Quarterly Update

Tom Galvin, Chief Investment Officer | Jan. 2022

Market Update: End of Easy Money –Volatility Is Back

Financial environment remains positive for stocks

Corrections are normal and often healthy events

Speculative investments face increased risk

For much of 2021, the overwhelming majority of economists, strategists and market pundits were not expecting any Fed rate hikes until 2023. By the fall, though, with pandemic-driven supply/ demand imbalances keeping pressure on inflation longer than originally forecasted, expectations for higher Fed Funds in 2022 started to increase. Still, when minutes from the December FOMC meeting were released in early January, the surprisingly hawkish tone, aka the Powell Pivot, caught many investors by surprise.

As incoming inflation and wage data continued to run hotter than expected, market expectations quickly pivoted to four rate hikes in 2022, while concerns the Fed was falling behind the curve, along with lack of clarity on the balance sheet runoff, exacerbated market fears. Rates across the yield curve rose, which in turn triggered one of the steepest sell-offs in equities since the pandemic in general, and speculative technology stocks in particular. And, with 80% of the global asset classes we track, including bonds and alternatives, starting the year in the red, the sell-off has not been limited to equities.

So, what’s behind the sell-off? It has not been one thing, but rather the confluence of multiple events. The Powell Pivot, the end of easy money, rising U.S. and global interest rates, real yields increasing globally, geopolitical risks, profit taking after a great 2021, and continued concerns over inflation and wages all have come together to produce a healthy dose of fear that’s been amplified by panic selling, with anecdotal evidence that leveraged investors, algorithmic and short-term traders and hedge funds have been rushing for the exits. The “rotating correction” we’ve discussed for a few months, which started with EM Asia in the spring and was followed by U.S. Mid/Small cap stocks in the summer, spread in November to speculative tech stocks, which went from a corrective stage to a bloodbath quickly, before finally shifting to include quality and growth stocks in the NASDAQ and S&P 500, both of which ended 2021 near all-time highs and were ripe for a correction. No matter the exact cause, a real correction after the historic run since the market bottom is one we have long felt was overdue. Corrections are normal and often healthy events, helping to eliminate excesses that have built up after an extended period of optimism and setting a firmer foundation for future gains. As the chart below illustrates, stocks have experienced intra-year declines of 14% on average since 1980 with most years ending positive.

So, is it all the Fed’s fault? Yes and no. Were it not for the Fed, aggressive fiscal stimulus and best-case outcomes with COVID-19 vaccines, the multiyear economic growth outlook would not be as solid as we see it. Also, can we really blame the Fed for being off on the use of “transitory” in its messaging and being behind the curve on inflation? Not completely. The last pandemic was 100 years ago, and quantitative predictive models, as much as they have improved over the many years, can’t really factor in supply/ demand distributions brought about by government lockdowns and other pandemic distortions, unprecedented fiscal stimulus, and behavioral shifts that have impacted working from home, including the Great Resignation and increased retirements. Indeed, the rise in inflation is not a U.S.-centric issue but a global phenomenon. While the release of the Fed minutes in January has been blamed for the market sell-off, as we see it the Fed deserves some credit. The “messaging channel” has simultaneously deflated excessive valuations in speculative stocks, real interest rates have increased, the yield curve has widened from 70 bps to 90 bps and five-year forward inflation expectations have declined from 2.3% to 2%.

What are the implications of the end of easy money? Although much depends on the continued impacts from COVID-19, direct and indirect, we expect that the pace of Fed hikes, along with a gradual runoff of its balance sheet, will not be enough to change our long-term outlook for multiyear expansion. Economic fundamentals remain very strong, and Fed policy, while tightening, will still be far from restrictive. Nevertheless, there are areas that should be positively and negatively impacted. On the positive side, consumers and corporations will see increased interest paid in money market funds and related accounts, asset-sensitive financial stocks will benefit from higher rates as well as likely increased loan demand, and quality companies with pricing power and low debt levels should perform well. Areas that can be expected to be negatively impacted include speculative stocks, consumers with high exposures to speculative investments, investors and companies that have used high leverage in producing above-average gains, and companies that lose money from current operations and were relying on the never-ending flow of easy money to fund growth initiatives.

