MIKE TOWNSEND: Geopolitical risk is one of the great unknowns of investing―it's always there, but no investor knows exactly how or when or what it will impact.
We're just about a month into 2024, and it already feels like a year in which geopolitics is and will remain on the front burner for investors. In two weeks, we will hit the two-year mark since Russia invaded Ukraine. Four months ago, the Hamas attack on Israelis took place, and the military response of Israel is rearranging the geopolitics of the Middle East. Rebels supported by Iran are attacking container ships moving through the Red Sea, disrupting supply chains and prompting a U.S. military response that could further destabilize the region. And China's economy is slowing at the same time as its irritation with Taiwan increases.
Not one of these issues has a clear and certain outcome. So how should investors be thinking about these geopolitical challenges in the context of their own portfolio?
Welcome to WashingtonWise, a podcast for investors from Charles Schwab. I'm your host, Mike Townsend, and on this show, our goal is to cut through the noise and confusion of the nation's capital and help investors figure out what's really worth paying attention to.
Today, I want to explore some of these international hotspots and their implications for investors. In just a few minutes, Schwab's chief global investment strategist, Jeffrey Kleintop, is going to join me to offer his perspective on these complex issues. Jeff is fantastic at cutting through the headlines to explain what's going on beneath the surface and how it could affect the markets.
But first, here are my three things to know about what's going on in Washington.
To start, I want to follow up on something I discussed on the last episode, and that's the modest tax bill that is an exceedingly rare―at least these days―example of legislation that has a little something in it for everybody. It combines an expansion of the child tax credit, a key priority for Democrats, with the extension of several business tax breaks, a key priority for Republicans.
Well, last week the House of Representatives overwhelmingly approved it. The vote on the House floor was 357-70, a reflection of the broad bipartisan support.
The bill now heads to the Senate, where it faces a much rockier path. Senators from both parties have expressed frustration and are likely to want to amend the bill with some of their own tax priorities―but that could upset the delicate bipartisan balance in the House. It's likely the tax bill would have a better chance as an attachment to something else, rather than as a standalone bill in the Senate. I'll be watching to see if it gets attached to legislation to extend government funding, which will be necessary at the end of this month to avoid a partial government shutdown. That would be an easier way to pass the tax package while avoiding a drawn-out amendment process that could derail the bill.
Meanwhile, the other major legislative development was the unveiling of the long-awaited Senate border security package. It was introduced as part of a larger emergency spending bill that includes $60 billion in aid for Ukraine, $14 billion for Israel, as well as $10 billion in humanitarian aid for civilians in Gaza and other hotspots around the world. The bill also includes about $5 billion for Taiwan and other Asia-Pacific allies and more than $2 billion to address the escalating conflict in the Red Sea.
But the debate over how best to secure our own border has held emergency spending up since October, when President Biden first requested it from Congress. This new package includes more than $20 billion in spending for the border―up significantly from the president's October request―as well as a host of policy changes to restrict border crossings, toughen standards for asylum seekers, and more.
Now the question is whether the bill can pass the Senate, where it will need a supermajority of at least 60 votes to ensure that it can overcome a filibuster. Right now that looks like it won't happen, and it may not really matter whether it does or not, because Speaker Mike Johnson has loudly proclaimed it to be "dead in the water" upon arrival in the House of Representatives.
And that comment raises something notable about the political calculations that are coming into play with these two significant bills―both the tax bill and the Ukraine/Israel/U.S. border security bill. Because this is a presidential election year, our attention tends to focus on that race. But it's important to remember that this is also a year in which the balance of power in both the House and Senate will also be determined. Now we know that political calculations are always part of the equation in Washington. But in the last week or so they have really bubbled out into the open.
Senator Chuck Grassley, a Republican from Iowa, last week said publicly that he was reluctant to pass a tax bill that might make President Biden "look good" and help him get re-elected. And some Republicans, including their likely presidential nominee, Donald Trump, are opposing the border security bill because it might boost President Biden before the election.
Polling shows that immigration has become the number one policy issue for voters―and that the border crisis is President Biden's biggest liability right now in terms of his re-election. So it makes sense that Republicans want to campaign on this issue―it's just that politicians aren't usually quite so direct about saying that's the reason they don't want to get behind a bill.
Of course, it could also backfire. Democrats would likely say that they put solutions on the table that had the support of many Republicans, but that other Republicans were more interested in scoring political points than in actually solving problems.
We'll see in the coming weeks how all this plays out. No matter what the final outcome is on these two bills, expect these issues to be front and center during the long campaign season ahead.
