Economy shows shifting pockets of strength and weakness, says Charles Schwab strategist

Key Concepts

• K-Shaped Recovery/Dichotomy: Uneven economic recovery where different sectors and demographics experience vastly different outcomes.
• Rolling Recessions/Expansions: Instead of a broad, simultaneous recession, different sectors experience recessionary or expansionary periods at different times.
• Dot Plot: A visual representation of Federal Open Market Committee (FOMC) members’ individual projections for future interest rate levels.
• Manufacturing PMI (Purchasing Managers' Index): An indicator of economic health in the manufacturing sector; a reading below 50 indicates contraction.
• Bond Yield/Stock Price Correlation: The relationship between bond yields and stock prices, which has shifted over time based on whether yields reflect inflation or growth expectations.
• GARP (Growth at a Reasonable Price): An investment strategy focusing on companies with solid growth prospects but not excessively high valuations.
• Earnings Revisions/Surprises: Changes in analysts’ earnings estimates (revisions) and the difference between actual earnings and expected earnings (surprises).

Market Instability and the Shifting Economic Landscape

The discussion centers around the increasing instability in financial markets, triggered by President Trump’s comments and highlighted by a recent article from Charles Schwab and Lizzie Saunders. They argue that investors are entering an era characterized by volatility, rotating leadership, and uneven growth – a “new normal.” Saunders describes this environment as a “K-shaped” recovery, or more accurately, a “bifurcation” in the equity market, marked by rapid sector rotation and instability. This isn’t a linear path with predictable data points, but rather a complex interplay of geopolitics, monetary policy, fiscal policy, and tariff-related issues. The environment is characterized by rapid shifts, where conditions can “turn on a dime.”

The Federal Reserve’s Position and Internal Debate

Regarding the upcoming Federal Reserve (Fed) meeting, Saunders doesn’t anticipate any immediate action. She suggests the Fed is in a “timeout” following its previous interventions. However, internal disagreement within the Fed is expected, reflected in the “wider range of expectation” visible in the updated “Dot Plot” released with each FOMC meeting (excluding the January meeting). This Dot Plot displays individual members’ projections for future Fed Funds rates. The dispersion of these projections underscores the prevailing uncertainty and instability.

Rolling Recessions and Sectoral Divergence

Saunders elaborates on the concept of “rolling recessions,” a phenomenon she previously identified. Unlike traditional recessions, where the entire economy contracts simultaneously, different sectors experience downturns at different times. Manufacturing, for example, entered a recession “a number of years ago” and continues to struggle, as indicated by a Purchasing Managers' Index (PMI) below 50 (the dividing line between expansion and contraction). However, this weakness has been offset by the continued strength of the services sector, which constitutes a larger portion of the economy. Housing is also attempting to recover from its own recession. This pattern of “pockets of weakness and strength” rolling through the economy is becoming the norm, rather than a synchronized downturn. In 2023, the economy shed nearly 70,000 manufacturing jobs.

The Evolving Bond Yield/Stock Price Relationship

The conversation shifts to the changing relationship between bond yields and stock prices. Traditionally, these assets moved in opposite directions – falling bond yields typically corresponded with rising stock markets. However, this relationship has been “upended” in recent years. Saunders explains that from the mid-1960s to the mid-1990s, bond yields primarily reflected inflation expectations. Higher yields signaled higher inflation, which was unfavorable for equities. Conversely, from the mid-1990s to the start of the pandemic, bond yields became more closely tied to economic growth. Higher growth, without significant inflation concerns, created a “nirvana” scenario for equities. Currently, the market is oscillating between these two regimes. If bond yields rise due to growth expectations, a positive correlation with stock prices may re-emerge. However, if inflation drives bond yields higher, the outlook for equities becomes more challenging.

Investment Strategy in an Uncertain Environment

Saunders advocates for a “factor-focused” investment approach, emphasizing investment based on specific characteristics rather than broad sector or style allocations. In this environment, she recommends focusing on companies exhibiting “positive earnings revisions” (upward adjustments to earnings estimates) and “positive earnings surprises” (actual earnings exceeding expectations). Crucially, a strong “balance sheet” is also paramount. As stated by Saunders, “you want to look for positive earnings revision positive earnings surprises and you want to focus on the balance sheet.” This strategy aligns with a “Growth at a Reasonable Price” (GARP) approach, seeking companies with growth potential but avoiding excessive valuations.

Conclusion

The discussion paints a picture of a complex and unstable economic landscape. The era of predictable, linear growth is over, replaced by “rolling recessions,” shifting sector leadership, and an evolving relationship between bond yields and stock prices. Navigating this environment requires a nuanced investment strategy focused on fundamental factors like earnings momentum and balance sheet strength, prioritizing “growth at a reasonable price” and acknowledging the inherent uncertainty. The key takeaway is that adaptability and a focus on underlying company fundamentals are crucial for success in this “new normal” of market instability.