The biggest known unknown for economies and financial markets is what will happen with tariffs – are they just being threatened as a bargaining chip for transactional purposes, if they come to fruition what will their breadth, size, and duration be, and will trading partners retaliate. Unfortunately for investors, the matrix of possibilities is endless, and each has a low probability chance. In this edition our asset class experts provide answers to the difficult questions.

Participants:

• Jason Daw (Desk Strategy), Head of North America Rates Strategy
• Elsa Lignos (Desk Strategy), Head of FX Strategy
• Lori Calvasina (Research), Head of U.S. Equity Strategy

* Research Analyst opinions are their published views, independent of those expressed by Desk Analysts

Jason Daw:

Hello and welcome to Macro Minutes. During each episode, we'll be joined by RBC Capital Markets experts to provide high conviction insights on the latest developments in financial markets and the global economy. Please listen to the end of this recording for important disclosures. Hello everyone, and welcome to this edition of Macro Minutes called the Art of the Deal, which we're recording on January the 27th. The biggest known unknown for economies and financial markets is what will happen with tariffs. Are they just being threatened as a bargaining chip for transactional purposes? If they come to fruition, what will their breadth, size and duration be and will trading partners retaliate? Unfortunately for investors, the matrix of possibilities is endless and each has a low probability chance. But in today's discussion, Lori, Elsa and myself are going to focus on some of the big picture issues, the chance of the worst case scenario and what could be the most likely outcome, how investors are positioning and is risk premia evident in markets and what could be the impact on different asset classes. So let's kick it off with a quickfire round tackling the most difficult and uncertain question. Elsa, you're in the hot seat. What probability do you give to meaningful across the board tariffs being applied to Canada or other large trading partners, and as a follow on, do you see a tariff scenario that is the most likely?

Elsa Lignos:

Sure. Well, I think we have to be careful to define what we mean by meaningful. So there was certainly a small minority who thought President Trump would come out all guns blazing on day one or week one, and clearly that didn't happen. Here's where I stand. I think the action we saw over the weekend on Columbia actually reinforces my view that yes, Trump really likes to use tariffs as a negotiating tool, is not afraid to impose them to achieve non-trade related policy goals. But at the same time, the fact that he was so quick to act on Columbia where he hasn't acted on any larger trading partner, I think reinforces my sense that there is a limited appetite to inflict real economic pain on the us. So yes, Columbia is by some measures the fourth largest source of crude imports for the us, but if you give it some context, 60% of US imports on crude come from Canada compared to about 3% from Colombian.

Lori Calvasina:

Thanks El and I would say this has been one of the top things that we've discussed in our year ahead outlook really since December. We put our piece out at the end of November. And look, I would say my take is slightly different. The question in my mind is, are meaningful tariffs a risk to dismiss or a risk to be vigilant on? Because I've told people that while I saw one competitor make a claim that the chance of meaningful broad-based tariffs were 30% and I don't have it as more than 50%. It's not something that's showing up in my own forecast, but I did feel like the 30% was a little bit too low. And I do get concerned when I hear the risk dismissed outright. And I think there are a couple of things rolling around in my head on this is number one, I do think that protectionism and the use of tariffs are a core belief of the new administration.

And I've spent I think a fair amount of time, three different campaigns, reading all of the policy documents, listening to policy speeches, and it's clear to me that this is something that is really truly believed. And to some extent it reminds me of Paul Ryan and his desire to reform corporate taxes way back in the day, just really kind of a true motivating core belief that keeps coming up time and time again. And we really saw this front and center back in September when Trump gave a speech to the New York finance community, and this was a speech that back in his first campaign had really emphasized taxes. I remember I didn't attend that speech, but I remember talking to people who had, and people were really impressed on the idea that he wanted to reform taxes and really stimulate the US economy. And I can tell you this speech back in September in New York of this past cycle, we heard terrorists brought up time and time again as something that was going to be a revenue source to pay for just about every other campaign platform.

And I generally share that view. However, I am reminded back in the 2018 tariff war with China that we did have a 20% drawdown. And so there are some limitations to political influence on the stock market that we've seen in prior experience. So those are really the three things rolling around in my head. Low probability, yes, but maybe not quite as low probability as I feel most people think. And then Jason, let's maybe sort of turn the tide back in your direction. Canada has been very vocal in applying retaliatory actions against any US imposed tariffs. Has this changed your assessment of the worst case scenario unfolding for Canada?

