The Charles Schwab Corporation (SCHW) Earnings Call Transcript & Summary

I am Keith McCullough, and welcome back to the Investing Summit. I hope you enjoyed that conversation I had with Dan. We focused mainly at the end there on Japan and gold and all the different asset allocation decisions that you can make. On this conversation, which I tend to have some of my best, one of my faves for the Investing Summit, Liz Ann Sonders. I'll focus more so on U.S. dollars, U.S. equities. But if you want to go there, Liz Ann, we can go wherever you want.

Sounds good. Always love being here, Keith.

Well, thanks. And I said to Dan, I said, "Look, Liz Ann might be upset with me because she usually leads off," and there's nothing to read into that. So I said...

Okay. I'm not insulted. I couldn't have been the lead-off anyway, so I had more important things on my schedule, but thank you.

Well, I appreciate that. I told Dan what I told Dan. But let's just get into this -- I want to get into the rate cut or not rate cut. We go back and forth, flipping around. We can show it in different pictures and slides, but never in our careers has that flipped around so much, mainly because we've not gone from A to B and towards whatever C is going to be, I don't think at all, with inflation staying higher for longer. So like just want to get your thoughts on that and how the equity market, in particular, is trying to read it.

Well, arguably, there's been a tendency by the market in terms of positioning to get a little bit over its skis with regard to future assumptions around Fed policy. I mean, that was to an extreme at the beginning of the year when the assumption was that the Fed would start cutting in March and cut up to 7x. And we were certainly on record saying, that made no sense based on the backdrop of either side of the Fed's dual mandate. And once you got the sort of turn-up, the short-term turn back up in the inflation data, of course, Powell had to come out, as did other speakers, and pushed back on that narrative, and they've had to do that a little bit recently. And I think the extrapolation of the decision to go 50 at the outset, into 50 basis point increments didn't make a lot of sense. And then, of course, we got the exclamation point on that perspective with the stronger-than-expected jobs report. So we've taken 50 off the table. I looked, just before we came on, I think it was about 80% -- 88% probability of 25 basis points, which leaves 12% probability the Fed does nothing, but we've got a lot of data between now and then. We've got several inflation reports, this week's CPI, PPI. We've got another jobs report and, to your point, Keith, I think the probabilities are likely to still jump around. The thing about data dependency on the part of the Fed is the data will lead to changing expectations for near-term Fed policy.

Well, what people -- what the Street, I'll affectionately call the old Wall, really wants is they want it to be the beginning of a long interest rate cutting cycle. And that's -- you can see that in the lens of what you just walked through. Maybe not everybody saw it that way, but it certainly happened, and you being as empirically driven as you are and as fact-based as you are, I can fact-check you. So we got on Slide 46, just to show picture on what Liz Ann said, like at the beginning of the year, she didn't -- I didn't either buy into all these rate cuts. I think at one point, there were like 8 or 10 of them priced in. So on the left side, we're showing this what we call the pendulum of expectations on rate cuts. Then they took them all out and then they put -- then we actually saw inflation go up, obviously, from January to April, only 40 basis points, Liz Ann, but that took out all the cuts. And then let's go right back to where we've always wanted to be, cowbell. And now we're having a problem with how much cowbell. So we're going to have like a fourth picture there, I guess, whether or not -- I mean, I have my answer on this, but do you think they overshot on how many rate cuts after the 50 basis point? At one point, they were pricing in 50 for the November meeting.

Well, it certainly looks like that now based on the data that we have in hand. But again, that could change. I think the real point, and Keith, you mentioned it in terms of what the market has been hoping for, that we would be at the start of a lengthy cutting cycle. But we've been cautioning investors with a sort of couched and be careful what you wish for if you're hoping for a Fed that continue to be aggressive in rate cuts sort of eyeing the elevator down, not the escalator down. Because if there's one way to differentiate past Fed cycles, the cutting part of the cycles is fast versus slow cycles or aggressive versus less aggressive cycles. And that's where you run into a more consistent distinction is if you look at things like average maximum drawdown within, say, 6 to 12 months after the initial cut, the fast cutting cycles, the maximum drawdown has been more than twice as much as in the slow cutting cycles. So all else equal, you actually want a Fed that is not approaching this like, "Okay, open the elevator, we're going to jam rates down." Because at least based on history, an aggressive cutting cycle is usually because they're trying to combat a recession or a financial crisis or some combination thereof. So the shift to a more methodical Fed, I don't think, is a bad thing for the equity market, all else equal, which that's an important emphasis.

