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.
How strong is the labor market?
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).
Should investors be concerned about the flattening yield curve?
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.
How will midterm elections affect the market?
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.
What is expected to happen at the Fed meeting this week?
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.
What are the implications of Hurricane Florence on affected communities’ credit quality?
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.