Making Sense of Recent Market Volatility

KATHY JONES: I'm Kathy Jones.

LIZ ANN SONDERS: And I'm Liz Ann Sonders.

KATHY: And this is On Investing, an original podcast from Charles Schwab. Each week, we analyze what's happening in the markets and discuss how it might affect your investments.

Well, hi, Liz Ann. Now, I want to say we normally publish these episodes on Friday morning, but this week, due to our travel schedules and the amount of crazy stuff that's going on in the markets, we decided to record this on Monday and not wait until Friday to release this one. So it should be out on a Wednesday. So if you're listening to this on Wednesday, the reason is that there's a lot going on, and we just didn't want to hold off.

LIZ ANN: Now, all that said, Kathy, you and I could be taping this on a Monday morning—it happens to be a Monday afternoon—with the goal of posting it on Monday afternoon, and it would be out of date. So I don't know. 

KATHY: True.

LIZ ANN: I suppose one guarantee is that the news between now and when this posts will be fluid. And so, again, a reminder that we are taping this toward the end of the workday on Monday. So keep that in mind if, as you're listening to it, you wonder why the heck we haven't addressed, you know, fill in the blank. So I'm going to toss to you first, Kathy, because there's been so much focus on volatility in the equity market, which has been extreme. But even on a day like today, I think we had, what, a 30-basis-point range in the 10-year yield. So a lot of swings up and down in Treasuries as well, as I think all market participants are trying to navigate an amount of uncertainty that I think wasn't eased by virtue of last Wednesday's announcement. So what do you make of what the bond market is saying about all of this, if there is something to make of it?

KATHY: Yeah, it has been extremely volatile. There is an index called the Move Index, which is based on option volatility. It measures volatility in the underlying bond market. And that has spiked really, really high, not surprisingly. So it's kind of like the VIX for bond people, although it's not nearly as popular. But it reflects, I think, all this uncertainty. So you know, initially when we got the rollout of the tariffs, the reaction was a big drop in the equity markets because the prospects for growth were diminished, greatly diminished. There was a lot of fear and dislocation. And people moved into Treasuries as sort of a safe haven and for liquidity, basically. And then that persisted for a while, but now we've gotten so much back and forth and back and forth that now Treasuries are starting to sell off. 

And I think there's a couple of reasons for that. One is that at the basic level, tariffs raise prices. So it's very difficult for bond yields to fall significantly, even if the growth prospects are declining, if prices are rising or expected to rise. So that's one negative. But I think more that's driving it is we are at the point where investors who are perhaps leveraged or need to sell are selling what they can sell, that's liquid, and Treasuries are liquid. So you can get in and get out, and sometimes when you get to this point in the market where people are just scrambling to get out of things, maybe it's a margin call or maybe some other obligation, they're selling what they can sell, and what they can sell right now is Treasuries.

And then I think the third factor is just the uncertainty level. The people would rather go to cash, I think, than try to make decisions about their portfolios right now because they just don't know what's coming down the road. We've had numerous announcements and counter announcements and imposition of tariffs and counter tariffs and back and forth and back and forth. And I think people are simply saying, "We need to be in cash. We can't be leveraged because there's too much uncertainty, there's too much risk involved." And that's when you see market action like this. I will say, "This too probably will pass, as it always does," but we do see it at this sort of stage where people are just throwing in the towel right, left, and center and saying, "I just want out. I don't know what's going on. I can't predict what's going on, so I'm going to sit on the sidelines in cash."

So that's my interpretation of what's going on in the Treasury market. What about you, Liz Ann? You know, equity is all over the place again, but mostly down. So yeah, what's your perspective right now?

LIZ ANN: Yeah, I mean, it was … it was an epic two-day decline in the immediate aftermath of the announcement. Ten and a half percent in the case of the S&P 500®. The decline, at least as we speak, had already gone into bear market territory for the NASDAQ, the NASDAQ 100, the Russell 2000. Intraday Monday, earlier in the day, we did have the S&P go into bear market territory, but the up and down that occurred throughout the course of the day and where we ended up closing kept the S&P out of bear market territory. But I think that move down there might have been a bit of a short-term technical trigger for some dip buying to step in. But you mentioned the VIX, which is the volatility index. And that kind of pre-"Liberation Day" was somewhere in the mid-to-high teens that had been hovering for much of the March period of time ultimately spiked up to 58. It's since come down as we're taping this in kind of the high 40s, and I think maybe it's stating the obvious, but I think a retreat in volatility would be the first thing that's necessary in order to stabilize the backdrop here, but clearly what we saw was a pretty big lift to most recession probability forecasts. Any economists that I follow, firms that I know that publish probabilities, upped their odds from where they were pre-"Liberation Day" to post-"Liberation Day." 

