Adjusting Investment Strategies During Uncertainty
Summary of July 27th National Webinar
The headwinds of inflation, rising interest rates and global political uncertainty continue to roil markets and raise fears of a recession more than halfway through 2022.
Managers at City National Rochdale, City National Bank's investment advisory organization, provided their July 2022 update on July 27, the same day that the U.S. Federal Reserve raised the federal funds rate by 75 basis points in an attempt to tame inflation.
STRATEGY AMIDST GLOBAL UNCERTAINTY
The level and magnitude of uncertainty around domestic and global issues create a lack of consensus about the upcoming quarters, managers said.
“Because of the wide range of potential outcomes for any of these uncertainties, the ability to have confidence that we are or are not going to go into recession is very low," said Garrett D'Alessandro, City National Rochdale's CEO. “No one has high confidence in their ability to predict what will unfold over the next couple of quarters. That's uncomfortable, but everyone on Wall Street is dealing with it."
That said, Rochdale's leadership has developed investment strategies to manage uncertainty for different risk profiles and anticipates “higher for longer" volatility in the equity and fixed-income markets. They expect it will be at least two or three quarters before the Fed reaches its goal to reduce inflation.
Global volatility is also expected to last for the foreseeable future, so Rochdale has pulled out of European and Asian investments and is underweight in overall equity investments focusing exclusively on high quality U.S. companies. Investment grade corporate and municipal bonds offer reasonable returns at this time, instead of cash.
INFLATION REMAINS A CONCERN AS FED SLOWS ECONOMY
The biggest headwind currently is inflation, that continues to reach levels beyond most economist's expectations, said D'Alessandro. Rochdale doesn't anticipate inflation will be pushed back to less than 3% by the end of 2022, which means the Fed will continue to take aggressive steps and drive interest rates higher.
Rochdale's economic outlook is less optimistic and more cautious than the consensus view. While household and business fundamentals remain strong, inflation pressure is anticipated to continue and Fed actions are likely to slow wage growth and the economy. Rochdale anticipates GDP to be 2% for 2022 and range from 0% to 2% in 2023. Inflation is expected to remain elevated at 7% to 8% for 2022 and moderate to 3% to 4% in 2023, according to their projections.
Economic momentum is slowing, and Rochdale is evaluating several potential growth probabilities. The risk of recession is now at 50% but continued unprecedented levels of uncertainty may negatively affect the U.S. economy, particularly those that are out of control of the Fed, such as supply chain issues and global political and economic pressures.
Rochdale's Speedometers, a forward-looking indicator of numerous economic metrics, would ideally show every dial green. This month, the array of headwinds means most are yellow, with only the labor market and consumer spending green.
WOULD A POTENTIAL RECESSION BE SEVERE?
Rochdale anticipates economic volatility to continue and expects the Fed to be more aggressive in its policies.
“We are lowering corporate earnings expectations into 2023," said D'Alessandro. “We're not calling for a severe recession or even a normal recession at this point. All we're saying is that we don't have rosy-colored glasses on."
In addition to domestic pressures, global issues continue to impact the U.S. economy, including Ukraine and commodity problems. Rochdale added China to its list of global headwinds.
“China is taking a very harsh stand and buckling down on capitalism and business and corporations," said D'Alessandro. “We're unwilling to be exposed to that type of potential risk."
A longer-term issue is wage pressure, with the balance of power shifting between corporations and labor since 2018 and escalating now because of labor shortages, said D'Alessandro.
The share of corporate profits was about 60% from the 1950s into about 2000, when corporations began keeping more profits.
“Companies need to bid up, pay more, be aggressive and share more of their corporate profits with their workers," said D'Alessandro. “We actually think that's a very good trend even though it might lower corporate profits. I believe in the resiliency of companies. They'll be more productive and innovative. Sharing more with workers, we think, will be healthy in the long-term."
WILL THE BEAR MARKET CONTINUE?
Rallies are normal during bear markets, but investors shouldn't necessarily anticipate stocks to continue to go up, said Tom Galvin, chief investment officer for City National Rochdale. He doesn't believe the bottom has been reached yet.
“The average length of a bear market is about 14 months and we're in about seven months on this one," said Galvin. “So, we're about halfway through timewise. We're down about 23% so far, which means we're about two-thirds of the way for an average bear market in terms of declines."
While the consensus is that corporate earnings in 2023 will be 11%, Rochdale believes that is too high, given the uncertainty in the economy. Galvin said Rochdale forecasts earnings of 5% in 2023, which could cause market declines. Rochdale's approach is to consider all potential scenarios when making investment decisions. Investors should anticipate more modest equity returns in 2023.
Investors looking for long-term capital appreciation who don't mind some short-term volatility should stick with high quality U.S. stocks, Galvin said.
Investors with an equity income strategy will also want to focus on high quality U.S. stocks but with companies that have less downside risk, and with stable earnings, cash flow and dividends, said Galvin. Those stocks should provide a 4% yield and withstand a recession, he said.
An unusual scenario in recent months has been the volatility in the bond market, said Galvin. The calendar year 2022 to date has seen the largest pullback on record in fixed-income investments since 1980. Galvin anticipates this volatility to continue because of the pressure of inflation and high interest rate sensitivity. The Fed's more aggressive actions created a shock for the fixed-income markets that led to this unprecedented volatility.
Fixed-income investment recommendations are based on long-term yield opportunities, with 6-month Treasury bills anticipated to perform better than other options in either a normal recession or a slow-growth economy.
AN ECONOMIC REBOUND IS NOT IMPOSSIBLE
Despite the uncertainties in the markets and the economy, there's room for optimism that the possibility of a rebound exists, said Galvin. However, it's difficult to have sustainable confidence in a rebound because of numerous global and domestic pressures on the economy.
Over the course of the last several months, Rochdale took multiple actions to proactively raise the defensive profiles of their client's portfolios.
“We at CNR believe capital preservation is as important as capital appreciation," Galvin said. “When meaningful risks arise, we take appropriate action."
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