so much of it is available to all of us.

China is a difficult economy to measure. I often get asked, are they lying to us? No, I don’t believe so. I think they just don’t have good tools or practices or incentives to measure things as accurately as we would like them to. I find that air pollution, which is something that is… A gauge of air pollution is done in every one of the major cities in China by U.S. State Department officials at the various consulates in China. I didn’t know this until I went there and met with some state department officials. Every hour they do EPA air quality tests. And so, I can see on a real-time basis, NO2 emissions, particulates. These things tend to correlate very closely with economic activity in China because a lot of manufacturing is so dirty there and transportation. So, I found that is a really good real-time way of measuring what’s actually going on on the ground in China.

So, sometimes it’s putting together a lot of these things that just intuitively make sense. And I think often we tend to fall back on official pieces of data. But what I’m paying attention to isn’t always evolving. I think if you’re looking at the same things you were looking at 10 years ago, you may be missing what matters today. It’s a totally different cycle, right? Inflation, interest rates, geopolitics, valuations, fiscal policy in Europe, drivers of growth in Asia. So, I’m always looking for finding the truth in data, but often that’s nontraditional data.

Benz: You’ve referenced a couple of the economic indicators that you consider to be useful and intuitive. You’ve had the opportunity over the span of your career to assess which indicators or metrics have staying power and which don’t. What’s an example of an indicator that’s maybe passed its useful life and another that’s still signal-rich in your opinion?

Kleintop: Staying on China for a second, it used to be that copper was all you needed to pay attention to with China. So much of its growth was infrastructure-spending-driven by the government. So, if you look at copper prices or copper inventory levels in China, it told you a lot about what was happening in that economy. But no more. Growth in China is consumer-driven like it is in almost all major economies these days. And so, you’re just not seeing that same correlation between copper, copper prices, copper inventories, and economic activity. I don’t think that’s worth anything. I know there are many prognosticators that still rely very heavily on copper or as copper is a major input into watching what happens in China. I just don’t think it has the same signal it used to.

I guess one that I think does continue to have tremendous value is—I’d have to say it’s my favorite economic piece of data. If I’m on a desert island and I can only get one piece of economic data, because what else would you want on a desert island? Maybe you’re a Beyonce and a bottle-of-rum person. I am a PMI guy. I love the Purchasing Managers’ Index. I think it’s a wonderful tool. It’s a survey of business leaders. It’s broken up into many different components. You all know about this. But it’s done in so many different countries, it has a really, really strong track record of catching turning points in earnings and economic activity and pricing. And I just love it. That’s one that I make sure I don’t miss.

Ptak: I wanted to ask you about another data point. The consumer is obviously a huge part of the economy. Consumer confidence is often cited. What does it really tell us? And conversely, where do you see it misapplied in your experience?

Kleintop: There’s a real depth of consumer confidence data in the U.S. There isn’t as much outside the U.S. So, I find with much of my purview being directed outside the U.S., it’s not a crutch that I rely on very often. And as we all know, what people say and what they do are often two different things. Consumer confidence, I think, has become much more politically influenced than it used to be. It always had some political element to it now, but certainly going into an election year next year, you’re certainly going to see different things in different groups of consumers as we move through the election process. I just don’t find it’s as useful as it used to be. I think investor confidence can still tell us something about sentiment in the markets and whether it’s overly bullish or overly bearish, at least in the near term. But consumer confidence, I’ve never really found it a particularly useful tool. I like to look and see what people are actually doing in terms of foot traffic—it’s amazing the data we can get on things like, hey, we’re recording this in the 11th. It’s Prime Day. So, getting that kind of data in real time and understanding people’s actual behavior, I think, is worth so much more.

Benz: You publish a lot of work with your colleagues, Liz Ann Sonders and Kathy Jones, both of whom we’ve interviewed for this podcast before, Liz Ann a couple of times. As one would expect, you’re closely aligned with them on most matters. But what’s a fundamental or economic issue on which you have divergent views from them?

Kleintop: We communicate constantly. And so, we always know where our collective heads are at. I think what’s amazing to me isn’t so much that where there might be shades of gray in our opinions. It’s that we have vastly different processes in how we come to our conclusions, yet 95% of the time, 98% of the time come to the same conclusions. I am a data junkie. I get up in the morning and I plug my Bloomberg in like an IV. And I tend to not read a lot of third-party research. I really dig in and really focus a lot on the data, a lot of nontraditional data that I like to filter and use. And my team is very good at processing data. I’ve got just a wonderful team that really knows how to work with large quantities of data. They’re almost like a big AI tool that I use.

Liz Ann is not that way. Liz Ann really reads and talks to so many different people and really filters. She probably reads 10 times as much as I do. And so, even though we both cover the stock market—I’m the global strategist, she’s the U.S. strategist—we really have very different processes, but we so often sync up. And it’s such a wonderful thing to work with someone like that. When I came to Schwab, I was used to being the solo voice on equities, on fixed income, on alternatives, on cash, gold, whatever. And to be able to share that role with someone who has a very different process and therefore brings in a lot of different insights, we come to the same conclusion.