Finally, there was no surprise from the Federal Open Markets Committee at their first monetary policy meeting of 2024 last week, as they left the federal funds rate unchanged for the fourth straight meeting. In his press conference after the meeting, and in a rare sit-down television interview that was broadcast Sunday night, Fed Chair Jerome Powell made clear that the FOMC is pivoting towards rate cuts, but that a rate cut is unlikely to come at the next meeting, scheduled for mid-March. Those comments, coupled with last Friday's blockbuster jobs report, which saw the economy create about twice as many jobs as analysts expected, resulted in a big shift in investor sentiment about rate cuts.
Just a week ago, according to the CME FedWatch tool, traders were split about 50-50 on whether there would be a rate cut at the March meeting. By the start of this week, less than 15% believed there would be a rate cut. About 53% believe there will be a rate cut by the May meeting, but that's down from 88% just a week ago. And where many analysts were forecasting six rate cuts in 2024, the consensus now is that three to four rate cuts this year is more realistic.
On my Deeper Dive today, we're going to take a closer look at some of the world's hot spots and how they may impact the global economy and international investing opportunities. Investors have a lot of questions about the implications of China's slowing economy, Taiwan's recent election, the attacks on container ships in the Red Sea, and the growing instability in the Middle East. So I want to bring in someone who can really help us better understand the complicated dynamics at play. I'm really pleased to welcome back to the podcast, Jeffrey Kleintop, Schwab's chief global investment strategist. Jeff, thanks so much for joining me today.
JEFFREY KLEINTOP: It's great to be here, Mike.
MIKE: Well, Jeff, I want to start in China. Economically, there is a lot going on, and not much of it looks good. Consumer confidence, along with business and investor confidence, is running low. Analysts point to the ongoing property downturn as a big part of the problem, and it was dealt another blow last week, when a Hong Kong court ordered the liquidation of Evergrande, one of China's largest property developers. Consumer spending is down, manufacturing is slowing, businesses aren't making the profits they anticipated, and the stock market has continued to trend down. And it's not just on the domestic front. Foreign firms are making decisions not to expand their investments, and, in some cases, even selling off assets. While other major economies have been fighting the inflation battle, China is dealing with deflation. So with all this as background, the Chinese government is still looking for 5% growth in 2024. Does that seem achievable? I mean, what's it going to take for China to turn this around? And what should investors here in the United States be watching for?
JEFF: Five percent is achievable, but it matters for investors where the growth comes from. China could just do more government-directed and funded infrastructure spending to hit that number, but markets and China's leadership would prefer the growth come from consumer spending. While policymakers around the world are looking at rate cuts to stimulate growth, high interest rates have not been China's problem. As you mentioned, it's weak consumer business and investor confidence. And further measures to revive the economy have been hinted at, but this slow drip of policies, which are often reactive and uncoordinated and targeted, rather than prompt and broad, have thus far not been sufficient to spark any kind of turnaround.
Consumer confidence remains low, due to the hangover from the zero-COVID policies and weakness in consumers' biggest asset, their property. Business confidence is also low due to weak demand and just some regulatory flip flops. One of the biggest hits to consumer confidence came when homeowners put down big deposits with developers to build a home, and now those developers are failing. And those consumers are worried about not getting a home or not getting their money back, so they've pulled back on their spending elsewhere.
A first step at turning economic momentum around would be, in my opinion, a government guarantee of home buyer deposits at these troubled property developers. That could help boost consumer confidence from its recession-like lows. Second, measures to reduce government regulations and encourage entrepreneurship could support business confidence. And third, the current focus on supply side stimulus amid already excess capacity seems to be fueling a deflationary environment. China's CPI has been below zero for the past three months. In fact, in a few days from when we're recording this, they're going to get probably the fourth month in a row of CPI below zero. So focusing on improving consumer demand, which is weak and leading to these falling prices, by addressing the housing concerns could help the inflation picture as well.
I think these measures are likely coming in some form, but the rollout has been disappointing to investors so far, and there's just no signs of an imminent and major shift in policy coming soon.
MIKE: Well, sticking with China, I think one of the most common, overlapping questions between your speaking appearances and mine has been about Taiwan. Taiwan just had a major election last month. The outcome didn't seem to please China much. So maybe just catch us up on the outcome of that election, what impact it may have on U.S.-China relations, and whether you think it changes the outlook for a potential Chinese military action in the region.
JEFF: In January, Taiwanese voters didn't just choose their next president and legislature. They also helped set the course for U.S.-China relations for the next four years. Voters chose a ruling party that has historically been pro-independence over an opposition party that seeks closer ties with China as Taiwan's only viable path. And there's continued risk to U.S.-China tensions over the next four years as a result of the outcome of that election, but there are offsets to how China might react.
