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 the potential pro-growth policies forthcoming in 2018, including tax cuts and stimulus spending, we project corporate profit growth improving over the next two years at about 5% per year, supported by a globally synchronized economic expansion.
We expect moderate inflation from wage increases and stimulus spending, which should cause interest rates to rise moderately over the next 18 months. We do not expect a recession now through the middle of 2018 at the earliest.
Surveys show consumer and business optimism has reached multiyear-high levels while real economic growth in the U.S. and globally validates these surveys.
Equity investors should benefit, while fixed income investors could experience modest downward bond value pressure as interest rates rise.
With an uncertain legislative process and delayed fiscal stimulus, investors should expect bouts of downward equity price volatility until we know the outcome for tax changes, healthcare rules, and regulatory changes.
2. With weak Q1 GDP growth and the recent moderation in inflation, will the Fed still raise rates several times over the next 18 months?
Although GDP growth was 0.7% in Q1 and CPI unchanged for the past three months, we fully expect the Fed to raise the federal funds rate at its June 14 meeting and a few times further over the next 18 months.
The Fed has been clear about its view that the beginning of the year slowdown was transitory.
Offsetting the recent drop in inflation has been consistent strength in the labor market, with the unemployment rate falling to just 4.4% and headed lower. This will likely lead to a moderate increase in wages. In addition to that, the underemployment rate (U-6 report) is now at a cycle low of 8.6%, nearing the low of 7.9% of the previous expansion.
3. What are the reasons behind City National Rochdale's equity underweight to Europe?
Despite the recent rally, European equities have lagged U.S. equity returns significantly over the past three years and City National Rochdale investors have benefited from our underweight position.
European equity outperformance this year has been driven by improving economic and earnings data, as well as lessened political risk.
However, the current market trend is principally from a tactical perspective, and the Euro Area economic surprise indicator seems to have now topped, possibly signaling a slowdown in the near future. Competitiveness factors across the EU, including ongoing Brexit negotiations, have also not gone away.
Longer-term growth prospects compared to the U.S. remain less attractive due to unresolved structural issues (i.e. low productivity growth, unfavorable demographic trends, onerous regulatory environment, and high debt levels) and a continued emphasis on austerity.
As a result, earnings have been, and may stay, in a slow growth trend. Valuations are not meaningfully attractive on a relative or historical basis (see chart).
While Europe has benefited near-term from the synchronized upturn in global growth, we believe there are better ways to access this strengthening demand, such as U.S. multinational companies and emerging markets. However, we are considering finding attractive opportunities within specific regions in Europe.
4. What is happening with oil prices?
Oil prices have rallied $5.20 from a recent low of $45.13 on May 3rd. Prices have been pushed up on news of Saudi Arabia and Russia's planned extension of production cuts.
Late last year, OPEC and some other producers (like Russia) agreed to reduce production for six months. Now, they plan to extend those production cuts for nine months after the six-month plan expires, which will likely keep production down until March 2018.
Saudi Arabia and Russia are the largest of the 24 producers that agreed to reduce supply for six months. By reaffirming this deal, they hope to bring global inventories back to their five-year average.
Industrialized nations have over 3 billion barrels in inventory, which is almost 10% above their 5-year average. We expect oil prices to remain in the $50-$60 range within our 18-month forecast period.
5. Is the U.S. economy bouncing back after the first quarter slowdown?
After the slow start to the year, there is growing evidence that the U.S. economy is regaining momentum this spring.
Fed GDP trackers and consensus forecasts are currently estimating real GDP to rise 3% over the second quarter from just 0.7% in the first. This is not surprising, given that much of the weakness in the first quarter was due to transitory factors that affected consumer spending rather than any problem with the underlying fundamentals of the consumer or businesses.
The unemployment rate now sits at a 10-year low, manufacturing output is at a 2-year high, business investment just recorded its strongest gain since 2012, and housing sales have risen to the fastest pace in a decade.
Most importantly, households continue to enjoy a number of tailwinds that should support better spending in the quarters ahead, including a tightening labor market with rising income growth, high confidence, and a significant boost to wealth from increases in home and stock prices.
6. The state of Connecticut was recently downgraded. What were the factors that contributed to its lower ratings, and how has the market digested this news?
Prolonged economic weakness in the state has led to deterioration in Connecticut's financial position.
The state recently revised its current year budget to account for a steep decline in revenue collections, in particular personal income taxes. The sizeable shortfall will likely necessitate draws on its reserve fund, rendering it depleted. Moreover, the upcoming biennial (2-year) budget forecast now projects a multibillion-dollar cumulative deficit.
Constraining Connecticut's flexibility is its very high levels of debt and long-term retirement obligations, which results in elevated fixed costs relative to discretionary resources. Despite strong fiscal decision capabilities, such as broad authority over cash management, revenue-raising, and expenditure containment, the weakened budget condition makes closing the deficit quite difficult.
The credit downgrades (to the A quality tier) by all three major rating agencies was not wholly unexpected. The value of Connecticut bonds has weakened, as evidenced by the higher yield required by investors versus peers in the sector. The City National Rochdale fixed income team continues to limit its exposure to the state and its local governments.
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