Strategist on debt ceiling, retail earnings, banking crisis

Charles Schwab Chief Investment Strategist Liz Ann Sonders joins Yahoo Finance Live to discuss the Fed's pending rate decision, Treasury Secretary Janet Yellen's comments, the state of the consumer after retail earnings, and the regional banking crisis fallout.

Video transcript

JULIE HYMAN: Investors are expecting the Fed to take a breather at the much anticipated June meeting, pausing further hikes for now. Now, despite these expectations, they could move another quarter point higher, have ticked up in the last couple of weeks. Notes from the Fed's May meeting out yesterday reveal officials were split on further rate hikes. Several participants noting that if the economy followed the projected outlook, further policy firming, quote, "may not be necessary."

Joining us now is Liz Ann Sonders, Charles Schwab Chief Investment Strategist. Good to see you Liz Ann. And you wrote a recent note where you sort of looked at the history of what happens to the markets once the Fed is done with a rate increase cycle. But you sort of couched it in a healthy dose of this time won't necessarily follow the other playbook. So how should we think about if the Fed is done, what then happens?

LIZ ANN SONDERS: You know, it's funny that you said playbook. There actually really isn't a playbook. And I wrote about it both in a report. But I also am a contributor or column contributor to Financial Times and it went in there. And you don't have a long history of rate hike cycles. And too often I see comments like, well, the typical move after the Fed pauses or the average move.

And it always brings in my mind that phrase of analysis of an average leads to average analysis. And if you do look at the average, you see-- you think you see a pattern. But the reality is you've got a 30% swing. I think that's what we're showing here. 30% swing. From minus 30% to plus 30% in terms of what the market has done six months after the pause.

So there are so many extreme examples. It comes to, well, what are the background conditions. And the background conditions right now I think suggests that you're probably not going to follow the average, not to mention the fact that I think there's a little added uncertainty regard to something else going on in Washington.

So I think you have to be really careful about looking at an average or even a median when you have historical ranges as wide as this. Not to mention the fact that we're seeing probabilities move closer to 50/50 for the June meeting, from a much higher likelihood of a pause just a few days ago.

- Liz Ann, let's switch gears a little bit and let's talk about this debt ceiling debate that's been going on-- negotiations, if you will, that's been going on. We've been here before. And now, you have kind of this cloud on the horizon with Fitch threatening downgrade to the US credit rating.

When we saw this before, we certainly saw a dramatic impact on markets. It doesn't seem to be-- the threat of that now doesn't seem to be as dramatic of an impact. Why?

LIZ ANN SONDERS: That's a good question. I'm not sure why. And I certainly hope it's not the case that we have to go through what we went through in 2011 where it took a riot on the part of the market to light a fire under the feet of Congress. We also have to remember that when S&P did its downgrade in 2011, it was after a deal was struck, not before.

And I think the Fitch warning should be taken seriously. And even if a deal is struck, doesn't necessarily mean that they won't downgrade like S&P did. The other interesting thing that happened was back in 2011, there was an initial concern when you saw the downgrade about institutions, pensions, foundations, endowments, many of which had in their bylaws that they couldn't own any government debt less than triple-a rated-- that there would be mass selling.

It turned out what most of those institutions did was just amend the language. And what I'm not sure is whether that language was amended back-- probably not. So it may lessen the concern of Fitch does a downgrade that there's going to represent forced selling. But it's not a good thing if we've now had in the last 12 years a downgrade of US debt by two different agencies.

JULIE HYMAN: No, it's not. Although, to your point, last time we saw people actually buying US debt, which was sort of counterintuitive at the time following that downgrade. So we've got the backdrop of that. We've got the backdrop of the Fed doing whatever it's doing. And something else that you pointed out in recent chart is what we are seeing in consumer discretionary and staple shares sort of versus one another versus the S&P 500.

And we've seen this play out during this earnings season. By and large, with some exceptions, the theme being that people are using more discretion in their spending and not maybe buying as much discretionary. So how are you thinking about that also consumer spending backdrop and how it relates to stocks?

LIZ ANN SONDERS: I think it is really important at this point in the cycle to take a more nuanced approach to looking at how the consumer is doing, whether it's looking at the relationship between discretionary and staples. Even within singular categories, look at what the behavior of consumers are. And we're hearing it from not just big box retailers, but up to luxury retailers, that there is a shift in consumption patterns, in behavior-- either moving down the price and value spectrum.

