An Interview with Liz Ann Sonders
It pays to listen to Liz Ann Sonders. The chief investment strategist at Charles Schwab has been on the right side of the economy and market since the autumn of 2006, when she warned about the ripple effects of a housing collapse. She followed this prescient call up a year later when she warned about an imminent recession. As history shows, most people were caught flat-footed by the severity of the downturn. Then, earlier this year, she parted ways once again with the consensus crowd and became increasingly optimistic about the economy and the market.
Sonders currently chairs Schwab's Investment Strategy Council, which provides strategic asset allocation guidance and tactical sector recommendations for the firm's investor base. She has been a fixture on television for years, appearing regularly on CNBC, Bloomberg, and a host of other major networks. She was also a regular panelist and guest host on Louis Rukeyser's Wall $treet Week, and was just named one of the "25 Most Powerful (Nonbank) Women in Finance" by American Banker.
For more about what she currently sees in the stock market and economy, please read on.
RealClearMarkets: You've had quite a run since 2006 when you wrote a major report warning about the ripple effects of a housing collapse. You followed it up a year later with another report warning about an imminent recession. Then, earlier this year, you became more optimistic when it certainly wasn't the consensus view. This was partly based on your improved outlook for housing. Today, there remains considerable debate over where we are exactly in the housing recovery process. Where do you think we are?
Liz Ann Sonders: By and large, I think housing has bottomed, though much like at the early stages of the downturn, it was more regional than national; I think we'll see the recovery stronger in certain regions, while remaining troubled in others. The spread will be driven both by local economic prospects as well as the prior hit to pricing (i.e., area hit hardest will see the largest percentage rebound). The inventory overhang has largely been erased for the new home market, but that only represents about 15% of the overall residential real estate market. Although a major dent has been made in existing home inventories, we have more to go, and face the rising threat of another upward move thanks to rising Alt-A and prime foreclosures in the pipeline.
Housing affordability recently hit a dramatic cycle high thanks to low mortgage rates, dramatically lower prices and flat incomes. Affordability is starting to retreat, but for now that's good news as it reflects prices that are no longer imploding generally. We still have a "real mortgage rate" problem though: Just like real GDP is the difference between nominal GDP and inflation, the real mortgage rate is the difference between the nominal 30-year fixed mortgage rate and inflation (or deflation) in home prices. Here's an illustration: At the peak in the housing market in 2006, mortgage rates were around 6% and home price appreciation was running at about +17%. Do the math: 6% - 17% = -11% ... who wouldn't want to borrow at negative interest rates?! You were borrowing at 6% to buy an asset appreciating at 17% annually.
Fast-forward to today ... mortgage rates have come down, but now home prices have been declining, too. Do the math: 5% - (15%) = 20% ... that's the real mortgage rate. It begs the question, who would want to borrow at any rate if the asset you're purchasing is declining at a double-digit pace? So, for those who thought it was only mortgage rates that needed to drop to entice buyers, clearly it's more about the "rapidly appreciating home price" part of the equation that needed to be solved to bring back meaningful demand. We appear to be on that path.
RCM: Plenty of smart investors predicted a major stock market pullback in September. The conventional wisdom was that the market had gained too much ground, and was due for a correction. So far, this pullback has failed to materialize. What's your take? Should investors be on heightened alert as we head into the fall? Could an October surprise be lurking around the corner?
Sonders: Too many investors fretted about September based on its historical record, and I'll be the first to admit I wrote a report showing the historical tendencies. But, the greater the number of folks expecting a correction, the less likely it'll happen ... and with so much negative energy attached to September, it's no surprise to have seen a strong month unfold. Bucking the tide of conventional wisdom is at the heart of contrarian analysis. Now after a strong month, the pessimists are saying we've simply pushed the weakness into October and that we're now REALLY overdue for a pull-back. Look, we probably are, but when the masses are positioned for a sell-off, it means there's a lot of ammunition for a rally if the market doesn't "cooperate."
RCM: A big debate has been brewing in the bond market over inflation and interest rates, and whether we're approaching a top in the Treasury market. Heated arguments exist on both sides, especially from those who believe the bubble is about to burst. Among other things, they cite massive amounts of new debt issuance and incipient inflation signs like a tumbling dollar and the surge in gold prices. What's your position here?
