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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, and 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.

Forecasted-expected-returns-Jun-23-2017_Chart1

2. Is Q2 GDP expected to bounce back?

Yes, consensus estimates of Q2 economic output are for 3% growth, which would be well above the Q1 rate of 1.2%.

Overall Q1 GDP was subdued in large part because slower vehicle sales and a weather-related pullback in utility spending held consumption growth to just 0.6% (see chart).

Consumer spending typically accounts for more than two-thirds of GDP.

Early data for Q2 is showing higher levels of consumption. This is supported by higher levels of income, continued strength in stock prices, higher levels of confidence, and low levels of volatility.

Looking beyond Q2, consumer spending is expected to return to its 2.5% average that has occurred over the past several quarters.

Consumer-spending-Jun-23-2017_Chart2

3. What does the latest Fed interest rate increase mean for investors?

We believe there is a reasonable probability the Fed will raise rates another 25 bps this year as well as begin the process of slowly unwinding its balance sheet sometime in the fourth quarter. An additional two or three rate hikes are likely in 2018.

Monetary policy should continue to be stimulative. The current tightening cycle is not intended to squeeze inflation out of the economy. Instead, rates are being normalized from emergency lows.

In our opinion, the Fed is correct in its assessment that the economy is strong enough to begin to reduce the amount of monetary stimulus that has been in place since the financial crisis of 2008. Waiting too long to remove accommodation could eventually require the Fed to raise rates rapidly and risk pushing the economy into recession.

Importantly, Fed officials are well aware of the 2013 taper tantrum and favor a gradual approach to tightening, which is friendly to risk assets, supporting our overweight to domestic/ high dividend equities and opportunistic credit.

The U.S. equity market can continue to rise during slow Fed tightening cycles against a background of solid economic growth and low inflation. Fixed income continues to price in the expected path of Fed hikes as reflected in the slope of the yield curve. Our underweight reflects expected returns below historical averages.

Fed-funds-rate-Jun-23-2017_Chart3

4. Is the narrow sector and stock leadership behind the recent market rally a cause for concern?

No, rotating sector leadership is a common feature of equity bull markets, and it is not unusual for certain stocks to dominate a particular rally over the course of months or a year.

For example, in 2015 market leadership was very narrow and “FANG” stocks (Facebook, Amazon, Netflix, and Google) strongly outperformed, only to give way to a more broad-based recovery in 2016.

Furthermore, market breadth over the recent rally has been a lot wider than generally perceived with half of the 24 industry groups having outperformed the broad market this year. This supports our view that the bull market has further to run as other areas of the market can take up the leadership mantle at some point.

Typically, sector and stock leadership shifts multiple times during lengthy bull market cycles, which is why we recommend holding a diverse portfolio.

YTD-industry-group-performance-Jun-23-2017_Chart4

5. What does the surprise UK election result mean for Brexit?

The implications of the second extraordinary UK general election in the past year will not likely be clear until a new government is formed. For now, the UK faces a period of political uncertainty and Britain’s hand in negotiations with the European Union will likely be weakened somewhat.

There has been speculation that the election result could lead the government to push for a “soft” Brexit and more market-friendly outcome, where the UK maintains ties with the EU and adopts a European Economic Area-styled agreement.

Everything else being equal, a “hard” Brexit would increase uncertainty because it would imply more adjustment of the British economy from the status quo. A “soft” Brexit, in which only modest changes to trade and immigration policies would be required, would imply less adjustment.

Our underweight to UK equities reflects the weakened economic outlook and political uncertainty ahead.

UK-indicators-Jun-23-2017_Chart5

6. Are the deterioration of Illinois’ fiscal position and credit ratings a harbinger of other state financial woes?

The state of Illinois’ weakened credit profile reflects chronic political divisiveness of its decision-makers, which has resulted in budgetary deficits, a large backlog of unpaid bills (to governmental entities and vendors), as well as high levels of economic debt, including unfunded pension liabilities. Illinois is approaching its third FY (begins July 1) without a spending plan in place.

U.S. states are sovereign powers with ample flexibility granted to them under the U.S. Constitution, which, in the context of credit quality, underscores the unusualness of “borderline” IG ratings of Illinois state GO bonds. The failure of the legislature to adopt a budget by the beginning of FY 2018 will likely lead to an unprecedented sub-IG rating, according to agency data.

From a ratings perspective, the median quality of U.S. states is AA, an indicator of generally diversified economies, strong institutional frameworks, and the tools that are available to them (i.e., cash management) to responsibly manage resources.  While each state may face its own set of challenges, the unique circumstances of Illinois are the result of very poor political decisions that have eroded their finances, and not economically driven. 

Many states have taken advantage of the recovery, with improved financial wherewithal, but in our view, Illinois is considered an outlier. Our fixed income team does not currently consider Illinois state credit to be an appropriate investment for our core IG mandates, as its valuation and behavior is more consistent with non-IG municipal bonds.

Illinois-state-spreads-Jun-23-2017_Chart6
 

Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell, any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts, and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources, and although believed to be reliable, it has not been independently verified, and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as of the date of this document and are subject to change.

There are inherent risks with equity investing. These include, but are not limited to, stock market, manager, or investment style risks. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices.

Investing in international markets carries risks such as currency fluctuation, regulatory risks, and economic and political instability. Emerging markets involve heightened risks related to the same factors as well as increased volatility, lower trading volume, and less liquidity. Emerging markets can have greater custodial and operational risks, and less-developed legal and accounting systems, than developed markets.

There are inherent risks with fixed income investing. These may include, but are not limited to, interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond risks. When interest rates rise, bond prices fall.  This risk is heightened with investments in longer-duration fixed income securities and during periods when prevailing interest rates are low or negative.

Investments in below-investment-grade debt securities, which are usually called “high-yield” or “junk” bonds, are typically in weaker financial health, and such securities can be harder to value and sell and their prices can be more volatile than more highly rated securities.  While these securities generally have higher rates of interest, they also involve greater risk of default than do securities of a higher-quality rating.

The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the federal Alternative Minimum Tax (AMT), and taxable gains are also possible.

Investments in the municipal securities of a particular state or territory may be subject to the risk that changes in the economic conditions of that state or territory will negatively impact performance. These events may include severe financial difficulties and continued budget deficits, economic or political policy changes, tax base erosion, state constitutional limits on tax increases, and changes in the credit ratings.

Floating rate loan securities generally trade in the secondary market and may have irregular trading activity, wide bid/ask spreads, and extended trade settlement periods. The value of collateral, if any, securing a floating rate loan can decline, may be insufficient to meet the issuer’s obligations in the event of nonpayment of scheduled interest or principal, or may be difficult to readily liquidate.

Investments in emerging markets bonds may be substantially more volatile, and substantially less liquid, than the bonds of governments, government agencies, and government-owned corporations located in more-developed foreign markets.

Returns include the reinvestment of interest and dividends.

Investing involves risk, including the loss of principal.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money.

Past performance is no guarantee of future performance.

Index Definitions

The Standard and Poor’s 500 Index (S&P 500) is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.

The Financial Times Stock Exchange 100 share index; an average of share prices in the 100 largest, most actively traded companies on the London Stock Exchange.