1. What is City National Rochdale’s outlook for 2018?
The global economy continues to experience a synchronized period of growth, rising corporate profits, moderate inflation, and low interest rates that is expected to last into 2019.
As a result, we believe that despite the recent financial volatility, the stage remains set for further worthwhile gains in equities and select opportunities in the credit segment of fixed income (see chart).
Moderately higher inflation and interest rates do not pose a significant danger for the U.S. economy which continues to exhibit strong momentum and low recession risk.
We expect recently passed tax cuts to provide a modest boost to GDP growth over the next several quarters and a meaningful increase in corporate earnings, which should help extend the long-run bull market for at least another year.
However, we do appear to be in the later stages of the market cycle and investors should recalibrate expectations for lower returns and higher volatility over the next few years.
2. What happened at the January Fed meeting?
Janet Yellen presided over her last FOMC meeting. Jerome “Jay” Powell will be the chair at the next FOMC meeting on March 21.
This transition is expected to be smooth with no radical change in policy in the near-term.
In the annual change of some voting members of the FOMC, a few are viewed to be somewhat more hawkish than their predecessors. There are also some vacancies to be filled by the President.
We expect three rate hikes of 25 bps this year, the first will be in March. There is an outside chance of a fourth hike if GDP stays strong, inflation picks up, and financial conditions continue to ease.
Despite five rate hikes, financial conditions (a measurement of stock prices, interest rates, credit spreads and value of the dollar) remain favorable (see chart).
3. Is the recent stock market correction signaling the end of the bull market?
No. We see the current pullback as a healthy and long overdue correction which can ultimately help extend the long running bull market, rather than the prelude to a more severe downturn.
The sell-off has been spurred by fears of higher real interest rates, as stronger than expected economic growth along with signs of wage pressures have lifted both market expectations for inflation and Fed rate hikes.
However, this represents a shift in sentiment rather than fundamentals. Recent data continue to indicate some of the best economic conditions for the eight-year U.S. expansion thus far, and double-digit earnings growth is forecast to continue through 2018, even with potentially higher interest rates.
While painful in the short-term, corrections in the vicinity of 10% are a normal part of market movements, and help prevent stock prices from rising too fast and out-of-line with the earning potential of the underlying companies (chart).
Importantly, bear markets outside recessions are not common and none of the other factors that have been traditionally associated with bear markets – soaring commodity prices, aggressive Fed tightening, extreme valuations – are evident.
A correction like this can run further, but it also provides an opportunity as stocks become more attractively valued for clients to bring portfolios closer to their long-term strategic objectives.
4. What caused the 10-year note to spike in yield?
The 10-year note jumped 30 basis points in January to end the month at 2.71%.
That monthly increase, while it seemed meaningful, was not that unusual.
What made it noticeable was the fact that it was the highest month-end yield we have seen in seven years.
Investors have begun to focus on a world of “easy money” moving away from us.
Fear of the possible rise in inflation was the catalyst for the recent increase in longer-term interest rates.
We continue to believe the 10-year note will end the year with a yield in the range of 2.5% - 3.0%, but the path there will be bumpy with the increased level of volatility in the markets.
5. Is the upturn in global growth sustainable?
There is little evidence that the synchronized upturn in global growth is running out of steam. In fact, with most of the world now growing in lockstep, the global economy appears set for a period of its strongest and broadest growth in more than a decade (chart).
In the U.S., recently passed tax cuts are boosting growth expectations for an economy that already has considerable momentum going into 2018. At the same time, the latest business surveys suggest that activity in the Eurozone, Japan, and China remains strong.
The recent breakout in global growth reflects a number of positive developments. A rise in corporate profits has helped revive capital investment, while strong labor markets and relatively depressed inflation are fueling consumer spending.
Together this has lifted confidence and a positive feedback loop has fallen into place, where the pickup in global GDP and financial conditions is in turn further boosting spending and investment.
It is possible that heightened geopolitical risks (such as tensions with Korea, missteps in trade negotiations, or policy mistakes as major central banks begin to reverse years of ultra-accommodation), could at some point disrupt global activity and financial markets.
Still, the upswing in global growth is looking increasingly resilient and will likely continue well into 2018.
6. Are higher interest rates and inflation a concern for the U.S. economy?
The U.S. economy remains on firm footing, even with the prospect of slightly higher inflation and interest rates ahead.
Improving economic momentum is well supported by healthy fundamentals and increasing confidence, which in turn is helping drive stronger business investment and consumer spending (chart).
Tax cuts and other fiscal stimuli are likely to modestly boost U.S. growth further for at least the next 12 months.
With the economy now finally operating at potential, we have moved into the later stages of this expansion, but we continue to see little evidence of excesses –massive debt growth, overinvestment, capacity constraints or extreme inflation – that normally precede recessions.
Inflation is showing early, but not pressing, signs of firming. While a tightening job market may increase wage and price pressures somewhat further in the coming year, the structural forces that have kept inflation subdued should enable the Fed to stay the course with its gradual normalization of policy.
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