Sonders: You managed to get a lot of questions embedded in that one! Let's start with inflation. Although it's on my list of longer-term concerns, it's way down my list of near-term concerns. Inflation feeds off not only excess liquidity, but also rising velocity of money, upward wage and unit labor cost pressures, and constrained capacity. None of those latter forces are presently elevated. Yes, the monetary base has exploded, but the money multiplier (velocity of money), measured by the ratio of M2 money supply to the monetary base, is literally on the floor. Some blame banks for "hoarding" capital, and that's a component, but there's a demand problem, too. The trough has been filled, but the banks aren't trotting it out, nor are the horses lining up to drink. That to me is the key variable to watch ... as the economic recovery gains more traction and if it's accompanied by rising velocity, then inflation expectations are likely to heat up.
Many point to the latest surge in gold to suggest the inflation bogeyman is out ... that isn't squared by the drop over the same period in the 10-year Treasury yield. It also isn't necessarily supported by history ... most of gold's major rallies historically (save for the early 1980s) were NOT accompanied by rapidly rising inflation ... quite the contrary. What I think we're seeing, that's reflected in rallying commodities, rallying equity markets, and a weak dollar, is the mirror image of the momentum trade(s) during the heat of the crisis last year and early this year. The risk aversion trade only supported Treasuries and the dollar at the expense of every other asset class. But animal spirits are back and momentum trades are in vogue again ... gold is but one of those.
As for whether Treasuries are a bubble, I would say there are some bubble characteristics evident (certainly last winter when T-bill yields went negative), but if it is a bubble, it's unlikely to burst any time soon. There remains no viable alternative for global excess reserves in terms of stability/liquidity; and the US household sector is only beginning its deleveraging process and renewed focus on rebuilding savings ... that should keep an underlying bid under Treasury demand. Finally, with a greatly improved US current account deficit, the current demand for Treasuries is well ahead of what's needed to fund the deficit.
RCM: The Conference Board's index of leading indicators recently notched its fifth consecutive month in the plus column. How much weight do you assign to this index? Do you think it heralds a more robust economic recovery than many people think?
Sonders: I assign a lot of weight to this index at inflection points and it was one of the key set of readings I was looking at when I wrote in May that I thought the recession would end in the second quarter. In addition to the LEI, there is an alternate leading index that works quite well coming out of recessions and that's the co/lag index, which is the Conference Board's index of coincident indicators divided by the lagging index. It turned a month after the LEI turned.
There are 10 sub-components of the LEI and although some remain weak in an absolute sense, all have been rising. The only one giving a recent troubling sign is M2 money supply, but the latest weakness is off a very elevated reading. The most powerful drivers of the LEI's improvement, outside of M2, have been stocks, the interest rate spread, and more recently initial unemployment claims. The new orders components also recently upticked, suggesting the recovery's gaining traction. I remain outside the consensus and believe the recovery is going to look more v-shaped than many believe.
Coiled springs are in place for inventories, industrial production, and even employment and I think the consensus (though more optimistic than several months ago) remains skeptical at best. What I think is being underestimated is the power of unprecedented global monetary stimulus, which is already producing many v-shaped recoveries outside the United States. Even with no contribution from the US consumer (which I think is too bearish an assumption) you could get 3-4% GDP for the third quarter just from the boosts to exports, housing, autos, inventories (and of course government spending).
RCM: In a recent op-ed for the Wall Street Journal, economist Arthur Laffer argued that while a tight-money Fed undoubtedly played a role in the economic collapse of the 1930s, tariffs, rising taxes, and currency devaluation were the chief culprits. According to Laffer, we face a similar scenario today. What do you think of this prognosis?
Sonders: I think they all conspired to bring the economy to its knees in the 1930s. I thought Laffer's detailing of the rising taxes component was compelling given that I don't think many put that on the top of the list of the Depression's contributors. As for today, we certainly face the prospects of rising taxes to fund the deficit. We also have a depreciating currency, although as previously expressed, I think there are momentum trade factors behind that this time. And, I will admit to be troubled by rising protectionism. That said, I remain hopeful that the path of least resistance for the economy is now up and that we will avoid a Depression fate. It's with a decent amount of faith in the Fed's ability to tap the brakes as necessary that puts me in this camp.
Speaking of op-eds in The Wall Street Journal, there have been two recent ones that I read with great interest and thought hit the mark.
The most recent was written this week by my friend (and Fed governor) Kevin Warsh, in which he gently suggested that the Fed would likely begin withdrawing liquidity and/or raising rates before it becomes obvious they need to. That was music to my ears in terms of keeping inflation expectations at bay.
The other was by Jim Grant (that perennial bear and fellow panelist on Wall $treet Week with Louis Rukeyser). In his very optimistic outlook for the economy, he cited a quote that I think tells it all today: "The error of optimism dies in the crisis, but in dying it gives birth to an error of pessimism. This new error is born not an infant, but a giant."
Many investors dug their pessimistic heels in last March -- that was unfortunate.