Quarterly Update ECONOMIC AND INVESTMENT MANAGEMENT PERSPECTIVES. The Economic Trifecta. Synchronized Global Economic Growth a Benefit to the U.S.

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1 Quarterly Update ECONOMIC AND INVESTMENT MANAGEMENT PERSPECTIVES JULY 2017 THIS ISSUE The Economic Trifecta Synchronized Global Economic Growth a Benefit to the U.S. Stocks Post Strong Gains, Outlook Remains Favorable Yield Curve Signaling Fewer Rate Hikes Expected

2 QUARTERLY UPDATE PAGE 2 From the Desk of Garrett D Alessandro, CFA, CAIA, AIF The American presidential election and the Brexit vote in the United Kingdom (UK) demonstrated the beliefs of millions of citizens in both countries that their governments were dominated by elites who were not attending to the interests of ordinary people. This view, generally known as populism, is driving policy in directions that are important for investors to understand. As investment managers, it s vital for us to reflect on and understand the economic and social impacts of populism and its policy ramifications, regardless of one s political views. Consequently, we are studying the economic impact of government policies and the resultant distribution of incomes, wealth, and mobility for U.S. citizens. The chart below illustrates how the U.S. and UK have performed in developing equal opportunity and/or equal wealth/incomes across the population. The fact that the U.S. and UK have the highest inequality and/or the least upward mobility helps explain what has driven the appeal of populism and populist candidates in both countries Social Mobility vs. Income Inequality Generational Earnings Elasticity Less upward mobility Finland Norway Denmark Sweden France Germany Canada Italy Japan Spain New Zealand Australia UK More income inequality U.S Gini Coefficient (At Disposable Income, Post Taxes and Transfers) Source: OECD as of November 2016 Generational earnings elasticity refers to the elasticity of the child s earnings with respect to the parent s. Higher elasticity means that the child s earnings are highly dependent on the parent s, implying low social mobility. Focusing on the U.S., the data shows that, compared to other developed nations, our society has become less balanced in terms of the distribution of income and wealth and less able to offer equal opportunities to all Americans. While there are several reasons for this, the belief that the elites in positions of power throughout U.S. society have worked against the interests of the population as a whole is the essence of the populist appeal. However, there are other factors at work. It s true that the amount of U.S. GDP earned by workers has declined from 48% to 44% over the past three decades a significant decrease. But globalization, which enabled businesses to shift jobs (and therefore wages) overseas, and technological advancements (automation, robots, etc.), which diminished the overall need for employees, played substantial roles in the declining share of GDP flowing to workers. In other words, the issues fueling the rise of populism cannot all be blamed on the elites. In thinking about how well citizens in developed countries have fared, it s important to note that there is a fundamental distinction between creating equal opportunity for all citizens and creating equal outcomes. The U.S. was founded on the premise and promise of equal opportunity, while Europe as a whole has preferred the ideal of equal outcomes. In some ways, the average European household has been taken care of better by its governing institutions. However, this comes with a trade-off. Most European economies have become less favorable to business relating to global competitiveness and growth rates of real per capital incomes. Each country thinks about the kind of society it wants and then pursues those policies best suited to achieve that society. Adopting the populist concept of equality of opportunity would fundamentally align with the premise upon which the U.S. was founded.

