On the Radar

City National Rochdale, | Aug. 26, 2019

FAQs on the Markets and Economy

What did Fed Chair Powell discuss at his speech in Jackson Hole last week?

Powell is prepared to provide more stimulus to the economy if needed. He did not commit to a rate cut, but the market fully expects to see another 25bps reduction in the federal funds rate at the Fed’s monetary policy September meeting.

He noted that the U.S. economy was doing well. Although business investment and manufacturing have weakened, solid job growth and rising wages have been driving strong consumption, which is lifting the entire economy (see chart).

But Powell’s assessment of the global situation has deteriorated since the Fed last met in July. The international economy continues to downshift; he cited the notable slowing in Germany and China along with the growing possibility of “Hard Brexit” in the U.K., rising tensions in Hong Kong and the dissolution of the Italian government.

Also, the standoff with China represents “a new challenge” for the Fed. For the Fed, there is no game plan for dealing with trade issues. Setting trade policy and managing the negotiations of that policy is the responsibility of Congress and the administration. The Fed can only deal with the economic impact of that process.

We are not dismissive of a negative yield curve altogether-- it is an important input to our forecasts. Historically, an inversion is rare and has proven to be a good, although not perfect, recession indicator. However, several factors make us believe this time is a little different and too much emphasis is being placed on the current shape of the yield curve.

Over this expansion, the yield curve has been distorted by an extremely accommodative monetary policy. This includes quantitative easing which affected longer-term interest rates. Longer-term U.S. yields are almost certainly being driven lower by the extremely low or negative rates seen in Europe and Japan as well as strong U.S. pension fund demand. Downward pressure on global longer-term interest rates has increased due to lower global inflation and weakening growth expectations. In response, foreign investors have been buying U.S. treasury securities because they yield more than their own sovereign debt.

Indeed, we think the yield curve is saying more about the global state of affairs, and that fundamentals in the credit markets are more relevant to the U.S. economy. From that perspective, relatively low and stable BBB and high-yield spreads, coupled with an upward sloping U.S. corporate credit curve, suggest a U.S. recession is not imminent.

During the financial crisis, SLG employment as a percentage of the non-farm total increased roughly 100bps, to 15 percent, then gradually declined (currently ~13%) which suggests the private sector reduces jobs more quickly in response to a downturn but only to rebound at a faster pace during the subsequent recovery as employment opportunities accelerate; a similar behavior observed during earlier cycles. SLG employment is less scalable due to a social service delivery model, often constrained by mandate.

However, the total number of SLG workforce per capita (1,000 U.S. resident factor) sits near multi-decade lows of about 60 workers (versus approximately 65 workers in the early 2000s). If SLG employment trends had continued at the rate experienced in 2008 (relative to U.S. population growth), the size of the public sector workforce would have been 1.6MM workers higher today (see graph).

Since the financial crisis, many SLGs implemented austere measures to counter tepid, yet uneven, annualized GDP. Consequently, the lagging public sector employment recovery is a function of “doing more with less,” with SLGs forced to rethink how they conduct business (size and composition of the workforce, service levels, community investment, etc.). A more granular review of data shows reasonably weak local education trends. likely caused by demographics (declining school-age populations), private-sector competition and charter schools, and disparate state K-12 funding.

Equity valuations, although still reasonable in the context of today’s low interest rates, are beginning to look high from a historical perspective and do require close attention. High valuations are associated with lower long-term returns and provide a higher perch from which to fall in the next downturn.

Per our late-cycle playbook, we have taken measures to reduce this risk by focusing on lower P/E and higher quality, large cap and dividend paying stocks. However, it is important to note that bear markets historically have rarely been linked to high valuations alone. Usually, a combination of other factors such as recession, aggressive Fed tightening, or some kind of external shock is needed.

Over the shorter term, research shows that valuations have limited predictive value, and that factors such as the state of the business cycle, profit growth, sentiment and momentum all tend to be more important. As a result, equity markets can and have remained expensive for extended periods.

The U.S. federal deficit will expand about $800 billion more than previously expected over the next decade. The annual deficit is expected to be shy of $1 trillion this year and is expected to average $1.2 trillion per year over the next ten years.

The deficit, measured against the size of the economy, is expected to fluctuate between 4.4% and 4.8% over the next 10 years. That is well above the 2.9% average of the past 50 years.

The previous forecast was in May, and since then new legislation has been enacted (the Bipartisan Act of 2019) which will increase spending. It is interesting that despite the increased supply of bonds that will be required to service the debt, the CBO projects that interest costs over that period will decline due to lower than previously expected interest rates.

Given our continued positive assessment of the fundamental backdrop, we remain positive on equities in general and continue to see attractive prospects in the opportunistic fixed income class.

Still, downside risks have increased somewhat and the investment landscape is growing more challenging.

Late-cycle conditions of slowing growth and greater vulnerability to policy missteps will require investors to change their approach and be more selective in their portfolios.

None of this means there are not more opportunities ahead for investors, but gains are likely to be more muted. At the same time, concerns over global growth, trade tensions and the path of interest rates mean markets will likely continue to be subject to periodic swings in sentiment and potential pullbacks.

Our equity and fixed income research teams have made deliberate risk-mitigating changes to help fortify client portfolios against the type of market turbulence we have recently experienced, while leaving them well-positioned to take advantage of opportunities that present themselves.

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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.

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.

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

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