On the Radar

City National Rochdale, | Jul. 30, 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.

All indications are that this earnings season will be another strong one. According to FactSet, S&P 500 EPS is on track to increase 21% year-over-year in Q2, setting up a second straight quarter of 20% or higher growth and marking the eighth straight quarterly increase.

Several factors have continued to drive earnings growth in Q2, including solid revenue, tax cuts as well as higher oil prices and a lower U.S. dollar vs. one year ago.

In the quarters ahead, some of these tailwinds may begin to slow or reverse, but we believe the economic expansion has a good amount of runway left, which should continue to support healthy corporate profitability.

Although it’s too soon to see widespread impacts, we will also be watching for management commentary on potential hits to profitability from recent tariffs and other trade policies.

At this point we estimate the impact from trade disruptions to be manageable and continue to expect 16-18% earnings growth for 2018.

U.S. economic growth rebounded very strongly in the second quarter with an annualized 4.1% gain, boosted by a sizeable expansion in consumer spending, business investment and exports.

Can such robust performance continue? Tax cuts and fiscal stimulus spending should broadly support economic activity in the second half of the year. But trade policy uncertainty has dented business confidence somewhat, possibly leading companies to delay further investment.

As evidenced by the strong export numbers for agricultural commodities earlier in the quarter, tariffs have already acted to distort economic activity. For one quarter, at least, trade tensions could have actually led to faster growth, as foreign buyers rushed to stock up on American goods before tariffs took effect. The resulting surge in exports alone added a full percentage point to GDP.

However, exports will almost certainly slump in the third and fourth quarters and turn into a drag on overall economic growth. Looking ahead, U.S. economic fundamentals remain strong, and growth is expected to continue near a 3.0% pace in the second half of the year, but an escalation in trade tensions could push that estimate down.

In prepared remarks, Powell pretty much reiterated what was stated in the FOMC’s statement of just a few weeks ago. The Fed believes the economy is performing extremely well, improvement in the labor market will persist (the Fed believes the unemployment rate will continue to fall), and that inflation will remain stable around the Fed’s target rate of 2.0%.

Powell noted that trade tension could be a downside risk but at this point they have not affected their outlook. He noted that offsetting those risks is the fiscal stimulus, which should boost growth over at least a year or two.

The Fed believes that – for now – the best way forward is to keep gradually raising interest rates. The Fed’s current plan is for two more hikes this year, probably in September and December, which will bring the total to four hikes for 2018. For 2019, they expect to slow the pace down to just three hikes and in 2020, they plan on one hike.

A flattening of the yield curve is not worrisome at all, but an inversion of the yield curve is. An inverted yield curve is a powerful signal of recessions. Every recession in the past 60 years has been preceded by an inverted yield curve (see chart).

An inverted curve has correctly signaled all nine recessions since 1955 and had just one false positive, in the mid-1960s (when there was an economic slowdown, but not a recession).

It cannot predict when a recession will happen. In the past, recessions have come in as little as six months, or as long as two years, after the inversion.

It is important to remember that a yield curve inverting doesn’t cause the recession. Rather, the economic events that cause the yield curve to invert are what cause a recession.

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 by 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.

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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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