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 underweight bonds.
Given the potential pro-growth policies, including tax cuts and stimulus spending, we see corporate profit growth likely improving over the next two years, supported by a longer economic expansion.
Inflation from faster wage increases may cause interest rates to rise moderately. Depending on the specifics of tax cuts and spending increases, they may cause higher deficits.
Surveys of consumer and business optimism have reached multi-year high levels, which real economic growth in the U.S. and globally validate.
Equity investors should benefit, while fixed income investors could experience downward bond value pressure as interest rates rise.
However, as the legislative process elongates and new expected U.S. fiscal proposals are delayed, downward equity price volatility is possible.
2. How does this Fed tightening campaign compare to others?
At just 15 months, the current tightening campaign is below the average of 21 months, and it is tied for the fourth shortest of all the campaigns since the late 1970s, when the Fed became aggressive at adjusting the federal funds rate.
It is unique that the Fed would wait a whole year for a second rate hike. Of the tightening campaigns during this period, the average period of time for the Fed to have their second rate hike has been just three months.
This tightening campaign is coming off the longest period of time (84 months) with no Fed action. This “tortoise” approach to reducing monetary stimulus has fostered improving valuations of many risk assets.
Based on current Fed communications, it is likely rates will gradually rise over the next 12- 24 months. Eventually the Fed thinks that the Fed funds rate would reach 3%. If this course of rate hikes occurs as the Fed thinks, ultimately we believe those rate increases will cause economic activity to weaken at a later date.
3. What does Fed tightening mean for investors?
The current Fed tightening cycle is not intended to slow an overheating economy. Instead, rates are simply being lifted from emergency lows, and monetary policy remains extremely accommodative.
Moreover, the Fed is painfully aware of the market impact from 2013’s taper tantrum and continues to favor a gradual, well-advertised approach toward policy normalization.
This combination is friendly to risk assets and supports our overweight to domestic and high dividend equities, as well as opportunistic credit.
Economic conditions are what matter. Low but rising interest rates are not a concern as long as economic and earnings growth is good, and inflation is anchored at low levels.
Not until rates rise to a level that causes slowing economic activity in interest-sensitive sectors of the economy, like housing, autos, and business capital spending, will broader economic activity trends and earnings growth be at risk.
The U.S. equity market in particular has done well during past Fed tightening cycles against a backdrop of solid growth and low inflation. In contrast, fixed income investors will likely experience downward bond value pressure as interest rates rise. Our underweight reflects the limited return upside beyond the yield.
4. Is the Trump rally over?
The equity rally so far has been driven by expectations of coming tax cuts, deregulation, and more infrastructure and defense spending.
However, the failure of Republicans’ health care bill last week is the clearest indication yet that implementing President Trump’s legislative agenda won’t be as easy as investors had hoped.
Although there is no procedural reason why cutting taxes depends on health care reform, the fact that the latter proved so difficult doesn’t bode well for Republicans’ ability to work together on future legislation.
While we still expect a package of tax cuts to be passed by early next year, the risk of a further delay to Trump’s fiscal stimulus has increased somewhat as result.
Until we get greater detail on the composition and timing of new fiscal proposals, a pullback in the stock market is to be expected and we believe a better buying opportunity is ahead.
5. Is the weakness in recent “hard” economic data a cause for concern?
No, weakness in first quarter GDP has not been unusual in recent years, with average growth well below that of other quarters.
While some recent “hard” activity data has disappointed, this stands in stark contrast with a wide range of survey measures, or “soft” data which have moved up markedly over the past few months and are a better gauge of future growth.
Moreover, not all activity data has looked weak; the jobs market continues to show strength, equipment orders are picking up, and manufacturing output has climbed to its highest level since July 2008.
Consumer spending has been the most disappointing recently, but underlying fundamentals remain extraordinarily favorable and consumption has rebounded vigorously in the spring every time that first quarter growth has sagged in past years.
6. With the Fed raising rates, are high dividend & income stocks still attractive?
With rates at historic lows, many investors have used high dividend stocks, rather than low-yielding bonds, to pursue income. Conventional wisdom says that those investors should return to bonds when interest rates go up.
While that might be true if interest rates were at or above historical norms, our research has found that dividend stocks can do well in an environment where rates are rising gradually from low levels.
Although valuation is a concern, economic growth remains solid, and the companies we are invested in should continue generating solid operating results, which is what drives the dividend and ultimately the long-term total return.
Over the next 12 months, we feel that modest return expectations in the 5-7% range, as driven by yield (actual) and growth in yield (projected), should be realistic.
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