On the Radar

City National Rochdale, | Jul. 12, 2019

FAQs on the Markets and Economy

What is the federal funds futures market telling us about future Fed activity?

The December contract of federal funds futures market is currently pricing in a total of 50 bps in cuts this year. In the past year, expectations have swung from 50 bps in hikes (last autumn) to 75 bps in cuts (a few weeks ago) (see chart).

The movement in the past few months has been aggressively dovish with a 100% expectation of a 25 bps cut in the funds rate at the upcoming FOMC meeting on July 31. There was an outside possibility of the Fed cutting 50 bps at that meeting. This dovish view was brought on by the low level of inflation (1.6%), slowing global economy, increased trade tensions, and a weak labor report in May.

There has been a recent partial reversal in this view. Trade concerns have been tamed, fears of a trade war with Mexico are now gone, and there has been a resumption of trade conversation with China. Also, the payroll report for June shows the economy is not as weak as what was believed last month.

At City National Rochdale, we believe the earliest the Fed would lower rates is September. We believe the Fed wants to wait for more economic data and wants more time to measure the progress of trade negotiations before making a decision on changes to the overnight rate.

The June labor report was solid with gains in nonfarm payrolls leaping 224,000, much stronger than the 72,000 gain in May.

The monthly gain in jobs has been volatile this year, with a low of 56,000 and a high of 312,000, so we look at average gains to give us an idea of trends (chart). Clearly job growth this year is slower than last year, but last year’s growth was against the trend of the previous few years. Last year’s growth got juiced by the large corporate tax cut.

The longer-term trend in job growth has been slowing (arrow), a product of an aging expansion and difficulty in finding qualified workers.

The unemployment rate nudged up to 3.7%, from 3.6%. This happened for a “good” reason, with a 335,000 surge in the labor force.

The traditional view of the yield curve, the variance between the federal funds rate and the ten-year treasury note, has been inverted since late May.

Most of the inversion has been driven by very low inflation expectations and slower economic growth ahead.

The interest rate of the three-year treasury note is the lowest of the benchmark issues (chart). The yield fell significantly following the increase in trade tensions.

Although the economy is doing fine (unemployment rate at 50-year lows, low and stable unemployment), there is a growing expectation of the Fed cutting the federal funds rate to help ensure the expansion will continue for a longer period of time. That is what is driving demand for maturities in the next few years, so investors can lock in yields.

We continue to have enough confidence in the economic outlook and see sufficient scope for earnings growth, to remain positive on U.S. Equities.

For now, U.S. stocks are have rallied back to record highs on optimism over potential Fed rate cuts, as well over a resumption in U.S.-China trade negotiations and the suspension of new tariffs. However, we don’t expect the pace of recent gains to continue. With markets now fully pricing in these positive developments, downside risks have increased somewhat and we expect volatility to remain elevated.

The U.S. economic expansion is in its later stage, the global economy is slowing, and trade policy remains a significant concern. As a result, profit growth is becoming more challenging. City National Rochdale continues to be focused on higher quality and dividend-paying domestic companies, while minimizing exposure to cyclical and export-oriented sectors most affected by trade concerns and global headwinds.

Over time, we think the bull market will continue and that stock prices will move up in-line with modest earnings growth. However, we expect the market will likely be range-bound and volatile until we get more clarity on trade and the path of interest rates. A consolidation period or another pullback is also possible.

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.

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.

The Michigan Consumer Sentiment Index (MCSI) is a monthly survey of U.S. consumer confidence levels conducted by the University of Michigan. It is based on telephone surveys that gather information on consumer expectations regarding the overall economy.

The Bloomberg Barclays High Yield Municipal Bond Index is an unmanaged index made up of bonds that are non-investment grade, unrated, or rated below Ba1 by Moody’s Investors Service with a remaining maturity of at least one year.

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