First, the president-elect stressed in his campaign that he has no plans to upset the status quo with China and declare independence. That would steer clear of a red line for China. Declaring independence is definitely a big red line.
Second, the outcome was closer than it was in 2016 or 2020, when the winning candidate led the China-favored candidate by double-digits and went on to win comfortably with more than 50% of the vote. So this rise in support for the party that most favors closer ties with China may ease Beijing's concerns that Taiwan is drifting further from its grasp.
And third, the winning candidate also saw the loss of the party's majority in the legislature, which demonstrates political support for parties in favor of greater dialogue with China.
So it's possible the election outcome may mean little change to the market or political environment given these offsetting factors.
And furthermore, I think it's important, the election itself may not hold much significance for Taiwan's immediate future. I continue to believe that an invasion of Taiwan by China is a low probability, at least over the next year or two. Taiwan's National Chengchi University tracks sentiment among the Taiwanese people on independence versus reunification with China, and they've done so for decades. The latest reading, which is from the middle of last year, the next six-month update should be published soon, it's continued to show an overwhelming majority of Taiwanese in favor of the status quo, rather than a shift to either independence or reunification. In fact, sentiment favoring independence has actually declined in recent years, even as tensions over such a shift have increased. And the takeaway is that the people of Taiwan don't seem to favor a change in the Taiwan-China relationship no matter who won the election.
So I think it's worth remembering that despite the shifting tensions last year, Taiwan's stock market outperformed peers thanks to its exposure to the world's hottest AI chipmaker. So geopolitics have been taking a backseat to other factors even in Taiwan.
MIKE: Well, Jeff, I really appreciate those thoughts. Certainly, if I judge by the questions I'm getting at my events, I think a lot of investors here maybe overthink the risk of a Taiwan-China military confrontation, and it's good to have that perspective that that may not be in the offing.
Well, another major hotspot right now, Middle East. We have Israel's ongoing war in Gaza. We have the Houthi rebel effort to attack oil tankers and container ships in the Red Sea. Last week, there was a drone strike against U.S. troops in Jordan that killed three U.S. soldiers. That led to a targeted response by the United States. But there continues to be pressure here at home, and I think especially here in Washington, for the U.S. to more aggressively respond against Iran. The whole region feels like it's just teetering on the edge of something much bigger. Of course, both Iran and the U.S. say they don't want war, but what do you think the risks are of this escalating into a major military confrontation, and what would the implications be for the stock market?
JEFF: You know, it's important to remember that while each event may seem like a new threat, geopolitical conflict, especially in the Middle East, has been an ever-present risk of investing. One thing that's also true is that while escalating and aggressive statements get a lot of attention, there are other de-escalating ones that don't get much attention but may be worth consideration. During the Trump administration, the U.S. targeted Iran's military assets in Iraq and actually killed the head of the Islamic Revolutionary Guard. Iran then vowed an aggressive response to what it felt was an unwarranted escalation of that conflict, but the eventual response wasn't that material or impactful to the markets or to the region.
And it's worth noting that Saudi Arabia appears to have resumed talks with the U.S. about forging closer defense ties after a pause following the start of the Israel-Hamas war in early October. Also, the Iranian-backed militia group in Iraq that the Pentagon has said was likely responsible for the drone strike announced the suspension of attacks on U.S. forces.
That said, in response to the drone strikes, the U.S. has responded with strikes on Iranian targets within Iraq and Syria. And yes, that is some escalation from recent military actions. I'm no geopolitical strategist. It seems to me, though, that the overall conflict will likely remain this proxy war between Israel and Iran. And that's been going on for 39 years, and unlikely to have much market impact, outside of causing volatility in oil prices. The primary way Mideast conflict shows up in markets is through oil prices. And with oil currently in oversupply, this isn't likely to be a major factor for prices or the energy impact on overall inflation.
Now, the longer the conflict in Gaza goes on, the more the regional conflict can escalate. Yet it seems likely that Gulf oil infrastructure will not be targeted, and there'll be no direct attack on Iran. And Mike, I think that limits the market impact.
MIKE: Well, one aspect of the tensions in the region that is already happening is the impact on global shipping. As a result of the escalating danger in the Red Sea, some companies are starting to rethink their shipping routes. During the 2021 supply chain crisis, Jeff, you talked a lot about cardboard boxes as a metric to understand what's going on in the supply chain. So what's your cardboard box index telling you right now? Are we headed towards the type of supply chain issues that we saw in 2021, which really had a big global impact?