It’s just amazing to me every time. We don’t spend a lot of time on stage together but often marvel when we do because we’ll get a question from the audience and we both have the same answer. We look at each other like, wow, we didn’t even discuss this ahead of time, and we think that much alike. So, it is remarkable and unusual. But at the moment, I can’t think of anything that we really starkly deviate on. I think we both view the path ahead as one that’s more volatile for equities and an inflation environment that’s much more volatile. And we have a similar view here in terms of how investors should be positioned on that. And that’s just remarkable to me.

Ptak: I want to turn to a more serious matter, if I may, which is the Israeli conflict. We all feel great sorrow at the recent tragic events in Israel. Anticipating investor questions that might arise about it, you took a look at how markets reacted in the days following other geopolitical events involving Israel. I think you went back to the early ‘70s, if I’m not mistaken. Can you summarize what you found in that research?

Kleintop: Yeah, of course. The human toll is unimaginable. But the market tends to assess these geopolitical events very quickly. And unfortunately, we have a long history of conflicts in the Middle East. And to refine that even further, looking at 23 different conflicts involving Israel, looking back since 1970, what we found was that the markets tend to not react very sharply, even in the near term, even in the day that they occur. And usually within five days, the market is completely recovered. So, this experience in the market that we’re seeing this week in the aftermath of these events and ongoing events is not surprising, is not unique.

Generally, the markets look at developments in the Middle East as something that might directly affect energy, oil prices, gas prices. And while we saw a little bit of that on Monday after the events occurred, oil was up 4%, it had already risen so much and was already affected by so many other factors. I think there wasn’t really room necessarily for it to jump a whole lot higher. So, diminished impact physically. We haven’t seen a sustained disruption of energy supplies in the past in these types of conflicts, and we’re perhaps not likely to see one this time either, although no one’s sure exactly where the future may unfold. It seems unlikely to disrupt economic activity. And that is what the market is very quick at parsing out from these events. And these initial reactions are usually muted and reversed over the next few days, which is why it’s important to remember that geopolitical risk is an ever-present part of investing. We just can’t get away from it. It flares up from time to time. But it’s always there in the background. We never really know when there’s going to be a development. And what we’ve seen in general is that during periods of even modest economic growth, the market’s response to perceived threats have tended to be very short-lived.

Benz: We wanted to switch over to discuss the fixed-income market a little bit. We’ve seen the yield curve flatten pretty dramatically in the past month or so with intermediate- and longer-term bond prices getting clobbered. Most, if not all, of that move seems to be explained by a jump in real yields. Why are investors suddenly demanding more after inflation compensation to lend?

Kleintop: Financial conditions haven’t tightened dramatically, but if we look at what small businesses are experiencing right now, they have talked a lot more about a tighter credit environment. Banks have been tightening lending standards here and abroad. What we may not be seeing it at big firms who can self-fund out of cash flow to a large degree, we’re definitely hearing it from smaller companies, midsized companies. As I travel around the U.S., I’m in front of audiences of small businesses all the time. If you’re a florist and you were thinking about buying that extra truck and staffing it, it’s hard to do that now. Banks are demanding more collateral, higher rates, qualifying fewer borrowers. So, things are getting tighter.

I think that from a grassroots level is starting to cause me to worry a little bit more about the credit environment, about the growth environment. I think you see some of that in just tighter environment for credit, pushing up the cost of credit. I expect that maybe as the service sector slows down a little bit more—it’s already shown some signs of slowing down—we might see further weakness in the job market later in the fourth quarter and early part of next year. At that point, rates may begin to come down a little bit, reflecting this softer demand picture. But for the moment, I think it just reflects a tighter credit environment.

Ptak: Maybe building on that and you alluded to it—one of the other curious things is that corporate bond spreads, they haven’t risen that much, which is, I guess, all the more striking given that I think you yourself have shared some data on, if I’m not mistaken, the rise in bankruptcies that we have seen in recent months. So, maybe to focus on the high-yield market, in particular, you mentioned firms that are able to self-fund. I would imagine that’s probably a little bit less true of sub-investment-grade, and yet, we haven’t seen spreads blow out there. What do you think explains that?

Kleintop: Yeah, it’s been a very unique last few years for credit. One of the reasons is, normally when we go into an economic downturn, and we had that brief two-month recession in 2020, normally you get a spike in bankruptcies for obvious reasons. And we got the opposite in the U.S., in Japan, in France, in Germany. All around the world bankruptcies went the other way because of all the aid that was poured into households and corporations and businesses and all those loans and extensions that they got. We actually saw the number of bankruptcies plunge by 80% from normal levels. Normally they would spike. They went the other way. So, we’re now just seeing a normalization in that. We are only back to normal expansion levels of bankruptcies in all those countries that I mentioned. And so, we’re not seeing the type of surge in bankruptcies above normal levels that would normally drive banks to provision a lot more losses or spreads to really widen up that much more dramatically.

