Don't count Charles Schwab Chief Investment Strategist Liz Ann Sonders as among the stock market bulls for the near term.
Sonders, speaking during Schwab’s “Market Talk” webinar today, believes that the stock market has not hit the bottom of its bear market yet.
What is the biggest risk to the stock market that isn’t priced in yet and what is the likelihood of it occurring?
“I would say a much more significant decline in earnings than what is built into expectations. Like I said, we’ve seen 2023 come down, but the median is still north of where it was in 2022,” she said.
Sonders said she is worried about “not just a slight decline in year-over-year terms but a significant decline. To the extent that what is so far just a rolling recession turns into more of a cross-the-board economic recession, in which you see earnings declines from peak to trough of at least 20%. And that is not built into the forecast right now.”
That is of course leaving aside anything black swan related, “which is always out there as a risk. But the more obvious one I think is earnings risk,” Sonders added.
Black swan events are characterized by their rarity and severe impact, such as the recent Covid pandemic.
Nor is the U.S. economy likely to avoid recession, given the level of yield curve inversion, Sonders said.
An inverted yield curve is when long-term interest rates are less than short-term interest rates as they are with Treasury bonds right now.
“Given the level of inversion right now, if we were to avoid a recession it would be the first time in history that the economy had managed to do that,” Sonders said.
Right now, the yield on the three-month Treasury is above 4.5%, while the 10-year yield is more than a full percentage point lower.
The minimum time from inversion to recession is six to seven months, but the average is 12 months, the economist said.
“Sometimes it’s taken longer, but it’s never failed,” Sonders said.
The Federal Reserve raised its interest rates by a quarter of a percentage point last week in its ongoing war against inflation, increasing the benchmark federal funds rate from 4.5% to 4.75%.
Federal Reserve Board Chairman Jerome Powell said at a press conference last week that it would be “very premature to declare victory” against inflation that has remained stubbornly high.
A pivot from interest rate hikes to actual cuts may still be a significant way off, Schwab’s top economists said at the webinar.
“In my view there may be one less cut by the end of the year ... if inflation comes down to the Fed’s inflation target of 2%. That will be justification for a pause [in rate hikes], but in my view an actual pivot to rate cuts would not be predicated on just inflation coming down, but probably need weakness in the economy and the labor market to justify a rate cut,” Sonders added.
Kathy Jones, Schwab's chief fixed-income strategist, agreed. “Powell created a lot of confusion at his last press conference because he talked a lot about the progress that’s been made on inflation and mentioned disinflation 10 or 11 times. I think that gave people a lot of optimism that maybe the Fed was getting ready to pivot."
Two- and 10-year Treasury yields jumped 40 basis points and then fell back as a result of Powell’s messaging, she noted.
“It was a failure to communicate and I think any muddled message increases volatility in the bond market. ... I would expect this disconnect to continue to widen and narrow, widen and narrow as we go through an uncertain outlook in the economy,” Jones said.