3 QUARTERLY UPDATE PAGE 3 Again, we are not taking a political view here. Our focus is on the data and the trends we project, the governmental policies that may be enacted, understanding how those policies could impact social, economic, and financial conditions, and making investment decisions according to the interests of our clients. In that context, here are some of the investmentrelated issues we are considering: Will the policymakers in Washington produce truly beneficial policies that address the major concerns of all Americans, or will there be no real change in terms of social mobility and economic well-being? How will these policies specifically benefit Americans through better opportunities or through better outcomes? How much of each policy should be focused on economic affordability while preserving the well-being of all Americans? While the process of developing these initiatives is unfolding, it s clear who needs to benefit from the policies that will be enacted middle-class citizens. Identifying and enacting healthcare and tax reform policies requires that compromises be accepted to bring about a more competitive U.S. worker and a more competitive U.S. economy. Economic research has shown that areas best suited to creating long-term changes in productivity and competitiveness include improving education and creating job training programs, which are superior to short-term policies such as tax cuts for the wealthy or erecting trade barriers for uncompetitive industries. However, economists now agree that trade policies should measure their full impact and seek a better balance between profit maximization and social impact. Current areas of legislation being considered include regulatory reforms, healthcare reforms, and tax policies. If Americans want a country that makes the lives of all citizens better, these new policies should have as a principal objective achieving a balance of offering better opportunities and better outcomes for middle-class workers. All Americans and the rest of the world will be watching to see whether the new administration and Washington as a whole can bring about changes that make the lives of middle-class Americans better. Garrett R. D Alessandro, CFA, CAIA, AIF Chief Executive Officer and Chief Investment Officer City National Rochdale OUR CONTRIBUTORS Garrett D Alessandro, CFA, CAIA, AIF Chief Executive Officer, Chief Investment Officer Steven Denike Portfolio Strategy Analyst Thomas Galvin Managing Director, Senior Portfolio Manager William Miller, CFA Managing Director, Senior Portfolio Manager This material is available to advisory and subadvised clients of City National Rochdale, LLC, a Registered Investment Advisor and a wholly owned subsidiary of City National Bank. For additional information about the investment management services provided by City National Rochdale, please call (800) or visit cnr.com.

4 QUARTERLY UPDATE PAGE 4 The Economic Trifecta By Garrett D Alessandro, CFA, CAIA, AIF Consumers, businesses, and government are all contributing to moderate projected growth for the U.S. economy into mid Equity markets have fully recognized this by reaching high levels, justified by record corporate earnings and dividends. Consumers are enjoying rising disposable incomes, rising confidence, a strong job market, and increasing home values. These factors support City National Rochdale s outlook for moderately solid consumer spending into mid Businesses continue to earn solid profits, which, along with good business confidence, means continuing positive trends for job creation and capital investment. We project continued real wage gains for consumers in the year ahead, as unemployment rates are low and competition for labor is tightening. A tax cut would add even more disposable income. As Chart 1 shows, U.S. median weekly earnings are increasing for all economic groups, with the more positive increases occurring among workers with a high propensity to spend all their earnings. Equities and bonds have both generated positive returns in 2017, a situation that is unlikely to continue over the next two or three years. At some point, a decline in interest rates, although generating positive fixed income returns, would signal an economic slowdown that is likely to be accompanied by deteriorating earnings and equity prices. Alternately, the solid economic growth we are now experiencing will likely continue, leading interest rates to rise and fixed income returns to weaken. Our current view is that equities will have a better chance to generate positive returns as a globally synchronized expansion continues. Our support for this comes from expectations that both U.S. and global GDP growth will trend positively during While we are positive on the equity outlook for the next 12 months, we also recognize that we are in the later stages of this long bull market and economic expansion. This means investors should calibrate projected equity returns based upon the rate of future earnings growth, which we forecast at 4-6%. If corporate and individual taxes are reduced for 2018, that would be additive and potentially lift earnings growth into the 6-8% range. Median Weekly Earnings Total Less than a High School diploma High School graduates, no college Some college or associate degree Bachelor's degree and higher Bachelor's degree only Source: Bureau of Labor Statistics as of January 2017 Global Growth Forecasts Source: The International Monetary Fund as of January 2017 (Continued on Page 5) Political rhetoric distorts the realities of today s global economy Better education and innovation, not protectionism, are the answer Intelligently constructed trade agreements will likely help U.S. workers

5 QUARTERLY UPDATE PAGE 5 The Economic Trifecta (continued) Our projections require that interest rate increases remain controlled over the forecast horizon. We are watching the Fed s actions closely. While current inflation indications are lower than expected, Fed policy is highly dependent on wage trends and how overall core CPI behaves. We expect moderate rate increases between now and the end of 2018, but not enough to stop the economic expansion for at least another year. For clients with diversified portfolios and long-term investment horizons, the key investment decision is always how much to allocate to which asset class and when to do so. For many years now, City National Rochdale clients have had an over-allocation to U.S. equities and opportunistic income asset classes. This has contributed beneficially to our asset allocation investment returns. City National Rochdale s asset allocation decisions (not individual stock or bond decisions), have produced strong additive returns relative to a traditional balanced allocation of 60% to core equities and 40% to core fixed income Although we are enjoying this long bull market and economic expansion, we believe the next changes to our asset allocation positioning will reflect our expectation that all good things must eventually end. We will communicate the decisions of City National Rochdale s asset allocation committee as we make these changes. These decisions will make important contributions to client portfolio returns over the subsequent months. City National Rochdale has added substantial value to client portfolios through asset allocation during this bull market, and we believe our fundamental active investment decision-making should continue to provide competitive returns compared to passive approaches.

