On the Radar

City National Rochdale, | Aug. 13, 2018

FAQs on the Markets and Economy

Is City National Rochdale’s investment outlook still positive?

Based on our outlook for solid economic growth and improving corporate earnings, we remain bullish on equities in general and continue to see attractive prospects in the opportunistic fixed income class. Bear markets outside recessions are rare.

Still, we believe investors should prepare for more moderate returns in the months ahead and perhaps greater volatility. Patience and discipline will be more important than ever.

The investment landscape is growing more challenging as investors adjust to more typical late-stage expansion conditions of higher inflation, rising interest rates, and less accommodative monetary policy. Meanwhile, rising trade tensions and other geopolitical risks mean markets will likely continue to be subject to periodic swings in sentiment and potential pullbacks.

This does not mean there are not more worthwhile gains ahead for investors, but it does highlight the value of active management and the need for investors to become more selective.

We actively manage portfolios to be aware of where we are in the cycle, to take advantage of opportunities as they arise, and to be on alert if conditions deteriorate.

This year’s weakness has opened up a disconnect between prices and fundamentals.

From a long-term investor’s perspective, the reasons for owning EM Asia equities remain just as strong as they were before this year’s declines.

We invest in those economies that have compelling longer-term growth prospects relative to the rest of world, supported by attractive demographics, higher savings and investment rates, rapid pace of urbanization, and per capita income levels.

Moreover, the region is becoming increasingly attractive given current valuations and strong earnings growth expectations.

However, EM Asia equities do face increased tail risks currently from tightening financial conditions and rising U.S.-China trade tensions.

Policy uncertainties are likely to prevail in the months ahead, which may continue to hurt market sentiment, and we are waiting for a more favorable entry point before recommending increasing exposure.

The headline may not have been as strong as expected, but the underlying details continue to point toward continued strength in the labor market.

Nonfarm payroll came in at a tepid 157,000, 36,000 below expectations. However, that was more than offset by the revision of 59,00 for the two previous months.

The unemployment rate dropped to 3.9% from 4.0%. The cycle low was 3.8% back in June.

The underemployment rate (a broader measure that takes into account people who are unemployed, working part time but seek full time, or have given up looking for work) hit a cycle low of 7.5%, coming off a peak of 17.1% back in 2009 (Chart).

The manufacturing sector added 37,000 new jobs, the largest monthly increase this year. This may be showing that trade tensions have not yet affected employment activity in this sector.

The Fed opted to leave the federal funds rate unchanged at the median level of 1.875%. That was fully expected.

The members of the Committee appear increasingly confident in their plan for gradual increases in interest rates. The Fed is expected to raise the funds rate at its upcoming September and December meetings, the same as our view (Chart).

The Fed did upgrade its assessment of economic growth to “strong” from “solid” back in June. These subtle changes to its outlook are closely followed by Fed Watchers. The last time the Fed referred to economic growth as “strong” was 2006.

The Fed also upgraded its view on consumption, which is now characterized as “grown strongly” from “has picked up.” This is probably referring to the consumption portion of the recently released GDP report, which was a robust 4.0% in Q2, up from the paltry 0.5% growth rate in Q1.

Going only by what has actually been implemented, rather than merely threatened, we believe that the fallout for economic growth and corporate profits will be relatively manageable. Should tensions continue to escalate, and further actions be put into place, the impact will become increasingly significant.

Unfortunately, the current situation is both complex and fluid, making it difficult to confidently predict an eventual resolution. Moreover, the history of trade actions like we are now experiencing is rife with unintended consequences.

Our asset allocation and investment strategies are positioned to take this uncertainty into account. We are overweight U.S. equity markets and underweight international equity markets, which we believe will be more affected to rising trade disruptions. Likewise, our domestic equity strategy has little exposure to the sectors most likely to be impacted, such as autos and semiconductors.

It’s from this relatively strong position that we’re watching the markets, looking for signs that conditions may deteriorate but also keeping an eye out for opportunities. For example, we recently added some short-term EM credit as spreads widened out to levels we felt incorporated a worst-case outcome.

The current and future cost to public agencies and taxpayers to fund retirement benefits will increasingly contribute to budgetary stress for the most at-risk government plans.

According to the Milliman Pension Funding Index, which measures the funding adequacy of the 100 largest plans sponsored by state governments, as of Q2 2018, the estimated deficit was $1.45 trillion.

Analysis conducted by the Pew Charitable Trusts underscores the gradually building budgetary demand of pension contributions, which have nearly doubled in size (to more than 7%) relative to state own-source revenue between 2001 and 2016.

A combination of underfunding of contributions, large performance deviations (from those assumed), weak plan design, and asset allocation riskiness have elevated longer-term pension risk. As pension plans continue to mature, and differences between benefit outflows and contribution inflows widen (negative cash flow), plans are more sensitive to investment return volatility than ever before.

Reform is likely to take on further significance, the outcomes of court cases could shape future flexibility, and service modifications and revenue enhancements will also continue to be a part of the response to address unfunded pension liabilities. Pension analysis is nuanced, the range of pension health is wide; not all governments face the same degree of pension underfunding.

At City National Rochdale, we consider pension analysis a critical element of our overall process.

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Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation 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 information. Certain information has been provided by third-party sources, and although believed to be reliable, it has not been independently 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. Emerging markets involve heightened risks related to the same factors as well as increased volatility, lower trading volume, and less liquidity. Emerging markets can have greater custodial and operational risks, and less-developed legal and accounting systems, than developed markets.

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 investments in longer-duration fixed income securities and during periods when prevailing interest rates are low or negative.

Investments in below-investment-grade debt securities, which are usually called “high-yield” or “junk” bonds, are typically in weaker financial health, and such securities can be harder to value and sell and their prices can be more volatile than more highly rated securities. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a higher-quality rating.

The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the federal Alternative Minimum Tax (AMT), and taxable gains are also possible.

Investments in the municipal securities of a particular state or territory may be subject to the risk that changes in the economic conditions of that state or territory will negatively impact performance. These events may include severe financial difficulties and continued budget deficits, economic or political policy changes, tax base erosion, state constitutional limits on tax increases, and changes in the credit ratings.

Investments in emerging markets bonds may be substantially more volatile, and substantially less liquid, than the bonds of governments, government agencies, and government-owned corporations located in more-developed foreign markets.

Indices are unmanaged and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.

Returns include the reinvestment of interest and dividends.

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.

Index Definitions

The Standard & Poor’s 500 Index (S&P 500) is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.

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