FAQs on the Markets and Economy
Is the outlook for stocks still positive?
We continue to have enough confidence in the economic outlook, and see sufficient scope for earnings growth, to remain positive on U.S. equities. However, downside risks have increased somewhat and we expect volatility to remain elevated. Economic growth is slowing as the effects of last year’s stimulus fade and further escalation of trade tensions remains a significant concern.
For now, we expect that the impact to corporate profits will be manageable, but if the U.S. administration broadens its trade disputes with Mexico and begins targeting other trade partners on key sectors like autos, the impact will grow more significant and troubling.
Fed officials are mindful of the burgeoning risk to the economy and appear set to reverse course on interest rates. This should help blunt some of the damages from trade and provide more support to the long-running bull market. Late cycle conditions of slowing growth, volatility and greater vulnerability to policy missteps require investors to be more selective in their portfolios.
City National Rochdale has responded by focusing on higher quality and dividend-paying domestic companies, while reducing exposure to cyclical and export-oriented sectors most affected by global headwinds.
With the escalation in the trade war, how has the Fed responded?
The Fed announced that it may cut interest rates if economic conditions deteriorate.
It is “closely monitoring” the trade developments but is unsure when and how they may be resolved. Just two weeks ago the president lifted steel and aluminum tariffs on Canada and Mexico to help smooth the passage of recently completed trade deal, USMCA (the new NAFTA).
Market expectations for Fed easing have increased in the past few weeks (chart). The federal funds futures market is a speculative market and currently is pricing in at least 50 bps in cuts this year.
With the trade war escalating, what is happening to corporate bonds?
An interesting phenomenon is occurring. The yield on the High Yield (HY) sector has been increasing while the yield on the Investment Grade (IG) sector has been falling (chart).
The yield increase for HY has been significant but not surprising as these securities tend to have price weakness during periods of market uncertainty. The yield decrease in IG is somewhat surprising.
This is a sector that is far more reliant on global trade compared to the HY sector. But it is much safer than HY and investors appear to view that as a benefit. It is worth noting that the yield drop in IG is not as great at government securities, indicating some concern for the future.
An important factor driving the HY market is the precipitous drop in commodity prices (down 8.0% since April highs). A big part of that is driven by the $15 drop in oil prices since the energy sector makes up more the 1/8th of the HY sector.
Should investors be concerned about the yield curve inverting?
While the yield curve may be telling us that we are moving late into the cycle, we don’t think it’s telling us it’s time to sell risk assets yet.The recent inversion is certainly something to be watched, but it has not been a good indicator to use for timing changes to one’s portfolio. In the past, when there has been a prolonged inversion, risk assets have tended to do quite well for a year or more.
We also think the recent curve inversion has partly been driven by pressure from negative rates and slowing growth abroad, as opposed to any significant deterioration in the U.S. economic outlook. For now, investor concerns have been partly calmed by signals from policymakers that any slowdown in U.S. growth will prompt the Fed to cut rates.
Low interest rates and accommodative monetary policy have been a key source of support for the long-running bull market and economic expansion. This may be a time to be cautious, but there should be gains ahead as we move into the second half of the year and corporate profit results improve from the current weak patch.
With the escalation of the trade war over the past year, how has that affected the manufacturing sector?
Manufacturing has been weakening since hitting a cycle peak back in August of last year (chart).
Although still in an expansive mode, it has slowed due to weakening global demand.
The series of trade disputes, mostly over the past year, have been largely responsible for the economic slowdown since 2017. The OECD estimates that business investment will grow at an average rate of just 1.75% this year and next year, which is half the rate of growth of the previous two years. The more the tariffs increase, the more damage this will cause.