On the Radar

City National Rochdale, | Sep. 24, 2018

FAQs on the Markets and Economy

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.

It is very, very strong. More surprisingly, job growth has been trending upward in the past year, something that is rare at a later stage of an expansion.

To start with, the unemployment rate is at just 3.9%. This is one of the lowest levels in the past 50 years. It is down from a peak of 10.0% in 2009. This is the largest drop in the unemployment rate of all expansions since the end of WWII. There has been a powerful rebound of 19.5 million jobs since the worst of the recession, more than offsetting the 8.7 million jobs that were lost as a result of the recession.

Demand for labor is so strong that employment opportunities are reaching groups that have historically faced disadvantages due to their lower level of formal education. The unemployment rate for those that have not finished high school is at 5.7%, down from a peak of almost 16%. It is lower than the lows of the past expansion (chart).

While an inverting yield curve has been a good predictor of past recessions, there is almost no broader relationship between the relative flatness of the yield curve and economic growth or equity returns.

For example, 10- and 2-year Treasury yield spread was close to zero over the second half of the 1990s, but the economy remained unusually strong for most of that period and stock markets soared. More recently, the yield curve was unusually steep between 2010 - 2015, yet GDP growth averaged only slightly more than 2%.

A flattening yield curve is a natural byproduct of a maturing business cycle and, over the last five cycles, it has taken about four years on average between a flat curve (0.5% spread or less) and recession.

We wouldn’t be dismissive of a flatter yield curve altogether – it is an important input to our forecasts – and if the curve were to actually invert, we would be more concerned.

Still, the outlook for the economy, profits, inflation, and interest rates are more important for determining the direction of the stock market than the shape of the yield curve, especially after a period of substantial manipulation by central banks.

Historically, midterm years have on average endured elongated corrections in Q2 and Q3 before rallying strongly over the next three quarters. The S&P 500 has been higher one year after the midterm election every time since 1946.

The economic rationale behind this is that the government historically tended to remove stimulus during midterm years, before boosting the economy with pro-growth policies ahead of the next presidential election. The opposite is true today with recent tax cuts and an increase in federal spending.

Going by past voting patterns and recent polling data, there is a good chance that political control of at least the House will flip this year to Democratic. This would mark a return to divided government and a likelihood of little new legislation or policy change. The good news is that the stock market tends to do well during periods of gridlock because it does not disrupt the status quo.

Though we may see market volatility ahead of next month’s election results due to the policy uncertainty, we continue to expect the economic and corporate profit backdrop, backed by a fiscal stimulus, to provide a tailwind for stocks over the coming months.

It is widely expected that the Fed will raise the federal funds rate 25 basis points to the median rate of 2.125%. This will mark the eighth increase in this cycle.

This will be the third increase this year and will help fulfill the Fed’s plan of four rate increases this year. The final hike is expected in December.

The Fed continues to have an optimistic view of the domestic economy. Throughout this year it has been increasing its projection for economic growth. This has been brought, in part, by the strong labor gains and fiscal stimulus plans of the past year.

The Fed does expect economic growth to slow in 2019 and 2020 as a result of the “phasing out of the excitement of the fiscal stimulus” and the restrictive nature of the Fed’s plan for future rate hikes (chart). The Fed will give us its first peak at its expectation for 2021.

Hurricane Florence delivered high winds, record rainfall, and flooding to the Carolinas. The impact of the storm has resulted in the loss of life, damage to infrastructure, and service delivery and mobility disruptions. Moreover, natural disasters could inflict substantial financial costs on communities. Many counties in North and South Carolina received a federal disaster declaration, thereby making various program funding (i.e., FEMA) available to supplement state and local efforts. Federal cost-sharing reimbursement and grants/loans help stabilize municipal credit quality.

The economic, financial, operational, and administrative impact will vary widely, with the ultimate effects of the disaster evolving over the medium-to-longer term. In the near-term, however, reserves and liquidity dictate the ability to absorb unbudgeted costs, like debris removal, public safety, infrastructure repair, or hazard mitigation. Cities or counties could also experience declining property tax collections, while diminished business activity or population displacement may reduce certain revenues of public enterprises (i.e., utilities, transportation).

The high quality of the governments in North and South Carolina, coupled with intergovernmental support and strong repayment history of municipalities post-disaster, is likely to repeat during this recovery.

The City National Rochdale fixed income team applies a holistic credit framework that considers a multitude of risks, including naturally occurring weather events. Our base case is not broad erosion in fundamental credit quality, but should specific issuers weaken, appropriate action would follow.

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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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