Investment Strategist Liz Ann Sonders on the “Rolling Recession”

Liz Ann Sonders is the chief investment strategist at Charles Schwab. In this podcast, Motley Fool host Deidre Woollard caught up with Sonders to discuss:

• Why investors should pay attention to the S&P 600.
• Cracks in consumer spending.
• The year of efficiency, Part 2.
• A major tailwind for the economy.

To catch full episodes of all The Motley Fool’s free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on January 13, 2024.

Liz Ann Sonders: The headlines are always payrolls and then the unemployment rate. But more often than not the details under the surface of those two headlines tell a better story than just those headlines. Alongside the uptick in wage growth was actually another move down in hours worked.

Mary Long: I’m Mary Long and that’s Liz Ann Sonders, chief investment strategist at Charles Schwab. Deidre Woollard caught up with Sonders to go beyond the economic headlines. They discuss holiday spending and the ascent of buy now, pay later, the rise of part-time work, and why investors should be careful when concluding past averages.

Deidre Woollard: Well, let’s start by looking a little bit back at 2023 and just a quick thing about what surprised you most about the year.

Liz Ann Sonders: Well, coming into the year there was a decent amount of momentum associated with let’s call it the average stock. Equal weight doing fairly well relative to cap weight. We had expected that to persist a bit more to the year. I think really what prompted what became an incredibly concentrated market with rightly so all the attention on the magnificent seven and just how dominant they became. That really started in mid march not coincidentally at the same timing as the banking crisis. I think that that initially just fueled an interest in the mega cap companies that had strong balance sheets that weren’t going to be at the mercy of any significant problems in the financial system, which that didn’t become a contagious event, of course. Then it was exacerbated by all of the interest in AI. It was that, that concentration kicked in such rapid fashion and persisted throughout the year was the biggest market surprise. Obviously, geopolitics these days the Israel-Hamas war was the biggest external surprise.

Deidre Woollard: It sounds like what we saw was really that run to safety and then the start of generative AI kind of fueling that rise of the Magnificent Seven. Is that correct?

Liz Ann Sonders: Yes, it’s not uncommon for cap-weighted indices to be biased up the cap spectrum in a relatively small handful of names. The problem arises when the rest of the market, the rest of an index like the S&P is significantly underperforming. That was the case end of May into beginning of June, where you not only had the Magnificent Seven accounting for more than all of the year-to-day performance, at that point you had less than 15% of the index outperforming the index itself over the prior 30 day period, 60 day period. It was the book ends of concentration and really weak breadth and lack of participation that developed the risk associated with concentration. As the year unfolded particularly during the correction phase, that we had from late July to October that you started to see a broadening out and that has continued, I think that that’s a healthier underpinning for the market.

Deidre Woollard: Do you see that as one of the ongoing stories of 2024?

Liz Ann Sonders: I do. But one thing we’ve been cautioning investors about is in the interest of moving away from just the top 5-10 names from a size perspective. There is a lot of interest in moving down the capitalization spectrum into smaller cap areas. I would say don’t sacrifice quality. In an index like the Russell 2000, it still has a decent percent of the combination of non profitable companies and what are often called zombie companies that don’t have sufficient cash flow to even pay interest on their debt. I think there’s an opportunity to look for interesting ideas and spots within the market that are not just the biggest names but you definitely don’t want to sacrifice quality. On that note a lot of people don’t realize that even though the Russell 2000 is more commonly used as a benchmark for small caps, there’s also the S&P 600. Although not used as commonly as a benchmark, S&P uses a profitability filter in constructing that index. You automatically start, I’m not suggesting buy an index fund based that but if you’re a stock picker and you maybe typically start with an index as a source, just know you’re getting a higher quality profile in the S&P 600 because of that profitability filter.

Deidre Woollard: Thinking also about the thing that everybody wanted to talk about last year, of course continues on with this year is interest rates. We’ve heard so much about the soft landing versus the recession. In a report that you had you came up with this different take the rolling recession concept, I think is very smart. Can you explain what that is and how it might play out?

