Navigating the Global Cross Currents
The U.S. economy is experiencing a resurgence in consumer spending and business investment
Although the Fed is now two full years into its current tightening cycle, interest rates are still meaningfully below long-term averages
While painful in the short term, corrections are a normal part of market movements
During major market moves, it’s natural for investors to question their investment strategy, but one of the benefits of professional management is decision-making based on facts, not emotions. In our analysis, the long-term outlook is growing more complicated. However, for now the positive fundamentals underpinning the equity bull market have not changed, and our position is to stay invested. Market volatility like what we are presently experiencing is normal, and it provides an opportunity, when stocks and non-investment-grade bonds become more attractively valued, to bring client portfolios closer to their long-term strategic objectives.
For investors, we believe the most important thing to keep in mind is that the economic outlook continues to be positive and that bear markets outside recessions are rare. Amid a synchronized global expansion, the U.S. economy is experiencing a resurgence in consumer spending and business investment, bolstered by booming confidence and strong corporate profitability (see Figure 1). Expansionary fiscal policy is expected to provide an additional jolt to output in the near term, and this could lift real GDP by up to 0.5% as lower tax rates and deficit spending filter through the economy.
Against this backdrop, we continue to be optimistic about equities going forward. Already strong corporate earnings growth will likely see a significant boost in 2018 due to recently enacted tax cuts, and we estimate that average overall earnings per share for the S&P 500 could rise 12-14%. A look at historical corporate earnings and market performance shows that profits tend to be the most influential driver of stock prices over time. Meanwhile, valuations, although still full, have become a bit more attractive.
Investors have recently worried that a stronger economy and inflation will lead to a more restrictive Fed. While this may be true over time, we believe we still have a ways to go before we reach the point where higher interest rates undermine economic health and stock prices. Although the Fed is now two full years into its current tightening cycle, interest rates have only crawled above their crisis lows and are still meaningfully below long-term averages (see Figure 2). Inflation, meanwhile, is showing early, but not pressing, signs of firming. In fact, it’s likely inflation-targeting policymakers will be inclined to let the economy run a little hotter than necessary, rather than risk tightening financial conditions too fast and ending the expansion prematurely.
In this context, we see the current pullback as a healthy and long overdue correction that can ultimately help extend the long-running bull market, rather than the prelude to a more severe downturn. It’s worth remembering that this is not new territory for investors. Since this bull market began in 2009, there have been five other corrections of at least 10%, and in each instance, stock prices were higher three months later. While painful in the short term, such corrections are a normal part of market movements, helping prevent stock prices from rising too fast and becoming out of line with the earning potential of their underlying companies (see Figure 3).
Still, financial markets seem to be coming to terms with the idea that things are beginning to change. The investment landscape is growing more challenging, and it will likely become more volatile as investors adjust to more typical late-stage expansion conditions of higher inflation, rising interest rates, and less accommodative monetary policy. Moreover, while valuations have proven to have very limited predictive value in the short run, history demonstrates that at current levels, overall average annual returns will likely be lower over the next several years.
None of this means there won’t be worthwhile gains ahead for investors, but it does highlight the value of active management and the need for investors to become more selective. This is why over the past several quarters, City National Rochdale began to adjust our equity and fixed income portfolios in order to be appropriately positioned for a later cycle environment.
Within equities, we have carefully and methodically lowered our risk exposure. Today, our emphasis is primarily on quality companies rather than on cyclical earnings growth. In our equity income strategy, we’ve reduced exposure to rate-sensitive sectors like utilities and are focusing on companies that can consistently and predictably grow their dividends, which we feel can offset some of the effects of rising rates and help drive our longer-term total returns.
For fixed income portfolios, we have made a number of changes in response to prospects of higher interest rates, such as shortening duration, while also increasing credit quality in recognition of late-cycle indicators. Most notably, though, has been our greater focus on floating-rate securities, which have a coupon that adjusts higher when short-term interest rates move upward. With the Fed expected to hike rates another three times this year, these bonds provide extra income with lower price sensitivity.
All together, we believe these changes leave client portfolios well positioned as we navigate the cross currents ahead. A maturing investment cycle brings unique challenges but also opportunities for investors who can proactively respond to a shifting investment environment. Our best advice is to rely on your long-term and tactical strategy being well positioned for where we are in the economic expansion and focus on the long-term earnings power of your investments.