The other factor, I think, is that a number of companies are still hoarding cash. I know the high-yield universe not as much, but there still is quite a bit of that out there. And now that cash is offering a return and that’s helping offset the higher interest cost for a lot of businesses. So, we haven’t seen a huge spike in the interest burden for businesses in part because of their cash holdings are offsetting that with the interest that they’re receiving. The high-yield marketplace is one that still stresses us a little bit. I still think there’s a long tail to these downturns and we’re still in a downturn, we’re in a very lackluster global economic environment. And the longer that drags out, the more you’re going to see stresses in that area. And so, our view is, if you’ve got to have some high-yield exposure, keep that fairly minimal. We’re finding much more attractive, higher-grade exposure than high yield. Everyone wants to chase yield, but I don’t think it’s a good time to do that.

Benz: You’ve been a proponent for investing in what you call short-duration stocks that you say can be useful hedges against rising interest rates. What defines a short-duration stock and how have they done lately?

Kleintop: That’s a great question. I’ve been talking about this for a couple of years now. A short duration, as you might expect, is a company that would have more of their cash flows in the near term. A long-duration stock might be a company, a growth stock that would have a greater proportion of its cash flows way out into the future. But a short-duration stock, they’re earning those right now. A classic example might be energy or financials right now. So, the market I think is focusing more on these types of companies. And you might think that this is something investors would always want to prefer, a company that’s got more cash flow in the near term, but not true at all. In the last cycle, it was so inexpensive to borrow. In some cases, free or even paid you to borrow that people weren’t really focused on that. Growth was fine. Cash flows decades out into the future were fine. Inflation was low. So, the discounted value of those cash flows wasn’t eroded. And it didn’t cost much in the near term to borrow to achieve that. Now very different environment. And so, shorter-duration stocks have been in favor by investors. And that’s been the case since August of 2020 when rates began to climb. They have outperformed the overall market by a huge margin.

And I’m measuring this based on low price/cash flow, or I guess you could think of it as free cash flow yield. So, the highest free cash flow-yielding companies or the lowest price/cash flow companies have been performing the best. And there was only one exception to that over the last few years, and that was during the banking turmoil earlier this year. We had in March and April into May, we had a downturn there. And those stocks, because they were so concentrated in financials, underperformed a little bit. Well, they’re back to outperforming by 5% or 6% since then year to date. So, I think if you’re looking for an interest-rate hedge in your portfolio, short-duration stocks are a way to focus on that. Of course, we might be nearing a peak in rates. Maybe we already saw the peak in rates. So, take that with a grain of salt. But we’ve been really focused on these higher-quality companies that tend to have more of their cash flow in the near term. That’s really been working out for investors.

Ptak: I wanted to shift over and return to something that you mentioned earlier, which is the cardboard box indicator. And I think that you have termed some of the economic weakness that we’ve experienced, the cardboard box recession. I think you wrote a commentary earlier this week in which you stated you expected the cardboard box recession to broaden in the second half of this year. So, I thought maybe we would check in to see whether you’ve seen any evidence of that sort of broadening. And if so, where has it happened?

Kleintop: So, I’m worried coming out of the box more so than I’m excited that manufacturing is rebounding. I’m worried things are going the other way. The services PMI—I mentioned, big fan of PMI, I am—that has been deteriorating. Really wherever we look, it’s been coming down. We’ve been hearing more from airlines that services… We know travel and entertainment has been strong. Just ask Taylor Swift. It’s been big, but it’s coming down. And we’ve heard that from airlines. I think it was Spirit and Frontier that both talked about having to do some heavy discounting around the Thanksgiving holiday just to get people to book. It seems like that revenge travel period where people said, you know what, I don’t need to spend on goods anymore. I did that during the lockdowns. Now I want to experience life again. Maybe that’s rolling over a little bit and you’re seeing higher vacancies at hotels, more open reservations on OpenTable.com. You can find that. I live three miles from Walt Disney World here in Florida. You know what? You can actually get on Space Mountain lately. You don’t have to wait two hours.

So, I think all these signs are indicating that we’re seeing a bit of a slowdown in the services sector. And that’s important because there are 10 times as many services jobs as manufacturing jobs in the U.S. So, if we start to see the service sector reflect more signs of this slowdown in demand, well, we might see a weakening labor market and then that could feed into the retail space and construction and so many other areas. So, I’m focused on that—a slowdown on the service side of the formerly strong service side of the economy, both in Europe and Canada, in the U.S., around the world, that’s what I’m focused on. Not a deep downturn, but even a small pullback there could really mean a lot when it comes to the labor market.

Benz: How long has it typically taken for the economy to enter recession after the Federal Reserve stops hiking interest rates?

