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April 01, 2022

Interest Rates, Ukraine & Inflation: Is Economic Growth Possible?

City National Bank's investment leaders have tempered their forecast for U.S. economic expansion this year. The change was influenced by high near-term inflation and the Federal Reserve's plan to tame those rising price pressures by stepping up interest rate increases.

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U.S. Economy Remains Strong Despite Conflict in Ukraine

U.S. economic fundamentals remain strong, however, and should offset some inflationary headwinds, according to the team, which expects gross domestic product to grow by 2.75% to 3.75% this year, compared with 5.7% in 2021. The team previously had forecast 3.5% to 4.5% GDP growth for 2022.

While Russia's war in Ukraine will likely deal a significant financial blow in Europe, it probably won't derail the global economic expansion, according to leaders at City National Rochdale, the bank's investment advisory organization.

The U.S. economy should remain fairly well insulated from the war, aside from inflationary effects, the team said.

"We still feel reasonably confident that the economic expansion is intact for 2022 and we're hopeful that the economic expansion will continue into 2023," City National Rochdale CEO Garrett D'Alessandro said during a market update on March 30.

D'Alessandro also confirmed that the team is keeping an eye on the Fed's “strong commitment to raising interest rates."

“We have to watch that because rising interest rates do impact consumer and business behavior," he noted.

Chart - GDP Growth
CNR Speedometers℠

Investing During Interest Rate Hikes

The team is staying the course in terms of its investment priorities while lowering its outlook across asset classes for the year. City National Rochdale will stick with high-quality companies that should perform better as the Fed raises interest rates throughout the year, D'Alessandro said.

Robust stock performance likely won't resume until the market gains more certainty surrounding inflation, rising interest rates and the war in Ukraine, he continued.

City National investment leaders continue to favor high-yield bonds, corporate and municipal bonds, U.S. and Emerging Markets Asia stocks — including small, midcap, growth and high-dividend U.S. equities — and alternatives such as collateralized loan obligations and U.S. leveraged loans. They're also recommending short-duration and floating-rate fixed-income investments.

Consumer Spending Projected to Slow, Corporate Earnings Remain Strong

While consumers remain in strong shape, with healthy savings, job gains and rising wages, Rochdale leaders expect spending to slow a bit toward year end, D'Alessandro said.

Corporate earnings remain strong and should support equity prices and modest equity returns throughout this year, according to D'Alessandro. Rising interest rates are likely to curb business and consumer spending by at least 1% this year, however, which should moderate earnings.

The Current Inflation Outlook

In addition to lowering their GDP forecast, City National Rochdale leaders have raised their outlook for inflation. Inflation may peak by mid-year and trend downward in the second half but will likely take more than a year to reach the Fed's 2% target, D'Alessandro said, citing City National Rochdale and Bloomberg data.

Chart - Consumer Price Index

Transportation has proven a key inflation driver, along with the shock to global energy supplies resulting from the war in Ukraine. Shelter expenses — the costs associated with living in a home —also are fueling inflation, as are surging wages in certain sectors, D'Alessandro noted, citing Bloomberg data.

Graphs - CPI Component Breakdown & CPI Component Weights
Graphs - Unemployed Person Per Job Opening & Wage Growth Year-Over-Year

Many inflationary sources should naturally abate over the next year. However, D'Alessandro cited shifting preferences, pandemic supply disruptions and geopolitical shock from the war in Ukraine as current key causes of inflation. Long-term deflationary factors, including demographics and faster productivity growth, should keep inflation in check.

Chart - Inflation

Overall, the recovery from the 2020 recession is going well, with most measures of economic and financial activity having met or surpassed pre-pandemic peaks, with only the labor market yet to fully rebound, D'Alessandro said, citing Bloomberg data.

Is the Economy Strong?

Paul Single, City National Rochdale managing director, senior economist and senior portfolio manager, called the U.S. economy "stellar," citing Bureau of Economic Analysis data showing GDP expansion far stronger now than after the 2001 and 2008 recessions.