6 QUARTERLY UPDATE PAGE 6 Synchronized Global Economic Growth a Benefit to the U.S. By Steven Denike This year is shaping up as the most synchronized for global growth in a decade, a development that could ease the burden on the U.S. as the world s economic engine. World trade is at a seven-year high, and for the first time since 2010, no G20 economy is expected to post a decline in output. Across the Atlantic, Eurozone economies are experiencing better, albeit moderate, growth and inflation a sign that easy monetary policies are yielding positive results. Economic sentiment in the EU is the highest since 2011, and unemployment the lowest since Japan is experiencing its longest stretch of growth in more than a decade, and China is apparently still growing as it transitions to a lower-growth but more balanced economy. At home, the U.S. economic expansion has entered its ninth year and may well continue for some time. Recent data indicates a solid rebound in second-quarter GDP, and expectations are for growth to be modestly above trend over the next year. With all the world s economies growing in lockstep, the difficult question is whether a more fundamental shift is occurring. An important component to sustaining global growth would be to see a sustained expansion in business investment to improve productivity and make economies more efficient. Investment is a key indicator of economic strength because it shows how extensively firms are committing resources to increasing future output. The good news is that various factors affecting the investment outlook have turned supportive, including corporate profitability. Investment growth in advanced economies is forecasted to overtake consumption growth over the next year. Significant challenges may arise when central banks reverse years of ultraaccommodative monetary policies, and the possibility remains of policy mistakes and unintended consequences that could damage the global economy and financial markets. Still, many economic indicators appear to be pointing in the right direction. Quarterly World Merchandise Trade Volume (Indices 2005=100) Q1 06Q1 07Q1 08Q1 09Q1 10Q1 11Q1 12Q1 13Q1 14Q1 15Q1 16Q1 17Q1 Source: World Trade Organization as of 6/8/2017 Real Consumption and Investment Growth 6% 5% 4% 3% 2% 1% 0% Seasonally adjusted Not seasonally adjusted Advanced Economies Emerging Economies Global Economy 2016 Consumption 2016 Investment Dots indicate 2017 forecasts Source: Bank of International Settlements as of 6/30/2017 Economies of Europe, China, Japan all doing well U.S. economic expansion still on track in ninth year Business investment critical to improve productivity

7 QUARTERLY UPDATE PAGE 7 Stocks Post Strong Gains, Outlook Remains Favorable By Thomas Galvin The S&P 500 recorded a strong first half, finishing ahead 9.3%, which was near the higher end of our original expectations for the entire year. This strength has been driven by improved economic activity on a global basis, which in turn has produced better than expected earnings and improved confidence in the durability of the corporate profit cycle. Our outlook for the next 12 months remains favorable, although there are challenges. We believe the economic backdrop is supportive of EPS growth of 4-6% in the next 12 months. The components, as illustrated in the chart, are real GDP +2.3%, inflation +1.8%, international GDP +0.2%, stock buybacks +2%, oil +0.5%, margins -1%, and dollar -0.5%. This produces a forward 12-month EPS base case of $133 and makes markets appear fully valued, selling at 18.3x PE. A couple of insights on these factors. On earnings, a new accounting standard recently took effect that gives companies a tax benefit when employees exercise stock options. This helped Q1 earnings, and many strategists raised their forecasts after Q1 results were in. We did not, as we view this as a nonrecurring item. 12-Month EPS Outlook 6% 2.3% 5% Real U.S. GDP Inflation 4% 1.8% International GDP 3% +6.7% Stock Buybacks 0.2% 2% Dollar Impact 2.0% Margin Change 1% Oil 0% 0.5% -1% -1.0% -0.5% -1.5% -2% = 5.2% EPS Growth Source: City National Rochdale as of 6/30/2017 On valuations, history shows that bull markets generally end in euphoria, with PEs exceeding 20x. While low interest rates and the earnings yield for the S&P compared to investment grade corporates and inflation remain favorable, unless animal spirits get unleashed via pro-growth stimulus measures, multiples may not rise significantly from current levels. While a correction could occur in coming months, potentially triggered by concerns over monetary and fiscal policy actions or geopolitical/exogenous shocks, we believe the moderately favorable longer environment for GDP, inflation, and interest rates is likely to keep the secular bull market moving forward. However, overall, we believe that expected returns looking ahead are likely to be more in line with 4-6% earnings growth than the very strong returns expected this year. Stocks advance on economic strength, confidence in durability of profits Earnings comparisons become more difficult in second half Secular bull market appears to be intact