Liz Ann Sonders: Sure, it’s not really a formal financial markets textbook term that has a lovely definition of a recession from the NBR but I think it is the most apt way to think about this unique cycle. No one wants to rehash the last 3.5 years but we do have to go back to the stimulus era of the early part of the pandemic when you had both massive monetary and fiscal kicking in at the same time. What that had the effect of doing was obviously boosting demand and it pulled the economy very quickly out of what was a very short lived but painful recession. But it was also at a time where the services side of not just the US economy but the global economy was effectively shut down. All of that stimulus and the demand associated with it got funneled into the goods side of the economy. It didn’t just happen in terms of where economic growth resided, it happened in inflation data as well the initial surge in inflation was very goods-oriented. But fast forward to the more recent period you’ve seen goods inflation go to goods disinflation to now in many categories, goods deflation and many of the goods categories within the economy like housing, housing related manufacturing a lot of consumer oriented goods that were big beneficiaries of the stay-at-home lockdown phase of the pandemic. Those have had their own recessions. In fact, fairly deep recessions in some cases. But more recently you’ve had the later pent up demand revenge spending on the services side, it has also woven its way into services categories of inflation later. Inherently many of those categories are stickier in nature like many of the shelter components. We are starting to see disinflation there, but it’s happening at a much later point in time and a bit slower. You’ve had some weakening on the services side of the economy but not to the degree that you saw on the goods side. When I think looking forward, best case scenario is not really a traditional soft landing because that ship already sailed from many of those parts of the economy that have had hard landings. It’s that we continue to see some roll through, meaning if and when services related to labor market gets hit, that you’ve got offsetting stability or maybe even recoveries underway in areas that have already taken their hit. I’ve sometimes been criticized for using rolling recessions as a term. Fine, that’s fair but the reality is that is what has happened. What term you want to use to describe it? That’s personal choice but that is what has happened. It’s a very unique cycle for lots of reasons. I think visually it’s the best way to think about this whole simplistic recession versus soft landing debate which I think this is the important nuances of this cycle.

Deidre Woollard: Yeah, absolutely. I’m sort of fascinated by that goods and services thing that we saw play out last year things like travel. The so called revenge travel, still going on but what are you looking for with regard to the consumer, the holidays were good, it seemed like the spending numbers were strong. What are you looking for for this year?

Liz Ann Sonders: Yeah, the holiday spending was fairly strong, clearly biased toward online versus in-store. Then you had some underlying things that probably bear watching. Not much of an increase in credit card use for spending but a huge surge in buy now pay later. That makes sense for the user of a system like that because the fees are less, the rates are less. But when you look at the background conditions for the consumer particularly if you look at various sort of income segments or net worth segments, you have for the most part seen a full drain of excess savings for those lower income cohorts. That suggests that we do have some segment of consumers that are arguably a bit tapped out. Savings rate is down, the X savings isn’t there. Obviously, things like increased credit card use which has been significant notwithstanding the shift recently to buy now pay later brings with it incredible interest costs then you add in the return of student loan payments. You’ve started to see auto delinquencies pick up broadly but particularly for subprime do the income spectrum you’re seeing the same thing in credit card delinquencies. There are some cracks that have started to form. Maybe not in the aggregate for the consumer, but where the health still exists is more up the income net worth wage spectrum. But even there, you have started to see a rolling over in things like luxury goods. I think we’re probably at the tail end of an environment where consumer spending was much stronger than a lot of people thought it would be, particularly given that consumer confidence has been so weak. We’ve been in this weird environment, what they’re saying is pretty dour, but what they’re doing is in stark contrast to that. I think we may be now at a point where we’re going to notice more frugality, even if inflation continues to come down, which is obviously a particular benefit to those on the lower end of the income spectrum. Because that just acts as a much more direct kind of tax on lower income consumers. But I think that excess savings story is largely in the rear view mirror now.

Deidre Woollard: But it’s interesting too, thinking about, you talked about jobs and wage growth and how that factors in. You’re looking at delinquencies, you’re looking at how the consumer is saving or not saving. What else are you looking at to judge where we’re at right now?