Jason Daw:

Thanks, Lori. As you mentioned, as Elsa mentioned, there is a lot of uncertainty with tariffs. I do feel that large across the board, tariffs are probably the least likely outcome in the matrix of possibilities. I think the mere fact that he did not do it last week right after inauguration, I think is very telling. It's quite easy to apply tariffs to smaller trading partners than it is for large, systematically important ones, especially ones where supply chains are integrated. Trump usually approaches the problems that he faces to achieve a win. And a win is not that I'm going to hurt you more than you hurt me, which would happen with Canada or Mexico and counter tariffs. A win for him is border drug trade, U-S-M-C-A concessions military spending or something. Yes, that he can point to that on shores US jobs. Looking at the risk of large and broad tariffs like nuclear war game theory I think is kind of helpful.

I think that just sums it up, doesn't it? Interesting diverging perspectives even amongst the three of us within the same team. And I think it underscores the difficulty investors are having trying to navigate this abnormally high policy uncertainty. So Lori, is there anything you are observing in the price action in the equity market at the index or at the sector level that indicates people are really worried about tariffs or what have you heard from the equity client base on the tariff topic?

Lori Calvasina:

Sure, that's a great question also. So I would say in terms of both broader s and p 500 price action and some of the most tariff sensitive sectors under the surface, what we're seeing is that there's a lot of optimism being baked in right now. If you look at the s and p 500, it has become anchored to Trump's net approval and we've also seen it start to move in tandem with Bitcoin and all of those saw an initial post-election euphoria, really strong moves up as the tariff discussion evolved, we got the announcement of Mexico, Canada tariffs. We saw all of those pull back a bit. And if I look at industrials and materials, things have been similar. They initially outperformed post-election faded in December and now they've bounced back more recently and been quite strong, strong. If I think about equity investor conversations directly, I would say I'm seeing very different things.

And some of this may be a function of time, some of this may also be a function of geography, but I have the cleanest read from back in December. And if I think back again to the trajectory of my marketing, I started out in Canada in early December and I heard some concern that maybe there was too much optimism around policy outcomes in the US and tariffs specifically. I went to Europe the following week and found that there was just a lot more concern when I was talking to global equity investors and those who specialize in the US directly. And I was very careful to solicit the feedback from the clients before I started talking. And I found in just about every one of my meetings, tariff and tax were two things people really wanted to focus on. When I got back to New York and I would say this has continued into January, I found much more optimistic assumptions about what the policy outcomes would be. And just to give you some color, I did a dinner with clients with some other macro colleagues maybe about a week and a half ago or so, and I found people were much more interested in talking about AI than tariffs. So I think there's a fair amount of optimism being baked in right now to be honest, that hasn't been uniformly true as I think back over the last two months, but I think there's certainly a point of optimism baked in on this issue right now.

Then Jason, there are obviously ramifications for the rates market from tariffs. Are you observing any risk premium or unusual price action in the Canada or US bond markets and what have your client discussions yielded?

Jason Daw:

I would characterize it as quite a unique situation. Usually when you're faced with a major risk event, there is a lean in markets or consensus in one direction or the other, but that doesn't seem to be the case with tariffs, at least in client discussions with fixed income clients. Tariffs are definitely discussed, usually me prompting the discussion, but I would've expected more reverse inquiries on the macro and market implications under different scenarios. And this is maybe because as I alluded to at the start of the podcast, there is a wide range of possibilities all with pretty low conviction levels from the investor base. And I would say this contrasts pretty sharply with say the US elections where market positioning was maybe a little bit more discernible. So right now there isn't a whole lot going on in rate space when you look at spot forwards or the volatility market that would suggest a risk premium for any outcome. And I haven't really come across a fixed income investor that tells me that they're highly convicted in a certain tariff scenario and that they're positioned in markets to benefit from it. So I do think this means the price action will probably be purely reactionary to any tariff outcome. And Elsa, your market is where the rubber usually meets the road changing relative prices, possibly trade and investment flows changing and associated FX adjustments. I would guess the currency markets kind of on edge and is showing signs of dislocations. Am I wrong here?