As you know, Kathy, we were already in the recession watch camp. Kevin and I published a report in mid-March about recession risk and laid out what were already some of the kind of falling dominoes that tend to happen when you're heading into either a major growth slowdown or recession. And that certainly has been elevated as a result of what we have seen. I think what's also going to be important, and I'm not sure it represents an equity-market stabilizer, but maybe a little bit more clarity or more clarity about the lack of clarity will come when we start getting earnings reports for the first quarter, which starts next week. It's the financials that come out of the blocks first. 

And I joked about clarity around the lack of clarity. I wouldn't be surprised if first quarter season was not bad, relative to expectations. I just don't think it matters really at all, because that's highly backward looking. I think what matters is what companies say about the future. And my guess is we're going to be in a backdrop similar to what happened in the early part of the pandemic, which was a very, very high percentage of companies that simply just withdrew guidance altogether, for the obvious reasons that during the pandemic, the early part of it, there was no way to provide, you know, cents per share guidance, one quarter out, let alone two, three, four quarters out. So that's probably the overarching theme. 

But I wouldn't be surprised, too, if analysts at least try to get companies to talk about visibility, to talk about how they plan to navigate around this uncertain playing field. Are they continuing to postpone investment plans, capex plans? What does their own individual labor market situation look like? Do they have a way to think about protection of profit margins, especially if you're a company in an industry really on the front lines of being at the mercy of these tariffs proposed and otherwise?

I'm not sure that that is going to add a lot of positive clarity, but I think it will reinforce just how unique this period of uncertainty is. I want to, you know, one of the things I wanted to toss back to you, Kathy, is a lot of the commentary I've seen over the past day or two is with regard to whether the Fed steps in here. And, you know, I have to think, "OK, how do I think the equity market would act if the Fed either started to telegraph a move toward easier policy or if they decided to do some sort of emergency meeting?" And I think the knee-jerk move on the part of the equity market would probably be a rally. That's just par for the course. But I think the more existential question is, "How would that be at all an elixir for what ails us here?" This is not a major seizing up of the credit markets. This is not a problem of interest rates having been too high that has stymied the economy. So what are your thoughts on maybe what the Fed might do, and would it help?

KATHY: Yeah, you make a good point. I think that they're certainly watching this very closely and trying to analyze it as best they could to see what the impact is likely to be on the economy. But you're right—this is not a financial crisis per se. It certainly could develop into something like that, but it's really not similar to, say, 2008 when the whole banking system appeared ready to collapse, and they had to do something to shore that up. 

This is really, though, in many ways, very serious in the sense that it's a reordering of the economic model that we've had in place for decades. So really since post-World War II and certainly since the '80s, we've had a free trade sort of ideology that pervaded everything, every administration, Democrat, Republican. All were in favor of that. And the globalization has been a huge trend for decades and decades and decades. And now we're sort of doing a U-turn and saying, "No, that wasn't good. That wasn't a good thing. We want to go back the other way." And so for the Fed, are interest rates really going to assuage the problems that we're facing or the issues that are arising? I think not. 

They can help on the margin by reducing financing costs, but reducing the financing costs would not affect corporate profit margins that much, you know, versus everything else that's going on. So I think that they have a real dilemma because inflation's still high, relative to their target, and tariffs lift prices. So that's a negative for changing policy. On the other hand, if the real economy is softening and weakening as a result of this policy changes, then they probably will address that. 

And so I think that they're sitting and watching, hoping they don't have to do any emergency-type move, and they'll signal that they're on hold until they see something change and they're able to kind of analyze it. And the things that'll change are unemployment. If the unemployment rate starts to go up, and we start to see serious slowdown in job growth or negative job growth, then I think the Fed will say yes, we need to address that with lower interest rates. And the other is financial conditions tightening. We've seen that happen with the sell-off in the stock market and the bond market. 

