Higher for Longer: A Deep Dive into CNR’s Non-Consensus Outlook and Investment Implications
Summary of September 29 Market Update Webinar
INFLATION, THE BEAR MARKET & AN ECONOMY IN FLUX
An increased risk of a recession, higher interest rates, geopolitical conflict, high inflation and slower economic growth. All of these factors impacted the investment strategy in our September 2022 market update. The biggest change in the update was that CNR's estimate of the likelihood of recession has risen to 60%, up 10% from our August recession forecast of 50%.
The U.S. Federal Reserve has made it clear that they will continue to raise the federal funds rate to combat inflation. They have also acknowledged that their actions are likely to cause more pain in the economy, said Garrett D'Alessandro, CEO of City National Rochdale.
Despite continued strength in the jobs market, wage gains and strong household net worth, higher interest rates, high inflation and a volatile stock market have potentially created a "negative feedback loop that leads to lower returns," said D'Alessandro. CNR's investment managers expect markets to remain highly volatile, and further downside is possible until investors have better clarity on both the path of inflation and Fed tightening, as well as prospects for economic and corporate profit growth.
In response to a variety of global economic and geopolitical pressures, CNR's strategy is to continue to avoid exposure to European and Asian equities, and to focus instead on high quality U.S. companies with strong balance sheets. In addition, CNR is focusing on investment-grade corporate and municipal bonds, where yields are now attractive, and some high yield corporate and municipal bonds that offer attractive yields despite higher levels of volatility.
THE RISK OF RECESSION
Despite strong fundamentals, the risk of a recession has increased, and uncertainty continues to roil the markets. CNR's economic outlook is more conservative than some other economists and financial analysts because of the negative feedback loop that continues to drive the Fed to raise rates and to impact business and consumer sentiment, explained D'Alessandro.
CNR continues to think that inflation and the Fed's response will determine the direction of travel for markets ahead. Until a pattern of lower inflation readings is established, equities will likely have a hard time mounting a sustainable rebound, and bonds could remain under pressure.
UNCERTAINTIES DRIVING INFLATION & RECESSION RISKS
CNR's SpeedometersSM, forward-looking indicators of numerous economic and financial market metrics, continue to weaken reflecting a slow growth to mild recessionary outlook. Among the more negative indicators this month is monetary policy, with the Fed taking an even more aggressive stance in its attempts to rein in inflation. The impact of higher borrowing costs is already evident in the housing market, which is the most interest rate sector of the economy.
More positively, the job market remains historically tight and continues to keep wage gains high, which has provided the disposable income growth for households to continue spending despite higher inflation. However, CNR believes that wages are ultimately the key to the inflation outlook, and that the Fed will have to continue tightening until it slows labor demand. The prospect of even tighter monetary policy in the near-term points to the potential for a sharper slowdown in economic and corporate profit growth than is currently factored into market expectations.
It could take years to get inflation down to the Fed's target rate of 2%, said Paul Single, managing director, senior economist and senior portfolio manager for City National Rochdale. While inflation trended down recently, that was primarily because of lower gas prices, which tend to move more quickly due to supply and demand, said Single. This slide, based on research by the Bureau of Labor Statistics, compares the Consumer Price Index (CPI) and the Atlanta Federal Reserve's Sticky-Price CPI, which includes about 70% of the CPI index. The "sticky" elements, such as food and energy costs, as well as rent, tend to move more slowly and continue to trend upward, said Single.
CONSUMPTION IS MAJOR FORCE BEHIND US ECONOMY
Consumption is the biggest part of the U.S. economy, representing about 70% of GDP. However, a lack of recent stimulus checks means this sector of the economy is rapidly changing.
"Although the Fed's actions haven't had much of an impact on inflation, they are starting to impact behavior, which will help out quite a bit," said Single. "A lot of this has to do with the fact that people are no longer getting stimulus checks and inflation has moved up, so people have less disposable income."
HOUSING DEMAND AFFECTED BY INCREASED INTEREST RATES
Housing is one part of the economy where the Fed does have a lot of control, said Single. Housing inflation is at the highest level in about 40 years, according to the Bureau of Labor Statistics.
The Fed's actions that have led to higher interest rates are beginning to slow down demand in many housing markets, but CNR's experts do not expect home prices to fall on an annual basis, due to the continued supply shortage. Instead, home appreciation is likely to return to a more normal rate of 5% annually and mortgage rates are also expected to be closer to the average of 5.5%.
CNR is below consensus expectations on GDP and corporate earnings growth, and above consensus expectations on interest rates.
"We're more conservative than the majority of people in all these categories," said D'Alessandro. "We've been through many of these cycles, and we think our prudent and conservative views have served us well."
HOW LONG WILL THE BEAR MARKET CONTINUE?
To place today's bear market in historical context, we compared the average decline during bear markets, the average length of the decline and the average time to recover. On average, for example, the S&P 500 declines about 31% in a bear market, which means the current bear market decline of about 21% year-to-date is still well below average.
CNR's researchers anticipate modest equity returns in 2023. While valuations adjusted over the first half of the year, the earnings adjustment process has a way to go. CNR thinks that consensus expectations remain too optimistic given elevated uncertainty around the outlook and rising recession risk.
INVESTMENT-GRADE & CORPORATE MUNICIPAL BONDS
For the first time in many years, investment-grade corporate and municipal bonds are offering attractive returns, said D'Alessandro. As a result, CNR is recommending more allocation going into fixed income than in the past.
Higher yields are a welcome change, but price volatility will remain. Rising recessionary probability will hurt credit based investments, however long-term yield opportunities drive CNR's allocation recommendations. There continues to be volatility in the bond markets, but investors who buy and hold bonds to maturity will get their yield, which makes this an attractive asset class, said D'Alessandro.
We continue to be proactive in making defensive decisions for their clients as risk to the outlook rise and is ready with potential further actions for some investors if necessary. In the meanwhile, CNR's investment managers remain focused on owning high quality companies with strong balance sheets, strong management and good long-term projections.
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