Why the Fed is in a 'pickle' when dealing with the market

Charles Schwab Managing Director & Chief Investment Strategist Liz Ann Sonders joins Yahoo Finance to discuss the inflation in the market, the effects of raised wages, and her prediction on the Fed's response.

Video Transcript

BRIAN CHEUNG: You know, the running theme in this market environment-- we don't need to tell anyone this-- but it's inflation, inflation, inflation. And you'll recall that we got the print on the consumer price index just last week, showing that prices rose by 5.4% on a year over year basis in September. That's the fastest pace that we've seen since 2008.

So let's get more on this from Liz Ann Saunders, the managing director and chief investment strategist at Charles Schwab. And Liz Ann, you have a note out called "The Beast of Burden of Inflation"-- always love a Rolling Stones reference. But we were talking during the break about the definition of transitory. Break down what is the definition of transitory maybe from a more legalistic perspective and whether or not what we're seeing right now fits that definition.

LIZ ANN SONDERS: Well, it's funny because I perused myriad online dictionaries about definition, and the Oxford Dictionary definition is not permanent. And based on that very simple definition, even 1970s style inflation was transitory. And then the Webster dictionary has two different definitions. One, I think is something like very short-term. Clearly, we're beyond that. The second one, though, is more loose in terms of, you know, doesn't last forever.

And the one thing that gets missed, I think, in a lot of the analysis, we were so focused on base effects in the early stages of the spike-up in measures like CPI and PPI. But the longer they stay elevated, the base effects will work in the opposite direction a year from now. So percentage-wise, we may have math in our favor as we look into next year.

JULIE HYMAN: So it sounds like, then, you think things are going to alleviate at some point, Liz Ann. I guess, the question is what you do with that information now, right? We were talking about a few moments ago Procter & Gamble being among the companies, just there are examples now of companies that are talking to us about these input costs having an effect on their bottom line. So do you try to avoid those types of situations in this market? Is it even possible to do so?

LIZ ANN SONDERS: Well, I'll tell you, the factor that has been most dominant in terms of outperformance in the recent few months and I think probably will persist as a factor of outperformance is steadily rising earnings revisions, and especially if it's accompanied by the ability to maintain profit margins. And what's interesting about that factor is, first of all, you can apply it to any sector.

But it's almost a hybrid value growth factor because if we're going to continue to see a rolling over in broad earnings revisions, then there's a premium that investors would pay for companies that have that steadily rising earnings revision. And of course, when you pull valuation into the mix, if you've got a steadily rising E in terms of expectations, that brings down the forward PE. So I think that's how investors should approach this environment.

I also think rotations are going to continue to be really, really swift. And in that environment, that suggests maybe upping the pace of rebalancing, have it be more volatility-based rebalancing versus, say, just calendar-based rebalancing. And I think those disciplines are the best ones to apply in this kind of market environment.

BRIAN CHEUNG: Just to kind of stick to this theme of earnings, what else are you watching in terms of whether or not this story of maybe transitory becoming more persistent comes in the form of commentary on wages? Because we know that one possible thesis for these inflationary pressures becoming more persistent is if these types of producers and kind of managers here have to raise wages as well. We know that in the case of P&G, they actually had another 20 basis points of wage inflation net of other impacts in this quarter. Is this kind of starting that spiral that we've heard talked about within the context of possible further price increases?

LIZ ANN SONDERS: There's no question that trends in the labor market and wages are important. You just have to be really careful what metric you use to measure wages. The most common metric, of course, is average hourly earnings, which is reported with the monthly jobs report. The problem is it can get very, very skewed, as it has in the past year and a half, by mix shifts.

So, in April of 2020, wage growth on that metric showed is more than 8%. Well, that was the month we lost more than 20 million jobs. Clearly, we were not in a rising wage environment. But most of the people losing their jobs at that time were on the lower end of the wage spectrum. The opposite happened more recently when we reopened up. We pulled a lot of low wage workers back into the numbers, and that skewed the numbers down.

So I think you have to either look at median measures of wage growth. Atlanta Fed has one called the wage tracker, a little bit more subdued and less volatile, and then broader metrics like unit labor costs and the employment cost index. And you have to maybe even look at a two-year trend so you smooth out some of the effects of the pandemic. There's no question we're moving up.

And at 4% to 4 and 1/2% wage growth, that's certainly above the pace that would allow inflation to come back down or be maintained at the 2% Fed's target. The question is whether it's sustained wage increases. That was the problem in the 1970s. It wasn't kind of a one-time reset. It was sustained. And that was because the psychology around inflation really kicked in. And that helps to trigger the spiral. And I'm not quite sure we're there yet.

BRIAN SOZZI: Liz Ann, to that point, do you think the Fed will respond appropriately to inflation that doesn't seem to be going anywhere anytime soon?

LIZ ANN SONDERS: You know, I don't envy the Fed in this environment right now. They're in a bit of a pickle because they certainly know that stepping up and tightening more quickly, either with tapering or maybe moving up a bit time horizon the rate hikes, that's not the elixir for what ails global supply chains and the bottlenecks. That rub, of course, would be if they feel that they have to step in to quell demand in order to allow for supply to catch back up.

A better scenario, of course, is you start to see some quelling of demand because of the effect of high prices, the old adage of high prices is the cure for high prices. Because we're already seeing this inflation act, to some degree, as a bit of a tightening in terms of on the economy. We saw the weaker housing data today. We've seen weaker consumption data. So it's a bit of a race. Does the inflation problem weaken growth enough that the Fed doesn't feel compelled to step in, knowing that they don't have the precise tools to ease global supply chain bottlenecks?

BRIAN CHEUNG: All right, Liz Ann Sonders, managing director and chief investment strategist at Charles Schwab, thanks for hopping on Yahoo Finance this--