Evaluating Recession Risks During a Bear Market & Inflation
For most of 2022, City National Rochdale, City National Bank's investment advisory organization, had predicted that economic volatility would remain higher for longer periods of time. While the organization maintained its "higher for longer" thesis during its December market update, there was also a note of optimism for 2023.
Rochdale's leaders still anticipate lower GDP, lower earnings and a lower S&P 500 fair value compared to some other forecasts. They also have higher-than-consensus expectations for inflation, interest rates and volatility, said Garrett R. D'Alessandro, Rochdale's CEO.
However, D'Alessandro also anticipates that 2023 will be a “tale of two years," with the first half likely to see a mild recession and continued market volatility, and the second half seeing return to positive territory for both equity and fixed income investments.
Looking Back at the 2022 Economic Picture
Reviewing 2022, D'Alessandro explained that this was one of the most challenging markets experienced in years, with the traditional 60/40 balanced portfolio seeing its worst returns in half a century.
Rochdale's team was able to predict several important trends in 2022, such as anticipating the equity correction, and they de-risked their portfolios by selling non-U.S. equities and focusing on quality U.S. stocks.
In addition, the firm avoided investing in speculative tech and cryptocurrency but included other alternative investments. The team didn't anticipate the pace of inflation and interest rate increases, but neither did other analysts across the financial industry.
Also unexpected were the aggressive actions taken by Russian President Vladimir Putin and the magnitude of negative fixed income returns.
What's Ahead for the 2023 Economy?
Rochdale's Speedometers®, forward-looking indicators for the next six to nine months, are all yellow or red this month. However, the Rochdale team provided reassurance that these outlooks aren't as negative as they first appear.
“There's no green on this page of Speedometers because of uncertainty about monetary policy, uncertainty about consumers, uncertainty about interest rates and uncertainty about corporate profits," said D'Alessandro. “They're not necessarily overwhelmingly negative, the yellow indicators just tell you we're uncertain."
He also pointed to an encouraging note: The Speedometers inflation dial has moved from red to yellow, reflecting the Rochdale's team belief that inflation has peaked. While still elevated, the inflationary trend over the next year will likely be lower, they said, making it less of a headwind to economic growth.
The Rochdale team anticipates GDP to pivot around zero for 2023 but believes the strong fundamentals in household and business balance sheets will help the economy weather what they anticipate to be a 60% chance of a mild recession.
Global Economic Outlook
The U.S. currently has the strongest economy in the world, which is one reason Rochdale has pulled all allocations from Europe. Rochdale's concern is that Europe will continue to experience high inflation, high unemployment and high energy costs. China's increasing state control, property bubble and difficulties with COVID-19 policies contribute to the concern about investing there.
The Fed's Battle With Inflation Continues
While inflation has shown signs of cooling recently, a prime contributor that has concerned the U.S. Federal Reserve is wage growth.
“The Fed has been very transparent that they want wages to come down to a range that's consistent with their inflation target of 2%," said Paul Single, Rochdale managing director, senior economist and senior portfolio manager. “If the labor market doesn't soften, the Fed will keep rates higher for longer."
Inflation pressures are expected to moderate in 2023, especially with food inflation coming down. Higher prices and higher financing costs are likely to slow consumer spending, too.
“Our view is that inflation is heading in the right direction, but it will take time to come down enough," said Single.
Investment Opportunities Exist Amidst Volatility
Investors have found some opportunities over the past year that should extend into 2023. Yields have been substantially higher on some fixed income assets. Investors can take advantage of higher short-term rates on investment grade bonds that have been close to 5% for a year and provide income with less risk, said Charles Luke, managing director and co-director of fixed income for City National Rochdale.
Owning high yield bonds is still beneficial over time, too, Luke said. Rochdale's team has also found success investing in alternative assets for more yield, such as direct lending, rail car leasing and reinsurance contracts, all of which are typically more stable than some other investments.
“What we're illustrating here is that opportunities for investors in bond markets have significantly improved through the year," said Luke. “With these elevated returns, we do expect bond returns to increase over the next three to five years."
Specific asset allocation decisions will depend on whether the U.S. economy is in a slow growth period or a mild recession. But over the long term, high-yield bonds are more appealing, Luke said. In a mild recession, short-term bonds and two-year Treasury notes are options to consider.