JEFF: Well, Mike, the boxes I'm watching most closely now are actually the ones cardboard boxes go into, those big metal shipping containers that move the world's goods. Unlike cardboard box prices, which have been falling over the past year, the cost to rent a shipping container is on the rise for the first time since the peak of the supply chain problems two years ago. The attacks on ships by those Houthi rebels in the Red Sea and the Gulf of Aiden is rerouting shipping around Africa and has made Asia to Europe shipping rates rise 500% since November, according to Drewry Maritime. The Panama Canal also remains a problem, due to a prolonged drought, which has limited the number of ships that can pass.
And it's not just the traffic through these critical shortcuts, the Panama Canal and the Red Sea, that's being impacted. It's the longer routes that are tying up container ships for much longer periods, resulting in a price spike for other routes, like the most popular route, Shanghai to LA, where the cost of shipping a 40-foot container to Los Angeles has risen substantially compared with as recently as November.
China is not the biggest trading partner of the U.S. Those are Mexico and Canada. But for countries in Europe, like Germany, China is number one. And an urgent issue for Chinese exporters is the lack of containers. Those longer shipping times around South America and Africa, rather than through the Panama and Suez canals, have delayed the return of those empty boxes, those empty containers to China. And exporters are facing a pretty severe container supply crunch this month, when factories are kind of scrambling to export stock before they close for the Chinese New Year coming up real soon. The Baltic Exchange estimates a shortfall of 780,000 containers. And that immediate container shortage should ease by March, but the rerouting of freight around Africa is likely to continue through the first half of the year, even if the risks in the Red Sea subside.
But so far, this isn't anywhere near the supply disruptions that followed the pandemic, partly because demand just isn't as strong as it was then. We've been in this global cardboard box recession, I've been calling it, in manufactured goods for a year, and inventories are at normal levels. So there isn't a sudden shock that would then quickly ripple through to consumer prices.
MIKE: I like this idea of moving from worrying about cardboard boxes to worrying about metal boxes. But from a U.S. standpoint, how concerned should we be as consumers and investors? I mean, what is the potential that this will ultimately impact prices here in the U.S., not just for things like oil and gas, but those consumer goods that are actually on those container ships?
JEFF: Well, in the U.S., the cost to ship goods makes up about 1% of costs. So seaborne freight makes up about 1% of the cost of producing a good. So it would take a big move to turn around the trajectory on overall inflation from just that. In fact, researchers at the International Monetary Fund found—and they just published this study last year—when they were looking at the period from 1992 to 2021, so that's just after the '91 recession to just before the pandemic, a one standard deviation increase in global shipping costs increased domestic headline inflation by about 0.15%, with the effect building up over the course of 12 months. What that all means to me is that while it's been a sizable move, and it's not over yet in terms of shipping costs, it's unlikely to be sustained over 12 months. And so there's likely to be some measurable impact, but perhaps not enough to offset other factors, and will probably still allow inflation to continue to trend lower.
If on the other hand, it worsens, and the effect lingers for much of the year, the rising cost that flows through to the economy, I guess, could mean central banks may not be as aggressive in cutting rates in 2024, as the market currently expects. And that could be bad news for stock valuations, especially those that thrive on a flood of market liquidity, like the Magnificent Seven stocks.
It's worth pointing out that while the cost to ship goods has been back on the rise, it's mainly around goods, much less so grains. Dried bulk shippers are not seeing the same kind of increases. And oil tankers aren't really seeing the same type increase either, given ample supplies of both the oil and grains. So the impact is worth watching, but we're not changing our base case on inflation continuing to recede in most countries.
MIKE: You mentioned a moment ago, Jeff, central banks, and I know you watch what central banks all around the globe are doing. Clearly, we're coming up on rate cuts in the relatively near future here in the U.S. Other central banks also contemplating rate cuts, though possibly not on the same time schedule, and it's possible that the Bank of Japan could begin hiking rates. So what will you be watching for as central banks make their decisions over the next, say, six to 12 months? And do you think investors' hopes are maybe too high for rate cuts at this point?
JEFF: I think that's what central bankers are telling investors. You know, the message from central bankers over the last two weeks, really since mid-January, has been the same, to dig in against pressure to cut rates in the spring, and to keep the focus on the inflation outlook. Essentially, they've been telling markets that recent better inflation data is good news, but we need more evidence inflation will return durably to 2%. Sometimes central bankers can be a little vague. They weren't. They were unusually clear about a summertime time frame as more likely as the start of when cuts will begin. So I think it's interesting that the markets kind of dismissed all that pushback from central bankers.