Kleintop: Well, usually, it’s one of the reasons they stop hiking interest rates is they recognize there’s some weakness in the economy. It’s interesting, as we look around the world, so much is tied to the U.S. Fed cycle. All these countries around the world, they have their own central banks. But there’s something about the depth and the breadth of the liquidity provided by the U.S. that really does matter globally. And so, when we take a look at global recessions, they tend not to lag too long. After the Fed stops hiking interest rates, we tend to see this downturn.

Again, I think this is very different. Maybe what we’re looking for here is part two. Maybe we had part one of this recession, if we want to call it that, back in 2020 when manufacturing was booming, and the service sector fell into recession because we couldn’t travel or go anywhere. And now, maybe we’re getting the reverse of that. Everyone’s traveling, no one’s spending on goods because manufactured output is down, and trade is down on a year-over-year basis. So, maybe these are bookends, kind of like the 1980-82 recession put together. It really took two back-to-back recessions to turn the cycle, to turn the leadership into markets and to really get things turned around. And maybe we’re seeing that again in maybe a smaller and less painful way to start a new cycle, because I think this does feel like a new cycle. I mentioned the very different environment in terms of inflation and valuations and interest rates and credit conditions—very different from the last cycle leading to very different leadership in the market. So, to me, we’ve turned the corner on a new cycle, whether we ultimately define what we’re experiencing right now as an official recession or not.

Ptak: Wanted to turn to the global economy. The U.S. and European economies seem to be on divergent paths, which is surprising given I think what a lot of us have been conditioned to think in terms of global interconnectedness. Why is the U.S. economy expanding as seemingly robustly as it can, albeit with some challenges, while Europe contracts by some measures?

Kleintop: Europe had a tough third quarter relative to the U.S. Prior to that, growth wasn’t all that different in the first half of the year. In fact, Europe outpaced the U.S. I think in the first quarter, looking a bit stronger on some of the optimism of China’s recovery. And that’s really what it gets back to. Europe is more of an export-oriented economy, and China is the biggest customer. So, that downturn in Chinese demand tied to their property market troubles really hit Europe much harder than the U.S. Germany, huge export-driven economy, for example, and biggest customer is China, and a lot of consumer goods from autos to you name it, and that really had a negative impact and weighed much more on their economy than ours. That might be showing some signs of stabilizing, turning around. That could be good news for Europe here in the fourth quarter. I think very similar growth forecasts among economists for the U.S. and the eurozone for the fourth quarter. So, maybe that’s stabilizing a little bit here.

What’s more interesting to me than the economic trajectory, because what we know is that the businesses in Europe sell to the same customers as the businesses in the U.S. do. I often like to use an example like Nestlé and Coca-Cola. Nestlé is second largest stock in Europe. Coca-Cola, big stock here in the U.S. They literally have the same geographic distribution of sales by continent. It’s like the same percentages. They have sales and operations in the same countries, both selling beverages and snacks around the world. Revenue growth is almost always very similar, if not the same. But valuations are quite different. And Coca-Cola has recently traded at a premium to Nestlé. I think that’s likely to change. I think we’re likely to see some convergence there. European investors are much more pessimistic. They’ve gone through a downturn, a recession. Germany has gone through now four quarters of flat to negative growth. There’s a war going on in Europe. There’s a variety of reasons why European investors, which make up the bulk of Nestlé's shareholder base, are more pessimistic and valuing the company at lower price/earnings ratio than the comparatively more-optimistic U.S. investors are valuing Coca-Cola for essentially the same revenue and earnings growth.

I think that changes. And it’s one of the reasons why I’m optimistic about European stocks, international stocks in general outperforming the U.S. market. They don’t appear to have done so this year, obviously, with the capitalization-weighted indexes that we watch. But on an equal-weighted basis, international stocks are outperforming the U.S., including those in Europe. The average European stock is outperforming the average U.S. stock this year. I think it has a lot to do with the valuation backdrop, which ties back to your question, the economic picture being more lackluster in Europe. Again, sales growth is very similar to the U.S. companies given the footprint. But what that’s meant is a lower P/E. And I like lower P/E stocks right now. I think they’re more positioned, more braced for the environment that we’re in, and therefore, there’s more upside.

Benz: Sticking with the European economy, you concluded that Europe’s funk doesn’t appear to be a function of the European Central Bank overdoing it with rate hikes. Can you explain your reasoning?

Kleintop: Well, I guess because real rates in Europe are still slightly negative and they’re positive in the U.S. and yet the U.S. had a solid third quarter. So, I’m not saying they haven’t mattered at all. I’m just saying on a relative basis. I don’t think we can explain Europe’s lackluster third-quarter performance relative to the U.S.’ strong performance based on real policy rates because they were higher in the U.S. So, certainly, higher rates around the world have had an impact on slowing growth, but I don’t think proportionally or on a relative basis, they were that much tighter in Europe. As inflation continues to come down in Europe, that real rate is going to increase. Even though I think the ECB has probably done hiking rates, the drag from policy rates will likely continue. But I would say that’s my reasoning there. Very different growth trajectories in the economies, but not one that’s supported by real policy rate.

