June 2023 Mid Year Outlook

Market Update Summary

City National Rochdale provides an economic and investment outlook for the second half of 2023. The majority of economic indicators it monitors continue to suggest that a mild recession is likely sometime later this year. Although inflation is moderating, it remains too high for Fed officials who are expected to keep monetary policy tight until they see more progress or there is evidence of material economic weakness. The labor market continues to be healthy, and real wage gains are helping to support consumers spending for now. However, banks are reducing lending to consumers and businesses, which will weigh on investment, hiring and spending ahead. Despite the recent stock market rally, slowing economic growth could lead to earnings disappointments in coming months and renewed declines in equity prices. The speakers advise remaining underweight in stocks, particularly in Europe and Asia, and instead investing in fixed income and cash management returns. They emphasize the opportunities projected in short term investment grade corporate bonds, high yield bonds and structured credit.

[00:00:00] To begin, City National Rochdale CEO Garrett D’Alessandro discusses the economic and investment outlook for the second half of 2023. The majority of forward-looking economic indicators CNR monitors continue to suggest that a mild recession is likely sometime later this year. However, the recession is expected to be mild by historical strength given the strength of households and the labor market. Almost all measures of inflation have peaked and are now in a downward glide path, but they remain elevated and the Fed is likely to keep interest rates higher for longer as a result. Banks are reducing their lending to consumers and businesses, which tends to lead to slowing economic growth. The labor market is still strong and wage increases are now growing faster than inflation which should help consumers remain resilient in their spending and supports the mild recession outlook. However, high wages are also a factor contributing to lower profits and potentially negative stock trends. Mr. D’Alessandro states that equity markets have not yet fully priced in the risk of recession. He advises remaining underweight in stocks, particularly in Europe and Asia, and instead investing in fixed income and cash management returns.

[00:8:00] In this section, Mr. D’Alessandro reviews CNR’s 2023 economic forecasts, including those for GDP growth and corporate profits. While below consensus, their relatively moderate negative forecasts reflect a mild recession rather than declines that would be expected in more normal recessions. Overall, CNR sees a 78% chance of recession ahead, with a 65% likelihood the recession will be mild. CNR’s forward looking speedometers reflect this outlook, with most of their dials either negative or signaling caution. He discusses how after a year of Fed rate hikes, interest rates are only now starting to restrict economic activity. The money printed and distributed during the pandemic has benefited households and supported spending, but now that cash is dwindling. Real wage increases versus unemployment will determine how mild recession and restrictive the Fed will be. Although the stock market has gotten off to a strong start this year, returns have been due primarily to just three growth sectors: technology, communications and consumer industries. Tech stocks have contributed heavily to the total return while the contributions from several economically sensitive value leaning sectors have been the lowest on record. The limited participation from other sectors casts doubt on the sustainability of the current rally. 

[00:15:00] In this section, Paul Single discusses the recent activity of the Federal Reserve and their efforts to fight inflation. Despite some recent economic data showing weakness, the Fed has upgraded its view of the economy for this year and increased short-term interest rates. In particular, they remain concerned about the stickiness of inflation in the service sector and the strength in wage growth. The market is starting to realize that the Fed is serious about this, which can be seen through an increase in the Fed funds futures for the December contract. The Fed has several tools to control economic growth, including the Fed funds rate, which is currently at a very high level compared to the natural rate of interest. The Fed is also using quantitative tightening by reducing the size of their bond portfolio, making it harder for people to take out credit. As a result of these actions, the banking system is slowing down their lending.

[00:20:00] In this section, Mr. Single discusses the significance of the decrease in loan growth amongst banks recently, particularly in commercial and industrial loans to businesses. Decreases in lending are seen historically to correlate with increased restrictions in bank lending policies and ultimately a recession. Credit is an integral part of growing the economy. While labor demand remains strong, tightening in credit availability can lead to a reduction in hiring ahead. This is part of the Fed’s plan, as officials want to see a greater balance between labor demand and supply, which should lead to lower inflation. Mr. Single then discusses the US economic outlook in relation to other global economies. The US has led the global recovery, with its economy growing at a rate of 5.4% since the quarter before the pandemic, significantly above other regions of the world. Inflation has been a shared global issue and has led central banks to aggressively raise short-term rates to combat the problem. China is the exception, as its economy has not been as affected by inflation due to the country’s COVID-19 lockdowns and low levels of spending. China is lowering rates to try and stimulate its economy, which has begun to taper off and is causing concerns.

