FAQs on the Markets and Economy
What does impeachment mean for the market?
U.S. constitutional clashes like impeachment are rare events, with market outcomes too context-specific to draw definitive conclusions regarding current developments. However, going by the limited history we have, market reaction over the long term seems more linked to economic fundamentals.
Although the S&P 500 fell almost 50% through the Watergate affair and its aftermath, this decline reflected much more than concerns surrounding the fate of the Nixon administration. The country was slipping into recession, hit by an oil embargo and spiking inflation. In contrast, with the U.S. economy growing well over 4%, earnings strong and moderate inflation, President Clinton’s troubles did little to blunt the bull market of the 1990s.
We think the same is true today. Rather than political turmoil in Washington, recent market movements appear driven by developments in trade negotiations, as well as incoming data on the economy and corporate profits.
Nevertheless, it would be complacent to think that potential impact from impeachment will be limited. At a minimum, it adds another layer of uncertainty to the economic backdrop and should contribute to further market volatility ahead.
Our late cycle playbook has positioned us well for an environment of heightened policy and political uncertainty, and we will be closely monitoring developments for signs that this uncertainty is bleeding into the broad economy and affecting consumer confidence. If so, we will act to further de-risk our portfolios as conditions warrant.
With three cuts under its belt, what is the Fed thinking?
Fed chair Jay Powell recently told Congress that monetary policy is on hold in the near term, but the Fed could resume its easing of monetary policy if the economic outlook falters.
Knowing that it takes 9-18 months for moves in monetary policy to work their way through the system, the Fed would like to see the impact of the summer interest rate cuts before it makes further adjustments, all else being equal.
The Fed continues to have the primary concerns with slowing global growth and trade developments. Another concern, inflation and inflationary expectation, continues to run slightly below its target.
The Fed learned a lesson from last year when it was raising short-term interest rates. At the time, it was somewhat fearful that the low unemployment rate would bring on higher inflation. Since then, the market has experienced even lower unemployment, and inflationary pressures are remaining subdued. This is being interpreted as a dovish view; the Fed will tolerate even lower unemployment, if it happens, without raising interest rates. As it stands now, the federal funds futures market expects just one more reduction next year.
What is the change in the term premium telling us?
The term premium has snapped back 44 bps from the August low of -1.29% to stand at -0.85%. This happened at a time the U.S. 10-year treasury has increased about 37 bps to the yield of 1.83%.
The term premium is the extra yield required by bond investors to hold a long-term bond instead of rolling a series of short-term bonds. Unlike yields, the term premium is not visible directly. Researchers at the Federal Reserve Bank of New York have developed a model to estimate term premium (chart). It is one of three components that make up the yield on a bond, the other two being inflation and monetary policy expectations.
Up until August, there had been the flight to quality where global investors flocked to high-quality, longer-term sovereign debt, fearful of the economic uncertainties of the to trade war, Brexit and other concerns, thus pushing down longer-term yields. But easing of economic anxiety over the past few months has reduced the need for those assets, and investors have returned to riskier investments, thus yields on those securities and the term premium have moved up, and riskier assets, like equities, have rallied.
What does the recent decline in productivity tell us?
Productivity in Q3 was significantly weaker than expected, slipping 0.3%, following a surge in the previous two quarters. Hours worked increased 2.4%, which more than offset a 2.1% gain in business output. The yearly change stands at 1.4%, slightly above the 5-year average of 1.0%.
Productivity that accelerated last year has begun to fade. The forces behind the decline in productivity rest on the shoulders of the sharp decline in business investment (Q3 at -3.0%, Q2 at -1.0% and y-o-y stands at 1.3%, well below the expansion average of 4.2% ), which is due to trade uncertainty.
Productivity is a volatile report, and economists tend to look at 5-year (yes, you read that right — changes in directions are often compared to turning an oil tanker...) moving averages (see chart). Throughout this expansion, it has been erratic and sluggish, averaging just 1.2%, well below the 2.9% average of the 10 years prior to the financial crisis.
Some economists question the accuracy of this report; it was developed shortly after WWII when the economy was far more focused on manufacturing. It is hard to determine the accuracy of productivity of a service based economy because it is hard to define “output.”
What is City National Rochdale’s investment outlook?
Given our continued positive assessment of the fundamental backdrop, we remain positive on U.S. equities in general and continue to see attractive prospects in the opportunistic fixed income class.
Still, downside risks have increased somewhat, and the investment landscape is growing more challenging.
Late-cycle conditions of slowing growth and greater vulnerability to policy missteps will require investors to change their approach and be more selective in their portfolios.
None of this means there are not more opportunities ahead for investors, but gains are likely to be more muted. At the same time, concerns over global growth, trade tensions and the path of interest rates mean markets will likely continue to be subject to periodic swings in sentiment and potential pullbacks.
Our equity and fixed income research teams have made deliberate risk-mitigating changes to help fortify cli-ent portfolios against the type of market turbulence we have recently experienced, while leaving them well-positioned to take advantage of opportunities that present themselves.