The market's high confidence in rate cuts by the Fed, and the European Central Bank, and the Bank of England beginning as soon as March, and continuing it every meeting after that this year, establishes a pretty high bar to deliver on those expectations, setting up the potential for disappointment and a volatile first half of 2024, similar to what the markets experienced in early January, when the market temporarily backed off on its most aggressive rate cut expectations.
And, I also say, while the stock market seems to get excited about rate cuts, history shows a mixed track record in every major country and region for the 180 days―the six months―after the start of central bank rate cuts. And that's true not just for the U.S., but it's true for Europe, and Canada, and many others as well. About half of the six-month periods following the start of rate cuts saw the stock market go up, and about half they went down. So history shows that rate cuts are far from a guarantee that stocks are going to go up.
And as you mentioned, there's an outlier to all of this, and that's the Bank of Japan, which is widely expected to hike rates this year for the first time in 17 years, possibly boosting its currency as a result, and encouraging Japanese investors to move their money back to Japan, as we've now seen each month since the Bank of Japan signaled their intentions back in October. Japan's stock market, measured by the Nikkei 225 Index, is the best performing in the world so far this year, building off its 28% gain last year. And that money may increasingly come from selling U.S. investments as it comes back home to Japan. So at the margin, that might weigh on U.S. markets.
MIKE: Well, Jeff, we've talked about a number of big issues around the globe. I think it's fair to say that geopolitical risk right now is high. It certainly feels that way to a lot of investors. But is it so high that investors should avoid investing globally, or are there some opportunities that are emerging that investors should be looking at?
JEFF: Perspective is so important around this. You know, geopolitical risk was high for Taiwan last year for many reasons. Yet Taiwan's stock market outpaced the S&P 500®, thanks to its AI semiconductor exposure. So fundamentals can overcome geopolitical risks—and usually do. And that's important to keep in mind when reading the disturbing headlines each day.
But if you're looking for shelter from the geopolitical risks, on a relative basis, Japan faces few geopolitical risks in 2024. There's no major elections, like in the U.S., there's no military conflicts on its borders as in Europe, and it's got a more balanced position on the Gaza issues. And it offers exposure to a manufacturing and trade recovery, with low stock market valuations, and, increasingly, shareholder-friendly initiatives. So that's something to keep in mind.
But more broadly, I've been saying for a couple of years that international stocks are likely to outperform U.S. stocks for a range of fundamental and behavioral reasons, including that international markets are priced for a difficult environment in terms of a challenging economic and political backdrop, with price-to-earnings ratios below their 10-year average, while U.S. stocks are not, and actually priced at a premium.
But a quick look at the indexes shows that hasn't been the case. Or has it? Since the bear market ended in October of 2022, the average international stock has outperformed the average U.S. stock. I feel like this is a secret, but in fact, international has roughly doubled the U.S. stock market return. And we can measure this by comparing the equal-weighted EAFE Index to the equal-weighted S&P 500 index. But because we all track markets using the capitalization-weighted indexes, where the biggest stocks get the biggest weight, the leadership by the Magnificent Seven stocks has resulted in the cap-weighted outperformance by the U.S. Now, this is rare, historically. The equal- and cap-weighted indexes usually trend in the same direction for relative performance. I think the broader outperformance by international stocks offers more support than the U.S.'s narrow leadership, and that might soon begin to show up even in the capitalization-weighted indexes.
While global diversification can mitigate the volatility that comes from heightened geopolitical risk, it may also benefit returns in 2024. So Mike, I think it makes a lot of sense for investors to be broadly globally diversified right now.
MIKE: Well, great advice, as always, Jeff. With geopolitical issues likely to be on the front burner for much of 2024, we will definitely have you back on the podcast in the months ahead to help investors sort it all out. But I really appreciate you taking some time to talk with me today.
JEFF: Thanks, Mike. It's always great to be on.
MIKE: That's Jeff Kleintop, chief global investment strategist here at Charles Schwab. Make sure you follow Jeff on X, formally known as Twitter, @JeffreyKleintop. That's where he posts his Weekly Market Outlook video every Monday morning, where he shares what investors should be watching in the week ahead in just 90 seconds. It's a great way to start your week.
Well, that's all for this week's episode of WashingtonWise. We'll be back with a new episode in two weeks, when we'll focus on what to make of the bond market right now. Take a moment now to follow the show in your listening app so you don't miss an episode. And if you like what you've heard, leave us a rating or a review—those really help new listeners discover the show.
For important disclosures, see the show notes or schwab.com/washingtonwise, where you can also find a transcript.
I'm Mike Townsend, and this has been WashingtonWise, a podcast for investors. Wherever you are, stay safe, stay healthy, and keep investing wisely.
