1. What are City National Rochdale’s expectations for economic and investment outcomes in 2017?
We project low risk of recession given the solidity of the U.S. economy as we look ahead into 2018. Consumer and business optimism has reached multi-year highs, and real economic growth in the U.S. and globally validates these surveys. Moderate inflation pressures are also expected, which should cause interest rates to rise moderately over the next 18 months.
We continue to overweight U.S. growth and dividend equities and opportunistic credit. We remain underweighted in investment-grade bonds.
Our base case forecast for S&P EPS growth is 4-6% in 2018. With modest pro-growth policies potentially forthcoming in the second half of 2018, including tax cuts and stimulus spending, we project corporate profit growth improvement could improve to 6-8%, supported by a globally synchronized economic expansion.
However, investors should be aware that with equity returns up strongly YTD, valuations have moved to the lower end of overvalued range and earnings comparisons are expected to be more challenging going forward. As a result, a lowering our exposure to U.S. growth equities from overweight to neutral may be warranted in coming months.
Equity and opportunistic credit investors should benefit in such an environment, while investment grade fixed income investors could experience modest downward bond value pressure as interest rates rise.
Although 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. Has the global economy turned a corner?
With signs of renewed momentum coming from all corners of the world, we believe the global economy looks set for a period of its broadest and strongest growth since the immediate aftermath of the last recession. We are in a globally synchronized expansion, which helps create positive feedback flows into the U.S. and European economies.
Business surveys and hard data on industrial output have been on the rise across both advanced and emerging economies. Particularly encouraging has been the pick-up in world trade volumes after several years of stagnation.
The IMF now forecasts global GDP will likely increase 3.5% this year and 3.6% in 2018. This would be the first time growth has been at or above the 20-year average since 2011. We continue to adhere to our long-held assessment of the potential for the U.S. and European economies to experience only moderate growth in the 2-2.5% range. We do not believe sustainable growth above that is likely.
We will need to see further progress on structural reforms (like taxes, education, technology, innovation) which we believe is needed to raise potential output in all countries.
3. What did the Fed decide at its July meeting?
The Fed voted to keep the federal funds rate at the median level of 1.125%, unchanged from the previous meeting. This is what we and the markets expected.
The Fed will likely begin rolling back its massive balance sheet “relatively soon,” in a process called “balance sheet normalization.” We believe it will be announced at the next meeting on September 20.
The Fed will then have two tools to reduce monetary stimulus: raising the federal funds rate and balance sheet normalization. With the recent drop in inflation (CPI from 2.7% in February to 1.6% in June), we believe the Fed will take a break in September from the recent quarterly increases in the federal funds rate and focus just on the balance sheet normalization. If inflation can resume its upward trajectory, it will likely look to raise the funds rate in December.
We believe that the Fed will raise rates one more time before Yellen’s term is up in February. This is faster than the market consensus, which puts the next hike in March or later. We also believe that balance sheet normalization has been well broadcast and should have little impact on market pricing.
The risk to our outlook is that the Fed’s recent cautious tone becomes hawkish again if economic activity picks up into the fall. Fixed income markets are not pricing in a faster Fed or much fiscal stimulus from Washington. We have added floating rate exposure to mitigate this risk.
4. After the recent rally, are EM Asia equity markets still attractive?
We continue to view the outlook favorably for those with a 7- to 10-year investment horizon.
Despite the past year’s outperformance, Emerging Asia equity valuations are still relatively inexpensive, both on a long-term historical basis and relative to other geographies.
Improving corporate profits have helped drive the recovery in EM Asia equity prices recently and the region’s growth outlook remains resilient, supported by positive fundamentals including demography, income growth, urbanization trends, and saving/investment behavioral characteristics.
Our focus continues to be on sectors and companies in Emerging Asian economies that should benefit from these long-term structural tailwinds.
Relative underperformance over the last decade versus the S&P 500 may lead to further appreciation if the global expansion continues, which enhances the chances of further mean-reversion trades favoring emerging markets for long-term investors.
5. What is the takeaway from the 2.6% gain in second quarter U.S. GDP?
The pick-up in Q2 GDP growth confirms the economy is growing at the rate we expected. Our view for GDP growth through the first half of 2018 is 2-2.5%.
After eight years of expansion, the real economy remains in good shape, but with the recent low level of inflation, the Fed is likely to be somewhat patient in interest rate hikes in 2018.
Consumer spending led the rebound last quarter, helped by steady job and income gains, as well as better household finances boosted by stock and home-equity appreciation. Real disposable income has now posted the best back-to-back quarters since the first half of 2015.
Even more encouraging was another healthy increase in business investment. Investment is a key indicator of economic strength because it shows how confident firms are in committing resources to increasing future output.
Looking ahead, incoming data is providing early signals that the positive momentum is carrying over into the third quarter.
A still-strengthening labor market should help further support consumption growth, while business sentiment remains at a high level and suggests that investment should continue to recover.
6. What are the catalysts behind high yield (HY) municipal bond outperformance, and will it continue?
According to the Bloomberg Barclays family of indices, HY municipal bonds have recorded a total return of 7.09% through July 26, versus 6.06% for HY corporate bonds and 2.06% for U.S. Treasury securities, respectively.
Underpinning HY municipal bond outperformance are technical tailwinds that have resulted in stable demand and price support. Through the first half of 2017, tax-exempt bond supply has declined 13% year-over-year, and inflows into the asset class remain positive overall. Total YTD inflows into HY municipal bond mutual funds through July 19 was $4.3 billion. The forward net municipal bond supply calendar is projected to remain subdued through at least August, which is a typical seasonal pattern for the municipal market.
The relationship between HY municipal and HY corporate bond index yields reveals HY municipal bonds continue to offer a tax-adjusted advantage over HY corporate bonds.
A combination of tight supply, healthy demand, stable credit quality, and scaled-back expectations for federal tax reform should provide near-term support for HY municipal bonds. In our view, HY municipal bonds currently represent good relative value and offer an opportunity for competitive tax-exempt income.
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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