Schwab’s Sonders: More Pain Before Gains

January 11, 2016 What’s your view on oil? Will oil remain a central player this year?

Sonders: Yes; because it's certainly impacting the credit market and the high-yield market. The concern is that it will eventually spread more broadly into the economy. Right now, what we've seen in terms of credit spread, which does have implications for equities, has been largely concentrated in the commodity space. But were that to start to filter more broadly, and were we to start to see risk of defaults increasing outside the commodity space, that would be an important factor on markets.

You could say the same thing about the impact of falling oil prices on the economy. Right now, its impact in terms of the real damage has been concentrated in the energy sector, but it could spread. It’s something to be mindful of. But we've never had a recession in history that has been caused by or preceded by a crash in oil prices. It's almost always been the opposite case. Generally speaking, it seems you think the U.S. economy is doing OK.

Sonders: I think this sort-of-slow-at-times, below-trend, choppy economic pattern is likely to persist. Even though I don't believe a recession is a high risk, the likelihood of the economy lifting from here to anything resembling healthy growth is also fairly low.

The 2-2.5% range in which GDP has been in for much of this recovery/expansion would probably be the most likely scenario for 2016. That’s not a bad environment for risk assets. It's kind of the Goldilocks scenario that keeps inflation from running away and keeps the Fed in a position to be able to adopt the slow trajectory that they certainly would like to. Given high correlations, what are good portfolio diversifiers today?

Sonders: Unfortunately, the answer to that is less exciting when you've got a bunch of neutral ratings. Across the global equity asset classes—U.S., developed, international and emerging markets—we have neutral ratings on all of them heading into 2016. So, our broad outlook across all asset classes is a view that you want to be a bit cautious here.

However, diversification is important. Stay diversified across asset classes, but there's not one particular area that we think is worth a significant bet on the upside at this point. I’ll say that within U.S. equities, we have ratings at the sector level, and right now, the two outperforming ratings are on technology and financials. What could derail markets and the U.S. economy?

Sonders: China's probably the biggest factor from a global risk perspective. Not so much because we are inextricably linked economically to China. In fact, our economic ties are relatively limited in that only 7% of our exports go to China. And in turn, exports are only 12% of the U.S. economy.

But the problem is, our markets have become highly correlated. You've seen a big increase in the correlation between the S&P futures and the Shanghai exchange, so what China does overnight matters to the market, at least in the very short term. But the China slowdown story is largely baked in the expectations and the market.

The consensus is a global growth weakness story. The risks are binary in nature. There are upside risks here, as well. The story could actually turn out to be quite a bit better in 2016 than worse, and there are fewer people talking about that. It’s intriguing to think: What if things are actually better from here?

Contact Cinthia Murphy at [email protected].

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