[00:26:00] In this section, Charles Luke delves into fixed income and cash management, highlighting the high levels of liquidity available and the opportunities for staying short. He notes that fixed income performance tends to be particularly strong before and after GDP troughs, with the defensive characteristics of the bond market beginning to come back. CNR expects that there will be robust performance in fixed income as we head toward the end of 2023 with a high yield indicating strong returns. However, the potential economic slowdown and the possibility of defaults in corporate names remains a concern. The data shows that defaults have ticked up to 3.1%, although they still remain below long-term averages of 4.1%. To limit negative impact, Mr. Luke suggests investing in high quality debt with yields above 7% and focusing on the top tier of bonds.

[00:35:00] Mr. Luke explains that investing in high yield bonds within a fixed income portfolio will help to achieve goals and targets and should be viewed as a long-term investment. While he expects some near-term price headwinds due to an expected default rate of around 5%, he believes that this is offset by the income component of around 8.5%, making it a core holding in a fixed income portfolio. Mr. Luke emphasizes that opportunities to generate income in the fixed income market are abundant, with tremendous opportunities projected in the short term for investment grade corporate bonds, high yield bonds and structured credit. He also discusses the potential for high returns for fully taxable investors in municipals, representing a tax-efficient way to invest in the market, and he concludes by analyzing the losses suffered by bond portfolios in 2022 and showing how long it would take for bonds to recover.

[00:41:00] In this section, Tom Galvin focuses on equities and states that they are modestly underweight due to negative EPS revision trends and overvaluation when compared to fixed income opportunities. He also notes that while there has been a 20% advance in stocks, a sustainable rally is unlikely to occur in the near term due to continued reduction in earnings and the stronger performance of stocks when earnings revision trends are upward and positive. Additionally, Mr. Galvin reiterates CNR’s emphasis on holding high quality US stocks during uncertain times. The disappointing performance of the Chinese economy recently is due to its export engine being unable to start, corporations and countries de-risking their exposures to China, less job creation and high unemployment rates for recent college graduates. European economies have seen modestly negative economic activity for two quarters in a row after the benefits from a mild winter and declines in energy prices have worn off, while the US economy has been very resilient. Mr. Galvin remains optimistic toward the US economy long term and recommends staying invested, and he sees opportunities for buying undervalued stocks in the Equity Income strategy after a difficult start to the year. The Equity Income strategy also offers counter-cyclical capabilities with a dividend yield of around 4.5%.

[00:49:00] In this section, Mr. Galvin discusses the S&P 500’s strong rebound this year, noting the narrow market leadership. The seven Tech Titans have driven the lion’s share of the index’s total 15% return YTD. The rest of the S&P 500 is up only 3%. Much of the strong performance in the tech stocks has been driven by enthusiasm over developments in artificial intelligence. Although there is a lot of excitement surrounding the breakthrough of generative AI, there is also a great deal of controversy and potential dangers to society. Microsoft’s recent investment in OpenAI and the creation of ChatGPT have sparked a surge in spending, which is likely to continue in the short term. However, there is skepticism about the long-term impact of AI on the economy, as some believe it could lead to worker layoffs and have negative effects on economic growth. Overall, CNR believes the outlook for generative AI is strong, but the cost of development is high and resources are limited. Valuation matters; CNR sees the best opportunities in large cap companies with established earnings, while advising to stay away from speculative tech stocks.

[00:56:00] In this section, Mr. Galvin concludes by stating that CNR is maintaining its modestly defensive positioning given elevated recession risk and uncertainty. As it relates to fixed income, it remains optimistic on returns going forward and sees numerous opportunities depending on an investors’ liquidity requirements, tax budgets, income needs and volatility thresholds. With ST treasuries yielding 5%, IG corporates and munis around 5% and HY corporate and munis over 8%, many opportunities exist. These higher rates are competitions for stocks, and the return premium you can get from stocks vs bonds is the lowest in many years. While the approaching end of the Fed’s rate hiking cycle is a clear positive development for risk assets, higher returns from bonds is a headwind for stocks as are the next stages of revision trends at a time of high valuations.

Looking forward, Mr. Galvin notes that there are several critical variables on watch for potentially increasing equity exposure. On the fundamental side, this would include increased confidence in the outlook for sustainable economic and earnings growth, as well as a faster than expected decline in inflation that could lead to lower interest rates and set the stage for a durable expansion. While CNR is not forecasting, nor positioned for a secular decline in tech stocks, a removal in tensions around Taiwan would also be beneficial. Finally, if the markets fell to a level where the risk/reward was attractive enough a strong long term buying opportunity in stocks may present itself that could supersede these other factors.