I don't think it's reached the point where markets have seized up. But we have, in the corporate-bond market, a lot of issuers have pulled back and said, "The markets are just too volatile for us to issue in. We can't sort of have a good vision into what rate we're going to get when we try to do this." So we are seeing a little bit of that going on. 

I don't think it's reached crisis levels yet that the Fed needs to kind of jump right in there. But those are the two factors, unemployment and financial conditions. We may get there. I think the Fed will try very hard to hold on as long as they can and get solid evidence before moving. Because one of the problems they face, like the markets, is this could all change in a heartbeat. There could be one post on social media that says, "OK, you know, we've come to an agreement with XYZ countries, and it's all good." And everything goes in reverse. So they don't want to be seen cutting rates three or four times because they're concerned about the impact of a policy that could change tomorrow. So right now markets are all over the place. Yesterday, markets were pricing in three or four rate cuts by the Fed. Today, not so much. 

So I think they'll hold off as long as they can. But if the tariffs stay in place, if they have the economic effects that we think they're likely to have, then I think the Fed will be cutting rates in the second half of the year as the economy slows down and the prospects for … once the economy slows down, inflation is likely to follow, even if it doesn't in the near term.

But it's a very, very tricky position to be in. We have a raft of Fed speakers this week. I can imagine how they're honing their speeches today to try to send the right message, because that's going to be a real problem.

LIZ ANN: You know, I think there's something else that's really important to talk about that maybe still doesn't get the attention it deserves. You and I talk about it and write about it all the time, which is that the mirror image to a trade deficit, which seems to be in focus as a rationale behind these tariffs, is a capital account surplus. And what that has meant, of course, is that all the dollars that head overseas by virtue of us importing more than we export, those dollars have to go somewhere, and they tend to get recycled back into our Treasuries, our corporate bonds, our equities, direct investments. So talk a little bit about that as you think about the potential unwind of that force.

KATHY: Yeah, that's what probably troubles me the most about all this because as you say, I don't personally think that running a trade deficit is necessarily a bad thing. It's the old Ricardian comparative advantage, right? You grow bananas really well, and I grow wheat really well because we live in different parts of the world. Well, I'll buy bananas from you, and you buy wheat from me. If it doesn't quite come out 100% on each side, who cares, right?

We're each getting something at a good price that we want. And that's just the way it's been for a long time. We happen to be a really wealthy country that pulls in a lot of imports from around the world. Less wealthy countries ship us a lot of stuff. We get it at low prices. To the extent that there are barriers to fair trade, those typically get addressed in bilateral trade agreements, at least they have over the years. But I don't know that the existence of a trade deficit per se is necessarily something that needs to be addressed because that's just not how the world has worked for 40 or 50 years. 

And it's not necessarily the case you can draw a line to a loss of jobs. I mean, we came into this with the unemployment rate around 4%, which is pretty much full employment. So it's not like we had a huge, high unemployment rate that we were trying to address with this policy. So, you know, that all gets you back to, "Well, what problem are we solving, and what are the tools that we're using?" So by using trade, I think what we put at risk is, you know, sort of weaponizing trade, we put at risk the dollar and the support for the dollar and for our markets, which has been foreign investment.

People have wanted to invest in the U.S. because we've been growing faster than the rest of the world. We have innovation. We have had attractive markets for them to invest in. And if we cut back on the trade side, well, there's probably going to be less inflow of capital. And that, I think, is something that's not really taken into account very often.

LIZ ANN: Right. And it matters in the equity market, too, not just the Treasury market, because as recently as the mid-1990s, foreign investors owned only about 5% of the U.S. equity market based on total capitalization. That's 18% now. That's by far an all-time high. And the data on monthly net purchases or net sales, if it turns out to be the case, is very lagged in nature. So the most recent data is only monthly through January. I think we get an update to it in a week or two. But you did see already, and this was January, a big decline. I think from $135 billion in net purchases by foreigners down to less than $17 billion. 