Liz Ann Sonders: Wage growth continues to be strong and there’s nothing wrong with that. We all want people to be employed and make, decent wages. The rub of course, is as it relates to Fed policy. I think that that was one of the clouds that maybe came onto the horizon with the most recent jobs report for December is you saw that uptick in wages. There’s that potential connection point to inflation and maybe provided the Feds some discomfort that they maybe have a little bit more to go in terms of bringing inflation down to or near their target. But in addition, also as part of the monthly jobs report, which the headlines are always payrolls and then the unemployment rate. But more often than not, the details under the surface of those two headlines tell a better story than just those headlines. Alongside the uptick in wage growth was actually another move down in hours worked. That’s a sign of what is also unique in this cycle. This notion of labor hoarding is very valid. Companies are hanging onto their labor. They’re more hesitant to put out large layoffs. But hours works reflect whether it’s an interest in protecting margins or just a demand side of the economy story. I think that tells a story of a little more economic weakness then you might pick up if you only focused on the headline beat of payrolls or the lack of any move up in the unemployment rate. The other thing I’d say about payrolls and the unemployment rate is payrolls comes from the establishment survey that the Bureau of Labor Statistics does that counts businesses. Every month they have something called the birth death adjustment. It’s not the birth and death of people, it’s estimated birth and death of businesses and they tend to overestimate births and underestimate deaths when you’re in a slowing economy. For the 216,000 payroll jobs created per that survey that we got last Friday for the December jobs report, I think it was 110,000 of that was driven by these birth-death assumptions. That’s probably outsized. It’s one of the reasons why every month in 2023 with the exception of July has been revised down. We don’t know whether December will be revised down because we won’t get that until the January jobs report, which doesn’t come until February. But also the household survey, which is a survey of people, that’s where the unemployment rate is generated from, that saw a decline of 683,000 jobs. You also had a similar, I think it was 657,000 decrease in the overall labor force. The fact that those two offset each other is why the unemployment rate didn’t go up. However, that’s the unemployment rate staying steady for the wrong reasons. A decline in the labor force, and a huge decline in jobs. It’s also the case that more than all of the job declines, the household survey job declines were full time. The only job gains per the household survey were part time. That’s another underlying message of some weakness, some cracks, that if you only listen to the headline of 216 versus 170 consensus and still low 3.7% unemployment rate, you’d say, wait, everything’s hunky, dory. The details are a bit more cloudy, if not dour in some cases.

Deidre Woollard: A good reminder to look at those revised numbers because I think those don’t get reported the same way that the originals do.

Liz Ann Sonders: They do not, and it really matters. In fact, in a recent report that I wrote that was just posted a couple of days ago on the December jobs report, it was called Mixed Signals. It’s on Schwab.com, the public site. Talked about as an example, what happens when you’re in the moment heading into a recession? I used the period from late 2006 to the end of 2008. What’s interesting is if you go back and you look at, say, a chart of what monthly payrolls were in that period leading into and during the financial crisis, what you would see now if you pulled up a chart is the data post all the revisions. What I did in this report is I put a comparative bar chart together where for each month, the first bar was what was initially reported versus what ultimately we know was happening based on all the revisions that the BLS does. The net is that over the period of time we looked at. At the time, you would have thought one million jobs were created, which is part of the reason why even into the first half of 2008, look at a lot of headlines, newspaper headlines, magazine headlines, research report headlines that we’re saying, there’s stuff going on with housing, but no recession risks because job growth is so strong. Well, during that period, at the time, we thought a million jobs had been created over that span of time, when in fact, post-revisions, 2.2 million jobs were lost. Context is really important. Again, I’ll just remind you that if you go back through any typical charting service and you look at a chart of payrolls or any other economic data point that is subject to revision, what you’re seeing is the post-revision numbers, which at that time you didn’t have those.

Deidre Woollard: That’s not what people were reacting to.

Liz Ann Sonders: By the way, I know I often sound like Debbie Downer when talking about recession or rolling recessions. To be perfectly honest, we’re going to get an officially declared recession by the NBR. That’s how cycles end. It’s always going to happen, we never know when. I think the economy cracking a little bit more here sooner rather than later would actually be better from a market backdrop perspective and maybe even from an economic perspective. Because that would allow the Fed to not just be in pause mode, which they’re in now, but actually be able to look at loosening policy. I think the market is right now, a little bit over its skis in terms of expecting five or six rate cuts this year, including the first one coming as soon as March. I think maybe that’s a little aggressive, but more weakness sooner rather than later, I think would keep the weakness more constrained, I think would be better for the economy from a Fed policy perspective and probably a better backdrop for the stock market.

