On the Radar

City National Rochdale, | Nov. 20, 2018

FAQs on the Markets and Economy

What is behind the slowdown in the housing market?

The housing recovery has increasingly become a story of headwinds vs. tailwinds. Affordability is clearly an issue as mortgage rates have marched higher and income growth, while improving, has remained below that of home prices.

A lack of inventory is contributing to the increase in prices. Though inventory levels are up on a year-to-year basis, they remain low relative to history. Meanwhile, new housing construction faces headwinds in the way of rising labor and input costs, which have also put upward pressure on home prices.

Fundamentally, the pace of construction should continue to march higher and demand remain supported by a strong job market and increasing household formation. However, the current dynamics of limited existing inventory and moderate new supply are contributing to the affordability crunch and slowing the pace of improvement.

The Fed did not change interest rates at the meeting, which was universally anticipated. The median level of the federal funds rate remains at 2.125%. They made modest changes to the statement, noting strong household spending growth and a moderation in business investment.

They made it clear that despite the turmoil in some markets, they are not wavering on the view that employment is strong, inflation is stable near their target level of 2.0%, and that they will continue with their gradual increases in interest rates. So far in this cycle, the Fed has raised interest rates eight times (a total of 200 basis points) and they have five more hikes planned, the next one coming this December.

The Fed expects three more rate hikes in 2019, which will bring the federal funds level to 3.125%. The federal funds futures market is less sanguine; they currently expect the rate to be 2.79% (chart). It has fallen recently with the turmoil in the stock market and lower oil prices, which may lead to lower business investment spending, a drag on GDP.

The size of the investment grade bond market has doubled in size and is now just over $5 trillion in size (chart).

The composition, based upon credit rating, has changed. BBB-rated credits, the lowest level of investment grade bonds, now account for 49% percent of the index. Their share of the market has been growing for some time; at the end of the recession it was 38% and back in 2000 it was 31%.

With the recent volatility in the markets, there is growing concern regarding these bonds and the potential for a tidal wave of downgrades.

But BBB are not the powder keg they might seem, as the rising cost of debt, lower tax rates and robust earnings growth seen in 2018 should drive new issuance and leverage downward.

We continue to view the current pullback as a correction, which can help ultimately extend the long-running bull market. The sell-off has been spurred by concerns over a number of issues, including: peaking corporate profits, slowing global growth, ongoing trade tensions, and rising interest rates.

In terms of monetary policy, our view is that as long as inflation remains at or near 2%, the Fed can continue to slowly hike short-term rates without derailing economic growth. Likewise, negative sentiment on earnings is not about the direction of growth, but on the magnitude. We agree that earnings growth will slow in 2019, particularly as corporate tax cuts roll off, but to its normal organic rate of about 5-7%.

The good news is that the sell-off has left valuations near or below long-run averages. We expect investors will eventually reconnect to the broader positive fundamentals, allowing the bull market to, over time, resume its gradual climb higher.

Our client portfolios are constructed with this volatility in mind and should withstand the correction relatively well, due to our high-quality equity allocation and overweight to U.S Large Cap stocks vs. Midsmall Cap and International.

Based on our outlook for solid economic growth and improving corporate earnings, we remain bullish on equities in general and continue to see attractive prospects in the opportunistic fixed income class. Bear markets outside recessions are rare.

Still, we believe investors should prepare for more moderate returns in the months ahead and perhaps greater volatility. Patience and discipline will be more important than ever.

The investment landscape is growing more challenging as investors adjust to more typical late-stage expansion conditions of higher inflation, rising interest rates, and less accommodative monetary policy.

Meanwhile, concerns over global growth, rising trade tensions, midterm elections, and other geopolitical risks mean markets will likely continue to be subject to periodic swings in sentiment and potential pullbacks.

None of this means there are not more worthwhile gains ahead for investors, but it does highlight the value of active management and the need for investors to become more selective. We actively manage portfolios to be aware of where we are in the cycle, to take advantage of opportunities as they arise, and to be on alert if conditions deteriorate.

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Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources, and although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed. Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change. There are inherent risks with equity investing. These include, but are not limited to, stock market, manager, or investment style risks. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices.

Investing in international markets carries risks such as currency fluctuation, regulatory risks, and economic and political instability. Emerging markets involve heightened risks related to the same factors as well as increased volatility, lower trading volume, and less liquidity. Emerging markets can have greater custodial and operational risks, and less-developed legal and accounting systems, than developed markets.

There are inherent risks with fixed income investing. These may include, but are not limited to, interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond risks. When interest rates rise, bond prices fall. This risk is heightened with investments in longer-duration fixed income securities and during periods when prevailing interest rates are low or negative.

Investments in below-investment-grade debt securities, which are usually called “high-yield” or “junk” bonds, are typically in weaker financial health, and such securities can be harder to value and sell and their prices can be more volatile than more highly rated securities. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a higher-quality rating.

The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the federal Alternative Minimum Tax (AMT), and taxable gains are also possible.

Investments in the municipal securities of a particular state or territory may be subject to the risk that changes in the economic conditions of that state or territory will negatively impact performance. These events may include severe financial difficulties and continued budget deficits, economic or political policy changes, tax base erosion, state constitutional limits on tax increases, and changes in the credit ratings.

Investments in emerging markets bonds may be substantially more volatile, and substantially less liquid, than the bonds of governments, government agencies, and government-owned corporations located in more-developed foreign markets.

Indices are unmanaged and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.

Returns include the reinvestment of interest and dividends.

Investing involves risk, including the loss of principal.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money.

Past performance is no guarantee of future performance.

Index Definitions

The Standard & Poor’s 500 Index (S&P 500) is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.

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