Schwab’s Sonders: More Pain Before Gains

January 11, 2016

It could very well be that the “violently flat” U.S. market action we saw in 2015 persists into 2016—at least in the near term, Liz Ann Sonders, chief investment strategist at Charles Schwab, tells us. But if a relatively neutral outlook seems boring, it may also prove to be just right for risk assets, she says.

Sonders, who will be a keynote speaker at the Inside ETFs conference on Jan. 27, recently shared with us her outlook on the market and the economy.

ETF.com: You're going to be a keynote speaker at our conference later this month. What do you plan to talk about?

Liz Ann Sonders: My overview, at least initially, is of the macro nature. I'll talk a bit about the economy with a focus on the U.S.—although I'll put it in a global context and talk a little bit about global monetary policy and policy divergences, and where we are in the economic cycle—the risk of recession; the Fed's mandates for jobs and inflation, and what that tells us about the trajectory of the interest rate increases, and the implications that that has for the market. I'll talk a bit about commodities—oil, more specifically—and currencies.

I’ll tie the macro into a market overview by looking at the implications of these things for the market; where we are from a valuation perspective; the very weak earnings growth that we have seen and the likelihood of that picking up.

ETF.com: Speaking of the Fed, the market seems to be pricing at a relatively slow pace of normalization of interest rates. Are you in that camp, and what does that mean to fixed-income investing?

Sonders: I'm not a fixed-income person. But the market expects a slow trajectory, and that's what our expectation is, too. In fact, the market has built an assumption into the futures curve of two rate hikes in 2016, whereas the Fed's assumption shows four hikes.

We think the market's going to be closer to right than the Fed. And at least based on history, a slow trajectory of rate hikes is a much more favorable backdrop for the equity market, and for risk assets in general, than a faster trajectory. I think that is one of the key determinants of how the market behaved this year.

We put ratings on asset classes, and my bailiwick is U.S. equities. In 2015, we had a neutral rating on U.S. equities, which is a pretty cautious outlook. It says to investors: “Don't have any more exposure than your normal long-term allocation to equities.” That’s the weighting—so far anyway—that we’re maintaining into 2016.

ETF.com: So the big slowdown we saw in 2015 in terms of equity market returns relative to, say, the last six years, will continue in 2016?

Sonders: Yes; at least to start. I think the kind of activity we saw last year, which was sort of a grinding market, violently flat, running to standstill—whatever analogy you want to use to describe it—is likely to persist at least within the near term.

But if we are—as I think we are—in a secular bull market, history has shown that after relatively weak years like we had last year, the year following tends to be pretty strong year. So, if we can avoid a recession, and if we’re indeed in a secular bull market, the ultimate break will be to the upside, but not in the near term; I think we have more pain to experience in the near term.

ETF.com: How big is the risk of recession?

Sonders: I think it's higher than it's been, but still relatively low. It would be unprecedented in history for a recession to come without the leading indicators rolling over first, which they have not. You have a manufacturing recession right now, but that's 12% of the U.S. economy, and the other 88% that is services is still doing fairly well. So, recession risk is still fairly low.

ETF.com: 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.

ETF.com: 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.

ETF.com: 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.

ETF.com: 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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