On the Radar

City National Rochdale, | January 12, 2023

FAQs on the Markets and Economy

As we are starting a new year, what is the Federal Reserve thinking?

The most important message from the mid-December Federal Open Market Committee (FOMC) meeting was the Fed reaffirming its resolve to tame inflation by bringing it back to its target rate of 2.0%.

In addition, it also warned the markets not to expect a pivot to lower rates in 2023, which many Wall Street firms are expecting.

At the same time, the Fed will slow the pace of its interest rate increases. At the December meeting, it raised the federal funds rate by 50 basis points, a slight decrease from the record four hikes of 75 basis points from its previous meetings. The outlook for the next FOMC meeting on Feb. 1 is for a 25 basis point (bp) hike (see chart). This is where the Fed is concerned. It does not want the markets to misinterpret the slower rate increases with the belief that the Fed will soon be cutting interest rates. Although inflation has turned a corner, it is still a long way from getting near the target rate, so the Fed believes it needs to stay on course with interest rates being higher for longer.

Understanding that 2022 was a red-hot year for the labor market is essential.

There were 4.5 million workers hired, which is about twice as strong as a good year (see chart). There are currently 153.5 million workers, 1.0 million more than the peak before the recession. In addition, hiring managers have 10.5 million job openings, which is about twice as many as the long-term average (5.1 million).

The outlook for 2023 is not as robust. With the Fed aggressively raising interest rates and the pace of the domestic economy slowing, and many parts of the global economy headed into a recession, job hiring is sure to slow down. There have been headlines of layoffs in some parts of the economy (technology, entertainment and real estate). Most sectors were over-hired during the solid economic rebound following the pandemic. The broader economy has not seen many layoffs.

The big question for the labor market is, “How severe will the recession be?” The answer will determine how most other businesses respond to changes in their labor force. If there is a mild recession, expected by economic surveys, there may not be a significant change in employment. Businesses may hold onto their workers during the mild slowdown for fear that if they lay off workers, it might be too difficult to hire back qualified workers. On the other hand, if the recession is more severe than expected, layoffs in the broader economy are expected to rise.

After the worst year for financial markets in decades, we see reason for optimism in 2023.

However, investors will likely need to first show a bit more patience. A recession in the first half remains our most likely economic probability, and we continue to recommend caution in the near term, with earnings expectations the biggest downside risk for equity markets.

The good news is that the argument for a relatively short and shallow recession remains strong. Despite the headwinds of higher interest rates, household balance sheets remain healthy, labor demand continues to be resilient and banks are well-capitalized. All of these factors should help mitigate against the risks of any downturn in economic activity turning into a deeper recession and a more serious structural bear market developing.

Still, even in a scenario where the economy enters a mild recession, we would expect earnings growth to contract, at least modestly. For some time, we have argued that earnings estimates will likely have to be lowered to reflect the challenging macroeconomic backdrop ahead and rising recession risk. Although consensus expectations for 2023 have declined over the past couple of months, they remain at a healthy 5%, suggesting further downward revisions are likely before a sustainable recovery in equity prices begins.

Market bottoming will be a process that could take more time to play out, and more volatility is likely until investors gain greater clarity on the path for rate hikes and inflation, and weigh their implications for the economy and corporate profits. In the meantime, we remain happy with the de-risking steps we’ve made over the past year, including our overall modest underweight to equities with a focus on quality and income U.S. stocks, and our increased allocation to investment-grade taxable and municipal bonds that now offer some of the highest yields and relative value in 15 years.

Since March of 2022, the Fed has aggressively increased its target interest rate in an attempt to curb the worst inflation seen since the 1970s.

That key figure has risen from a modest 0.25% to more than 4.5% today and is expected to reach 5% before the cycle is through — a boon for short-term investors.

Indeed, after years of near-zero certificate of deposit (CD), bank sweep and government bond yields, investors can earn a healthier return on their cash. As a result, demand for Treasury Bills, floating-rate and ultra-short bonds, and bond funds has spiked, with some retail funds doubling their assets over the past 12 months.

As the Fed gradually reins in inflation and potentially pushes the economy into recession, short-term rates will eventually fall. City National Rochdale® sees a ~60% probability of a mild recession in 2023, as well as an end to the Fed hiking cycle, which should encourage investors hiding out on the short end of the yield curve to consider re-adding duration to their portfolios.

Treasury Bills and floating-rate notes provide increased income during hiking cycles, but reinvestment risk looms large as those rates peak and begin to fall. The chart below illustrates not only how closely short-term government yields follow the Fed’s rate decisions, but how short-lived those “peak” rates can be. As a result, an investor rolling short Treasurys could see interest income halved in only a few short months.

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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 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.

Non Deposit Investment Products are: Not FDIC Insured, Not Bank Guaranteed, May Lose Value

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. Readers are cautioned that such forward-looking statements are not a guarantee of future results, involve risks and uncertainties, and actual results may differ materially from those statement. 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.

Past performance or performance based upon assumptions is no guarantee of future results.

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

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

All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. 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 adviser 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, including 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.

CBO: A collateralized bond obligation (CBO) is a type of structured debt security that has investment-grade bonds as the underlying assets backed by the receivables on high-yield or junk bonds.

Moody’s: Moody’s Corporation (MCO) is the holding company that owns both Moody’s Investors Service, which rates fixed income debt securities, and Moody’s Analytics, which provides software and research for economic analysis and risk management. Moody’s assigns ratings on the basis of assessed risk and the borrower’s ability to make interest payments, and its ratings are closely watched by many investors.

Penn Wharton Budget Model: Penn Wharton Budget Model’s (PWBM) tax policy simulator allows policymakers, members of the media, and the general public (“users”) to see the impact that potential reforms to tax policy will have on many the economy and the federal budget.

NDMC: National Drought Mitigation Center (NDMC) The National Drought Mitigation Center’s mission is to reduce the effects of drought on people, the environment and the economy by researching the science of drought monitoring and the practice of drought planning.

NOAA: The National Oceanic and Atmospheric Administration (NOAA) is an American scientific and regulatory agency within the United States Department of Commerce that forecasts weather, monitors oceanic and atmospheric conditions, charts the seas, conducts deep sea exploration, and manages fishing and protection of marine mammals and endangered species in the U.S. exclusive economic zone.

USDA: The United States Department of Agriculture (USDA) is the federal executive department responsible for developing and executing federal laws related to farming, forestry, rural economic development, and food.

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.

CalPERS: The California Public Employees’ Retirement System, also known as CalPERS, is an organization that provides numerous benefits to its 2 million members, of which 38% are school members, 31% public agency members, and 31% state members.

4Ps: The 4P analysis is a proprietary framework for global equity allocation. Country rankings are derived from a subjective metrics system that combines the economic data for such countries with other factors including fiscal policies, demographics, innovative growth and corporate growth. These rankings are subjective and may be derived from data that contain inherent limitations.

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