1. What are City National Rochdale’s expectations for economic and investment outcomes in 2017?
We continue to overweight U.S. growth and dividend equities and to underweight investment-grade bonds.
With potential pro-growth policies, including tax cuts and stimulus spending likely in 2018, we see corporate profit growth improving over the next two years, supported by economic expansion.
Inflation from wage increases and stimulus spending may cause interest rates to rise moderately over the next 18 months. Depending on the specifics of tax cuts and spending increases, these may cause higher deficits.
Surveys of consumer and business optimism have reached multi-year high levels while real economic growth in the U.S. and globally validate these surveys. We still expect only moderate growth.
Equity investors should benefit, while fixed income investors could experience downward bond value pressure as interest rates rise.
With an uncertain legislative process and U.S. fiscal proposals delayed, downward equity price volatility is likely until we know the outcome for tax changes, healthcare rules, and regulatory changes.
2. What is City National Rochdale’s current view of the year-end federal funds rate?
The Fed stated it would raise the federal funds rate three times in 2017, and it reiterated that view in March. We continue to believe it will raise rates two to three times this year. As the first expected rate hike occurred this past March, that leaves one or two remaining for 2017.
With the Fed’s announcement to reduce the size of its balance sheet, which is a form of reducing monetary stimulus, the market is beginning to view the Fed as being less aggressive in its rate hikes (see chart).
As a result, the December federal funds futures has fallen 9 bps in the past few weeks.
3. How has the UK’s economy performed since the Brexit vote, and what is expected in the future?
Since the Brexit vote, the UK economy has continued on a moderate growth path. Fourth-quarter growth was 2.4% (annual rate), and 2016 came in at 2.0%. The weakness in the pound sterling (down 14% since the vote) has made British exports more competitive, helping to improve corporate profitability, which has helped to push up stock prices (see chart).
The UK has two important issues ahead: separation from the European Union and setting up trade agreements with all its trading partners. On March 29, Prime Minister Theresa May triggered Article 50 of the Treaty on European Union, formally starting a two-year withdrawal process. Then, on April 17, she made a surprise announcement by calling for a snap general election to be held on June 8. This action appears to be driven by the desire to gain a stronger national and parliamentary mandate before Brexit negotiations begin in earnest.
In terms of the potential impact, the election announcement may create some additional uncertainty in the short term, and there may be concerns that a stronger mandate will increase the chances of a “harder” form of Brexit.
4. Why is the yield of the 10-year treasury falling recently?
Following the election of Donald Trump, the yield of the 10-year treasury quickly jumped 74 bps due to expectations for a highly energized economy and probability of higher inflation. However, the economic excitement around the “Trump Bump” seems to be fading.
The failed attempt to replace Obamacare has many wondering if the administration has the ability to pass tax reform or other economically positive agenda items. There are a few additional reasons, including:
- A drop in inflationary expectations
- Flight to quality due to issues in North Korea
- Re-emergence of UK Brexit concerns
- Easing being implemented by many central banks
5. Is the outlook for global growth getting better?
The synchronized global upturn that began in late 2016 has continued in the early months of this year, with business surveys and hard data on industrial output in advanced economies showing further improvement. At the same time, the recovery in emerging economies appears to be broadening out, with higher prices helping major commodity exporters, including Brazil and Russia, return to growth. Particularly encouraging has been the pickup, after years of stagnation, in world trade volumes. For the moment, the threat of protectionism seems to have faded.
The IMF now forecasts global GDP will rise to 3.5% this year and 3.6% next year. This would be the first time growth has been at or above the 20-year average since 2011. However, uncertainty and structural challenges remain. It remains unclear what approach the Trump administration will take on a range of important tax and trade issues. Similarly, the UK government must manage the Brexit process. In addition, several upcoming European general elections feature high-polling populist parties that advocate major changes in economic policy.
Nevertheless, the positive trends underlying the global cyclical upturn that’s under way do appear entrenched and supportive of the recent recovery in corporate earnings.
6. Will the failure to pass tax cuts in 2017 affect City National Rochdale’s earnings outlook?
The chances of tax cuts being delayed until 2018 are increasing, and political realities have led us to reduce the probability of any reforms being enacted this year to 50%. As a result, we are no longer assuming $4 of expected corporate tax cuts in our earnings forecast for 2017 and have lowered our base case EPS estimate to $130 from $134.
With our reduced 2017 earnings outlook, markets now appear a bit overvalued, and the possibility of a near-term market correction has increased.
Nevertheless we believe fundamentals continue to be constructive longer term and would view any pullback in stock prices as a buying opportunity.
The underlying EPS growth rate is improving, and our focus remains on 2018, when we expect the largest real economic impact from policy changes to occur.
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