Ptak: I wanted to shift and talk about quantitative tightening. You wrote a piece recently on quantitative tightening. Before we get into some of the key takeaways, can you maybe refresh listeners on what quantitative tightening means in monetary terms?

Kleintop: There’s a real page-turner, right? I report on QT. So, quantitative tightening—we talked about QE so much, quantitative easing, we just started referring to it as QE. Well get ready for talking about QT. So, QT is just the unwinding of QE, quantitative easing. When central banks reverse their former QE program asset purchases by not reinvesting maturing bonds or even outright selling bonds to reduce the overall size of their balance sheets. Stocks in a way are liquidity reservoirs. So, when there’s a lot of liquidity, because the Fed is buying a lot of bonds and pumping a lot of money into the financial system, stocks rise. They rise on that liquidity. They absorb that liquidity. And the opposite is true as well. When the Fed is then draining liquidity from the markets through quantitative tightening, well, that reservoir dries up and stock valuations tend to come down.

We can refer to this maybe more intuitively as the portfolio rebalancing effect, where investors tend to seek more risk when bond yields are low and they can’t find any value in the bond market, and they tend to reduce their holdings in stocks and other risky assets when QT drives yields higher and makes bonds more attractive. And so, that’s kind of how it works. We’ve seen this in the U.S. We’ve seen this to a lesser degree elsewhere. But it’s hard to draw solid conclusions from this.

We don’t have a lot of experience with QT. It’s a little bit of a roach motel. Like you can check into QE, but it’s real hard to check back out again. And so, we’ve only got a couple of experiences of QT. We had Japan do it in 2006 and 2007. And the U.S. did it from 2017 to 2019. During both periods, stock markets had above-average volatility. They had a peak/trough decline of 19%, so just below the threshold of a bear market. And they ended those periods of QT, the stock market did, right about where it began. So, overall, a flat, volatile period for the overall market. So, difficult to draw hard and fast conclusions from it, but enough to say that I think it is a bit of a drag on the overall market, at least from a valuation perspective.

Benz: Your research found a correlation between quantitative easing and the S&P 500′s valuation multiple. Can you explain what you measured there and what implications it could have amid a shrinking Fed balance sheet?

Kleintop: I think there’s this pervasive market view, perspective, myth maybe that the Fed has just driven all the valuation improvement in the markets. And it’s really just all about this liquidity reservoir effect that I talked about. I think it’s important at the margin but isn’t necessarily the only driver of the markets. But certainly, we did see with the Fed’s QE program in 2001 and 2002, we saw a valuation spike. Now, there’s a couple of reasons why valuation spike. The price can go up and the earnings can go down. And earnings certainly fell as we went through that downturn. Not terribly, but they did suffer a pretty big drop. So that alone would push up the price/earnings ratio. But that wasn’t the only factor. Prices went up at the same time. It’s kind of remarkable when you look back at that period, including 2020, and you see stocks bottomed on March 23 of 2020. That was six, seven, eight months, nine months before we had vaccines. That was just at the beginning of the lockdowns. I think a lot of that had to do with the perception that the Fed was going to rapidly shift gears along with other central banks and provide a wave of liquidity to the markets to support valuations. And support the economy and support consumers and businesses. And the market reacted to that. I think that’s often what we see. And this is the opposite scenario where the Fed is trying to pull back from businesses and consumers and the overall markets in terms of liquidity. And it may have a similar effect in dampening the price/earnings multiple.

Ptak: I wanted to go back to quantitative tightening, if I may. And I think you did a really good job of sketching out the other episodes that have taken place. I think you mentioned Japan in 2006 and 2007, the U.S. in 2017 to 2019. Not a big sample, right? We’ve only got like a handful of these to look at. But it does seem that during these periods, stocks became more volatile, but it was like a round trip to nowhere in a sense. They didn’t really move that much as long as you stayed in your seat, so to speak. So, do you feel like that’s the key takeaway for somebody that might otherwise be gripped about fears over quantitative tightening buckle up, but stay in your seat because if history, albeit not a big sample, is a guide, it doesn’t seem that markets pull back dramatically by the time you get through it. Does that seem like a fair way to characterize it or think about it?

Kleintop: It does. I think you want to brace yourself and expect higher volatility. But trying to time that is extremely difficult. I just mentioned the example there of March 23 when markets bottomed in 2020. There was no clear sign that the risk was over or some change by policymakers. Clearly, I think if you pulled anyone that day or week or month, they would have said, no way is the worst over, but it was for the stock market. And that’s the challenge. When we move through these periods, incorporating high volatility and geopolitical developments and political developments and a turnaround in the earnings cycle and so many other factors, is that it’s compelling to try to jump out.

