1. What expectations should investors have for portfolio returns?
Over the next year, we anticipate equity and fixed income returns to be below historical averages, tempered by the effects of global monetary policy, global economic growth, and uncertainty over Trump’s economic policy.
Trump’s surprise victory has thus far prompted a more positive market reaction than initially expected. However, it’s doubtful that the market has fully digested the issues raised and the many uncertainties that his presidency may bring.
While our continued overweight of U.S. growth and dividend equities has been rewarding for clients, from a risk/return perspective we are carefully considering whether a reduction in our equity exposure is warranted.
U.S. equities continue to create new record highs, supported by an improving corporate profit outlook, potential expansionary fiscal policy and prospects for lower taxes. However, we continue to be concerned about valuations that appear “full & fair.” This will likely limit stocks’ upside potential in 2017, while downside risk is expected to be at least normal, if not higher.
2. What is the outlook for the economy?
The 3.2% rate of Q3 U.S. GDP growth was the economy’s best performance since 2014 and a significant improvement upon the 1.1% pace averaged over the first half of the year. When measured from the income side, growth was an even more impressive 5.2%. This growth was due to a rebound in corporate profits and rising household incomes.
The consumer remains the driver of growth and is well-positioned to continue spending at a solid clip. Weakness in net trade will likely moderate growth somewhat in Q4, but final domestic demand appears healthy.
Looking ahead, the question is how the new President and Congress will influence the outlook over the next two years. A shift toward a more expansionary fiscal policy will likely modestly lift 2017 GDP growth above the 2.2% average annual rate of the previous four years. However, given the closeness in the economy to full employment, any significant fiscal expansion may also be met by a faster than expected pace of Fed rate hikes.
3. What is the outlook for the federal funds rate?
In our opinion, a mid-December Fed interest rate hike is pretty much “baked in the cake.”
The federal funds futures market assigns a 94% chance of 25 bp increase and a 6% chance of a 50 bp increase.
The important information to look out for from the upcoming December meeting will be the Fed’s new projections for rate hikes in 2017.
The Fed’s current 2017 projection is for two rate hikes. However, the proposed aggressive fiscal stimulus may cause them to increase that number.
4. With the Fed’s planned increase of interest rates next week, what is your outlook for the bond market?
We think the Fed will raise the federal funds rate twice next year, in the second half of the year. The market believes there may be more hikes depending upon the size and scope of a proposed stimulus plan.
We think the yield curve will flatten as the market has already built in the risk of greater inflation of several Fed rate hikes.
Municipal bond yields, which have already had a significant back up in interest rates, may decrease on a relative basis, as the proposed tax cuts have already been priced into the market.
We believe credit spreads will remain range bound as there will not be any significant changes to economic growth.
5. Has City National Rochdale’s outlook for corporate profits improved?
Yes. After six consecutive quarterly declines, S&P 500 earnings are on track to have risen an estimated 3% over the third quarter. Excluding energy, the growth rate is approximately 6.5%, which is a significant improvement from flat growth earlier in the year.
With indications of solid economic activity continuing, we have raised our 2016 EPS estimate to $123 and are now expecting $130 in 2017, an increase of 5.6%.
A potential reduction in the corporate tax rate could further lift earnings growth next year. For example, a decrease in the average effective tax rate from 28.5% to only 26.5% would raise our 2017 forecast by $3-4 dollars.
On the negative side, pressure on margins from rising costs and wages, as well as a stronger dollar, would likely offset some of these potential gains.
6. What has been happening to the U.S. dollar since the election?
The dollar has rallied 2.76% since the day before the election (as of December 2, see chart).
The near-term strength comes from a more imminent federal funds rate hike in December. The long-term strength is from the proposed sizable stimulus package that will probably be accompanied by accelerated monetary tightening; both of these will likely attract foreign investors.
Other central banks have been reinforcing their need to keep interest rates low for some time. Recently, the ECB highlighted central bank monetary support as a “key ingredient” for its economic outlook.
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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.
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.
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.
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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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