Deidre Woollard: Absolutely. Because I think that that happens where we wait, and Fed waits until it gets bad enough and then all of a sudden it’s rate cut. What you’re saying it sounds like is take a little bit of the pressure up and have a more gradual approach.

Liz Ann Sonders: Correct.

Deidre Woollard: That makes a lot of sense. I want to talk about something else that gets a lot of headlines, which is the yield curve inversion. I think it’s hard to make sense of, there’s a lot of headlines about it, but what is it and what might it be signaling right now?

Liz Ann Sonders: When the yield curve inverse. The normal relationship between shorter term interest rates, say, the three-month Treasury bill or a two-year treasury versus longer term interest rates, normally there’s a positive spread. Short-term interest rates are lower, long-term interest rates are higher reflecting that if you’re going to commit your money out for a longer duration, you want to be compensated for that. That allows the financial system, the banking system, to borrow at low rates and lend out at higher rates. That provides fuel for what the financial system does, which is provide credit and help businesses, etc. That’s the normal relationship. Inversion comes when it’s the opposite, where short-term interest rates are now higher than long term interest rates. It can happen for a variety of reasons, with a different ordering and timing. But in this case, obviously we saw the Fed embark on a very aggressive tightening cycle so they were dramatically raising short-term interest rates to the point where they went above long-term interest rates.

That was reflecting the inflation problem, with which we’re still dealing in the most aggressive cycle in 40 years. The yield curve inverted, I think it’s about 13 months ago. It has had a pretty strong track record of, I don’t want to say forecasting recessions, but being a precursor to recessions, especially because of the impact it has on banks and the financial system and credit availability. The lead time between a yield curve inversion and when recessions have occurred historically, I think the average is something in the, I don’t know, 13 months or so, but the range is really wide. It’s another example of when you don’t have a large sample size and you have a really wide range. It always makes me think of the old adage analysis of an average can lead to average analysis. The real net is if you look at the range, we’re not past the so called expiration date based on history, in terms of what they call the long and variable lags of a tighter monetary policy cycle that causes an inversion of the yield curve. But we’re not well past anything that has happened historically whereby one can say, all right, well the yield curve didn’t work this time, it was a false signal. Maybe we get there, but I don’t think we’re there yet.

Deidre Woollard: Interesting. We talked a little bit earlier about the Magnificent Seven and really that path that led 2023. Looking forward to with AI, what continues to happen? What questions are you asking about the biggest gainers last year?

Liz Ann Sonders: Well, I think 2024 could still be a year very focused on AI. But I think what we might be starting to see is a shift in interest away from, just call it the providers. The creators, the semiconductor, the gears of AI to the users of AI. Which of course, that spans just about any industry, any sector where companies are finding they can adopt AI, use AI whether it’s for efficiency or productivity or, growing their business in other areas. To me, that I think should be at least as much of a focus this year on just who are the providers of and creators of the engines of AI. Now who are the effective users of AI? Again, that’s across the spectrum of industries and sectors.

Deidre Woollard: Last year was Mark Zuckerberg called it the Year of Efficiency. We saw a lot of companies being more efficient, showing that they were cost cutting. Do you think that that is something that’s going to continue this year as well?

Liz Ann Sonders: I do. I think margin production I think will continue to be a pretty powerful force and so far so good because estimates for 2024 have been quite resilient. In part, it’s because companies have been focused on protecting margins in an environment where, unit demand has been coming down. The cost structure has been hefty, particularly on the labor side and that’s part of the reasons why a metric like hours worked shows that weakness even if wage growth or layoffs have not. It’s another example of to see how companies have been protecting margins, you do have to peel at least one layer back from the onion to see how they’re doing it. Absent solely via the typical labor markup part of the cycle where you have, mass layoffs and you see a pretty sharp increase in the unemployment rate. That has not been a characteristic, at least not yet, of this cycle. But companies have found ways to keep margins at a relatively healthy level and some of it is through what they’re doing and cutting hours. Other has to do with investments that they’re making in efficiency and productivity, inclusive of AI.

Deidre Woollard: There’s definitely this need to cut corporate debt. That was a big theme last year. What are some of the impacts now especially as money has become more expensive?