I get the question at events: “Hey, look, things seem so uncertain right now and maybe will be uncertain over the next year. Why don’t I just get out of the market? Cash is yielding 5%. Why don’t I just get out of the stock market right now? You’re telling me it’s going to be volatile. There’s risk. Why don’t I just step aside and pocket that 5%?” And the answer, of course, is because you have to make two decisions. This one’s the easy one. You know what you’re going to get. You’re going to get 5%. At least in the near term. It’s the other decision that’s hard. It’s when do you get back in? And we all have to get back in to get to our financial goals. Very few of us can coast on cash to our retirement goals. And so, we know we’ve got to get back in. We have every trade made at Schwab since 1976. And we know empirically how hard it is to get both sides of that equation right. They get out and they get back in again. Very, very, very few traders or investors get that right. And so, that’s the advice: expect a higher period of volatility, but that perhaps we end this period with a market fairly similar to where it is now. And that will happen when you don’t even realize it, and then you’ll remain on that path toward financial goals.

I can talk about this a lot, but I really think that is an important takeaway from all of this. Rarely do you hear us at Schwab talking about making asset-allocation changes in terms of stocks to cash, stocks to bonds. We tend to think you really want to stick to those long-term goals but be educated and be confident in those decisions that you’re making so that when these developments do occur, you’re prepared mentally and portfolio-wise to absorb them.

Benz: You wrote a piece earlier this year about the potential for central bank policies to diverge. A big X factor in all of this is their ability to combat inflation in their respective economies. Given that, can you give an update on how well contained inflation is in the U.S., the eurozone, and Japan respectively?

Kleintop: Well, for now, I think it’s pretty well contained. In fact, I think in Europe, in Canada, the outlook looks pretty good. I mentioned earlier, I’m a big fan of the PMI, and the PMI price component has done an amazing job for a couple of decades, giving us a real crystal ball view into where inflation is going to be six months from now. If you take a look at what businesses are paying for their materials and what their views are on their selling prices, they pretty much match up with about a six-month lead time for the overall CPI. What they’re pointing to for Europe and the Bank of Canada is that inflation is going to be at target probably early next year. That’s great news in that they can rest easy and feel like they’ve achieved their goals and maybe even begin to cut rates later next year. That is not the path indicated by the PMI in the U.S. or in the U.K., where inflation is proving much more stubborn. I think it’s going to be very difficult for the Fed and for the Bank of England to declare victory over inflation and shift the focus to rate cuts.

Variety of different reasons for that in terms of the composition of inflation being quite different in the U.S. than it is in Europe, other places. We measure housing inflation, very different here than we do in many other countries. So, that’s part of the issue. There are other factors at work as well. They’ve got Brexit-related issues in the U.K. But nevertheless, inflation is still coming down, just maybe not down to the level central bankers would like in those countries.

I’m looking beyond that and seeing that maybe we’re in a higher and more volatile period for inflation. Rarely have we seen in the past that inflation just came right back down and stayed flat and low. Usually, we get these echoes of inflation, like we had echoes of COVID, waves of COVID. Maybe we get these waves of inflation in the years ahead because of the structural differences, the very tight global labor market, which is very different than what we’ve experienced over the last 20 or 30 years. That can create waves of inflation that get transmitted very quickly. So, I think we need to get used to a higher level of inflation and a more active environment for central banks, which may be slightly out of sync with each other. That’s just a different environment going forward and one again that I still think favors lower price/cash flow companies, those that are braced for a more challenging environment than those countries where P/Es are higher. And that’s not just the U.S., but the U.S. falls into that bucket.

Ptak: You’ve pointed out in your research that it’s rare for central banks to cut rates in years in which economies are expanding. As you point out in that analysis, the OECD expects GDP to grow and accelerate next year. Given this, do you think market participants who are expecting rate cuts next year might be setting themselves up for a head fake of sorts?

Kleintop: This is something we’ve been pretty consistent on here at Schwab, that we think the idea that there will be aggressive rate cuts next year is misplaced. There were 100 basis points priced in a month or two ago to next year, and that has really been worked out in the markets here lately. But still, the market is enamored of this idea that everything is going to be turning around quickly next year. We just don’t see that.

We just got, in addition to the OECD numbers, the IMF World Economic Outlook, just came out. And again, they’re looking at an environment of pretty solid growth next year. Not great growth, and maybe slightly below-average growth, but we’ve never seen this shift, a wholesale shift by global central banks to rate cuts in an environment like this. And most central bankers, the rates aren’t that restrictive. So, it’s not like they moved rates up to where real policy rates are something like 2%, or 3%, or 4%, or 5% into positive territory—they’re not, outside of a few emerging market central banks, which do have room to cut. Brazil, a few others, they’ve got room to cut. But major developed central banks, I’d be surprised if we saw a lot of rate cuts across those. And so, yeah, I think the idea that we’re going to see this liquidity reservoir come flowing back into the market, supporting valuations, maybe unfounded.

Benz: You’ve warned that a potential unwinding of the popular yen carry trade could roil markets. Let’s start by explaining what the yen carry trade is and how it works. And then, maybe you could talk about in what sort of scenario such an unwinding would take place and how likely is that to happen.

