Quarterly Update

Apr. 2018

Gregory S. Kaplan, Director of Fixed Income, Managing Director | Apr. 2018

Rate Volatility Likely as Year Progresses

Short rates set to rise, with long rates range-bound

Rates will dominate fixed income returns

Expect positive but below trend returns

Our forecast entering 2018 suggested that fixed income returns would be affected primarily by higher rates, firming inflation, and the Federal Reserve. This view has proven correct, with the Bloomberg Barclays Aggregate Bond Index declining 1.46% in the opening months of 2018. Market rates rose in the first part of the quarter due to the tax cuts, rising optimism by businesses and consumers, and a commensurate increase in inflation expectations. As the quarter wound down, this optimism faded as consumption remained weak, policy uncertainty increased, and stock market volatility returned. As of this writing, the 10-year Treasury is up 35 basis points but remains 20 basis points below its 2.95% peak on Feb. 21.

The Fed, led by new chairman Jerome Powell, has played a large and visible role in market sentiment as the Federal Open Market Committee progresses further down its well-broadcast path of gradual rate hikes. In response to stronger fundamental factors and more hawkish voters joining the FOMC, City National Rochdale increased its expectations from three to four hikes this year (one more than Fed projections).

This expectation is largely priced into shorter maturity bonds, but inflation remains the key driver for longer-term yields. Deficit spending, coupled with an accelerating economic growth trajectory, led the market to price in higher inflation in the future, hurting long-term bonds for most of the quarter. This has largely reversed, however, as actual inflation remains subdued and the trade war heats up.

Looking forward, we expect continued volatility in rates as uncertainty about recent fiscal stimulus, future policy actions, Fed rate hikes, and the budget deficit weigh on sentiment. We are targeting neutral to short duration and utilizing a barbell structure to capture the anticipated further flattening of the yield curve. In anticipation of a potential turn in the credit cycle in 2019-2020, we are taking advantage of tight credit spreads and strong markets to upgrade the quality of our portfolios. Overall, we continue to expect returns for investment grade fixed income in the lower single digits this year with greater potential upside in the opportunistic income sectors.

Key Points

Short rates set to rise, with long rates range-bound

Rates will dominate fixed income returns

Expect positive but below trend returns

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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 risks include, but are not limited to, stock market, manager, or investment style. 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.

Concentrating assets in the real estate sector or REITs may disproportionately subject a portfolio to the risks of that industry, including the loss of value because of adverse developments affecting the real estate industry and real property values. Investments in REITs may be subject to increased price volatility and liquidity risk; concentration risk is high.

Investments in Master Limited Partnerships (MLP) are susceptible to concentration risk, illiquidity, exposure to potential volatility, tax reporting complexity, fiscal policy, and market risk. Investors in MLPs are subject to increased tax reporting requirements. MLP investors typically receive a complicated schedule K-1 form rather than Form 1099. MLPs may not be appropriate investments for tax-advantaged accounts because of potential negative tax consequences (Unrelated Business Income Tax).

There are inherent risks with fixed-income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. 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. 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 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.

Investments in emerging market 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. Emerging market bonds can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money. Returns include the reinvestment of interest and dividends. Investing involves risk, including the loss of principal. Diversification may not protect against market loss or risk. Past performance is no guarantee of future performance.

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