On the Radar

City National Rochdale, | May 27, 2020

FAQs on the Markets and Economy

Is it still advisable to hold cash in equity portfolios?

Although the recent recovery in stock prices is certainly welcomed, equity markets appear to have overshot fundamentals, with valuations now at levels higher than before the crisis.

At the same time, the COVID-19 shutdown has prompted an unprecedented number of U.S. companies to suspend earnings guidance. Visibility of business conditions has never been hazier.

For the most part, investors have looked past the grim news, forecasting a rapid recovery as state economies open back up across the country.

While we too are optimistic that economic growth path will begin to recover over the second half of the year, there is good reason to think the return to normalcy will be slow and bumpy as social distancing restrictions linger and the possibility of a viral resurgence remains.

In our minds, all this suggests there is volatility still to come for equities and potential for more downside. Indeed, history has shown that the first bear market rally is rarely the last.

Our “Out of the Crisis” framework is based on specific market price levels and risk/reward targets for risk assets, as well as a rigorous assessment of indicators in four broad categories: COVID-19, ECONOMIC, EQUITY and BONDS.

For now, the many indicators we’re monitoring are, on balance, still signaling caution.

To commit cash back into the financial markets will require for us a majority of the indicators we monitor to turn positive, including continued signs of falling COVID-19 infections, a better understanding of the reopening process for the economy and greater clarity on the impact to corporate profits.

After the worst contraction in economic activity since the Great Depression, all 50 U.S. states are now in some early stage of reopening, suggesting we’ve reached, or are close to reaching, the lowest point for the U.S. economy.

Nevertheless, there is good reason to think the return to normalcy will be slow and bumpy as social distancing restrictions linger and the possibility of a viral resurgence remains.

Indeed, the early evidence suggests that, even in states that have already eased lockdown measures, demand is initially recovering only gradually.

Businesses may be slowly reopening their doors, but whether or not consumers will have the income, job security and confidence to walk through them is yet to be determined.

We anticipate some return in demand to occur initially, but not all at once, and not fully until significant progress is made in testing and tracing infections, the development of therapeutic drugs or the creation of a vaccine.

Until then, the recovery will be difficult, suggesting that investors should remain cautious, focusing on quality in their portfolios.

In short, no. The pandemic is likely to cause more elevated stress within certain parts of the high yield market, but we believe the vast majority of [higher-quality] investment grade issuers should manage near- to medium-term challenges without a sustained material diminution in their long-term credit profiles.

Leading up to the pandemic, many state and local governmental issuers built reasonable balance sheet cushion in the form of rainy day funds and preserved ample financial headroom under their bond structures. The CARES Act should provide some relief to targeted sectors, and the federal reserve Municipal Lending Facility (effectively a $500B cash flow backstop), among other programs, shows the unprecedented actions taken to firm the market and calm investor fears and instability. Further stimulus is a possibility, which would additionally support the asset class.

Municipal bonds have historically displayed resiliency and durability, with defaults on rated obligations a fraction of a percent (e.g., Moody’s data since 1970). Municipal bankruptcy is a seldom-used option and one that does not easily receive court approval. Not all states explicitly authorize their municipalities to file a Chapter 9 petition, either. Moreover, some states attach conditions, like California, which requires mediation or a financial emergency declaration.

The market tone has improved in May, with less indiscriminate selling by investors, fund flows that appear to have stabilized and nominal yields that are less volatile. Market technicals are better today than in March or April, particularly new issuance trends. Yield spreads reflect more intrinsic value than emotional pricing, which offers attractive opportunities for the discerning investor.

The Fed has employed many of the tools it used during the Global Financial Crisis of a decade ago. This time, it has deployed them faster, and it has added a few more.

Most notably, the Fed reduced the federal funds rate to near zero (range of 0.0% to 0.25%). Then it offered “forward guidance,” stating that interest rates will remain low until it is confident that the economy can achieve maximum employment and price stability. This will help to keep longer-term rates low.

The Fed brought back quantitative easing (QE), the purchase of longer-term bonds. The QE grows its balance sheet. It went into turbo drive: In the 10 weeks of QE, it had increased the size of its balance sheet compared to the GFC, when it took more than six years to accomplish the same growth (see chart).

In total, the Fed has stepped in with a broad array of strategies to deal with the pandemic’s economic impact; there are seven programs to add liquidity to the market and six credit market programs.

Japan is in a technical recession; it has had two consecutive quarters of negative growth (Q1:’20 @ -3.4% and Q4:’19 @ -7.3%, annualized rate).

The drop in Q1 economic growth was driven by a significant reduction in private consumption, which makes up more than half of GDP. Like many other countries around the world, Japan has imposed restrictions like shelter in place orders, which has sharply reduced shopping.

In the past few months, the government has made significant moves to stimulate its economy, and the Bank of Japan has made just a few modest adjustments. Its actions are smaller, adjusted for size of its economy, than the financial packages in the U.S.

Japan was a powerhouse economy from the early 1960s until an asset bubble in 1991. Since the bubble, its economy has been plagued with sluggish growth, and its growth rate has been much slower than in the U.S. (see chart).

What was once called the “lost decade” turned into the “lost 20 years,” and will probably be soon be called the “lost 30 years.”

Japan has one of the world’s highest national debt-to-GDP ratios (236%) due to social welfare spending and an aging population.

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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.

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.

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