You're certainly seeing it with lower wage consumers just trying to be smarter about their spending. In addition, when you look at other metrics that judge consumer spending, like retail sales, for all the cheering of the strength of retail sales, we have to remember that it's reported in nominal terms. If you look at real retail sales are actually lower than they were two years ago. So also important given that, although inflation is down, it's not low. Any data that is reported in nominal terms, we have to continue to also look at it in real terms, because, pun intended, that's the real story.

- And I want to ask you about another sector. It hasn't quite been top of mind, or at least at the top of the news headlines lately, the banking sector. What is your analysis of where-- is there still cause for concern, say, with regional banks or the greater banking sector?

LIZ ANN SONDERS: So it looks like we've calmed some of the contagion issues that came about in not just the immediate aftermath of SVB, but the concentration of 3 out of the 4 largest bank failures. And that's a function of the implicit backstops, the actual funding facility set up by the Fed. And we get that data on a weekly basis on Thursdays looking at how much utilization there is of those funding facilities.

So a lot of that initial turmoil seems to have calmed. But we have to remember that there's the commercial real estate problem, particularly in offices. And when you look at the smaller regional banks, kind of sub $10 billion, that's where the concentration of exposure is. In those smaller regional banks, it's more than 50% of exposure to commercial real estate where the ultra large banks have mid single digit exposure.

So that's not necessarily a momentary shoe to drop that's coming. It sort of works itself out over a more extended period of time. But it's kind of a double whammy for many of those banks, that they're dealing with deposit flight. Now, in many cases, they're above the threshold in terms of loans to deposits and they're more exposed to the problems within commercial real estate, specifically offices. So you're probably going to continue to see some weakness, consolidation, and maybe a bit more power in the hands of the larger banks.

JULIE HYMAN: Liz Ann, putting everything that you've talked about together and sort of vibe wise what I'm getting from you, you don't sound like you're super effusively optimistic right now. You talked in your notes about the S&P being in a range. And it doesn't sound like there's anything in what you're saying that would cause it to break out to the upside-- or maybe the downside either. Are we just stuck in this range for the foreseeable future?

LIZ ANN SONDERS: Well, yeah, the overall index has been stuck in a range. And we've had higher lows, but we haven't seen that breakout on the upside. We've got the concentration issue that everybody's now very aware of, which I think started because of the macro backdrop of the bank failures but then has that AI kicker to it.

And we all know from history that heavy, heavy concentration can't last in perpetuity. But it can last maybe longer that a lot of people can remain solvent. And this is, to me, reminiscent of the birth of the internet and what a game changer that was. And remember, Alan Greenspan used the "irrational exuberance" comment in 1996 and the market didn't peak until 2000.

But I'd feel better if I started to see better breadth, improved participation by the average stock, so to speak. You only have 33% of the S&P trading above the 50 day moving average, 43% above the 200 day moving average. You want to see better participation.

Interestingly, back in October, when the indexes took out their June low, under the surface, breadth had actually improved. And that's the kind of positive divergence you wanted to see. But since the mid part of March, we've now seen that concentration risk.

But it can last a while. Our advice to investors is just don't get greedy. It's not an all or nothing thing, but no one ever went broke just trimming and taking some profits along the way as we wait for some sort of convergence that will inevitably happen. Just knowing the timing is impossible.

- So you say "don't get greedy," obviously. But where should investors be turning in a market like this where you have both the backdrop of the issues with regard to the debt ceiling, whatever the Fed is going to do in its June meeting, and then this earnings picture that has been kind of, generally speaking, better than expected.

But we've talked about this before-- low bar. Where should investors be turning? What sectors?

LIZ ANN SONDERS: So we've been sector neutral for more than a year now, believing that making investment decisions or equity decisions based on sectors is a bit monolithic. In contrast, we think taking a factor based approach, another word for characteristics, and we continue to stay in that mode with kind of a quality wrapper around the factors we think you want to screen for. And they represent kind of what's missing in the macro environment.

So you want companies with strong balance sheets that are self-funding. They don't need to come to the capital markets or the banking system to run operations. You want to look for strong free cash flow yield, positive earnings revisions, positive earnings surprise.

And so we think that that is the way to approach the market. By the way, leadership at the factor level has been more consistent than leadership at the sector level. Even the mega-cap eight, which that's where the concentration has been, people think of them as all tech. But they actually span tech, consumer, discretionary, as well as communication services.

So even wanting to do sort of a-- chase the move in those mega-cap names, just buying the tech sector doesn't give you that exposure. We think-- that's one of the reasons why we think you want to stay more factor oriented, especially with that quality wrapper. This is not the time to go down the quality spectrum.

JULIE HYMAN: Liz Ann, great to see you as always this morning. Thanks for spending some time with us. Liz Ann Sonders is Charles Schwab Chief Investment Strategist. Thanks.