May 2023 Market Update:

Inflation, Interest Rates & Market Volatility Remain Focus as Debt Ceiling Woes Subside

 

The probability of a recession has increased to 78%, according to City National Rochdale. Our team now predicts a mild recession unfolding over the second half of 2023, despite the debt ceiling issue being resolved by Congress and the White House for the near term.

Other issues impacting investment strategies, according to CNR, include the ongoing push to reduce inflation, credit tightening, higher interest rates and geopolitical risk.

Banking Sector Strength

Despite the failure of several banks, the banking industry is still healthy and in overall good shape, said Tom Galvin said, CNR's chief investment officer. Most banks are well capitalized and he does not expect a repeat of the Great Financial Crisis.

The main impact to the broader economy will likely come from tightening credit conditions. Banks are becoming more conservative and trying to shore up their balance sheets, which will constrain borrowing.

 

Recent Financial Stresses Easing

On a positive note, much of the financial stress that has put pressure on markets has eased in recent weeks, said Charles Luke, co-director of fixed income and CNR managing director.

 

The key indicator that is causing the most concern and fear in the market is rate volatility.

While CNR continues to predict a mild recession in the latter half of 2023 and core services inflation remains sticky, some inflation on housing and goods is easing.

The bigger challenge is wage growth, which the Fed continues to need to tamp down. However, wage growth has eased in recent months and, if it continues to decline, inflation should become less of a headwind for the economy and markets by the end of the year, Galvin said.

 

Inflation Remains Central Issue

CNR continues to anticipate that the Fed will keep rates higher for longer and does not expect any rate cuts this year as some other analysts believe.

 

The U.S. money supply is contracting for the first time since quantitative easing began, which is likely to impact liquidity. Typically, a shrinking money supply precedes a recession, which provides another recessionary signal, Luke said.

 

 

The inversion of the 10-Year/3-Month Treasury yield curve has also consistently preceded every U.S. recession, with a recession beginning within an average of 12 months of the first day of the inversion.

However, inflation is higher, consumer balance sheets are healthy, and the job market is healthy, all of which indicates that the inversion rate could pivot. Still, odds for a mild or normal recession before year's end are 78%, Luke said.

The Current Economic Outlook

 

CNR Speedometers®, which are forward-looking indicators for the next six to nine months, are all yellow (neutral) or red (negative) this month.

The headwinds are credit availability, monetary policy, geopolitical risk and slowing GDP, Galvin said. But expectations of easing inflation should help improve real disposable income and consumer confidence.

“Inflation is public enemy No. 1 in terms of consumer confidence," he said.

Macro uncertainty in the economy supports CNR's continued defensive economic strategy, which remains modestly underweight on equities, modestly overweight on fixed income and focused on high-quality U.S. stocks and bonds.

 

The recent market rally may not be sustainable because a handful of stocks — mostly the tech titans — have kept returns up above 9%, Galvin said. Meanwhile, the broader equity universe struggled to post positive returns.

Investment Adjustments During Volatility

CNR's strategy continues to focus on high quality companies with less cyclicality, Galvin said.

 

 

“We're looking for the right blend of defense against a potential recession and an offensive game plan for the post-recession," Galvin said.

CNR believes that for most investors it's not time yet to add exposure to longer maturity bonds since they remain volatile. However, longer maturity bonds are likely to be more attractive during the second half of 2023, Luke said.

For now, shorter term bonds provide income and benefit from the higher federal funds rate. However, for new portfolios, longer term bonds still make sense as part of the investment mix.

 

 

Tightening lending standards typically lead to an increase in default rates, so there's potential for more defaults in the coming months. The peak default rate is about 5% to 6%, but even with the pressure of tighter standards, yields are more than enough to offset this for now. Yields above 8% have driven returns and limited volatility so far and CNR projects high yield bond interest rates to peak around 10%, a level 5.8% above U.S. Treasuries.

However, more cautious investors may want to shift away from high yield bonds if more defaults appear on the horizon.

Municipal bonds in many cases are yielding more than taxable asset classes for the first time in 2023. The municipal bonds market is supported by the dynamics of demand against limited supply, which is a tailwind to the market and a major reason for the relative outperformance to corporate bonds since rates reached over 4.2% last year.

Based on your specific tax bracket and needs, you may want to talk with your portfolio manager about the balance between taxable and tax-exempt investments.

 

City National Rochdale Continues to Monitor Volatility 

CNR's investment committee continues to evaluate a variety of factors that could impact portfolios. The major issues this month include the continued higher for longer thesis about interest rates and the continuing elevated risk of a mild recession.

 

CNR forecasts moderate equity returns for 2023 and above average volatility, which makes an equity income strategy attractive. Investment grade corporate and municipal bonds offer healthy yields with lower volatility, while high yield corporate and municipal bonds offer reasonable reward in exchange for the risk of more volatility.