For 2023, Diversification Is Back, and So Is Volatility: Schwab's Kleintop

Jeffrey Kleintop, managing director and chief global investment strategist at Charles Schwab, anticipates more market volatility in the near term, noting that stocks have gone up or down by at least 5% every month in the past six months.

Schwab expects the Federal Reserve to halt interest rate hikes around the end of the first quarter next year, given the central bank's recent signals, depending on how rapidly China reopens from its zero-COVID policy shutdowns, Kleintop told ThinkAdvisor on Friday, days after the firm issued its 2023 global outlook.

"Hopefully that will turn out to be the case and create a better backdrop for 2023," Kleintop said, noting that the Fed has signaled a possible slowdown and many other central banks have indicated they're nearing the end of their rate-hiking cycles.

Kleintop hopes to see stocks and bonds do better next year after both asset classes fell in 2022. Investors expected diversification to work in their portfolios, he noted, adding, "We'll get that back next year."

Schwab predicted markets may continue to see volatility early in the year as they navigate global economic growth and inflation fears, central banks slow rate hikes, recession potentially lingers and China reopens. A global recession likely started in the third quarter, according to the firm.

In the U.S., the Fed meets this week to decide on its last rate move this year. Analysts expect a 50 basis-point rate hike — a step-down after four consecutive 75 basis-point increases. Also this week, the Bureau of Labor Statistics will release consumer inflation data from November.

Economic uncertainty has made it difficult for investors to figure out when to rotate sectors, Kleintop noted.

He suggested investors focus on high dividend-paying stocks and companies with low price-to-free cash flow ratios, which have done well during this volatile year, both as the market declined in the first three quarters and during the fourth-quarter rally. To maintain a diversified portfolio, he recommended looking for the highest dividend payers across sectors.

"We're definitely seeing an emphasis by investors on higher quality stocks" rather than growth stocks with cash flow prospects way out in the future, he said. These are companies with strong income statements and balance sheets and the cash to pay dividends, he added.

"Efforts to rotate among groups of stocks to try to insulate from elevated volatility or try to time a recovery may be unnecessary," the firm said in its outlook. "We believe that investors can simply stick with what has been working in 2022. For the past year we have been highlighting characteristics of stocks that are outperforming, focusing on quality stocks, which we have defined in different ways.

"High-dividend-paying stocks have outperformed during past recessionary bear markets and are outperforming again this year across sectors and countries," according to Schwab. "There can be no guarantees, but investors may be able to navigate 2023 by sticking with what has been working in both up and down markets during 2022."

Stocks with immediate cash flows, so-called short-duration stocks, have also outperformed, according to the firm, which noted that "the lower the price to free cash flow, the higher the quality."

Schwab early this year shifted to a bias toward international stocks, which have outperformed U.S. shares this year for the first time in about a decade. International stocks tend to possess characteristics like high dividends and lower price-to-cash-flow ratios, Kleintop said. "Earnings growth is also looking stronger outside the U.S. for the first time in a long time," he said.

A decline or stability in the dollar might fuel even higher outperformance for international stocks next year, according to Kleintop, who noted European stocks have gained 25% in the fourth quarter, their biggest leap ever.

While the firm recommends investors rebalance toward international stocks after a decade of U.S. outperformance, it isn't overweight in them, Kleintop noted. Schwab recommends people allocate 30% to 50% of their portfolios to international stocks, which is higher than most investors have, he said.

China's reopening poses a risk for a rebound in inflation for commodities and goods globally driven by pent-up demand from 1.4 billion consumers, according to Schwab, which doesn't expect the country to fully reopen before winter's end.

The nature of the current economic downturn is different from the 2020 recession and the Great Financial Crisis, Kleintop said. "Those were the everything, everywhere, all-at-once recessions" and it was obvious when the economy bounced back, he explained. "That isn't true this time," as some parts of the economy are flourishing and others are doing poorly, he said.

Manufacturing is in a slump now, a recession, because inventories are high, "yet the service sector is still booming," Kleintop said.

Kleintop expects to see conflicting data points probably through the first half of next year. Perhaps in the second half it will become clear that the U.S. economy is in a recovery, he added. Inflation will feel elevated and should boost stocks and bonds if it comes down, he said.

The strategist believes bond rates have peaked and are headed lower; he's looking for positive returns in 2023 after the worst year for bonds in half a century.

Supply chain issues and war in Ukraine led to a lot of this year's volatility and should ease over the next year, barring unforeseen developments, according to Kleintop, who said China's reopening is his biggest focus now.

"Other than that I think things go better," he said.

For 2023, Diversification Is Back, and So Is Volatility: Schwab's Kleintop

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For 2023, Diversification Is Back, and So Is Volatility: Schwab's Kleintop

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