| Sep. 10, 2018
FAQs on the Markets and Economy
Is City National Rochdale’s investment outlook still positive?
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, 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.
With all the trade tensions, how is the U.S. manufacturing sector holding up?
Domestic manufacturing is doing really well despite the uncertain trade environment. The most prominent manufacturing index, the ISM Manufacturing Purchasing Managers Index, hit the highest level in 14 years (chart).
Manufacturing employment has been on a strong upswing, with 159,000 being added to the payrolls so far this year. That compares favorably to the 112,000 for the same period of time last year and -13,000 for the same period in 2016.
With strong domestic demand (consumption was up a hefty 3.8% in Q2), households are buying many of these products here. But international demand has been waning. A sub-index for exports has been falling for a few months, which might be due to the stronger U.S. dollar.
Does the municipal yield curve provide investor opportunity versus Treasuries?
The tax-exempt yield curve juxtaposed with comparable U.S. Treasuries reveals incremental value is achievable by moving further along the municipal maturity spectrum.
Investors could pick up approximately 75 bps of yield spread between two-year and 10-year tenors, while the Treasury market will reward you with just 25 bps. Therefore, the value of the tax benefit increases with time, as 10-year, and even 15-year municipal bonds for that matter, currently present attractive valuations. The steepness of the municipal curve relative to Treasuries is the widest the market has seen since before the financial crisis.
Historical market patterns suggest the municipal curve steepens during a Fed tightening cycle and then flattens once the angst over higher benchmark rates subsides. The retail nature of the municipal market results in demand for short-term bonds as fear over rising rates transcending the curve take hold. However, this simplistic view of the curve fails to consider the lag of Fed policy in affecting the longer-term rate structure.
The City National Rochdale fixed income team continues to balance interest rate risk (duration) and relative value opportunities within its strategies. Focused attention on portfolio optimization given all relevant market factors will be the primary catalyst for investment decisions.
Did the market gain any insight from Fed Chair Powell’s speech in Jackson Hole?
At the annual Kansas City Fed’s Economic Policy Symposium in Jackson Hole, where many central bankers meet to discuss key long-term policy issues, Powell gave a speech.
He reiterated the view that the “gradual process” of rate increases “remains appropriate” as the domestic economy continues to strengthen and the labor markets tighten. The Fed has two more rate increases planned for this year, three hikes in 2019 and one hike in 2020 (chart).
He noted that most people who want a job can find one. Combine that with strong household and business confidence, rising incomes, and fiscal stimulus and there is good reason to expect that strong performance will continue.
The recent tax cut has stimulated the economy. It has created a great deal of wealth for households as the S&P 500 is now in its record longest bull market rally.
Is the U.S. equity outlook still positive?
Strong fundamentals have helped U.S. stocks climb a wall of worry to record highs. At the same time, interest rates, though rising, remain historically low, keeping stocks attractive versus other investment options like bonds. Concerns over global growth, trade, and geopolitics are likely to weigh on sentiment in the future and raise volatility, but we believe there are still worthwhile, if more modest, gains ahead.
We have long argued that stocks eventually follow earnings, and lately earnings growth has been particularly robust. The S&P has just had two consecutive quarters of nearly 25% earnings growth, while sales growth, an even better barometer of companies’ underlying strength, posted the strongest rate since the third quarter of 2011. This is signaling that the earnings story is not just about tax cuts and that the economic foundation is supporting rising demand, allowing companies to grow profits beyond just cost-cutting measures.
We expect earnings growth to moderate over the next year, particularly as benefits from tax cuts fade. However, the economic expansion still appears to have a good amount of runway left, which should continue to support healthy corporate profitability and extend this bull market further.
Will EM troubles derail global expansion?
There are good reasons to believe a full-blown global debt crisis is relatively unlikely to erupt and that the crisis in Turkey and a few other countries will not spread.
As of now, the IMF, if necessary, has sufficient resources to handle a first wave of crises. Argentina already is negotiating a $50 billion rescue package. Moreover, emerging markets have evolved quite a bit over the past two decades, and the current crop of trouble cases is the exception rather than the norm.
On the whole, emerging economies are much better managed these days, and key improvements, such as higher foreign currency reserves, flexible exchange rates and lower inflation, have made them more insulated from the risk of contagion.
In the event that financial crises spread further through EM economies, as they did in 1997-1998, exposure of advanced economies, particularly the U.S., appears limited. Exports to developing countries make up a relatively small share of GDP in major economies, while exposure of the banking systems as a share of financial assets is also relatively small.
While there’s always a possibility that risk aversion becomes more deep-seated and impacts other markets, the structure of the global financial system today, which includes stress tests for banks and more floating exchange rates to absorb some of the financial pressure, should be able to contain the damage from this episode until it gets resolved.