Research from Bloomberg and City National Rochdale show that fixed income investments can offset volatility and generally move higher as economic growth bottoms out. Fixed income yields will generally outperform the 10-year average if interest rates are more stable.
Investment Risks in 2023
While equity valuations have adjusted, consensus earnings estimates still are not reflecting a more challenging economic outlook and negative revisions to forecasts could be a source of further downside in the near term.
Among the other critical issues Rochdale is watching, that could have a negative impact on equity markets in 2023, is the possibility that interest rates go even higher and the potential for further exogenous shocks.
“We believe our core equity strategy is well-positioned for a mild recession and we've proactively lowered our exposure to companies and industries that are most at risk," said Tom Galvin, chief investment officer for City National Rochdale. “Conversely, we've increased our exposure to companies and industries that are more steady growers."
Mild Recession Likely in 2023
Among three likely 2023 scenarios - slow growth, a mild recession, or a normal recession - Rochdale believes a mild recession is the most likely. The leadership team is particularly watching labor and wages as an indicator for the economy in 2023, along with geopolitical risks.
“For the Fed to succeed in its battle against inflation, we need to see a sustainable decline in wage growth to about 2.5% to 3.5% wage growth," said Galvin. “If this proves challenging, the tightening process may have to be sustained and go higher."
While history and research provide optimism about future returns, investors should expect volatility and perhaps further downside risk in the near term.
“Rest assured, if a severe recession risk goes up, as fiduciaries with a prudent responsibility to manage your capital, capital preservation is still as important as capital appreciation and we have a plan," said Galvin.
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City National Bank provides investment management services through its wholly owned subsidiary City National Rochdale, LLC, a registered investment advisor. Content from the December 15, 2022 presentation, "2023 Outlook" is reprinted by permission from City National Rochdale.
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 on 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.
As with any investment strategy, there is no guarantee that investment objectives will be met and investors may lose money.
Diversification does not ensure a profit or protect against a loss in a declining market. All investing is subject to risk, including the possible loss of the money you invest.
Returns include the reinvestment of interest and dividends.
Indexes are unmanaged and investors are not able to invest directly into any index.
The mention of a specific security is not a recommendation to buy, or solicitation to sell such security.
Quality ranking: City National Rochdale Proprietary Quality Ranking is the weighted average sum of securities held in the strategy versus the S&P 500 at the sector level using the below footnoted formula. City National Rochdale Proprietary Quality Ranking formula: 40% Dupont Quality (return on equity adjusted by debt levels), 15% Earnings Stability (volatility of earnings),15% Revenue Stability (volatility of revenue), 15% Cash Earnings Quality (cash flow vs. net income of company) 15% Balance Sheet Quality (fundamental strength of balance sheet).
Dividend Quality ranking: City National Rochdale Proprietary Dividend Quality Ranking is the weighted average sum of securities held in the strategy versus the S&P 500 at the sector level using the below footnoted formula. City National Rochdale Proprietary Dividend Quality Ranking formula: 15% Free Cash Flow Yield, 15% Free Cash Flow Margin, 10% Free Cash Flow Growth, 10% Dividend Growth (1-year and 5-year), 20% Dividend Payout Ratio, 15% Leverage (debt to equity ratio), 15% Return on Equity.
S&P 500 Index: The S&P 500 Index, or Standard & Poor’s 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S. It is not an exact list of the top 500 U.S. companies by market cap because there are other criteria that the index includes.
Muni Bond: A municipal bond is a debt security issued by a state, municipality or county to finance its capital expenditures, including the construction of highways, bridges or schools. These bonds can be thought of as loans that investors make to local governments.
Bloomberg Barclays U.S. Corporate High Yield Bond Index: measures the USD denominated, high-yield, fixed-rate corporate bond market.
Dow Jones Select Dividend Index: The Dow Jones U.S. Select Dividend Index looks to target 100 dividend-paying stocks screened for factors that include the dividend growth rate, the dividend payout ratio and the trading volume. The components are then weighted by the dividend yield.
The Intercontinental Exchange (ICE): The Intercontinental Exchange (ICE) is an American company that owns and operates financial and commodity marketplaces and exchanges.
The Bloomberg Aggregate Bond Index: "the Agg" is a broad-based fixed-income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.
