Quarterly Update

Apr. 2019

City National Rochdale, | Apr. 2019

Back to Regularly Scheduled Programming

Volatile markets require a strong investment process

Equity prices ultimately reflect fundamentals

Global economy shows early signs of bottoming

The past two quarters have been a study of sharp contrasts in investor sentiment. After ending 2018 by posting its worst monthly performance since 1931, the S&P 500 bounced back with its biggest quarterly gain in a decade, rising 13.7%, with bond markets also rallying strongly. Last year’s historic sell-off was driven by concerns over rising trade tensions and fears that higher interest rates could hurt the U.S. economy, along with broader worries about a slowdown in the global economy and corporate profits. So what has changed?

For one thing, we think investor sentiment likely overshot to the downside when markets teetered on the edge of bear territory back in December. Investors’ expectations simply fell faster than the economic backdrop suggested. But the new year has also brought with it a new wave of optimism. Recent developments in U.S.-Chinese negotiations have raised confidence that a more damaging trade war will be avoided. Meanwhile, early signs of a bottoming in the global economy have helped investors look through the current weak patch in corporate earnings growth.

Perhaps most importantly, though, has been the shot of adrenaline delivered to markets by the Fed’s pause in monetary policy normalization. Despite essentially full employment, with inflation remaining stubbornly below target, policymakers have signaled they are now focused on the risk of overtightening and ending the expansion prematurely. Higher interest rates are feared by equity investors because they raise borrowing costs, reduce profits and make fixed income more attractive relative to stocks. They also draw capital into the U.S., strengthening the dollar, which makes it tougher for U.S. exporters to compete and for emerging market companies to repay dollar-denominated debts.

We’re not surprised by the recovery in markets. For us, the rally has been an appropriate rebound in sentiment from December’s overly pessimistic outlook. As we have seen several times before in this cycle, markets eventually reconnect to positive fundamentals. But we doubt the pace of recent gains will be sustained. Risks and tailwinds have grown more balanced, but expectations on monetary policy have now been priced into the market, which could be a source of further volatility ahead.

Will the Fed be as dovish as expected, even if the tight labor market causes a sudden, unexpected flare-up in inflation? Much of the rally this year has been built on market expectations that policymakers are done raising interest rates over the next few years. In fact, the next move now expected by the bond market is a rate cut. Likewise, while President Trump has signaled that he is generally pleased with the progress of trade negotiations with China, little tangible evidence of an impending deal has emerged. And even if a lasting truce can be reached, there is no guarantee that the U.S. administration won’t turn more confrontational with other trade partners in areas such as autos or border security.

The first quarter was a good reminder of the importance of having a rigorous investment process that can protect client portfolios and prevent overreacting when markets grow turbulent. Good periods often follow bad, when underlying fundamentals remain positive. With late business cycle conditions of slower growth and higher volatility in mind, our equity and fixed income research teams have worked proactively to fortify client portfolios against periods when uncertainty dominates, as was the case in December, while also leaving them well positioned to take advantage of an improving investment environment, as has been the case recently.

We continue to favor high-quality U.S. growth and dividend equities over other developed markets such as Europe, which has weaker growth prospects and high political risk. We also like emerging market Asia equities. Policy across the region is turning more supportive this year through fiscal and monetary stimulus, and valuations — even after this year’s rally — are still attractive, both on a historical basis and relative to other regions (see chart). Longer term, the investment case remains particularly compelling (see article: “When It Comes to Diversification, Don’t Be Naïve”). In fixed income, we also continue to see opportunities in a number of select global credit sectors, including U.S. Muni HY, emerging market debt (see article: “Emerging Market Corporate Credit: An Overlooked Opportunity”), and senior bank loans and their CLO cousins. These sectors will likely lead fixed income returns in 2019 and serve as a valuable diversifier to other risk assets.

As investors celebrate the 10-year anniversary of the bull market, we seem set to return to the defining backdrop of this cycle: low rates, slow growth and an occasional bout of volatility. The long-running expansion is now in its later stages, and uncertainty tied to Fed actions, politics, trade and sluggish global demand will likely keep markets susceptible to swings in sentiment. However, economic fundamentals remain healthy and growth, while moderating, looks sustainable. Since the Second World War, all but two bear markets have been accompanied by a recession. We think corporate profits and stock prices can continue to rise higher in such an environment, but we also believe clients should prepare for a slower, bumpier climb.


Key Points

Volatile markets require a strong investment process

Equity prices ultimately reflect fundamentals

Global economy shows early signs of bottoming

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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.

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.

MSCI Emerging Markets Asia Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the Asian emerging markets.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. & Canada. As of June 2007, the MSCI EAFE Index consisted of the following 21 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

The MSCI Europe Index is a free float-adjusted market capitalization index that is designed to measure developed market equity performance in Europe. As of September 2002, the MSCI Europe Index consisted of the following 16 developed market country indices: Austria, Belgium, Denmark, Finland, France, Germany, Greece, Ireland, Italy, the Netherlands, Norway, Portugal, Spain, Sweden, Switzerland, and the United Kingdom.

The Dow Jones Select Dividend Index seeks to represent the top 100 U.S. stocks by dividend yield. The index is derived from the Dow Jones U.S. Index and generally consists of 100 dividend-paying stocks that have five-year non-negative Dividend Growth, five-year Dividend Payout Ratio of 60% or less, and three-month average daily trading volume of at least 200,000 shares.

The Barclays Aggregate Bond Index is composed of U.S. government, mortgage-backed, asset-backed, and corporate fixed income securities with maturities of one year or more.

The Barclays High Yield Municipal Index covers the high yield portion of the U.S.-dollar-denominated long-term tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds.

The Bloomberg Barclays U.S. Corporate High Yield Index is an unmanaged, U.S.-dollar-denominated, nonconvertible, non-investment-grade debt index. The index consists of domestic and corporate bonds rated Ba and below with a minimum outstanding amount of $150 million.

S&P Leveraged Loan Indexes (S&P LL indexes) are capitalization-weighted syndicated loan indexes based upon market weightings, spreads, and interest payments. The S&P/LSTA Leveraged Loan 100 Index (LL100) dates back to 2002 and is a daily tradable index for the U.S. market that seeks to mirror the market-weighted performance of the largest institutional leveraged loans, as determined by criteria. Its ticker on Bloomberg is SPBDLLB.

The Bloomberg Commodity Total Return Index, formerly known as Dow Jones-UBS Commodity Index Total Return (DJUBSTR), is composed of futures contracts and reflects the returns on a fully collateralized investment in the BCOM. This combines the returns of the BCOM with the returns on cash collateral invested in 13-week (three-month) U.S. Treasury Bills.

Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.

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