On the Radar

City National Rochdale, | May 21, 2018

FAQs on the Markets and Economy

Has City National Rochdale’s investment outlook changed for 2018?

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.

However, the investment landscape is growing more challenging as investors adjust to a more typical late-stage expansion environment of higher inflation, rising interest rates and less accommodative monetary policy.

None of this means 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.

Recently, we have moved up in quality in both our fixed income and equity portfolios to prepare for the volatility we have been experiencing. At the same time, there are pockets of value in the market, and we seek to selectively take advantage of those opportunities.

Consumption, which makes up about two-thirds of GDP, grew at a paltry 1.1% in Q1 after averaging a robust 3.2% in the previous three quarters. It now appears poised to move up significantly in Q2.

The retail sales report, which comes out monthly, gives us good insight into the quarterly GDP consumption report, which is not released until the month following quarter-end.

Retail sales have been much stronger the past two months, following weak growth in the previous three months (see chart). It appears that household spending has bounced back after the severe weather during the winter months. The yearly change in retail sales is up 4.7%, and sales have been on an uptrend these past few years since hitting a yearly low of 1.9% back in 2015.

The bullish outlook is based upon strong underlying fundamentals of a resilient labor market, increasing wages, easier access to credit and strong consumer sentiment that combine to fuel stronger consumer spending in the months ahead.

The natural rate, often called r* (r-star), is the level of an inflation-adjusted interest rate that does not create stimulus or contraction to an economy that is growing at its full strength (potential rate).

It is not observable; like the unemployment rate, it must be estimated. Economists from the Fed have created a model to calculate this rate.

The rate has been falling for several decades (see chart) due to changes in demographics (we are getting older and saving more, which puts downward pressure on interest rates, and the growth rate in the labor force is falling, which leads to slower economic growth), productivity growth has slowed from previous decades and global demand for safe assets has increased over the past two decades.

The Fed would like to see the natural rate move upward. They believe the economy is finally strong enough to reverse the downward trajectory.

The higher the natural rate, the higher the level of Fed funds. This will be beneficial down the road when the Fed needs to cut the rate to stimulate the economy.

GDP growth slid 0.6% (annualized) in Q1. This marks the first quarterly decline since 2015. The annual rate is still in the positive territory at 0.9% y-o-y.

The weakness was a result of a slowdown in private consumption (60% of GDP), which is being attributed to heavy snow in January and February causing many to stay at home.

This comes at a time when many have come to believe that Japan has escaped decades of stagflation. But this decline is viewed as a speedbump in a slow recovery. Consumption is expected to rebound in Q2 due to a solid labor market, stronger wage growth and better weather.

Abenomics, the economic policies put in place back in 2012 by PM Shinzo Abe, appear to be working to lift Japan out of its economic doldrums, which has helped suppress growth in the Nikkei 225 (see chart), the stock market index of the Tokyo stock market.

Ultimately, we believe markets follow earnings. If earnings go higher, then the market eventually will too.

S&P earnings were up more than 25% for the first quarter, surpassing already elevated expectations of roughly 16% coming into the reporting season, and double-digit growth is expected over the rest of the year.

A big reason behind this is the recently enacted tax cuts that have directly helped raise estimates higher for Q1 and the following quarters.

However, the improvement in earnings that is underway hasn’t been just a tax reform story, as the recovery in corporate profits can be traced back to the midpoint of 2016, when global economic conditions began to strengthen. The stronger dollar and higher energy prices have also been recent tailwinds. Revenues are typically a good indicator the economy’s health, and Q1’s 9% sales growth was the best in years.

These strong numbers signal that, despite the tepid start to 2018, global demand remains strong and should continue to support profit growth once the one-time effects of tax cuts roll off.

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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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