On the Radar

City National Rochdale, | April 12, 2022

FAQs on the Markets and Economy

How aggressively is the Fed reducing the risk of inflation?

Fed officials have stated that reducing inflation is of paramount importance. At the recent FOMC meeting in March, the Fed raised the federal funds rate by 25 basis points to 0.375% and announced its plans to increase the federal funds rate to 1.9% by year-end. At times, they may increase the rate by 50 bps.

The Fed will also start to reduce the size of its bond portfolio, which may put upward pressure on longer-term interest rates. The portfolio grew in the past two years from about $4 trillion to about $9 trillion (see chart). The Fed bought bonds to help push down intermediate- and longer-term interest rates to stimulate the economy. Since that is no longer needed, they will allow a preset amount of bonds to mature each month without reinvesting the proceeds. The Fed will allow $95 billion in bonds to mature each month; this is a much faster pace than the last time it reduced its portfolio (2017-2019) when it allowed $50 billion to mature each month.

The Fed also believes inflationary pressures will subside due to a decrease in federal spending, an increase in the number of people working and a decline in demand due to the higher borrowing costs.

The March labor report was another strong report. The unemployment rate fell to 3.6%, the lowest level of this expansion and the lowest rate since the pre-recession low of 3.5%. Nonfarm payroll increased by 431,000, and the previous two months were revised up by 95,000. Wages continue to grow and stand at 5.6% y-o-y. The labor force participation rate (percent of the working-age population working or looking for a job) continues to increase and now stands at the highest rate since the recession, but still well below the pre-recession rate (see chart). Higher wages, reduced savings, and a healthier workplace are the key reasons people are returning to the labor force. The continued strength in employment gains gives the Fed more reason to continue tightening monetary policy and it increases the Fed’s chances to raise the federal funds rate by 50 basis points at their next meeting in May.

In March, the Fed raised its benchmark rate by 25 bps and signaled that a more aggressive tightening campaign is likely to follow this year to help temper inflation. As a result, market pricing reflects a hawkish FOMC with shorter maturity yields experiencing a sharp rise since the beginning of the year. The SIFMA Index, a reference rate of 7-day municipal securities, exceeds 50 bps for the first time since 2020. Other security structures, like fixed-rate bonds and commercial paper, benefit from higher yields that offer investors attractive opportunities relative to 1-month Treasury bills. As the fed funds rate increases this year, variable rate demand obligations (VRBOs) and other floating rate securities should rise in tandem, paving the way for shorter-term investments to play a more important role in liquidity management and corporate cash portfolios.

Shorter-term strategies could unlock appreciable value compared to a year ago. Investors can shift duration risk given the flatness of the yield curve while being more “flexible” to take advantage of opportunities that consider the full range of monetary policy decisions. With fed funds anchored at or near zero in 10 of the past 13 years, a market previously starved of yield now offers more attractive risk-adjusted portfolio yields that better balance client objectives against duration uncertainty in the current environment. For example, a 1-3yr liquidity management strategy could currently earn approximately 1.4% gross yield (2.3% taxable-equivalent) versus a meager 20 bps a year ago (or 35 bps taxable-equivalent). As market volatility continues and evidence of a waning appetite for longer-term bonds persists, lower-duration, shorter-term securities help provide a defensive buffer and relative value opportunity within portfolios.

U.S. equity markets have rebounded nearly 6% from March lows, climbing several walls of worry, including the ongoing war in Ukraine, higher inflationary pressures, and an increasingly more aggressive Fed. Although the path forward for stocks has gotten tougher, we continue to see scope for modest gains over the next 12 months.

So far incoming economic data has been resilient. Corporate and household fundamentals remain strong, and the US economy is far more insulated from the direct impacts of the Ukraine War than other regions of the world, particularly Europe. The primary risk from the war has come from inflationary pressures driven by the global shock to energy and food supplies. Nevertheless, we still expect inflation to begin to move downward over the second half of 2022 as base effects turn favorable and reopening pressures moderate.

It should also not be lost that while interest rates are now rising, they still remain very low by historical standards. Although we think Fed tightening, and the implications that has for interest rates across the yield curve, could eventually pose a more credible headwind to economic momentum and stock market gains, our base-case view remains that the U.S. economy is not heading into a recession in 2022.

For investors, history shows that in most cases, after an initial period of flat returns, stocks have performed well during Fed tightening cycles. Even tightening cycles that preceded recessions saw higher equity returns on average 12 and 24 months later.

While we suspect markets will remain volatile until the uncertainty surrounding these key concerns subsides, we don’t think the bull market has yet run its course and that the strength of underlying fundamental conditions should offer broader support to stock prices over time.

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Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal or tax advice. This presenta-tion is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial infor-mation. Certain information has been provided by third-party sources, and although believed to be reliable, it has not been inde-pendently verified, and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts and forward-looking statements presented herein are valid as of the date of this document and are subject to change.

There are inherent risks with equity investing. These include, but are not limited to, stock market, manager or investment style risks. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices.

Investing in international markets carries risks such as currency fluctuation, regulatory risks and economic and political instability.

There are inherent risks with fixed income investing. These may include, but are not limited to, interest rate, call, credit, market, inflation, government policy, liquidity or junk bond risks. When interest rates rise, bond prices fall. This risk is heightened with in-vestments in longer-duration fixed income securities and during periods when prevailing interest rates are low or negative.

Investing involves risk, including the loss of principal.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money.

Past performance is no guarantee of future performance.

This material is available to advisory and sub-advised clients, as well as financial professionals working with City National Rochdale, a registered investment advisor and a wholly-owned subsidiary of City National Bank. City National Bank provides investment management services through its sub-advisory relationship with City National Rochdale.

INDEX DEFINITIONS

S&P 500 Index: The S&P 500 Index, or Standard & Poor’s 500 Index, is a market-capitalization-weighted index of 500 leading pub-licly traded companies in the U.S. It is not an exact list of the top 500 U.S. companies by market cap because there are other criteria that the index includes.

Muni Bond: A municipal bond is a debt security issued by a state, municipality or county to finance its capital expenditures, includ-ing the construction of highways, bridges or schools. These bonds can be thought of as loans that investors make to local govern-ments.

Bloomberg Barclays U.S. Corporate High Yield Bond Index: measures the USD denominated, high-yield, fixed-rate corporate bond market.

Dow Jones Select Dividend Index: The Dow Jones U.S. Select Dividend Index looks to target 100 dividend-paying stocks screened for factors that include the dividend growth rate, the dividend payout ratio and the trading volume. The components are then weighted by the dividend yield.

The SIFMA Municipal Swap Index: The Securities Industry and Financial Markets Association Municipal Swap Index is a 7-day high-grade market index comprised of tax-exempt Variable Rate Demand Obli-gations (VRDOs) with certain characteristics. The Index is calculated and published by Bloomberg. The Index is overseen by SIFMA’s Municipal Swap Index Committee.

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