Yes, you're exercising your own inner Danny Kahneman there, like cutting faster and cutting slow. I mean, it's like -- yes, that's the point. Like if you're panic-cutting, that means the economy is something you should be panicking about. And if you're cutting slow -- well, in this case, you could cut slowly and then, like obviously, risk happens slowly and all at once. But in this case, you could cut quickly than slowly than not at all. I mean, if we're right on inflation and clearly, we have a differentiated view on that versus the Atlanta Fed or whoever is trying to now cast whatever at this point, but the Fed guys, show Slide 26, they're trying to say that the inflation is going to go into the target 2%. And we're seeing this CPI number on Thursday is going to be the low print for the monthlies. And then the quarterlies are going to start going up again in the fourth quarter and then again into the first. You can tell me if you agree or not on that. But if I'm right on that, what do you think Fed policy will be?

So -- I'm not sure if you're right. I don't know. So I'd love to be able to forecast inflation. This would make my job a lot easier. But I think, to me, the important sort of force underway within the inflation data, whether it's in CPI data, less or so in PPI data but PCE data, is the wide spread between what we used to think of as sort of goods versus services inflation back in the earlier part of the pandemic. Now I think the more relevant breakdown within a metric like CPI is discretionary versus nondiscretionary components, which somewhat fit within that goods versus services categorization. But if you break CPI into the discretionary versus nondiscretionary components, thought in more simple terms as the wants versus needs components, you've wiped out all the inflation in the discretionary components. You're running at about a 0 level. Now that's before this week's update to CPI, obviously, where you're down on the nondiscretionary components but you're still up in the 4%, 5% range, whether it's insurance or health care-related costs. And I think by nature of what they are, they tend to be a bit stickier. And the lever that the Fed pulls with monetary policy, either with the Fed funds rate or the balance sheet, is not going to go a long way, if at all, to bring in something like auto insurance costs. So I think that's an important way to look at the inflation data in terms of where the sticky components are versus the components that are driven more by what's going on in the trajectory of the economy. So that's one of the things that I'll be looking for when we get the data this week is what that breakdown is between wants and needs.

Yes. There's -- I mean, there's a lot there. I mean, there's also shelter. I mean shelter, which is 1/3 of the CPI, didn't go down as much as the doves would have told you it would with interest rates going up, not even close. That's at 5%, right? So 1/3 is at 5%. And if base effects matter in -- starting like in T- really 3 to 6 months, shelter is going to be additive as it has been on a cumulative basis going back since inflation took off 3 years ago. What do you think about that? Like it seems that people tend to focus on what was already reported yesterday. But that, to me, I'm from the future, Liz Ann.

Yes. So certainly within a CPI metric, where you've got that owner's equivalent rent portion that is a much, much larger share of CPI than, say, the shelter components are as part of PCE, and of course, PCE is the Fed's preferred measure. But you're right. We have not seen what was the expected turndown in those shelter components in CPI. They did not or at least not yet have followed those real economy rent measures from the likes of Zillow or RealPage or Apartment List. They have been stickier on the high side. I don't love how much an OER weight exists in CPI. It's an imputed rent. It requires respondents to the survey to guess what their home would rent for. So it's a little wonky and I'm not sure really based in that much reality. But it is what it is and it's apples-to-apples at least over time, and it has been stickier on the high side. To your other point, I'm going to talk about this slightly more broadly with regard to moves up and down in interest rates and maybe the muted impact it's having on areas of the economy that it's had a more direct and shorter-term impact in the past, has to do with some of the behavior that was put forth by at least 2 major constituents within the economy, corporate America and households during the ZIRP environment that preceded the most aggressive tightening cycle in 40 years. And you saw it with large corporations in terming out debt. You saw it in the mortgage market when mortgage rates were at a high with an 8 handle on it. The average effective mortgage rate didn't even have a 4 handle on it. So that's not to say the impact of monetary policy is gone in this cycle. It's just been muted by some of the maybe intelligent decisions that were made by some constituents, leaving the government aside because they didn't do as much as they probably should have done in that ZIRP environment. But I think that, that has sort of elongated these long and variable lags, which, by the way, certainly was the case during and in the aftermath of the tightening cycle. I also wonder whether we should make assumptions about a quick impact on the economy from an easing cycle because some of those forces are still in play, just in the opposite direction.

Yes, there's always so many things in play, and I love how you do macro, obviously, in strategy because you incorporate everything. You don't anchor on one thing, like I think anchoring on core PC is ridiculous. I mean, at one point, the doves are [indiscernible]. If you look at the 3-month rolling PC, well, once the 3-month rolling PC rolls up your ears like starting like in T-2 months, you're not going to use that anymore. So that's called data mining. Obviously, you know...

