1. What are City National Rochdale’s expectations for economic and investment outcomes over the next 12 months?
The United States, Europe, and emerging market nations are experiencing a coordinated period of expanding economies, rising corporate profits, advancing wages, moderate inflation, and low interest rates.
Though there are some indications the U.S. economy is entering the later stages of the business cycle, the domestic expansion is expected to continue at a modest pace over the next several quarters, and likely longer, provided there are no policy mistakes by the Fed (which is proceeding cautiously), or major disruptions on the geopolitical front.
While we remain moderately optimistic over U.S. and global economic prospects, investors have fully priced in this positive outlook and currently we see few compellingly attractive asset classes, whether we look at equities or fixed income.
Consequently, we have trimmed our expected returns for growth equites over the next 12 months. On the fixed income side, given our forecast of moderately rising rates ahead, we are also trimming our projected returns for HY asset classes.
Overall, we believe economic conditions, relative valuations, and earnings growth expectations continue to support our overweight to U.S. equities and opportunistic credit, as well as our underweight to investment-grade bonds.
However, given the recent appreciation in financial markets, greater patience is warranted and we believe investors should adjust expectations for portfolio returns over the next 12 months.
2. Has the recent decrease in inflation affected the Fed’s outlook on interest rate hikes?
The yearly change in CPI has moved down from 2.7% in February to 1.7% in July and we believe this is the primary reason that the Fed will not hike the funds rate at their September 19-20 meeting.
Another possible reason for the Fed not raising rates at the September meeting is its planned announcement of the commencement for reducing the size of its balance sheet.
The Fed may want to spend the time clarifying the message of allowing its securities to mature without reinvestment. They want to ensure the market’s reaction to this supply is as benign as “paint drying.”
3. After the recent run-up, what can we expect from equities?
We believe the YTD returns in world-wide stock markets appear justified as investors have responded appropriately to a rebound in corporate profits and improving global demand.
However, given the recent appreciation, more modest gains in the range of 5-7% could be expected for equities over the next year and we believe it is wise to proceed cautiously in terms of initiating new positions in the U.S. and global markets.
The current environment of moderate economic growth, inflation, and interest rates is likely to keep the secular bull market moving forward, but investors should be aware that valuations seem to have moved to fully valued range and sentiment indexes indicate market optimism is high.
In keeping with excess optimism, it has been over one year since the S&P 500 last had a 5% pullback. There have been only three time periods longer than the current span over the past 50 years.
Downward equity price volatility is also likely depending on the outcome of tax policy, healthcare, and regulatory changes out of Washington.
As a result, a lowering of our exposure to U.S. growth equities from overweight to neutral may be warranted in coming months should the current rally continue.
4. What is causing the rate of inflation to decline?
There has been a 1.0% decrease in inflation in the past five months. This is a surprise, because inflationary pressures normally increase this late in the cycle. The sagging inflation has led some Fed officials to consider holding off on additional increases in the federal funds rate.
The two primary metrics the Fed focuses on for inflation have spent most of that time below the target. Much of the decline can be attributed to transitory events, like the lowering of energy prices and mobile phone plans.
Our outlook expects a gradual firming in the pace of consumer inflation over the next few quarters, leading to our forecast that the 10-year Treasury will rise to 2.5%-3.0% by the end of 2018, from the current level of 2.27%.
5. Is the flattening yield curve a troubling event?
Yield curves normally flatten at this stage of the business cycle due to the Fed raising short-term interest rates at a faster pace than inflationary expectations, pushing up longer-term interest rates.
But this time around, due to years of quantitative easing, the yield curve was generally flat before this Fed-induced flattening cycle started.
A very flat yield curve typically limits bank profitability as it reduces the spread between short-term liabilities (deposits) and longer-term assets (loans).
This would be troubling for the Fed since they would be counting on banks increasing lending to perpetuate this expansion.
We expect the pace of flattening to slow as short-term rates are not expected to increase at a pace faster than already built into market expectations and recent deflationary pressures should dissipate.
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.
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.
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 MSCI Emerging Markets Index is designed to represent the performance of large- and mid-cap securities in Emerging Markets 24 countries.1 As of June it had more than 830 constituents and covered approximately 85% of the free float-adjusted market capitalization in each country.
The MSCI Emerging Markets (EM) Asia Index captures large and mid cap representation across 9 Emerging Markets countries*. With 565 constituents, the index covers approximately 85% of the free ﬂoat-adjusted market capitalization in each country.
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