And as we get further updates to the more recent months, my guess is this has not been an impetus to foreigners ramping up purchases of equities. The other component of this that doesn't get much discussion, too, is that households' exposure, overall exposure in terms of their total assets, the equity portion of that is at an all-time high at more than 48%. And the reason why that matters is the wealth effect. And it makes me think back to the period of 2000 to 2001, when of course in 2000 started the equity bear market and the bursting of the internet bubble. At that time, households had the largest share of their assets in equities. I think it was in the low 40s at that point, but at that point it was an all-time record. 

And that was a major cause to the recession that happened in 2001. There weren't a lot of significant economic dislocations in the 2001 recession. The wealth effect played a bigger role than many of those typical economic drivers. And I think it's something that we have to consider at this point as well. And I have seen some commentary, especially on social media, you know, 42% of the public doesn't own, you know, any equities. Therefore, they don't care at all about what the equity market is doing. But of course, the mirror image to 42 is 58, not to mention the ripple effects, given that weakness in the stock market often corresponds to weakness in earnings, a potential recession, which of course feeds into what companies do, especially with regard to the labor market, that feeds into broader employment statistics. So we can't just separate it as if it's this thing that it only impacts the direct holders of equities.

KATHY: Yeah, that's a great point. You know, I also think a lot of people don't realize they own stocks, but they have 401(k)s or something like that. And I'm pretty sure that whatever is invested in those index funds in their 401(k)s, a lot of it's in equities. But I wanted to pivot a little bit just because we could go down a path that sounds really negative. And I don't think either one of us feel all that negative about the future. At least I don't. And I will sort of say that I think there are things people can do now if they are interested in doing something. Maybe the best thing to do is nothing if you have a good financial plan. 

But in talking with my colleagues Cooper Howard and Collin Martin, we were looking through the fixed income world and saying, "Well, what, you know, if you're starting fresh today, if you had nothing invested, what would you do today?" And we looked it over, and we said, "Well, you know, the corporate bond market, you want to stay in higher credit quality, because even, you know, even a mediocre company right now is going to face some trouble, let alone the junk companies, the high-yield companies." But if you're in the really big, solid companies with lots of cash, they're going to figure this out. They're going to figure out a way to manage this and ride through it. And they're going to be able to pay their bondholders. You can always own Treasuries. The yields aren't that bad. They're north of 4% for most of the yield curve. You could stay shorter term. We've been advocating being lower in duration. 

But it's not a bad idea to sit and clip a 4% plus coupon in this environment and just kind of wait things out for a while. So that's our "up in credit quality" kind of argument, but then we looked at the municipal bond market. And really kind of an interesting place to perhaps hide out for a little while, because we like munis for people in higher tax brackets. But know, credit quality is very high in the municipal bond market.

The yields have moved up. Seasonally, you tend to get kind of a sell-off in the Muni market in March, and it starts to come back. That's related to tax payments. It is sort of an individual investor market more than an institutional market. So it has these kind of quirks of seasonality that other markets don't have so much. So considering how high the credit quality is and how attractive the yields are if you're in a higher tax bracket, you know, might be time when you're looking at fixed income to say, you know, it's not a bad idea to be in some municipal bonds as a place to kind of get that attractive yield, and barring a default, relative stability, and not really have to be up at night checking the market to see what's going on. 

You know, just get your coupon, get it tax exempt if you can, and move on. So, you know, we're in the mind that "this too shall pass," but you want to look at places where you can sit it out, where you're comfortable, and how you can manage it. So that's what we've come up with. What are you and Kevin Gordon talking about these days?

LIZ ANN: Yeah, so same thing, as you know, staying up in quality. So for the past kind of better part of two years, we have really been emphasizing the value of what we call factor-based investing, which is becoming more and more popular. "Factor" is just another word for characteristic. So instead of making monolithic overweight/underweight at the sector-level calls that are really difficult, especially either when you've got really rampant sector volatility on a week-to-week or month-to-month basis, which we have, or more recently when you see correlations kind of shoot straight up, it makes it very difficult to try to navigate that with sort of monolithic sector calls. So we've had this emphasis on factors with a clearly a quality wrapper around the factors that we have said you want to focus on when looking for opportunities, either upside opportunities or just protective type of opportunities.

And interestingly, one of the factors that we kind of added to the factor-focus list as we came into this year, expecting there would be a pickup in volatility in light of policy related uncertainty. I'm not sure we anticipated this much policy uncertainty with this much of a pickup in volatility, but we added low volatility as a factor within this quality wrapper.