Graph - Tracking the Recovery
Chart - GDP Percent Change

Single said that labor is driving the recovery. He noted it took more than six years for the jobs market to get back on pace after the 2008 recession, while it's now nearly reached pre-pandemic levels, according to BLS stats.

Personal consumption is up more than 26% since the recession, far outpacing the levels after the two most recent previous downturns, he said, also citing the BLS.

Charts - Nonfarm Payrolls
Chart - Personal Consumption

Meanwhile, the costs associated with home buying have skyrocketed, up nearly 30% this year for housing prices and mortgage rates, according to Single, who cited U.S. Census Bureau and Bankrate.com data. While rising mortgage rates and home prices have started to affect housing, he added, "the housing market is still hot," with demand outpacing supply.

Charts - Mortgage Rates & Mortgage Payments

While Rochdale has moderated its economic forecast, Single said, "we have a very strong base." He noted that recent stock market moves indicate investors are pleased that "the Fed is going to get ahead of this inflation problem."

At the same time, Tom Galvin, City National Rochdale chief investment officer, citing FactSet data, noted that the S&P 500 is off to a weak start this year, through mid-March. Volatility should remain high, he said, while the relative strength of the U.S. economy should counter cyclical strains and "continue to carry the day barring any unforeseen negative outcomes."

While several factors including the strong U.S. economy could boost corporate earnings and valuations, inflation, the recession risk in Europe, further supply chain imbalances, Fed rate tightening and other potential headwinds could curb performance, Galvin said.

Chart - Worst Annual S&P Starts Over 40 Years
Chart - EPS & PE/Valuation

The Ukraine conflict has lasted longer than the team initially expected; they assume it will be resolved in the second quarter, Galvin said, noting the investment leaders are increasingly concerned about the war's effects on supply chains and commodity prices.

Historically, geopolitical shocks create buying opportunities and markets tend to be resilient when fundamentals are strong, he said, citing FactSet.

Chart - Largest Drawdowns Over Past 40 Years

While the Ukraine war should have a relatively limited influence on the U.S. economy, D'Alessandro said, “It's going to have an immediate and recessionary impact on Europe."

Charles Luke, co-director, fixed income, at City National Rochdale, cited Bloomberg and Rochdale data showing that the U.S. bond market is undergoing its largest drawdown since 1994 and one of the biggest in the past 40 years. Strong recoveries historically follow large bond selloffs, he said.

While the fixed-income market should be challenging for some time, Luke said, "nothing is broken" and default rates are low. “We believe the credit environment is still very, very healthy," Luke said.

He noted that the team has advised clients to invest in credit risk for most of their fixed-income allocation to mute the effects of stock volatility while reducing reliance on stable or falling yields.

The recent selloff has been driven almost entirely by interest rate increases, Luke said, noting that investment managers recommend that investors incorporate short-duration and floating-rate sectors in their fixed-income portfolios, including intermediate investment-grade corporate bonds.

Chart - Consumer Price Index With Forecast

Consider Individual Goals

Rachael Crane, City National Rochdale senior portfolio manager, noted that investment advisors navigate through an uncertain environment by integrating clients' specific needs and lifestyle goals into portfolio management.

They have been shifting clients from the traditional 60% stock, 40% bond portfolio to a moderate growth portfolio that includes higher-yielding asset classes.

Charts - Traditional Allocation & CNR Moderate Growth Portfolio

Focusing on clients' long-term goals rather than short-term volatility should increase the chances for success, she said, cautioning against emotional or behavioral investment decisions that can get in an investor's way. Working with an investment advisor can help clients correct faulty choices, said Crane.

City National encourages you to review your investment portfolio with your advisor. Contact our financial professionals today to ask questions and receive help with your wealth planning needs.

You also are encouraged to keep up-to-date with the latest economic perspectives and shifting global markets during the pandemic by signing up for City National Bank's newsletters here.

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.

