On the Radar

City National Rochdale, | Dec. 17, 2018

FAQs on the Markets and Economy

Should investors be concerned about recent inversion of part of the yield curve?

Market alarms were recently raised when for the first time in over a decade, yields on five-year Treasury notes fell below two- and three-year Treasury yields. However, this is more of a kink than an inversion of the curve. Historically, this narrow segment of the curve has inverted many times without an ensuing recession.

A more reliable yield curve measure is the difference between 3-month rates and 10-year rates, as these are more representative of Fed rate moves and long-term growth expectations. This measure has flattened, but it has not inverted. Even an inversion of the broader yield curve (if and when this occurs) is not a signal of impending near-term trouble.

Historically, when this yield curve inverted, it was an average of 16 months before a recession emerged. Moreover, the 3-month/10-year rate spread is currently 0.47%. When the measure first breached 0.50%, the average return in the stock market over the next year was 12% in the three instances that this occurred since 1991.

We wouldn’t be dismissive of a flatter yield curve altogether — it is an important input to our forecasts — and if the curve were to actually invert, we would be more concerned. Still, the outlook for the economy, profits, inflation, and interest rates are more important for determining the direction of the stock market.

Based upon recent statements from Fed policy makers, the market has become more dovish on their outlook for future Fed actions.

Back in early October, Chair Powell stated that the federal funds rate was a long way from the neutral level. The market was surprised by that comment and turned more hawkish. Since then, Powell and other policy makers have made statements stating that the funds rate is close to the neutral rate and the market has turned more dovish.

This has increased the uncertainty of the number of interest rate hikes that are expected in 2019. Based upon the most recent data from September, the Fed projects three hikes of 25 bps each slated for 2019. The federal funds futures market does not believe the Fed will be that aggressive. They now believe the Fed will hike about once in 2019.

This week the FOMC will meet and release their updated view of the economy, inflation, and the future direction of the federal funds rate. From that data, we will see if the Fed has turned more dovish.

We continue to view the current pullback as a correction, rather than a beginning of a more severe and prolonged downturn. In many ways, this market environment is similar to 2015/2016, when a slowdown in global growth, concern of the start of Fed tightening, and a collapse in oil prices put pressure on equities.

While the U.S. and global economic activity is expected to moderate in 2019, growth is still projected to be above potential and recession risk remains low. Likewise, we agree that earnings growth will slow next year, but to a more normal rate of about 5%. Trade tensions are headwinds, but we believe their effects on corporate profits should be manageable. The biggest risk to our outlook is interest rate backdrop. However, rates continue to be low by historical standards, and the Fed comments recently have provided some reassurance that central bankers are focused on the risk of overtightening policy and ending the cycle prematurely.

In the meantime, our client portfolios are constructed with this volatility in mind and should withstand the correction relatively well due to our high-quality equity allocation and overweight to U.S. Large Cap stocks versus MidSmall Cap and International.

There is a convergence of interest rates over various maturities, which is normal at this stage of the business cycle (chart). Since the Fed began tightening monetary policy back in December 2015, short-term interest rates have been moving up at a faster clip than longer-term interest rates. Short-term interest rates have been moving in lockstep with Fed policy moves while longer-term interest rates have remained relatively stable.

Throughout this expansion and the two previous ones, longer-term interest rates have been moving downward. There are a number of reasons for this: lower inflationary pressures, lower expected inflation, savings glut (population getting older and becoming more risk-adverse with investments), and central banks buying up bonds as part of their unorthodox monetary policy of quantitative easing.

As for our outlook, we expect the Fed to continue with their gradualistic approach to normalizing interest rates. We expect three more increases (75 bps), with one move this December 19 and two moves in 2019. Longer-term interest rates we expect to remain in the current range due to a continuation of the fundamental factors mentioned above.

Based on our outlook for solid economic growth and improving corporate earnings, we remain bullish on equities in general and continue to see attractive prospects in the opportunistic fixed income class. Bear markets outside recessions are rare.

Still, we believe investors should prepare for more moderate returns in the months ahead and perhaps greater volatility. Patience and discipline will be more important than ever. The investment landscape is growing more challenging as investors adjust to more typical late-stage expansion conditions of higher inflation, rising interest rates, and less accommodative monetary policy.

Meanwhile, concerns over global growth, rising trade tensions, midterm elections, and other geopolitical risks mean markets will likely continue to be subject to periodic swings in sentiment and potential pullbacks.

None of this means there are not more worthwhile gains ahead for investors, but it does highlight the value of active management and the need for investors to become more selective. We actively manage portfolios to be aware of where we are in the cycle, to take advantage of opportunities as they arise, and to be on alert if conditions deteriorate.

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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 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.

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

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.

Index Definitions

The Standard & 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.

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