1. What are City National Rochdale’s expectations for portfolio returns in 2017?
Given the potential pro-growth policies of a Trump administration, 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. Federal stimulus appears likely to contribute modestly to economic growth, as will cuts in business and personal taxes. However, those tax cuts and spending revenues will lead to higher annual deficits in the next few years.
Equity investors will primarily benefit in 2017, while fixed income investors will likely experience downward bond value pressure as interest rates rise.
Surveys of consumer and business optimism have reached multi-year high levels. Historically, when business executives and consumers feel better, spending increases. As the legislative process to bring about these growth drivers takes hold, it would not be surprising to see some downward equity price volatility.
We continue to overweight U.S. growth and dividend equities and watch carefully for the benefits of potential policies to stimulate growth.
Our confidence in a continuation of economic growth and improving corporate profits supports our preference towards equities over bonds.
2. Is the recent rise in optimism over the 2017 economic outlook warranted?
The November election results brought a wave of optimism that lower taxes, increased infrastructure spending, and a rollback in regulation would spur better economic growth.
While this seems likely, investors, consumers, and businesses may have gotten a little ahead of themselves with these high expectations. There remains considerable uncertainty surrounding the scope and details of President Trump’s proposed policy changes, as well as the potential impact and timing of such policies.
It takes time to formulate policies, usher them through the legislative process, and implement them. Once enacted, changes in fiscal policy typically impact the economy with lags, which means the bulk of the impact will not show itself until the second half of 2017 or later.
3. What did the Fed decide at its recent meeting?
The Fed kept the federal funds rate unchanged (median rate is 0.625%), as was widely expected. They gave no hint about raising rates at their upcoming meeting in mid-March, and their post-meeting statement did not vary much from the December statement.
That said, they were more confident that inflation will rise to their target level of 2.0%.
Given all the uncertainty of tax rates, fiscal stimulus, and trade policies, the earliest we expect the Fed to raise rates is at their June meeting. This is consistent with the belief of the federal funds futures market (see chart).
4. What is the 2017 outlook for U.S. equities?
The recent sideways movement of U.S. stocks is a healthy pause in the sharp post-election rally.
Improvements in economic data and corporate earnings have bolstered our confidence that the bull market remains in place, though with higher volatility likely and perhaps more modest returns with a base case of 6-8% and downside/upside range from 4-10%.
The new administration’s fiscal proposals are largely designed to bring forward economic activity, which is positive for stocks over bonds.
We have assumed a modest reduction in the corporate tax rate and raised our base case EPS forecast for 2017 from $130 to $134 to reflect this.
Although valuations appear full against an improved outlook, equity prices may also benefit from further modest multiple expansion.
5. Can the housing market withstand higher interest rates?
Housing demand should continue to modestly increase alongside a tighter labor market, rising wages, and a rebound in household formation.
The housing market is likely to face headwinds going forward, which include low inventory levels, rebounding prices and higher mortgage rates.
Nevertheless, with the economy on solid footing and only gradual rate increases expected from the Fed, we don’t expect this confluence of factors to derail the housing recovery.
Although higher mortgage rates do pose some challenges, they remain low by past standards, and mortgage payments will likely stay affordable.
Modest rate increases can also have the opposite effect, persuading many fence-sitters to get into the market before they are priced out of it.
6. What caused high yield municipals to rally so much in January, and what do you expect for returns in 2017?
In January, there was a reversal from the Q4 trade-off when yields spiked. Back then, there were concerns about government spending, rising interest rates, and inflationary fears.
Also in Q4, high yield muni mutual funds, which largely consist of retail investors, had large redemptions as investors saw it as an opportunity for tax loss harvesting.
The rally so far this year is driven by new investment flowing into mutual funds. As of February 1, $1.1 billion has come into high yield muni funds.
We expect high yield municipals to return between 4% and 6% in 2017.
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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.
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.
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.
Although inflation-indexed bonds seek to provide inflation protection, their prices may decline when interest rates rise and vice versa. Interest payments on inflation-protected debt securities can be unpredictable.
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.
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