FAQs on the Markets and Economy
Is City National Rochdale’s investment outlook still positive?
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, rising trade tensions and other geopolitical risks mean markets will likely continue to be subject to periodic swings in sentiment and potential pullbacks.
This does not mean 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.
How are corporate earnings doing?
All indications are that this earnings season will be another strong one. According to FactSet, S&P 500 EPS is on track to increase 21% year-over-year in Q2, setting up a second straight quarter of 20% or higher growth and marking the eighth straight quarterly increase.
Several factors have continued to drive earnings growth in Q2, including solid revenue, tax cuts as well as higher oil prices and a lower U.S. dollar vs. one year ago.
In the quarters ahead, some of these tailwinds may begin to slow or reverse, but we believe the economic expansion has a good amount of runway left, which should continue to support healthy corporate profitability.
Although it’s too soon to see widespread impacts, we will also be watching for management commentary on potential hits to profitability from recent tariffs and other trade policies.
At this point we estimate the impact from trade disruptions to be manageable and continue to expect 16-18% earnings growth for 2018.
What is the takeaway from the recent GDP report?
U.S. economic growth rebounded very strongly in the second quarter with an annualized 4.1% gain, boosted by a sizeable expansion in consumer spending, business investment and exports.
Can such robust performance continue? Tax cuts and fiscal stimulus spending should broadly support economic activity in the second half of the year. But trade policy uncertainty has dented business confidence somewhat, possibly leading companies to delay further investment.
As evidenced by the strong export numbers for agricultural commodities earlier in the quarter, tariffs have already acted to distort economic activity. For one quarter, at least, trade tensions could have actually led to faster growth, as foreign buyers rushed to stock up on American goods before tariffs took effect. The resulting surge in exports alone added a full percentage point to GDP.
However, exports will almost certainly slump in the third and fourth quarters and turn into a drag on overall economic growth. Looking ahead, U.S. economic fundamentals remain strong, and growth is expected to continue near a 3.0% pace in the second half of the year, but an escalation in trade tensions could push that estimate down.
What did we learn from Chairman Powell’s testimony to Congress?
In prepared remarks, Powell pretty much reiterated what was stated in the FOMC’s statement of just a few weeks ago. The Fed believes the economy is performing extremely well, improvement in the labor market will persist (the Fed believes the unemployment rate will continue to fall), and that inflation will remain stable around the Fed’s target rate of 2.0%.
Powell noted that trade tension could be a downside risk but at this point they have not affected their outlook. He noted that offsetting those risks is the fiscal stimulus, which should boost growth over at least a year or two.
The Fed believes that – for now – the best way forward is to keep gradually raising interest rates. The Fed’s current plan is for two more hikes this year, probably in September and December, which will bring the total to four hikes for 2018. For 2019, they expect to slow the pace down to just three hikes and in 2020, they plan on one hike.
How worrisome is the flattening yield curve?
A flattening of the yield curve is not worrisome at all, but an inversion of the yield curve is. An inverted yield curve is a powerful signal of recessions. Every recession in the past 60 years has been preceded by an inverted yield curve (see chart).
An inverted curve has correctly signaled all nine recessions since 1955 and had just one false positive, in the mid-1960s (when there was an economic slowdown, but not a recession).
It cannot predict when a recession will happen. In the past, recessions have come in as little as six months, or as long as two years, after the inversion.
It is important to remember that a yield curve inverting doesn’t cause the recession. Rather, the economic events that cause the yield curve to invert are what cause a recession.
How concerned should investors be about rising trade tensions?
Going only by what has actually been implemented, rather than merely threatened, we believe that the fallout for economic growth and corporate profits will be relatively manageable. Should tensions continue to escalate and further actions be put into place, the impact will become increasingly significant.
Unfortunately, the current situation is both complex and fluid, making it difficult to confidently predict an eventual resolution. Moreover, the history of trade actions like we are now experiencing is rife with unintended consequences.
Our asset allocation and investment strategies are positioned to take this uncertainty into account. We are overweight U.S. equity markets and underweight international equity markets, which we believe will be more affected by rising trade disruptions. Likewise, our domestic equity strategy has little exposure to the sectors most likely to be impacted, such as autos and semiconductors.
It’s from this relatively strong position that we’re watching the markets, looking for signs that conditions may deteriorate but also keeping an eye out for opportunities. For example, we recently added some short-term EM credit as spreads widened out to levels we felt incorporated a worst-case outcome.