Liz Ann Sonders: For well capitalized companies, even many that on the books have a decent amount of debt, it’s not really a problem. In fact, a lot of well capitalized companies with generally strong balance sheets took advantage of incredibly low interest rates. You know the ZIRP era of 0% interest rates, you know, the 10 year got down to a half a percent. A lot of companies took advantage of that. They might have borrowed, but typically it wasn’t because they needed to borrow to fund their operations, they might have borrowed to pay a dividend or to buy back a stock, or they termed out their debt. Which is why we’ve seen so much resilience in the corporate sector in the face of an aggressive 40-year record aggressive cycle on the part of the Fed. Frankly, a lot of consumers did something similar. The massive shift from adjustable rate mortgages to fixed rate mortgages meant that this huge surge in interest rates did not bite as quickly to the same degree on the corporate sector, on much of the consumer sector. Now on the corporate sector that’s exclusive of the weaker companies, the zombie companies that do have debt coming due. They have to roll over that debt at now much higher interest rates. Many of those zombie companies, even with lower interest rates that they’ve been paying on their debt, don’t have the cash flows. I think the hurt point is still to come for those weaker companies. Zombie companies, were really propped up or allowed to stay afloat courtesy of zero interest rate policy. But I think the bills literally and figuratively will be coming due. Now in my mind, it doesn’t represent some moment in time the bottom falls out because every company has a different maturation schedule. It’s a rolling problem over time, but it’s part of the reason why we’re saying you want to stay up in quality when going down the cap spectrum and avoid those non-profitable zombie type companies about the only segment that could have probably done a better job of lengthening duration, terming out debt if you want to use this is the government sector. That’s where the world of hurt is significant in terms of increase interest that’s being paid on debt. They didn’t do it, but corporations, and certainly homeowners did. That doesn’t mean we no longer have any impact of rising interest rates. They’re still our long and variable lags and there still will be an impact. But it’s been muted because of what many smart companies and smart individuals did when the going was good, in terms of very low, both short term and long term interest rates. That has muted the impact, which is a good thing.

Deidre Woollard: Interesting. As we wrap up here, you called yourself Debbie Downer earlier. I don’t think that’s true at all, but what are you optimistic about?

Liz Ann Sonders: I’m a realist.

Deidre Woollard: Realistic is good. What are you at least maybe slightly optimistic about for this year?

Liz Ann Sonders: Well, some of it we touched on, which is, I don’t want to say just AI specifically, but I think what we are shifting toward is an economic backdrop that is more investment driven and less discretionary consumption driven. In fact, we’ve already seen it. GDP as a data point is very lagging in nature. It’s also subject to revisions, but what you get when you look at initially released GDP figures but also the details within, and then you look at subsequent revised data. One of the interesting things that we’ve seen over the past year is about a year ago when we initially got, I think it was for fourth quarter 2022 GDP. Consumer spending represented more than 71% of the economy. The most recent data that we got for the third quarter, we won’t get fourth quarter GDP for another week or so, but the data we have for the third quarter, which has already had one revision now has consumer spending down to 68% of GDP. It’s the investment side that has picked up.

That doesn’t mean that capex is booming now, or will boom imminently. We’re in an uncertain time, especially for things like capex between geopolitics and just labor market uncertainty and recession uncertainty. Not to mention election uncertainty. I don’t think this is an environment where companies are likely to really kick in a capex cycle, other than in areas that they deem really important and strategic. But when I think beyond the next couple of quarters, I think this is going to be more of an investment driven economy and I think that’s a better backdrop for growth. I think it’s a better backdrop for the employment situation. Especially when you have not, maybe this most recent cycle, but in past cycles when consumption was growing so significantly as a share of the economy and it was happening off the back of debt. I think more of an investment driven economy both on the non residential side, which is the terminology used within GDP, which basically means business capital spending and the residential investment side. Then also weaving in government with public private partnerships associated with infrastructure spending in capex that has that bridge into public sector spending. I’m very optimistic about the investment side of our economy.

Deidre Woollard: Fantastic. Liz Ann Sonders, thank you so much for your time today.

Liz Ann Sonders: My pleasure. Thanks for having me.

Mary Long: As always, people in the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don’t buy or sell stocks based solely on what you hear. I’m Mary Long, thanks for listening. We’ll see you tomorrow.