And that has been the best performing factor, not just year-to-date, but in the past week too, given all of this turmoil and in general quality and especially value. There's an index, not that this is an index recommendation—that's not what we do—but the S&P, even though the Russell Growth and Value indexes, which are both large and small, are more popular as benchmarks, S&P has versions of both large and small and growth and value, and they have an index that's the S&P Pure Value Index, which means that its stocks in that index don't also coexist in a growth index. They purely screen them on value, and in the past week, that has been the best performing of the various S&P indexes. 

Again that's not a recommendation to go out and, you know, buy an index fund tied to that, it's just to point out that those sort of anchors to windward in tough times of not paying, you know, absurd valuations, looking for quality, looking for low volatility is a way to protect yourself a bit and find relative outperformance in a very tough market backdrop. So that similar higher quality theme to how to navigate within the confines of our asset classes.

KATHY: Yeah, I like your nautical metaphor there because you do get hit with these waves from time to time. And I look back and I think of some of the times when it seemed like, "Oh my gosh, we'll never get through this." And sure enough, within a matter of months, usually, we got through it and moved on. So the good thing is people are pretty adaptable in these markets and figure things out. I'm pretty sure that that's going to be the story when we look back on this time period. I certainly hope so.

LIZ ANN: So I think it's look ahead time now. Not that our binoculars or telescopes are anything but murky at this point, but just thinking about the next on a week or so. What is top of mind for you?

KATHY: Yeah, so we got the minutes of the last Fed meeting. Now it's pretty backward looking at this stage of the game, but I'm still interested to see what their mind frame was and what their considerations were at the last meeting. So we'll get some detail on that. And then of course we have some inflation readings coming up which are always important, CPI and then PPI, and that'll translate into what we're expecting on the …

LIZ ANN: Consumer Price Index and Producer Price Index. 

KATHY: Right, thank you. 

LIZ ANN: You're welcome. I'm front running our compliance people.

KATHY: Thank you for doing that because I would have had to do it later. And then that feeds into the Price Index for Personal Consumption Expenditures, otherwise known as the PCE, that comes out a bit later. And that's the one that is the benchmark for the Federal Reserve.

Those, to me, are going to be the big ones. And then I'm just going to be watching sort of the shifting around of the flow of money and seeing where people are landing and what's sticking and what isn't sticking. What about you, Liz Ann?

LIZ ANN: So even some of the data that's coming out, economic data that's coming out in the next week, is going to be backward looking and not fully reflective, if at all, of the turmoil of the past several days. But there might be something interesting that can be picked up in the import and export price data that comes out next week. We also get retail sales, and it's March data. So again, it's not going to pick up this very recent trade-related uncertainty, but as a reminder, one of the reasons why a lot of expectations for first quarter GDP growth went into negative territory, including NowCast-type models like out of the Atlanta Fed, is because of estimates that consumption may have moved into negative territory in the first quarter. And consumption is 68% of GDP. So that matters. 

So that means that something like retail sales as a proxy for consumption is important because it gives us a sense of how the final month of the quarter looked in a metric that is seen to have weakened throughout the course of the quarter. So in addition to the inflation readings, which are highly important right now, those are a couple of things on my radar.

That's it for us this week. Thanks for letting us riff back and forth here on a lot that is still very uncertain, but we always appreciate you tuning in and for listening. You can always keep up with us in real time on social media. I'm @LizAnnSonders on X and LinkedIn. Make sure you're only following me on one of those, and make sure it's the actual me because I continue to have a lot of imposters.

KATHY: And I'm @KathyJones—that's Kathy with a K—on X and LinkedIn. And you can always read all of our written reports, including charts and graphs, at schwab.com/learn.

LIZ ANN And if you've enjoyed the show, this one, or on an ongoing basis, we would be so grateful if you would leave us a review on Apple Podcasts, a rating on Spotify, or feedback wherever you listen. And you can also find all of our episodes on YouTube. Just search for "On Investing podcast." And we'll be back with a new episode next week.

KATHY: For important disclosures, see the show notes or visit schwab.com/OnInvesting, where you can also find the transcript.