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By Gregory S. Kaplan, CFA and David Krouth, CFA

Key Takeaways:

  • A flat, but not inverted, yield curve is likely to persist this year
  • A near-term recession is unlikely
  • Actively managed strategies should outperform passive/indexed products

Interest rate volatility remains near all-time lows as improving GDP growth, subdued inflation expectations and three rate hikes by the Federal Reserve in 2017 generated little change in longer-term interest rates, but did produce a significant uptick in shorter term rates. These trends resulted in a material flattening of the yield curve, with the differential between two-year and 10-year Treasury yields finishing 2017 at just 51 basis points, down from 125 basis points at the start of the year (see chart).

Recessions have historically been preceded by a flattening and eventual inversion of the yield curve, where longer-term rates yield less than shorter-term rates. With the current economic expansion getting long in the tooth, some market participants are worrying about this growth ending. Although an inverted yield curve is a leading indicator of a coming recession, it does not cause a recession and is not great at timing a downturn. As shown in the chart, the yield curve inverted 1.5 years prior to the 1990 recession, one year before the 2001 recession and nearly two years prior to the 2007 recession.

IMAGE_QU 4Q17-Kaplan Krouth Chart 1

For 2018, City National Rochdale expects an additional two to three rate hikes and a yield curve that will flatten, but not invert.

Investment Grade Taxable and Municipal bonds should benefit from strong inflows, open capital markets, and credit spreads near 10-year lows. Corporate tax cuts, synchronized global GDP growth and strong corporate fundamentals will also help the taxable market. The flat yield curve, tighter monetary policy and a potential uptick in M&A may serve as headwinds. Municipals should benefit from a reduction in supply.

We expect credit spreads to remain somewhat range-bound and Investment Grade Taxables and Municipals to provide modest single-digit total returns. 2018 looks to be a year where security selection, tactical yield curve positioning and the ability to tap into unique opportunities will provide superior returns relative to passive allocations.

IMAGE_QU 4Q17-Kaplan Krouth Chart 2

Read the next article in this series: High Yield Municipal Bonds Moving the Needle

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 risks include, but are not limited to, stock market, manager, or investment style. 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.

Concentrating assets in the real estate sector or REITs may disproportionately subject a portfolio to the risks of that industry, including the loss of value because of adverse developments affecting the real estate industry and real property values. Investments in REITs may be subject to increased price volatility and liquidity risk; concentration risk is high.

Investments in Master Limited Partnerships (MLP) are susceptible to concentration risk, illiquidity, exposure to potential volatility, tax reporting complexity, fiscal policy, and market risk. Investors in MLPs are subject to increased tax reporting requirements. MLP investors typically receive a complicated schedule K-1 form rather than Form 1099. MLPs may not be appropriate investments for tax-advantaged accounts because of potential negative tax consequences (Unrelated Business Income Tax).

There are inherent risks with fixed-income investing. These risks may include interest rate, call, credit, market, inflation, government policy, liquidity, or junk bond. 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. 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 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.

Investments in emerging market 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. Emerging market bonds can have greater custodial and operational risks and less developed legal and accounting systems than developed markets.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money. Returns include the reinvestment of interest and dividends. Investing involves risk, including the loss of principal. Diversification may not protect against market loss or risk. Past performance is no guarantee of future performance.

Index Definitions

The Conference Board Leading Economic Index is an American economic leading indicator intended to forecast future economic activity. It is calculated by The Conference Board, a nongovernmental organization, which determines the value of the index from the values of ten key variables.

The Goldman Sachs Financial Conditions Index (GSFCI) is a weighted sum of a short-term bond yield, a long-term corporate yield, the exchange rate, and a stock market variable.

The Standard & Poor’s (S&P) 500 Index represents 500 large U.S. companies. The comparative market index is not directly investable and is not adjusted to reflect expenses that the SEC requires to be reflected in the fund’s performance.

Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.