Well, it's not just data mining. But you and I live in the minutia.

Every day.

As analysts and strategists, we're focused on month-over-month versus year-over-year and core versus headline and core services ex housing and the differential between CPI and PPI and PCE. Here is the bottom line as it relates to sort of infiltrating into the economy and the psyche of investors, consumers is that's not the world they're living in. They're living in the world of stuff is a lot more expensive than it was pre-pandemic period. That's how they think of it. They think in level terms as opposed to the minutia of the month-over-month changes. And that's why inflation, the NFIB report that came out today, no surprise. Inflation is still the #1 cause of concern. And that's in part because customers, individuals, households, still see it as a big negative because they're not focused on rate of change like we are.

And they're not focused on monetary policy like they are. I mean, Wall Street is focused on their own language, their own data mining, their own way to get to the cowbell. That's the point. And if you can't get any more cowbell, the bond market just had a hell of a move in volatility terms in the last couple of days when it came to realize that a 15%, 17%, 18% rise in crude oil prices to join every other commodity that's breaking out post the Fed cut is the real world. I can't find, in rate of change terms, from the minute that the Fed cut rates, actually, it was -- the markets were -- commodity markets were front running before that, obviously. But let's just say a month, in the last month, double-digit increases in everything from milk prices, to basically the entire food complex, to now oil prices. I mean, that for some of you does -- my job is to now cast inflation. Those go directly to the vein and into the model, Liz Ann. And those things I can't, for the life of me against easing base effects, predict a down inflation environment.

Well, especially at the headline level, to your point about commodity prices, but in particular, oil prices, which obviously have been driven by what's going on in the world of geopolitics and wars. And that's not a force that any of us can either anticipate, forecast in terms of longevity and magnitude. And it's certainly not anything that the levers at the Federal Reserve can pull or other global central banks really can have much control over. And even though we can focus on the fact that those are feeders into headline inflation, not core inflation, there are still ripple effects not just within the inflation data, but again into sort of the psyche of households and consumers and businesses, which then brings in the animal spirits part of any economic conversation, which is such an important driver.

Yes. And of the bond market. I mean, like I don't -- I get that people want to talk about core but the bond market trades on headline year-over-year trending CPI. That's it. That's why I use it. I don't use it because I don't want to be intellectual. I'm not intellectual. Actually don't want to be one. But a couple of points just to show you on what Liz Ann said on the nonsense of it all, like Wall Street speak or the CPI for that matter. On Slide 95, we show what she called OER, right? Owner's equivalent rent. But again, I agree, it's like not a practical thing to describe it that way but it is base effects. That's what that chart is. It's base effects, right? So I'm just trying to remind people of that. And then this other big thing, Liz Ann, I wonder if you have thoughts on, on Slide 91, which what interest rates really did impact was multifamily, okay? So construction, right? Like if you're -- a lot of mom-and-pops or again, small businesses, construction, how many crews they have. You saw a tremendous drop-off in the supply of the one thing you need to solve for an immigration number that has been fake news.

Yes. No, I absolutely agree. That's clearly where you saw the biggest surge in supply. And I think there's lots of forces that cause that supply to come down. And the problem is the other supply problem has been outside of multifamily and single-family in the existing home market because of that differential between stated mortgage rates and actual mortgage rates. And basically that locked a lot of existing homeowners into their homes, even if they wanted to move, to go from a 3% mortgage to an 8% mortgage was just untenable. So we are now dealing with further supply problem. You're seeing a little bit of maybe loosening it up, and you're seeing increase in mortgage refinancings. But a Fed that puts the brakes at least temporarily on aggressive rate cuts, then that changes that narrative a little bit. The other thing I wanted to mention as it relates to the move up in yields is, for quite some time in this recent cycle, the post-COVID cycle, you shifted to a pre-great moderation correlation that went in negative territory between bond yields and stock prices. But that was during the era within this cycle where inflation was top of mind, and yields were driven both up and down based on trends and inflation. The more recent period where we've now seen a move to a positive correlation between yields and stock prices has been this backdrop of yields moving more based on the growth outlook and less based on the inflation outlook. I think that's an important point we sit right now because let's assume you're right and inflation based for base effects and other reasons start to tick back higher again. If you reconnect bond yields to inflation and that becomes the short-term driver, it wouldn't surprise me to see that correlation move, maybe not firmly back into negative territory, but maybe away from that positive territory. So I think it's -- is it the growth side of the equation that yields are keying off of or the inflation side of the equation? I think that has important implications for how equities behave in that kind of backdrop.

