FAQs On the Markets and Economy
1. Has City National Rochdale’s investment outlook changed for 2018?
Based on our outlook for solid economic growth and improving corporate earnings, we remain bullish on equities in general and continue to see attractive prospects in the opportunistic fixed income class. Bear markets outside recessions are rare.
However, the investment landscape is growing more challenging as investors adjust to a more typical late-stage expansion environment of higher inflation, rising interest rates and less accommodative monetary policy.
None of this means there are not more worthwhile gains ahead for investors, but it does highlight the value of active management and the need for investors to become more selective.
We actively manage portfolios to be aware of where we are in the cycle, to take advantage of opportunities as they arise and to be on alert if conditions deteriorate.
Recently, we have moved up in quality in both our fixed income and equity portfolios to prepare for the volatility we have been experiencing. At the same time, there are pockets of value in the market, and we seek to selectively take advantage of those opportunities.
2. Is consumption picking up from the low level of growth in the Q1 GDP report?
Consumption, which makes up about two-thirds of GDP, grew at a paltry 1.1% in Q1 after averaging a robust 3.2% in the previous three quarters. It now appears poised to move up significantly in Q2.
The retail sales report, which comes out monthly, gives us good insight into the quarterly GDP consumption report, which is not released until the month following quarter-end.
Retail sales have been much stronger the past two months, following weak growth in the previous three months (see chart). It appears that household spending has bounced back after the severe weather during the winter months. The yearly change in retail sales is up 4.7%, and sales have been on an uptrend these past few years since hitting a yearly low of 1.9% back in 2015.
The bullish outlook is based upon strong underlying fundamentals of a resilient labor market, increasing wages, easier access to credit and strong consumer sentiment that combine to fuel stronger consumer spending in the months ahead.
3. What is the natural rate of interest and why are Fed policymakers talking about it?
The natural rate, often called r* (r-star), is the level of an inflation-adjusted interest rate that does not create stimulus or contraction to an economy that is growing at its full strength (potential rate).
It is not observable; like the unemployment rate, it must be estimated. Economists from the Fed have created a model to calculate this rate.
The rate has been falling for several decades (see chart) due to changes in demographics (we are getting older and saving more, which puts downward pressure on interest rates, and the growth rate in the labor force is falling, which leads to slower economic growth), productivity growth has slowed from previous decades and global demand for safe assets has increased over the past two decades.
The Fed would like to see the natural rate move upward. They believe the economy is finally strong enough to reverse the downward trajectory.
The higher the natural rate, the higher the level of Fed funds. This will be beneficial down the road when the Fed needs to cut the rate to stimulate the economy.
4. What is happening with Japan’s economy?
GDP growth slid 0.6% (annualized) in Q1. This marks the first quarterly decline since 2015. The annual rate is still in the positive territory at 0.9% y-o-y.
The weakness was a result of a slowdown in private consumption (60% of GDP), which is being attributed to heavy snow in January and February causing many to stay at home.
This comes at a time when many have come to believe that Japan has escaped decades of stagflation. But this decline is viewed as a speedbump in a slow recovery. Consumption is expected to rebound in Q2 due to a solid labor market, stronger wage growth and better weather.
Abenomics, the economic policies put in place back in 2012 by PM Shinzo Abe, appear to be working to lift Japan out of its economic doldrums, which has helped suppress growth in the Nikkei 225 (see chart), the stock market index of the Tokyo stock market.
5. Does the corporate profit outlook support higher stock prices?
Ultimately, we believe markets follow earnings. If earnings go higher, then the market eventually will too.
S&P earnings were up more than 25% for the first quarter, surpassing already elevated expectations of roughly 16% coming into the reporting season, and double-digit growth is expected over the rest of the year.
A big reason behind this is the recently enacted tax cuts that have directly helped raise estimates higher for Q1 and the following quarters.
However, the improvement in earnings that is underway hasn’t been just a tax reform story, as the recovery in corporate profits can be traced back to the midpoint of 2016, when global economic conditions began to strengthen. The stronger dollar and higher energy prices have also been recent tailwinds.
Revenues are typically a good indicator the economy’s health, and Q1’s 9% sales growth was the best in years.
These strong numbers signal that, despite the tepid start to 2018, global demand remains strong and should continue to support profit growth once the one-time effects of tax cuts roll off.
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