Kleintop: This is something that doesn’t get a lot of attention, but really could. It could be the biggest story of next year. The yen carry trade is simply borrowing where it’s cheapest to borrow and then investing where you can get a higher rate of return. So, traditionally, Japan has low interest rates. They’ve had a zero-interest-rate policy officially since 1999. And so, for a couple of decades-plus, investors and speculators and hedge funds and the like have borrowed in Japan in yen and then bought dollars or bought Treasuries or other bonds around the world and invested those proceeds. And that tends to work pretty well in general, except if you’re worried about a spike in the value of the yen or a spike in Japanese interest rates. And the Bank of Japan has a history of surprises. They feel the need to surprise markets and have done so in the past and are looking with the new Bank of Japan governor to maybe make a change in policy, perhaps around rates, but even more so around policy rates, but even more so around their yield-curve-control policy where they have pinned rates across the yield curve to zero. They’ve widened that band in recent months, went from 10 basis points, plus or minus, around zero to 1% around zero—haven’t quite hit the 1% level yet—but they’re widening that and widening that because it’s become so expensive to maintain. And the consequence of that is perhaps a lot of money gets repatriated back to Japan with higher interest rates and the potential for a rise in the yen after 25% decline in the yen over the past couple of years. You could see a very rapid unwinding of that carry trade.

What would that mean? Well, it means selling of a lot of dollar and dollar-based assets or other high-yielding currency and assets. So, we don’t know how deep and how broad this is. We have a sense of it, but it’s been going on for so long. It’s one of those things where you just don’t know how many things could get broken when it starts to move. And again, the Bank of Japan likes to surprise. So, we’re not exactly sure when this might happen, but generally expecting it could happen early next year or give signals even perhaps late next year that it’s coming. So, a very rapid shift there could further add pressure to yields in the U.S. and maybe begin to undermine some of the strength in the dollar we’ve seen here lately. Difficult to gauge the magnitude, but the move could be sudden.

Ptak: You wrote a piece in September, and I’m going back to Europe here titled, “Europe Sentiment: So Bad It’s Good.” Can you explain what you mean by that title, what significance it has?

Kleintop: So, looking at Europe’s economic data, it had been surprising on the downside since April and continues to be fairly weak. We talked about the very weak third quarter in Europe and some of that tied to softness in China and Asia in terms of demand for their products, also some of it domestically based. Sentiment was so poor if you looked at surveys of consumers, if you look at surveys of investors, if you look at just valuations, trading 2 or 3 PE points below the 10-year average, which was already somewhat depressed because of a decade of austerity in Europe based on fiscal surpluses. Do you know those two words can go together: fiscal, surplus? Yeah, painful environment in Europe in terms of the growth environment of the last decade or so, really leading to a lot of pessimism there.

My point was, look for a catalyst to turn things around and paradoxically or counterintuitively, a weaker economic outlook could even cause a sentiment change because it could cause the ECB to not only halt rate hikes, but maybe even talk about cutting rates next year as the inflation rate begins to surprise on the downside as well. So, even weaker economic data could get the market optimistic around the end of rate hikes and maybe the start of rate cuts, lifting valuations there. So, there are a number of catalysts both in terms of what could move things—better economic data or even worse economic data. That’s how pessimistic the sentiment was.

And again, we are seeing the average European stock outperform the average U.S. stock. Not to say that’s been a stellar year either way this year, but still in positive territory. If I look back to the end of October of last year, when the bear market bottomed, the average European stock, or even if I just look at EAFE, because most of the stocks in the EAFE Index are in Europe, the equal-weighted benchmark is up 17% in terms of its total return from the end of October last year. That compares to the S&P 500 equal-weighted total return of 3%. So, wide margin of outperformance there, not tied to economic growth, really tied to very low valuations because of so much embedded pessimism.

Benz: We’re really zipping around the globe very quickly, but we wanted to touch on China again. In August, you wrote that you didn’t expect Chinese economic woes to lead to global financial contagion. What’s the firewall that prevents that from happening in your opinion?

Kleintop: I think there are three. And real quick on these. Number one is that it’s not consumers or banks that are overly leveraged into housing. It’s the developers. Like in the U.S., if it was Pulte and Lennar and Toll Brothers that had way too much debt and the consumers were fine and the banks were fine. That didn’t happen, right? It was the other way around. And in China, most would-be homebuyers are putting down 30% to 50% in cash as a down payment and borrow the rest, but very low leverage ratio. So, we’re not looking at the same kind of ninja loans in China that we had here in the U.S. leading up to the financial crisis—those no-income, no-job applications with nothing down. Totally different situation. That’s number one.

Number two is we’re not really seeing this infect even the other high-yield bond issuers, Bank of Communications, Industrial Bank in China. Those are two of the largest high-yield bond issuers in China. Their bonds are trading near par. So, they’re banks, and they’re tied into all of this, but their bonds are not reflecting the stress of a Country Garden or an Evergrande, which are trading at $0.05 to $0.07 on the dollar. So, even within the high-yield universe, we’re looking at a wall between those businesses that because of government policy, new rules around leverage that were designed to limit speculation in the housing market are really hurting those. I do think Evergrande and Country Garden probably fail. But what we’re seeing in the markets there is that their failure is not expected to even affect other banks or high-yield bond issuers within China.

