Market Perspectives: Into the Second Leg
FAQs on the Markets and Economy
Has inflation peaked?
The April consumer price index report came in 8.3% year over year (y-o-y), a slight decline from March’s 8.5%. That is the good news. The bad news is that inflationary pressures will not be falling quickly toward the Fed’s goal of 2.0%.
The main reason why inflation was lower in April was a temporary decline in energy prices and the base effect. There was no evidence that the underlying price pressures are easing. That said, there was some positive news that goods inflation is growing at a slower pace, but service inflation continues to grow (chart).
This is telling us that the supply chain problems and the strong demand for goods that occurred during the pandemic appear to be declining, but are being replaced by higher prices in the service sector. Higher housing costs and increased wages are keeping the heat high under service sector inflation.
Food and energy prices are expected to remain elevated for some time. The yearly change in food prices is the biggest since 1981 and includes record prices for chicken, fresh seafood and baby food. Energy prices, which had a slight reprieve in April with gasoline prices falling 6.1%, have since rebounded to a record high.
What is Fed Chairman Powell saying about the economy?
Powell is making it very clear that the Fed’s resolve in combating inflation should not be questioned. With inflation near 40-year highs, taming it is the Fed’s number one goal, even if it means pushing up the unemployment rate.
Price stability is needed for this economic expansion to continue for an extended period.
The Fed has been raising the federal funds rate to spur demand. They have already increased the rate by 75 bps, and expectations are for a 50 basis point (bps) increase at each of the Fed’s June, July and September meetings. If that happens, the median fed funds rate would be 2.375, close to the neutral federal funds rate. That is the hypothetical rate that neither stimulates nor restricts economic growth.
Adjusting monetary policy to achieve a soft-landing economy is a difficult task. Powell concedes that it is more challenging because of global events, like the war in Europe and China’s extreme response to COVID-19 with significant cities being locked down, resulting in exports being curtailed.
Should investors fear bond market volatility?
It is no secret that the swift move higher in interest rates has resulted in uninspiring year-to-date (YTD) fixed income returns. The move higher in interest rates is coupled with an increase in overall treasury market volatility as indicated by the MOVE Index.
The MOVE Index is a tool that measures the implied volatility of U.S. Treasuries options and is commonly used as a measure of bond market sentiment. Given this material increase in bond market volatility, it was prudent for broker-dealers to reduce the number of bonds held in inventory and thus reduce the number of securities available to sell to market participants.
This broad downturn in broker-dealer inventory best shows its face as an uptick in bid-ask spreads and thus a reduction in overall Treasury market liquidity. bid-ask spreads had been calm for a few years (see chart below) before the March 2020 pandemic-induced liquidity crunch, with the Fed announcing market placating policies soon thereafter. Now that the Fed has pivoted to a strong stance on fighting inflation and outlined the plan for quantitative tightening, we anticipate continued levels of heightened bond market volatility and bid-ask spreads leaking wider and wider.
To paraphrase an old investing adage: volatility creates opportunity. Treasury and corporate yields are at or near the highest level in more than a decade. The current yield environment, the low level of dealer inventories and continued levels of heightened volatility result in an attractive entry point for bond investors. Investing cash now and at a measured pace over the next several months will provide strong levels of income for years to come.
Is the S&P 500 headed for a bear market?
Despite what turned out to be a generally good earnings season, the correction in equity markets has continued for a seventh straight week, the longest streak in over 10 years.
With the S&P 500 flirting with official bear market territory (i.e., a 20%+ decline), many other major U.S. equity indices are already there, and further downside is possible. Investors remain concerned over the potential impact rising rates and inflation, as well as slowing global growth and high geopolitical uncertainty, will have on the economy and corporate profits in the quarters ahead.
While we agree that the risk to the outlook has grown, the recession is not our base-case scenario over the next 12 months. We continue to see broader support for stock prices over time. Economic fundamentals remain solid, and corporate earnings, while moderating, will likely remain in the mid-single digits. Encouragingly, bear markets without recessions have historically been much shorter and less severe than those accompanied by recessions.
At this point market declines have likely priced in much of the risk of an economic downturn ahead. Still, it remains too early to signal the all-clear just yet. Although the risk-reward ratio for equities has now improved, with valuations adjusted lower and sentiment reflecting a more bearish outlook, it will likely require greater clarity on the path of inflation for markets to find a durable bottom.
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, includ-ing 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.
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.
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