June 30, 2022

Higher for Longer: Adapting to a New Era

Summary of June 30 Mid-Year Market Update Webinar

Forecasts and financial strategies are being updated by economists and investment experts in light of ongoing challenges to the U.S. and global economies. Tom Galvin, chief investment officer for City National Rochdale, described this as the “era of higher for longer" in a special bulletin announcement ahead of the monthly investment webinar from City National Rochdale.

During our mid-year market update, managers from Rochdale focused on investor concerns given the potential for a recession, continued inflation and the fact that global financial markets have one of the worst yearly starts on record.

“Inflation will be higher for longer than we anticipated, interest rates will be higher for longer, geopolitical tensions and uncertainty will be higher for longer and high volatility in the economy and financial markets will be higher for longer," said Galvin.

Higher for Longer


Still, Galvin said the U.S. economy is fundamentally strong, especially compared to the rest of the world. That strength is anticipated to provide the economy with some resilience against increasing headwinds.

A number of developments in recent weeks led City National Rochdale to update their outlook, including dramatic declines in recent consumer and business confidence surveys. Inflation levels are not expected to begin moderating now until the first half of 2023, which will impact real income and slow spending, said Galvin. The persistency of inflation is also increasing the difficulty of the Fed achieving a soft landing and raising the possibility of a policy mistake, at the same time the risk of extreme scenario outcomes with the Ukraine crisis are rising.

Rochdale's updated economic forecasts include:

-Lowered base case GDP growth range forecasts to 1.5-2.5% for 2022 and 0-1% for 2023.

- Increased inflation rate estimates to a range of 7% to 8% in 2022 and 3% to 4% in 2023.

- Reduced S&P 500 growth estimates to 3-8% in 2022 instead of 5-11% and earnings per share to $220; 2023 base case estimate calls for 0-8% growth and $232 per share earnings, but given the uncertainty around the outlook the overall forecast range is an unusually wide.

- An anticipated federal funds rate increase to 3.25-3.5% in 2022 and to 3.25-4% in 2023, depending on depend on incoming data and whether or not the Fed sees indications inflation is starting to moderate.

- An increase of 10-year Treasuries to 3.5% in 2022 and 4% in 2023.

- An increase in overall US recession risk from 30 to 50% in 2023. The confluence of uncertainties around the outlook implies that a wider range of potential outcomes is now possible.

- European outlook is weaker with near term recession risk rising due to greater direct exposure to the Ukrainian crisis.

As a result of the new forecast, Galvin said that Rochdale advisors are focused on higher quality US companies with durable franchises, strong management teams and reasonable valuations.

“We're taking a defensive position to lower volatility in portfolios to weather the increased risks that lie ahead," said Galvin.

Economic Momentum Slowing


City National Rochdale CEO Garrett D'Alessandro said that the unprecedented number of factors with uncertain outcomes raises the risk of a “negative feedback loop" and the possibility of a mild recession. According to Rochdale, the probability of a mild recession in 2023 with 0% to -1% growth is 40%, while the probability of a period of slow growth of 1% to 1.5% is 30%. The likelihood of normal growth of 2% to 2.5% is 20% and a normal recession of -1% to -4% growth is 10%.

D'Alessandro pointed out that unlike during the great financial crisis, the U.S. banking system is safe, the housing market is strong, wages are growing, and consumers and businesses are strong.

"We're more likely to be in a normal cyclical experience," D'Alessandro said. “The only thing that we don't know is whether there will be other consequences of the Russian invasion of Ukraine and, possibly, the Fed making a policy mistake. All other signs indicate to us that we might have slow growth, no recession or a short or mild recession."

Bloomberg, CNR Research

Changes in the outlook since the beginning of 2022 show a continued expectation of an economic slowdown over the next two quarters, said D'Alessandro, but the 2023 outlook is more uncertain than normal.


Higher for Longer


However, US fundamentals are broadly strong with, many measures of the economy at record levels. That should help mitigate the headwinds and can act as a bulwark against the dangers of a mild recession, D'Alessandro commented.


Very Strong Expansion


The stock market's increased volatility stems in part from the Fed's aggressive actions to slow inflation.

“Sometimes when you slam on the brakes you get unintended consequences," D'Alessandro noted.

Equities have declined 30% to 35% on average during cyclical recessions. So far in this cycle, equities are down 20% to 30%, according to D'Alessandro.

“We've experienced a lot of the average decline already, and that's not good, but the good part of that is that we feel we're two-thirds or three fourths of the way through a potential full equity decline if we end up in a mild recession," said D'Alessandro. “If we have additional shocks and they're much worse than we anticipate, we could have a more normal recession."

S&P 500 Returns


This year’s correction has removed a significant amount of excess that had been built up in the market, and equities are approaching more fairly priced levels, according to Rochdale. However, higher inflation presents additional downside risks for equity valuations. Once equities do hit bottom, markets have historically shown strong 12-month returns on average.

Average S&P 500 Drawdown


Fed policies to bring down inflation have already slowed demand for homes because the housing market is the most interest-rate sensitive sector of the economy, said Rochdale Managing Director, Senior Economist and Senior Portfolio Manager Paul Single. As the housing market slows, other types of consumer spending are anticipated to slow as well.

The pandemic created a rapid increase in consumer spending on goods and a shift from spending on services. Recent data show that pattern is now reversing.

“Consumption is going to be more in line with what income is going to be, adjusted for inflation," said Single

Personal Spending


Short-term volatility in the bond market reached unprecedented levels in 2022 due to the surprisingly quick reaction to Fed tightening policies, said Rochdale Co-Director of Fixed Income Charles Luke. However, there is a potential that bonds could become more attractive in 2023.


Adjusting Investment Strategist


The 10-year Treasury yield will remain under pressure, Luke said.

According to Rochdale's research, a “flattening curve," which shrinks the difference between short-term and long-term interest rates, will limit the increase in yields in 2023 to 4%.

City National Rochdale 10 Year Treasury Projections

Allocation recommendations from Rochdale managers focus on long-term yield opportunities, which will vary depending on whether the U.S. enters a period of slow growth or a mild recession.

“Our main focus is yield for our investors," said Luke. “If you're a high net-worth investor looking for the best tax shelter, you should consider high yield municipal bonds."

Fixed Income Sector Annualized total Return Potential


Since the beginning of 2022, Rochdale has repositioned its investments to lower its risk profile, said Galvin. In addition to emphasizing U.S. companies, Rochdale remains unallocated to European equities given greater near-term headwinds and continuing longer-term structural challenges, and has also sold exposure to Emerging Markets Asia equities with the outlook for the region deteriorating amid higher policy and financial risks.

Overall, Rochdale managers have been reducing exposure to cyclical equities and increasing their investments in high-quality U.S. companies and income equities selling at reasonable valuations.

Rochdale is particularly focused on blue-chip stocks, which should perform well as the economy continues grows but also have defensive characteristics including consistent earnings growth and well-established market positions that can help weather a recession should one occur.

“We advise investors to avoid highly speculative tech stocks, and anything associated with cryptocurrency," said Galvin.

Overall Target Equity Exposure

2023 Consensus EPS Estimates


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