The material contains forward-looking statements regarding intent, beliefs, or current expectations which are used for informational purposes only. Readers are  cautioned that such forward-looking statements are not a guarantee of future performance, involve risks and uncertainties, and actual results may differ  materially from those statements as a result of various factors. The views expressed are also subject to change based on market and other conditions.  Furthermore, the opinions and information presented do not involve the rendering of personalized investment, financial, legal, or tax advice.

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.

Investing in international markets carries risks such as currency fluctuation, regulatory risks, 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.

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

Adjustments to portfolio strategies are based on guidelines set forth by City National Rochdale’s Asset Allocation Committee. Individual client allocations among  strategies, asset classes, portfolio weightings may be higher or lower given differences in portfolio holdings, client imposed restrictions, and/or the customized  strategy implemented by each client’s portfolio manager. These differences may have a material impact on individual client’s performance returns.

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

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.

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

This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events or a guarantee  of future results.

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.

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

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.

Muni Bond: A municipal bond is a debt security issued by a state, municipality or county to finance its capital expenditures, including the construction  of highways, bridges or schools. These bonds can be thought of as loans that investors make to local governments.

Bloomberg Barclays U.S. Corporate High Yield Bond Index: measures the USD denominated, high-yield, fixed-rate corporate bond market.

Dow Jones Select Dividend Index: 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.

The Intercontinental Exchange (ICE): The Intercontinental Exchange (ICE) is an American company that owns and operates financial and commodity  marketplaces and exchanges.

The Bloomberg Aggregate Bond Index: "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.

U.S. Treasury Yield Curve: refers to a line chart that depicts the yields of short-term Treasury bills compared to the yields of long-term Treasury notes and bonds.

Consumer Price Index (CPI): is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food,  and medical care.

Bloomberg Barclays US Aggregate Bond Index: 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.

MSCI Emerging Asia PE: The MSCI Emerging Markets Index is a selection of stocks that is designed to track the financial performance of key companies in fast-  growing nations. It is one of a number of indexes created by MSCI Inc., formerly Morgan Stanley Capital International.

Global Equity Markets: a global market in which shares of companies are issued and traded, either through exchanges or over-the-counter markets.

This presentation is for general information and education only. City National makes no representations or warranties in respect of this presentation and is not  responsible for the accuracy, completeness or content of information contained in this presentation. City National is not responsible for, and expressly disclaims  all liability for, damages of any kind arising out of use, reference to, or reliance on any information contained in or from the site. The information in this  presentation should not be used to obtain credit or for any other commercial purpose nor should it be construed as tax, accounting, regulatory or legal advice.  Rules in the areas of law, tax and accounting are subject to change and open to varying interpretations and you should seek professional advice from your  advisor. Nothing in this presentation should be construed as an offer, or solicitation of an offer, to buy or sell any financial instrument. It should not be relied  upon as specific investment advice directed to the viewer's specific investment objectives. Any financial instrument discussed in this presentation may not be  suitable for the viewer. Each viewer must make his or her own investment decision, using an independent advisor if prudent, based on his or her own investment  objective and financial situation. Prices and availability of financial instruments are subject to change without notice. Financial instruments denominated in a  foreign currency are subject to exchange rate risk in addition to the risk of the investment. City National Bank (and its clients or associated persons) may, at  times, engage in transactions in a manner inconsistent with this presentation and, with respect to particular securities and financial instruments discussed, may  buy from or sell to clients or others on a principal basis. Past performance is not necessarily an indication of future results.

The expected returns shown do not include fees for trading costs (e.g., commissions) or any fees charged by your financial advisor. Please speak to your financial  advisor for a complete understanding of all fees.

City National Bank provides investment management services through its wholly owned subsidiary City National Rochdale, LLC, a registered investment advisor. Content from the March 30, 2022 presentation, "Market Update" is reprinted by permission from City National Rochdale.

City National (and its clients or associated persons) may, at times, engage in transactions in a manner inconsistent with this article and, with respect to particular securities and financial instruments discussed, may buy from or sell to clients or others on a principal basis. Past performance is not necessarily an indication of future results. This article may not be reproduced, distributed or further published by any person without the written consent of City National. Please cite source when quoting.

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