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Sonders: A Fundamental Shift but Not End of Bull Market

Higher inflation and tighter monetary policy could lead to more volatility, but without the near-term prospect of a recession a bear market is unlikely, says Schwab's Liz Ann Sonders.

Jeremy Glaser: For Morningstar, I'm Jeremy Glaser. I'm joined today by Liz Ann Sonders, she's the chief investment strategist at Charles Schwab. We're going to talk a little bit about what's been happening over the last couple of days. 

Liz Ann, we really appreciate you taking the time today.

Liz Ann Sonders: Thanks for having me.

Glaser: Let's start by just putting what happened on Monday and also last week into context. There's been some scary headlines out there, but historically, is this really all that bad?

Sonders: I actually think many of the headlines were a bit irresponsible and certainly hyperbolic with "largest decline for the Dow in history." Yes, that is actually true from a point perspective, but it barely makes it in the top 100 on a percentage basis in the S&P 500, which is arguably a better index. It was the 138th worst single day decline. I think a little context is important. Not to suggest that this isn't painful, but I think the headlines were a bit hyperbolic.

Glaser: Let's look at potentially what was driving some of these moves. The conventional wisdom is that it was about potentially interest rates going higher. Does that ring true to you, or do you think this was more of a valuation-driven event?

Sonders: I don't think it was so much valuation-driven. I think fundamentals did drive the early part of this. The more economic fundamentals would be the spike we saw in wage growth to 2.9% for average hourly earnings on a year-over-year basis. That caused a spike up in the 10-year Treasury yield, broke through 2.8% on the upside, inflation expectations kicking in. I think was the more economically driven kicker. 

But then I think the other kicker was less technical, but more sentiment-based. Because of how low the volatility was last year, 3% maximum draw down, second-lowest year of volatility on that metric in history, and if you look back on years past when you've had really, really low drama years, they tend to be followed by high drama years, even if you ultimately still have decent returns. With that low drama year last year and strong returns, enthusiasm kind of just went off the charts. Most attitudinal measures of sentiment got to all-time high record levels of optimism. I just don't think you had a lot of room for error.

But then as the sell-off worsened, and in particular what happened yesterday was less about the magnitude of the decline in percentage or point terms, and more about the spike in volatility. That spike in the VIX triggered a lot of forced selling of some of these positions tied to low volatility. It was a market-structure thing more than anything else.

Glaser: When you look at the fundamentals of the economy, do you see anything that shows that there is potentially some trouble on the horizon? Or will this be more of an isolated kind of structural market event?

Sonders: We did see a change in the characteristic this year with that pickup in wage growth, the rising inflation expectations, the expectations for tighter monetary policy, the likelihood of an uptick from what has been record low levels of financial stress. The financial conditions, even though the Fed has been raising interest rates for two plus years, financial conditions have never been as easy as they have been until recently. The stock market is a feeder into that, so I would expect to see financial conditions worsen a little bit here.

It's been our view that the flavor of the background fundamental environment was changing this year. We're later in the cycle, that means higher inflation, tighter monetary policy. That adds to volatility, puts some downward pressure on valuation. I do think there has been a fundamental shift. 

What I don't think this represents is the beginning of the end for the bull market, i.e., I think the next true bear market will be one that is more traditional in nature and comes when the market starts to sniff out the next recession. I don't think that's in the near term cards. But, we may have more technical damage to come.

Glaser: Looking at that potential for tighter monetary policy, as Powell takes over the reins of the Fed, what do you think is going to happen with rates in 2018?

Sonders: We've had the view that three rate hikes is the base case for this year. I don't know that I would suggest we're changing our view as a function of this. Now, in the immediate aftermath of last Friday's jobs report when we saw that higher wage number, you did see a quick spike in expectations for maybe four rate hikes this year, and I think that that was a little bit of a spook factor for the market. Since that time actually, though, we've seen a ratcheting down of those expectations. In fact, the Fed fund futures market now doesn't even really have three as the base case. A lot can happen. Even between now and the March meeting, let alone the rest of this year. I think trying to game exactly how many rate hikes would happen is a bit of a silly exercise at this point, because it is data-dependent, but also to some degree, probably a function of market volatility to a lesser degree anyway. I think that a faster pace of rate increases is in the cards. 

It's not just rate increases. The Fed is trading its balance sheet right now too, so we have another form of tightening in the form of quantitative tightening. I think the liquidity coming out that is represented by that, I think that's a fact that is not getting maybe the attention that it deserves.

Glaser: Liz Ann, we really appreciate you taking the time and sharing your insights on the market today.

Sonders: Thanks for having me.

Glaser: For Morningstar, I'm Jeremy Glaser. Thanks for watching.