U.S. Treasury Yield Curve: refers to a line chart that depicts the yields of short-term Treasury bills compared to the yields of long-term Treasury notes and bonds.
Consumer Price Index (CPI): is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care.
Bloomberg Barclays US Aggregate Bond Index: The Bloomberg Aggregate Bond Index or "the Agg" is a broad-based fixed-income index used by bond traders and the managers of mutual funds and exchange-traded funds (ETFs) as a benchmark to measure their relative performance.
MSCI Emerging Asia PE: The MSCI Emerging Markets Index is a selection of stocks that is designed to track the financial performance of key companies in fast-growing nations. It is one of a number of indexes created by MSCI Inc., formerly Morgan Stanley Capital International.
Global Equity Markets: a global market in which shares of companies are issued and traded, either through exchanges or over-the-counter markets.
6M T-Bills: The 6 Month Treasury Bill Rate is the yield received for investing in a US government issued treasury bill that has a maturity of 6 months.
2-Year Treasury Notes: negotiable debt obligations issued by the U.S. Treasury Department (other than a Stripped Treasury Security) having a remaining maturity of more than one year but not more than two years.
Liquidity Management: The liquidity index calculates the days required to convert a company's trade receivables and inventory into cash.
Investment Grade Municipal Bonds: Investment-Grade Municipal Bond Investment-grade municipal bonds are debt securities, issued by state and local governments carrying the lowest credit risk that a bond issuer may default. Investment Grade Municipal Bonds: Bloomberg Municipal Bond Inter-Short 1-10 Year Total Return Index.
Investment Grade Corporate Bonds: Investment grade corporate bonds are low-risk bonds. Because they are bonds, they are not tied to equity. Instead, they are like debt notes issued by a corporation. Investment Grade Corporate Bonds: Bloomberg Intermediate Corporate Bond Index.
High Yield Corporate Bonds: “U.S. High Yield Corporate” is represented using the U.S. High Yield Index.
High Yield Municipal Bonds: Bloomberg 60% Tax-Exempt HY / 40% LB Municipal Investment Grade Total Return Index.
Leveraged Loans: S&P LSTA Leveraged Loan Index, 6m T-Bills – ICE BofA 6-Month Treasury Bill Index, U.S. High Yield Corporate: 1-3 Years – ICE BofA
U.S. High Yield 1-3 Year Index, Intermediate Municipal – Bloomberg 1-15 Yr Municipal Index, U.S. High Yield Corporate – Bloomberg U.S. High Yield Corporate Index, Intermediate IG Corporate – Bloomberg Intermediate Corporate Index, High Yield Municipal – Bloomberg 60% Tax-Exempt HY/40% LB Municipal Index.
Speculative Technology: Companies in early stages of business development with negative net income that provide technology products or services.
Digital Revolution: Companies that provide technology products or services, and/or use technology products and services in a manner that enhances their business.
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.
All investing is subject to risk, including the possible loss of the money you invest. As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money. Diversification may not protect against market risk or loss. Past performance is no guarantee of future performance.
This information is not intended as a recommendation to invest in a particular asset class, strategy or product.
The information presented is for illustrative purposes only and based on various assumptions that may not be realized. No representation or warranty is made as to the reasonableness of the assumptions made or that all assumptions used have been stated or fully considered.
This document may contain forward-looking statements relating to the objectives, opportunities and the future performance of the U.S. market generally. Forward-looking statements may be identified by the use of such words as: “expect,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to, general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Prospective investors are cautioned not to place undue reliance on any forward-looking statements or examples.
None of City National Rochdale or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-
looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.
All investment strategies have the potential for profit or loss; changes in investment strategies, contributions or withdrawals may materially alter the performance and results of a portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will be suitable or profitable for a client's investment portfolio.
References to indexes and benchmarks in hypothetical illustrations of aggregate returns do not reflect the performance of any actual investment. Investors cannot invest in an index, and such returns do not reflect the deduction of the advisor's fees or other trading expenses. There can be no assurance that current investments will be profitable. Actual realized returns will depend on, among other factors, the value of assets and market conditions at the time of disposition, any related transaction costs and the timing of the purchase. Indexes and benchmarks may not directly correlate or only partially relate to portfolios, as they have different underlying investments and may use different strategies or have different objectives than our strategies or funds.
CNR is free from any political affiliation and does not support any political party or group over another.