8 QUARTERLY UPDATE PAGE 8 Yield Curve Signaling Fewer Rate Hikes Expected By William Miller, CFA One measure we pay particular attention to when managing fixed income portfolios is the slope of the yield curve (measured by the difference between two-year and 10-year Treasury yields). This measure reflects the bond market s consensus estimate of the future path of interest rates, which is based on both the Fed s monetary policy as well as inflation expectations. During the second quarter, we saw the slope of the yield curve decline materially, from 113 basis points (bps) to 91 bps at month s end. Although some of this flattening was due to the Fed s mid-june rate increase, most of it was due to a decline in 10-year yields. This is important because it implies a change in market expectations, in this case declining inflation expectations. Lower inflation expectations have reduced market expectations regarding additional rate increases by the Fed. The market is signaling that it anticipates only one or two more hikes by the end of This contrasts with Fed projections of four additional rate hikes, supported by low unemployment with inflation of about 2%. City National Rochdale expects the Fed will likely raise rates again later this year and perhaps two or three times next year, with long-term rates rising only modestly. We also track corporate credit spreads, the incremental amount of yield that corporates offer over Treasuries. When credit quality deteriorates, corporate yields increase relative to Treasury rates. Corporate spreads declined modestly during the quarter, indicating stable to slightly improving credit quality. Leverage is higher, but this has been offset by lower interest costs, and we expect positive earnings growth going forward. Even though corporate spreads are lower than in prior years, they reflect stable credit conditions and result in yields that are more attractive than Treasuries. Given a stable macroeconomic environment with rising earnings, we remain comfortable with our allocations to corporate bonds. That said, we will look for opportunities to increase overall credit quality by swapping lower-rated issuers for higher-rated ones when the yield difference is minimal. Yield Curve Slope Source: Bloomberg as of 6/30/2017 Corporate Spread Source: Bloomberg as of 6/30/2017 Flattening yield curve reflects lower inflation expectations The Fed will likely increase rates again this year and two or three times next year Corporate credit quality remains stable to slightly better

9 QUARTERLY UPDATE PAGE 9 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 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. Concentrating assets in the real estate sector or REITs may disproportionately subject a portfolio to the risks of that industry, including the loss of value because of adverse developments affecting the real estate industry and real property values. Investments in REITs may be subject to increased price volatility and liquidity risk; concentration risk is high. Investments in Master Limited Partnerships (MLP) are susceptible to concentration risk, illiquidity, exposure to potential volatility, tax reporting complexity, fiscal policy, and market risk. Investors in MLPs are subject to increased tax reporting requirements. MLP investors typically receive a complicated schedule K-1 form rather than Form MLPs may not be appropriate investments for tax-advantaged accounts because of potential negative tax consequences (Unrelated Business Income Tax). 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. 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 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. Investments in emerging market 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. Emerging market bonds can have greater custodial and operational risks, and less developed legal and accounting systems than developed markets. Yield to Worst is the lower of the yield to maturity or the yield to call. It is essentially the lowest potential rate of return for a bond, excluding delinquency or default. As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money. Returns include the reinvestment of interest and dividends. Investing involves risk, including the loss of principal. Diversification may not protect against market loss or risk. Past performance is no guarantee of future performance. Index Definitions The Standard & Poor s (S&P) 500 Index represents 500 large U.S. companies. The comparative market index is not directly investable and is not adjusted to reflect expenses that the SEC requires to be reflected in the fund s performance. Indices are unmanaged, and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses City National Rochdale 4/17-7/