April 2023 Market Update:
A Deep Dive into CNR’s Economic and Investment Outlook
US Economic Momentum Slowing
The US is likely to fall into a mild recession during the third or fourth quarter of 2023, according to a market update presented by CNR's leadership team.
The economy is already beginning to slow because of the disappearance of stimulus money from the pandemic and tightening measures implemented by the US Federal Reserve, according to Paul Single, managing director, senior economist and senior portfolio manager at City National Rochdale.
Despite the likelihood of a mild recession, the positive news is there's nothing broken in the US economy. Both household and corporate finances are generally healthy, and there is no indication of a pending deep recession, Single said
CNR Speedometers®, which are forward-looking indicators for the next six to nine months, are all yellow or red this month. Approximately one-third of the speedometers are negative (red), which signifies the slowdown occurring because of higher inflation, higher interest rates and tightened access to credit.
Recession Risk Continues to Increase
While the probability of a mild recession is far higher than a period of slow growth or a more normal recession, CNR's economists raised the probability of a normal recession up to 12%, compared to our 10% probability in March. Single explained that the risk is slightly higher this month because of the uncertainty around the banking industry and expectations of tighter credit impacting broader economic activity.
CNR's analysts expect that the Fed rate hikes are approaching an end. However, normalizing monetary policy and eventual easing will take more time and will require inflation to show a more meaningful decline closer to the Fed target rates.
Banking Stresses & the Economy
The biggest impact on the economy from bank stress will come from tightening credit conditions, especially since the US economy significantly relies on credit. Lending standards have already tightened significantly and are expected to tighten further as bank deposits — an important source of funding for banks — continue to decline.
Commercial Real Estate Is a Concern for Banks
Overall, the commercial real estate market is the third largest asset market, with $23.5 trillion in the second quarter of 2022, according to the Federal Reserve. This compares to $53 trillion in residential real estate and $46.5 trillion in equities. Concern about the underlying collateral for commercial real estate loans is higher for smaller regional banks.
Office real estate is the biggest area of risk for banks, primarily because of the fundamental change in occupancy rates in office spaces since the pandemic drastically accelerated remote work. Office occupancy rates are lower in some locations than others, primarily in California and New York City.
Despite these concerns, CNR doesn't expect the situation with commercial real estate to spark a broader crisis in the banking system.
The Strength of the Dollar
The dominance of the dollar as the world's global currency has declined since the 1960s, when it accounted for 88.2% of global reserves, versus roughly 60% today, said Tom Galvin, chief investment officer for City National Rochdale. However, most of that decline occurred after the introduction of the euro in 1999. Since then, the dollar's status as a global reserve has actually remained remarkably stable, declining only a few percentage points.
Dollar strength moves in mini cycles with ebbs and flows. Recently, its strength has been driven by higher relative interest rates. A modest decline in the strength of the dollar may occur in the next year or two, with greater convergence of interest rates in major economies as the Fed hiking cycle ends.
“After this decade of dollar dominance and dollar strength, we do think that a moderate cyclical decline is likely and is unfolding," Galvin said.
The move to greater dollar diversification is slowly happening, particularly with China, but it will take a long time. For now, the dollar remains dominant and the most viable global reserve currency.
Geopolitical Risks Continue to Impact Markets
Geopolitical risks remain elevated with the potential for another exogenous shock as economic momentum slows.
“We're keeping our eyes wide open because geopolitical uncertainty is high," said Galvin.
CNR remains underweight on China and Europe.
China's reopening is boosting growth, but there are questions about the sustainability of its consumer recovery and other structural challenges.
Europe's economy has performed better than expected, but this is likely a temporary boost due to lower energy prices from a mild winter. Headwinds are still stiff, particularly with inflation and the European Central Bank's lagging policies to address it, especially when compared to the Fed's aggressive actions.
Debt Ceiling Remains a Central Concern
The ongoing debate over the debt ceiling is a concern for CNR, particularly because of the gap between Republicans and Democrats on the issue. Additionally, lower tax receipts in 2023 could accelerate the timeline for when the federal government runs out of cash.
Fitch Ratings, Inc., one of the "Big Three" American credit ratings agencies, has recently threatened to downgrade US debt. While CNR does not believe the US government will default on its debt, the issue could be another source of market volatility in the near term.
Although markets typically do well after debt limit issues, as seen in 2011, there is potential for a significant pullback in stock prices as the deadline to lift the ceiling approaches, especially as a resolution between political parties continues to be elusive.
Other Market Influences to Watch for 2023
CNR's investment team believes that equity valuations continue to be too high and that the markets don't reflect the economic risks ahead. While first quarter earnings have been better than expected so far, this has primarily been due to the bar already having been significantly lowered, Galvin said.
Further downward revisions to earnings expectations could be a catalyst for additional equity declines ahead, he said.
After one of the worst years in history, fixed income markets have rebounded in 2023. CNR remains optimistic about fixed income, particularly because of the yield available across categories to meet different client investment objectives and the diversification benefits that bonds historically provide to portfolios.
Despite the decline in 60/40 portfolio yields in 2022, CNR believes a balanced framework still provides a strong and proven option for investment returns. It's very rare for this type of portfolio to have two consecutive down years, and the investment team remains optimistic for 2023, especially since both stocks and bonds are off to a strong start so far.
However, stocks face a more challenging path forward from here, especially as the economy weakens and potentially enters a mild recession.
While CNR believes that the Fed is coming close to the end of its tightening phase, they continue to believe defensive positioning in investing is the most prudent course given growing recessionary pressures, ongoing geopolitical risks, the debt ceiling standoff and uncertainties around the banking system. The team remains modestly underweight on equities, overweight on fixed income and focused on high quality US stocks and bonds.
City National Bank provides investment management services through its wholly owned subsidiary City National Rochdale, LLC, a registered investment advisor. Content from the April 26, 2023 presentation, "Market Update" is reprinted by permission from City National Rochdale.
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