| Nov. 20, 2018
FAQs on the Markets and Economy
What is behind the slowdown in the housing market?
The housing recovery has increasingly become a story of headwinds vs. tailwinds. Affordability is clearly an issue as mortgage rates have marched higher and income growth, while improving, has remained below that of home prices.
A lack of inventory is contributing to the increase in prices. Though inventory levels are up on a year-to-year basis, they remain low relative to history. Meanwhile, new housing construction faces headwinds in the way of rising labor and input costs, which have also put upward pressure on home prices.
Fundamentally, the pace of construction should continue to march higher and demand remain supported by a strong job market and increasing household formation. However, the current dynamics of limited existing inventory and moderate new supply are contributing to the affordability crunch and slowing the pace of improvement.
What was decided at the recent FOMC meeting?
The Fed did not change interest rates at the meeting, which was universally anticipated. The median level of the federal funds rate remains at 2.125%. They made modest changes to the statement, noting strong household spending growth and a moderation in business investment.
They made it clear that despite the turmoil in some markets, they are not wavering on the view that employment is strong, inflation is stable near their target level of 2.0%, and that they will continue with their gradual increases in interest rates. So far in this cycle, the Fed has raised interest rates eight times (a total of 200 basis points) and they have five more hikes planned, the next one coming this December.
The Fed expects three more rate hikes in 2019, which will bring the federal funds level to 3.125%. The federal funds futures market is less sanguine; they currently expect the rate to be 2.79% (chart). It has fallen recently with the turmoil in the stock market and lower oil prices, which may lead to lower business investment spending, a drag on GDP.
How has the bond market changed since the end of the recession?
The size of the investment grade bond market has doubled in size and is now just over $5 trillion in size (chart).
The composition, based upon credit rating, has changed. BBB-rated credits, the lowest level of investment grade bonds, now account for 49% percent of the index. Their share of the market has been growing for some time; at the end of the recession it was 38% and back in 2000 it was 31%.
With the recent volatility in the markets, there is growing concern regarding these bonds and the potential for a tidal wave of downgrades.
But BBB are not the powder keg they might seem, as the rising cost of debt, lower tax rates and robust earnings growth seen in 2018 should drive new issuance and leverage downward.
Is the recent decline in stocks the beginning of the end for the bull market?
We continue to view the current pullback as a correction, which can help ultimately extend the long-running bull market. The sell-off has been spurred by concerns over a number of issues, including: peaking corporate profits, slowing global growth, ongoing trade tensions, and rising interest rates.
In terms of monetary policy, our view is that as long as inflation remains at or near 2%, the Fed can continue to slowly hike short-term rates without derailing economic growth. Likewise, negative sentiment on earnings is not about the direction of growth, but on the magnitude. We agree that earnings growth will slow in 2019, particularly as corporate tax cuts roll off, but to its normal organic rate of about 5-7%.
The good news is that the sell-off has left valuations near or below long-run averages. We expect investors will eventually reconnect to the broader positive fundamentals, allowing the bull market to, over time, resume its gradual climb higher.
Our client portfolios are constructed with this volatility in mind and should withstand the correction relatively well, due to our high-quality equity allocation and overweight to U.S Large Cap stocks vs. Midsmall Cap and International.
Is City National Rochdale’s investment outlook still positive?
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.
Still, we believe investors should prepare for more moderate returns in the months ahead and perhaps greater volatility. Patience and discipline will be more important than ever.
The investment landscape is growing more challenging as investors adjust to more typical late-stage expansion conditions of higher inflation, rising interest rates, and less accommodative monetary policy.
Meanwhile, concerns over global growth, rising trade tensions, midterm elections, and other geopolitical risks mean markets will likely continue to be subject to periodic swings in sentiment and potential pullbacks.
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.
