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 opportunistic credit. We remain underweighted in investment-grade bonds.
With potential modest pro-growth policies forthcoming in 2018, including tax cuts and stimulus spending, we project corporate profit growth improvement over the next year at about 4%-6% per year, supported by a globally synchronized economic expansion.
We expect moderate inflation, which should cause interest rates to rise moderately over the next 18 months. We do not expect a recession until the middle of 2018.
Consumer and business optimism has reached multiyear-highs, and real economic growth in the U.S. and globally validates these surveys.
Equity and opportunistic credit investors should benefit, while investment grade fixed income investors could experience modest downward bond value pressure as interest rates rise.
While we are moderately optimistic on the economy, all investments have fully priced in this positive outlook, so investors should expect bouts of downward equity price volatility until we know the outcome for tax changes, healthcare rules, and regulatory changes.
2. What is the interest rate outlook?
We believe the Fed is correct in its assessment that the US economy is strong enough to slowly begin reducing the amount of monetary stimulus that has been in place since the financial crisis. Waiting too long to remove accommodation could eventually require the Fed to raise rates too rapidly and risk pushing the economy into recession.
Given the present outlook, we expect the Fed will likely 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 2-3 rate hikes are likely in 2018. We believe the 10-year will likely end this year in the range of 2.25%-2.75% and end 2018 in the range of 2.50%-3.0%. Our rate expectations are fairly in line with consensus.
The current tightening cycle is not intended to squeeze inflation out of the economy, and overall monetary policy should continue to be stimulative.
Rates are simply being lifted from emergency lows. At these levels, they are not likely to have a meaningful adverse impact on the financial markets or economic activity.
3. Is the outlook for the U.S. economy still positive?
The U.S. economy continues to prove its resilience as the current expansion enters its ninth year. In fact, given the positive consumer and business conditions in the economy, we would not be surprised to see it continue past mid-year 2018.
Recent data has pointed to a solid rebound in second quarter GDP and expectations are for growth to pick up at a modestly above-trend pace over the next year.
Policy change from Washington could provide additional support that prolongs the current cycle, though any real economic impact is unlikely to be felt until 2018.
Even without stimulus, the U.S. economy has many tailwinds that should continue to support growth, including robust job creation, rising wages, high confidence, a solid housing market, reasonable consumer debt levels, and rising corporate profits.
4. What can investors expect from U.S. equities in the next year?
After a strong first half to 2017, we expect stocks to likely continue to post gains over the next 12 months, though at a more modest pace.
Market strength has been driven by improved economic activity on a global basis, which in turn has produced better than expected earnings and improved confidence in the durability of the corporate profit cycle.
U.S. corporate earnings are expected to increase by about 4%-6% over the next 12 months, which is the range of expected equity capital appreciation. If tax cuts are implemented, earnings growth has the potential to be even greater providing the fuel for higher equity prices. However, given fair but full valuations, we continue to be disciplined in deploying new cash.
While a correction could occur in coming months, potentially triggered by concerns over monetary and fiscal policy actions or geopolitical/exogenous shocks, we believe the environment for GDP, inflation, and interest rates is likely to keep the secular bull market moving forward.
5. Will falling oil prices knock the global economy off course?
Oil prices have fallen by almost 20% over the past couple of months, as supply continues to outpace demand and weighs on market sentiment.
However, the recent decline should be viewed in context and it is unlikely to have a major effect on the cyclical upturn underway in global growth.
Overall global demand prospects are stronger than they have been over the past few years, and even if prices fall further in the short term, the broader economic implications are likely to be limited compared to the much larger declines in oil prices seen in 2014-2016.
Moreover, there is good reason to believe prices will rebound or at least stabilize in the quarters ahead.
Current OPEC compliance with production cuts is well above the historical average, and it typically takes two to three quarters for inventories to reflect such cuts.
In the U.S., technological advances in shale are contributing to a supply surplus and keeping a cap on any oil price rise, but the growth rate of oil production has slowed recently and could be further constrained by reduced labor supply and rising input costs.
6. Is there significance to the flattening of the treasury yield curve?
The yield curve flattening is because of short-term interest rates moving up, in response to the four Fed rate hikes since late 2015 and longer-term interest rates falling in response to the recent dip in inflation. It is now at the flattest level in several years.
Historically, flattening of the yield curve has been a good predictor of recessions, but this time is a bit different. Normally in an economic expansion, the yield curve will steepen dramatically because of higher inflation and expected inflation. But in this expansion, there has not been much steepening of the yield curve because of low levels of inflation and aggressive buying of bonds by the Fed during its various phases of quantitative easing.
We do not view the flattening of the yield curve as increasing the risks of an economic downturn in the near future. We continue to focus on the strong economic fundamentals of continued gains in employment, improving credit and continued gains in consumption.
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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.
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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.
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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.
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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.
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.
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