Elsa Lignos:

I mean it depends where you look. FX is an interesting one. On the spot side. We've had a fair bit of interest in our estimate for the tariff premium baked into dollar cad. And now this is not an exact science, as I said a couple of weeks ago. I don't want to give it an undue level of accuracy, but we have a fitted framework for looking at dollar cad, decomposing the price action across its typical underlying drivers. And our current testament of the tariff premium sits just north of 1%. It's actually been relatively stable. I think there is some risk baked in, but pretty minimal relative to the fairly decent move in dollar CAD we've seen since the US election. Where you do see more of an impact is in the vol market, both in at the money vols themselves, but also in risk reversals. There's clearly still demand for people to hedge themselves against what most perceived to be a tail risk, but of course there's career risk involved, particularly for people not trading this as a source of alpha, but just looking to hedge themselves against adverse scenarios. And so yes, you can see the vol market has this tariff premium baked in fairly decent size that is likely to decay as more time passes if Trump doesn't deliver what he's said he might.

It's interesting, there's not a strong consensus or really conviction as you alluded to Jason or anything of normal. We're really all seen in market behavior and it's pretty clear the range of outcomes from small targeted or shortlived to large across the board or long lived can have an impact on different asset markets. So else I want to dig in a little bit deeper with you. Your team recently wrote about what could happen to the Canadian dollar under different tariff scenarios. Has anything in your line of thinking changed regarding CAD and do the same outcomes apply to the Mexican peso

Jason Daw:

First off, we need to understand the different starting points for the respective economies and the tariff impact for any level of tariffs with retaliation. Canadian growth is hurt more, but the US still suffers, especially in a high tariff drawn out scenario. The negative growth impact on inflation should outweigh the initial price increases from tariffs. Given Canada's an excess supply at the moment and the US is an excess demand, the disinflationary consequences beyond the initial price level adjustment could be higher than in the us the degree of fiscal support across countries. That's also going to be something important to consider. But all else equal, the Bank of Canada would probably have to cut more than otherwise while the fed reaction function isn't as clear cut. And to remind our listeners, we have a below consensus and market call on the BOC at a 2% terminal rate without factoring in tariffs.

So with tariffs, the policy rate could ultimately be lower, and the continuum of where policy rates could be under different scenarios is very wide, just like it is for tariffs for the Fed. We are out of consensus on the other side believing they're done cutting rates unless the data shifts weaker and here tariffs present probably more two-way risk for the Fed. So moving on to you Lori. The tariff scenario seems very nuanced for the equity market. There's the growth impact if other countries retaliate the margin impact from price changes and winners and losers possibly from both of those items, any views on how the market or sectors might unfold?

Lori Calvasina:

Sure, Jason, it's a great question. So let's start out with the broader market and I think the important thing to understand is that we are starting from a point of fairly elevated positioning in US equity market futures. If you look at the weekly CFTC data, so to go back to something you said earlier, I think the idea of reactiveness I think is something unfortunately we're going to have to be dealing with. I do think the main ripple effects that I'm monitoring for other macro indicators, what are any reverberations on 10 year yields? We've seen that our earnings yield gap model, if we were to see 10 year yields rise to 5% or more would flip our model into a range that's typically negative for US equities on a 12 month forward basis. And if we were to see some sort of modest impact to growth forecast in the US this year, say shave just a little bit off GDP, not just sort of take us into recession type territory, right?

But maybe just shave a few tenths of a percent off that could take GDP expectations for the year from a range that's pretty favorable to equities. 2.2% is the current number. Two to three is usually a good range for stocks down to something that's pretty tricky for stocks to navigate on. And we have typically seen stocks sell off in one to 2% GDP range because sluggish growth really does tend to be a problem for equities. These are all things we've talked about in our bear case for the US equity market this year. So those are things we're monitoring. And I'll tell you, Jason, as I think about some potential negative headlines, whether it's from tariffs or anything else throughout the year, I have baked in my forecast the idea of a five to 10% drawdown, but we could see something more material than that if we were to get some negative read-throughs right on some of these other macro indicators that equities are sensitive to.

Jason Daw:

Thank you everyone for joining this edition of Macro Minutes. Tariff risks are likely to linger for an extended period and likely to have material implications for global financial markets. So please contact your sales coverage or us directly if you any questions.

Speaker 4:

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