Well, if you take -- very well put. I mean, I've always thought of Fed policy is a 3-legged stool. Where is inflation, where is employment, where is the S&P 500? On that last one, that's not a joke. I mean, again, he cut by 50 basis points after the NASDAQ went down double digits in what we call quad 4. Economic data was terrible throughout the entirety of Q3 with the NFIB numbers coming out for September today, just putting an exclamation point on that. But it did what it did. And now you got to deal with both as opposed to forever in a day. It wasn't a healthy labor market and rate of change terms, to be clear, which we can show if people still don't know that. Labor peaked, as you know, across all metrics at the peak of the cycle in 2021. So you can look at anything from temp staffing, to hours worked, to any component of jobs and they've been deteriorating. It just so happens that the Fed didn't talk about that leg of the stool.

So you and I agree on a lot, but I don't want to take the other side of the NASDAQ 100 being down was a prompt for the Fed to go 50. I think the Fed put is still very much alive but as it relates to economic data. And I think what they were really keying off of, number one, somewhat simplistically, is just because inflation had come down, real interest rates were seen as too high. I think the price should have been more focused on broader financial conditions that continue to be pretty loose and maybe didn't justify 50. But I think it was some of those concerns creeping in, in what they view to be the leading indicators associated with further weakness in the labor market, the hires rate having come down even though we weren't seeing it in claims. So I think the labor market is not the sole driver of what the Fed has done and will continue to do. But I don't put a lot of emphasis on short-term moves in the market, leaving their dual mandate aside as a driver for Fed decision-making. I think it's really these days about the labor market and their views thereof.

I obviously think what I think on that. I mean, if the S&P 500 didn't go down 20% during quad 4 in Q4 '18 when Powell was a rookie on the job, would he have gone dovish?

Oh, I think at that time, there was absolutely a Fed put associated with the market. I just don't think that it's as robust a factor at this point. In fact, even in 2018, one of the more interesting things that Powell said at that somewhat famous/infamous New York Economic Club lunch, and I was there in person, I thought his sort of body language and emphasis was interesting. He said that the Fed is not going to operate monetary policy based on volatility in the financial markets. It operates based on stability in the financial system, only if volatility in the equity market threatens stability in the financial system. But separate from that, just simple volatility or weakness in the equity market that doesn't have feeders into the health of the financial system, I think that's the important differentiator. And I think there was concern at the end of 2018 that there was that connection. I think just weakness in the equity market right now, absent commensurate deterioration in the mandates, I don't think will be a trigger for further rate cuts.

I hear you, but we're old enough to remember, August 5 when the VIX went from 6 to 65. I don't think that, that looked like a stable situation to my buddy PE Powell.

No, but that was also the unwind of the yen carry trade and concerns about the infiltration into the global financial system. That wasn't just a market event. That was something maybe not potentially very systemic, but that intraday record spike in the VIX, which by the way, the same day, you had a record intraday decline in the VIX, so talk about a whipsaw on an intraday basis. But I think if you're sort of aligning Fed policy to that moment or what was a driver there, it was more than just a market-related spike in volatility. There was that yen carry trade unwind and how much more field could this go, and what kind of global financial system damage could be underlying this start to the yen carry trade unwind.

Yes. 100% agree on that factor. Dan Rasmussen and I actually discussed that in the prior conversation. But you can't -- again, you can't just -- it's not a vacuum, right? I mean, it wasn't just yen carry trade. It's the BOJ was getting tighter. The Fed was getting easier. This hasn't happened in our career and this is new. So it creates what we obviously call conditional factoring that was making the situation riskier. So I think it's going to be really interesting with 0 days to exploration, options trading becoming the bubble that it's become. What also happened that morning was that all the dealers just said, I'm out of here. This bid-ask spread is too wide. So you have a central part of the market structure, the dealers just walked away. And this is all, I think, on the Fed's clock. I mean, you can't print $22 trillion and say that you don't have -- this is due to supply shortages and yen carry trades. I mean, it's all -- to me, this is still all market structure being on Powell's watch. And I don't know how he's going to get away from it. But I think creating this volatility. Again, the Move Index yesterday had its biggest move since 2020, right? That's treasury bond volatility. So that -- you guys can show the chart. I mean, since 2020, Liz Ann, like that's showing you how all over the place, people actually are, about my point at the beginning, which is people just want their cowbell in a rate cut cycle that goes to rainbows and puppy dog land. But if they don't get it...