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 show consumer and business optimism has reached multiyear-high levels while real economic growth in the U.S. and globally validates 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 did Fed policymakers decide at the May meeting?
The Fed decided to hold short-term interest rates unchanged, which is exactly what was expected.
It left open the possibility of a 25 bps rate hike at the upcoming June meeting, which the market fully expects to happen (see chart).
The tone of its post-meeting statement reflected the slowing of economic growth in the first quarter (GDP at 0.7%) and the easing of inflation.
Also as expected, the Fed made no comment about adjustments to its balance sheet, which means we are not clear as to when the liquidity being pumped into the bond markets from the Fed’s buying activity will start to slow. When liquidity does start to slow, it will lead to new impacts on the investment grade bond market. We remain alert to such changes in behaviors, which are not entirely predictable.
3. What are the takeaways from the May 7 presidential election in France?
Macron’s larger than expected win in the French presidential run-off means he will likely receive a clearer mandate and greater backing to steer the country toward helping support and expand the EU/Eurozone.
Coming after elections in Austria and the Netherlands, his victory also serves as another check against the recent global rise of populism and turn against globalization. With Le Pen tail risk out of the way, the Eurozone does not face significant political risk again before the elections in Italy early next year.
Global markets have soared since Macron emerged as the front-runner in the first round of voting on April 23 and should likely be further buoyed, at least in the near term, as the risk of an EU breakup abates for now. Still, the results showed that voters are rather deeply divided on many issues, including participation in the EU and euro. It is highly unlikely that anti-euro voices, such as Le Pen and her National Front party, will just go away.
French parliamentary elections at the end of June will be the first test of Macron’s presidential authority, and it is uncertain whether the new administration will be able to work with an austerity-focused German government to stimulate growth measures.
The focus in Europe will now turn to Germany’s federal election in September and ongoing Brexit negotiations. With a pro-European French president now in place, the EU will have a strengthened hand as talks with Britain develop.
4. The Puerto Rico Oversight Board initiated proceedings for court-supervised debt restructuring. Was this expected, and will there be a market impact?
The inability of Puerto Rico and its creditors to agree on an equitable workout of certain types of debt obligations caused a federal district court to facilitate its financial restructuring. We expected this outcome, and the market is not surprised Puerto Rico has decided to file for court-supervised debt restructuring.
The insurmountable challenges that confront Puerto Rico are not systemic to the broader municipal market, in our view. The uniqueness of Puerto Rico should not cause a material impact or contagion.
Puerto Rico is speculative grade and the City National Rochdale fixed income team does not own its bonds in our investment grade portfolios or our HY municipal fund. The fund has a negligible (less than one half of a percent) legacy exposure to the island’s water and sewer utility.
In summary, the Puerto Rico situation was not a surprise and has no real consequence to the broader municipal market.
5. Is the slowdown in Q1 U.S. GDP growth a cause for concern?
No, weakness in first quarter GDP has not been uncommon in recent years, with average growth well below that of other quarters. 2017’s slow start appears largely due to some familiar forces, such as unusual weather patterns, rather than any problem with the economy’s fundamentals.
Moreover, underlying details of the recent GDP report generally support our outlook for a more broadly based increase in domestic demand to underpin activity this year.
Much of the moderation in overall growth reflected a slowdown in consumer spending that looks likely to reverse given the many factors supporting households (including wage growth and rising confidence), as well as the transitory nature of the dip in Q1 utilities spending.
Meanwhile, better corporate profits are supporting better business investment. We also see consumer confidence driving increases from the housing sector making for the best gain in private fixed investment since 2012.
Given improved business sentiment and less drag from the energy sector, we think the pickup in investment spending can be sustained (though perhaps not at Q1’s impressive pace).
6. How are Q1 earnings shaping up?
S&P 500 earnings are on track to grow 12.5%, the highest year-over-year increase since Q3 2011. This would represent the third consecutive quarter that U.S. corporations have posted positive earnings growth, after enduring four successive quarterly declines.
The expectations bar was set fairly high heading into this reporting season, but for the most part companies have been exceeding those elevated expectations.
Earnings growth is being driven by solid domestic economic fundamentals, as well as a renewed upturn in global demand.
We have seen fewer headwinds from dollar strength and tax benefits from newly enacted accounting measures related to stock compensation.
With equity markets near record levels and growing uncertainty about the timing and scale of potential pro-growth policy changes, we believe that fuel for the bull market will continue to come from improving earnings.
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