So, is it game over for stocks? Absolutely not. Growing concerns regarding the Russian troop buildup on the Ukrainian border, as well as heightened tensions with China, have led us to recently increase the risk level on our geopolitical speedometer. Still, absent any exogenous shocks that might come to pass, the fundamental outlook for stocks remains solid. We continue to believe economic activity on a global basis will begin to recover as Omicron recedes and winter ends, and we continue to expect above-trend growth in 2022 unfolding as the economy transitions from policy-induced recovery to more self-sustaining expansion. Nominal GDP growth (real GDP plus inflation) this year is likely to be around 8%, which is supportive of a positive outlook for healthy corporate revenue increases and EPS growth of 7-17%. Meanwhile, delinquencies and defaults for consumers and corporations remain low. Supporting this optimistic view has been the resiliency of BBB yields, which have moved up only modestly while equity markets have been pummeled. Stocks can sometimes initially struggle to adjust to changing policy conditions, but returns have historically been positive over the first two years of Fed tightening cycles (see chart below). More important than the direction of policy is the state of the economy. When the Fed is removing stimulus because the economy is on solid footing, and recession risk is low, stocks tend to do very well.

What’s the bottom line? While ever watchful for exogenous shocks, we’re staying the course on our multiyear expansion thesis and overweight to risk assets, and view this correction as long overdue and a buying opportunity.

Key Points

Financial environment remains positive for stocks

Corrections are normal and often healthy events

Speculative investments face increased risk

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Important Disclosures

Important Information

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.

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 re-flect 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.

Concentrating assets in a particular industry, sector of the economy, or markets may increase volatility because the investment will be more susceptible to the impact of market, economic, regulatory, and other factors affecting that industry or sector compared with a more broadly diversified asset allocation.

Private investments often engage in leveraging and other speculative investment practices that may increase the risk of investment loss, can be highly illiquid, are not required to provide periodic pricing or valuation information to investors, and may involve complex tax structures and delays in distributing important tax information.

Alternative investments are speculative, entail substantial risks, offer limited or no liquidity, and are not suitable for all investors. These investments have limited transparency to the funds’ investments and may involve leverage which magnifies both losses and gains, including the risk of loss of the entire investment. Alternative investments have varying and lengthy lockup provisions. Please see the Offering Memorandum for more complete information regarding the Fund’s investment objectives, risks, fees, and other ex-penses.

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 securi-ties. While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a high-er-quality rating.

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 height-ened 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 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 munici-pal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain inves-tors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT), and taxable gains are also possible. Investments in be-low-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.

All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guar-antee that investment objectives will be met and investors may lose money. Diversification does not ensure a profit or protect against a loss in a declining market. Past performance is no guarantee of future performance.

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

Alternative investments are speculative, entail substantial risks, offer limited or no liquidity and are not suitable for all investors. These investments have limited transparency to the funds’ investments and may involve leverage which magnifies both losses and gains, including the risk of loss of the entire investment. Alternative investments have varying, and lengthy lockup provisions.

This material is available to advisory and sub-advised clients, as well as financial professionals working with City National Rochdale, a registered investment advisor and a wholly-owned subsidiary of City National Bank. City National Bank provides investment man-agement services through its sub-advisory relationship with City National Rochdale.

Index Definitions

S&P 500 Index: The S&P 500 Index, or Standard & Poor’s 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S. It is not an exact list of the top 500 U.S. companies by market cap because there are other criteria that the index includes.

Bloomberg Barclays US Aggregate Bond Index (LBUSTRUU): The Bloomberg Aggregate Bond Index or “the Agg” is a broad-based fixed-income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.

GT2 Govt, GT3 Govt, GT5 Govt, GT10 Govt, GT30 Govt: US Government Treasury Yields

DXY Index: The U.S. dollar index (USDX) is a measure of the value of the U.S. dollar relative to the value of a basket of currencies of the majority of the U.S.’s most significant trading partners.

Dow Jones U.S. Select Dividend Index DJDVP: The Dow Jones U.S. Select Dividend Index looks to target 100 dividend-paying stocks screened for factors that include the dividend growth rate, the dividend payout ratio, and the trading volume. The components are then weighted by the dividend yield.

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