Then the third issue is that many of these banks are state-run and state-funded by the government. So, they’re well-capitalized. And it’s very easy—the government doesn’t have to step in and bail them out. They’re literally implicitly bailed out because of that government backing. So, I think all of that limits this to being a different environment for housing. Housing in China, home prices are down 0.5% year over year. China has achieved its goal of housing stability. No more speculation in the housing market. Put your money in the stock market. Fun Chinese businesses is what the government wants you to do, not fun Chinese real estate, which is becoming a social issue as people couldn’t afford housing. So, I think in a lot of ways they’ve achieved their objective here and ringfenced what the issue is. There’s been a spillover to consumer demand, but they’ve been incrementally trying to address that with support for households. And that’s why I don’t think this is a global problem as the housing subprime issue was for the U.S.

Ptak: Last question where we’ll maybe widen the aperture a little bit. You wrote a piece recently about artificial intelligence. What in your opinion is the biggest implication of machine-learning models for the global economy and markets?

Kleintop: I think there’s a lot of potential efficiency. We are dealing with a world where the global labor supply is tight. And it’s tight in part because we just aren’t going to get another wave of workers coming into it. When the Berlin Wall fell back in 1989, we had all of these workers in former Soviet republics coming into the global labor pool, around 750 million workers coming in and really helping to keep wage costs contained and keeping inflation down. And then, China entered the World Trade Organization in 2001 and we saw a wave of workers—1.1 billion workers entered the global labor pool and that helped to keep the labor market loose, if you will. It’s very tight now. And we just don’t have the same type of thing. Yes, India is getting more into manufacturing, but it’s a slower process and we’re just unlikely to see a wave to that degree of workers coming in. And so, we need to do more with the same people. And AI is a wonderful tool for that.

What we haven’t seen yet is a lot of investment. We know that AI is going to be an operating expense for a lot of businesses, but it’s going to be a capital expense for a lot of others. And we really haven’t seen an uptick in information processing, equipment, and software that normally come along with new waves of innovation and technology, like Global Positioning Systems, or the internet, or what have you. We haven’t seen it yet. A lot of talk on conference calls, earnings calls, and we’re going to hear a lot of that as we go through the earnings season as well, but not yet a lot of investment. And what we know is the productivity payoff comes after the investment gets done. Sure, ChatGPT may be part of all of our lives, but they’re not really a part of the corporate world yet. It will take some time for them to find solutions, adapt those solutions, and implement those solutions. But I think they’re necessary and I think they’re great.

One thing I’ll point out on this. It’s not just great for businesses, it’s great for workers, too. One thing we saw in China as they really began to become a huge manufacturing source for the world is that agricultural employment in China went from 60% of workers 30 years ago in the early ‘90s to just around 25%, 27%, 29% today. Huge turnover. Nearly 40% of the workforce came out of agriculture and into other things, but that didn’t mean agriculture wages stagnated. Those who stayed in agriculture made more money as they adapted to the new technology of tractors, and irrigation systems, and fertilizers, and all these different things. So, it even benefited the workers in those industries where workers were being displaced. And so, I think that’s a great story for both for workers and businesses. And it’s so essential right now with productivity having been so lackluster for so long. We need to do more with the same amount of people, and I think AI is a tool to do that.

Ptak: Well, Jeffrey, this has been a very enlightening discussion. Thanks so much for sharing your time and insights with us. We really appreciate it.

Kleintop: This has been great. Great getting to know all of you and look forward to doing this again sometime.

Benz: Thanks so much, Jeffrey.

Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.

You can follow us on Twitter @Syouth1, which is S-Y-O-U-T-H and the number 1.

Benz: And @Christine_Benz.

Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.

Finally, we’d love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.

(Disclaimer: This recording is for informational purposes only and should not be considered investment advice. Opinions expressed are as of the date of recording. Such opinions are subject to change. The views and opinions of guests on this program are not necessarily those of Morningstar, Inc. and its affiliates. While this guest may license or offer products and services of Morningstar and its affiliates, unless otherwise stated, he/she is not affiliated with Morningstar and its affiliates. Morningstar does not guarantee the accuracy, or the completeness of the data presented herein. Jeff Ptak is an employee of Morningstar Research Services LLC. Morningstar Research Services is a subsidiary of Morningstar, Inc. and is registered with the U.S. Securities and Exchange Commission. Morningstar Research Services shall not be responsible for any trading decisions, damages or other losses resulting from or related to the information, data analysis, or opinions, or their use. Past performance is not a guarantee of future results. All investments are subject to investment risk, including possible loss of principal. Individuals should seriously consider if an investment is suitable for them by referencing their own financial position, investment objectives and risk profile before making any investment decision.)