City National Bank investment leaders remain confident in the U.S. economy. They expect high inflation to ease by the second half of 2022 as supply chain bottlenecks resolve themselves.
“The economic backdrop still remains very positive. Consumers continue to spend money, they are driving the recovery," said Ben Goetsch, senior investment strategist at the bank's investment advisory organization, City National Rochdale, during a recent market update.
Now at a 30-year high, inflation is likely to peak this quarter and remain high into the mew year, then start to taper off after the first quarter, said Paul Single, City National Rochdale managing director, senior economist and senior portfolio manager.
Given high equity valuations, low interest rates and an outlook for strong American corporate earnings, the investment team maintains its preference for portfolios weighted toward U.S. and emerging market-Asia stocks and opportunistic fixed income, notably high-yield bonds.
The team expects positive, albeit moderate, returns in its portfolios.
Goetsch said that supply chain disruptions, a key inflation driver now, should resolve by the second half of next year. He explained that several dynamics tied to the pandemic, including volatility and dramatic shifts in consumer demand, have created these disruptions.
As consumers stayed home and canceled trips in response to the coronavirus outbreak, their spending shifted heavily away from services toward goods, including durable home improvement products, Goetsch noted, citing City National research and Bloomberg data.
At the same time, they enjoyed a healthy ability to spend as government emergency stimulus checks arrived in their bank accounts, Goetsch noted. The shifts in consumer spending patterns during the short, severe pandemic recession and subsequent recovery have placed significant pressure on manufacturers, who are more accustomed to gradual changes, he explained.
“There was a very sudden, jarring drop followed by a very sudden increase in demand," Goetsch said.
Transportation issues also have fueled supply chain disturbances, he noted. Pandemic policies at ports around the world, including strict measures for ships moving in and out of China, have created delays and greatly diminished the supply of ships on the go. Goetsch noted, however, that some of these pressures have started to abate.
"Ports are starting to work through their backlog," he said.
These disruptions have hit suppliers, leading to low inventories and higher prices as consumer demand for goods surged, Goetsch said, citing data from Opportunity Insights, Affinity Solutions, OpenTable, the TSA and Apple. The situation is starting to improve, he added, referring to Bloomberg data.
In addition, a domestic trucking shortage has hit "last mile" transportation, as many drivers left the workforce entirely or shifted to other industries, causing a "massive imbalance" that should start to ease next year, Goetsch said, citing Bloomberg and FTR data.
Meanwhile, Asian manufacturing has been slow to rebound from pandemic-related disruption but is now improving, according to Goetsch, who cited Bloomberg and World Bank data.
Economists expect gross domestic product and inflation to return to typical trends, Single noted, citing Bureau of Economic Analysis and Bloomberg data.
Bloomberg forecasts 5% GDP growth in the current fourth quarter, “an extremely strong number" driven by consumer spending, continued improvement in inventories, pandemic developments and the holiday season, Single said.
He predicted that GDP growth should return to a pre-pandemic 2.5% rate by late next year, voicing hope that supply chain shortages will be fixed by then.
Transportation prices are fueling the Consumer Price Index, a key inflation measure, along with rising food and beverage prices, while apparel is exerting downward pressure on growth, Single said, citing Bureau of Labor Statistics data. Most consumer categories, however, are well within their normal inflation ranges.
Single, citing comments from Federal Reserve Chair Jerome Powell, noted that the Fed doesn't appear greatly concerned about inflation long term. They have pointed to a lack of broad-based pricing pressures, and stable wage increases in most sectors. In addition, the Fed sees long-lasting forces, including demographics and free-trade policies, continuing to keep inflation low globally.
He also cited the Fed's references to moderating price gains in high-inflation items like used cars.
While wage inflation is up to some extent, the big gains are concentrated at the lower end of the spectrum — hospitality, retail and transportation — where businesses are trying to hire workers, Single said.
Higher wages for lower-income workers, and high savings and investments in other groups, are helping to keep consumer demand and the economy going, Single said. The long term 2.5% inflation rate won't support extended wage gains, he added.
City National Rochdale's interest rate forecast remains stable and low, with no Federal Reserve rate hikes expected until late 2022, according to Charles Luke, Rochdale co-director for fixed income. These low rates will support both the equities and high-yield debt markets, Luke said.
He said that market expectations for rate hikes are volatile and inconsistent with Fed projections, citing Rochdale and Bloomberg data.
Job gains, meanwhile, are outperforming those seen in the post-financial crisis recovery more than a decade ago, with openings outpacing the number of unemployed workers, Single said, citing BLS data.
"The demand to hire people is extraordinarily strong," he said. “There are more jobs available than there are people looking for jobs," a condition that should recede over time. Also, the number of people quitting jobs is at an all-time high, Single said.
Workers who are not seeking employment now appear less worried about COVID-19 than they did earlier in the crisis, but older people and women are participating in the workforce at lower rates than others, indicating that health concerns and child-care challenges are affecting their willingness to rejoin the labor force, Single said, citing statistics from the BLS, Haver and Jefferies Economics.
According to Luke, nearly $580 billion in newly approved federal infrastructure spending will boost construction and manufacturing and replace jobs over the next 10 years without adding new taxes, which supports investment. While the spending figure is lower than initially proposed, he said, “We think the infrastructure bill is good for growth, and it's good for our overall portfolios."
City National Rochdale continues to encourage investors to consider high-yield bonds in the current environment, Luke said. While the investment leaders are keeping an eye on stress in China's high-yield property sector, global high-yield markets appear insulated from these problems, he said.
The U.S. high-yield market has generated strong returns since hitting a low in March 2020, and EM debt remains stable despite issues in China's property sector, Luke said, citing multiple market sources.
City National Rochdale remains optimistic toward China long term but has the country on watch for the short term, Chief Investment Officer Tom Galvin said.
In the U.S., Galvin noted, earnings for S&P 500 companies continued to perform better than expected in the third quarter, with solid results across all sectors. He said that results have exceeded market forecasts in every quarter since the second quarter of 2020, citing statistics from Rochdale and FactSet.
Better-than-expected earnings provide support for rising equities valuation, he said. According to Galvin, the investment team is biased toward the upper end of its 2022 earnings forecasts and expects to update its outlook soon.
Speculative retail investing has surged during the pandemic and driven the stock market rally, with bullish call options reflecting increased optimism, Galvin said. He remarked that such speculative behavior is historically linked to market shocks, citing Bloomberg data that shows increased margin and option volumes leading to bigger rallies and sharper pullbacks.
Should there be another market shock, he said, "We think our positioning should serve us well." The organization believes its high-quality stocks will strongly outperform the S&P 500 in the long term and during market pullbacks, Galvin said.
Stocks historically are the best hedge against inflation and won't be derailed by modest inflation, he said, citing FactSet and St. Louis Fed data. Falling inflation is better for stock returns, Galvin added.
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