Markets in Motion (Special edition) - Positivity isn’t always naivete

Today, I’m excited to bring you a special edition – a recording of RBC Capital Markets’ Macro Minutes podcast, another podcast from the team at RBC Capital Market featuring conversations on hot topics with RBC’s macro team. In this edition, I joined Blake Gwinn, Head of Rates Strategy, to discuss our outlooks for our respective markets, and how our markets are priced under the Iran War. We hope you enjoy the show.

Blake: Hello and welcome to the May 8th edition of Macro Minutes. I’m Blake Gwinn, Head of US Rates Strategy at RBC Capital Markets. I’ll be your host for today. I’m joined by Lori Calvisina, Head of US Equity Strategy. So Lori, we’ve got US rates and US equities both here. We’ll try to split this time up - given we are equity/rates, I guess we can keep this 60/40. That’s really cheesy, I know. I’ll go ahead and kick this off.

There has been a persistent narrative among market participants pointing to performance in risk assets. We’ve had equities repeatedly hitting all-time highs over the last few weeks and last month, and they are saying that the markets are completely missing the boat on Iran risks —that can be in terms of how long the conflict will ultimately last, the breadth of the impacts beyond just oil and gas prices, how it’s going to affect fertilizer, helium, all these other things. Some also point to how long it will take for supply chains to actually get back to normal. So my question is: how are you looking at that narrative? Where do you fall on this? Have equity markets lost the plot here?

Lori: Great point to start with, Blake. I bring this in my meetings — I say US equities continually get accused of complacency. I do not think there is complacency in US equities. You know me, I live on the road. I love talking to clients in conference rooms. We discuss all sorts of things, and we talk a lot about the war with Iran in the meetings I’ve been doing recently. I can tell you just from having this conversation there’s concern, there is wariness — but investors are also listening to what companies are saying. This is what stock pickers tend to do, and I primarily live in the long-only world. And when I go to meetings, we spend a lot of time talking about what they’ve heard on earnings calls, what I’ve heard on earnings calls, and comparing notes. Going through this past reporting season, I’d say it sounds very similar to a lot of the commentary that I heard back in March, but essentially companies are sending the message right now that they are still able to manage through.

We are stunned by how much we are hearing companies refer back to COVID, refer back to the two tariff episodes, and even some financials companies referring back to the regional banking crisis. We’ve seen companies say things like, “We could not have handled this as well five to ten years ago as we are today.” They’re referring to the playbooks that they put into place most recently around tariffs. They’re talking about supply chain management. We’re also noticing conversations about inventories and hedges — I call these collectively “buffers.” And I do think companies are being a little cagey sometimes in terms of exactly how much of that they have. There’s a bit of black-boxiness to mitigation discussions. We saw that in tariff as well. But we have seen companies say things like, “We have a year’s worth of helium. We have a year’s worth of poly. We have a six to twelve months of hedges generally in terms of how we manage our business.” Not everybody has a year’s worth of stuff. We’ve heard some companies are saying a quarter or two. But the idea that buffers are in place is something we’re getting an earful of in single-stock land. That’s more of a bottom-up perspective on what we’re hearing from the companies affected by the war.

When we did the math, and I’m not going to nerd out completely in terms of my math with you this morning. But if we look at the PE side of things, we’ve baked in elevated inflation and 4.5% 10-year yields. I know that’s not your call, but we tried to bake in the higher inflationary environment from the PE perspective as well. When we put the new adjusted earnings number together with our adjusted PE, which represents some pretty significant compression versus the highs of last year, the number I still came up with for fair value on the market was 7,929. So our new target is 7,900, rounding that out. We have spent a lot of time thinking about the two sides of the economy — the fast lane, the AI lane, and the slow lane impacted by the Middle East — taking both into account from both an earnings and valuation perspective. I can still get you 7.7% appreciation in the S&P 500 over the next 12 months very easily. From a math perspective, I really push back against the complacency argument.

Blake: That’s really interesting. I get a sense of how you’ve changed your modal view. I’m a happy subscriber of your research and got an email from that distribution right before we started recording this, where you discussed that target change. What I’m also curious about are the risk scenarios around it. I’m not going to ask you how you see these things playing out — nobody can tell you that with any real conviction at this point — but where we can offer some insight is in thinking about how markets might handle different scenarios. Let me throw a couple at you.

Let’s say tensions continue, this cycle of escalation and deescalation just keeps rolling on into the summer, oil drifts back up into the $110–$120 range and stays there for a few months, and some of those time-limited buffers you were just describing start to expire — we’re seeing scattered shortages across supply inputs, not just here but across the globe. That’s the downside scenario. On the other side, let’s say — completely theoretical — Trump and Iran announce some kind of deal tomorrow, everyone starts standing down, and we get this process of turning back on the flow of oil and goods through the strait. How do you see those two different scenarios playing out in equity markets?

Lori: Let’s stick with the more constructive scenario first and then we’ll look at the more bearish scenario. If we are looking at this from a broader market perspective, using that same valuation and earnings model I just mentioned to you. We have a massive table in there where we flex the earnings assumption, we flex the different macro assumptions to arrive at different PE assumptions. Let’s look at the bearish and the bullish one on this one. But if we just take the consensus macro: so more benign inflation at 2.9%, another cut from the Fed by Q1 next year, and 10-year yields behave, I’m looking at roughly a 25x PE multiple on consensus earnings, completely unadjusted. Everybody’s right, you’re getting to around 8,700 on the S&P 500.

Now let’s bear that up a bit. If I just keep the current macro assumptions — 3.3% CPI, flat Fed, 4.5% on the 10-year — that implies roughly a 24x PE. If I then take earnings down in Q1 next year by 5% — not a haircut to consensus, but actually taking the numbers down — that gets you to around 6,700 on the S&P 500. If I want to look at a more dire PE scenario and push the PE down, say 10-year yields go up to 5% and CPI starts to approach around 4%, settle around 3.8%, on that same 5% earnings drop I can get you down to 6,300 on the S&P. This is the kind of math we can walk through.

Zooming out, if you think qualitatively about the GDP environment, what we tend to fear in equities is not a recession itself — it’s that point when you get into the zone where you’re about to tip into a recession. So zero to 1% GDP, when you’re at that stall speed, the median and average market drop in the market on a 12-month timeframe is around 10%. It’s not fun. That is really the trouble spot for equities. So those are really the scenarios you can think about.

All right. So Blake, let's turn it back over to you now. For the last few years, when we've done our macro dinners together, the Fed conversation often takes up the appetizer and the entree, and that just leaves me and Amy with equities and derivatives squeezed into the dessert course. Now, I don't mind, because it's always been helpful to me when I go into my own meetings the next week, but I just wanted to ask you, do you think that changes? What's going to happen at our next macro dinner? Are we going to be spending more than half the dinner on the Fed? Does this fade in the background? What does the conversation get replaced with? I know we've been talking a lot about war and AI recently. What do you think is going to replace the Fed as the topic of conversation? Or do you think the Fed's going to come back?

Blake: Lori, I think the ball is in your court for a while. I might finally get a chance to eat the appetizer and entrée instead of talking through them. A lot of that is simply because the Fed is going to be, for better or worse, a little boring for the time being. We titled one of our pieces around the last FOMC cycle “Wait and See Rides Again.” And we have the Fed on hold for the rest of the year. And I think this early summer period that we're entering into reminds us a lot of last year, what we saw post-Liberation Day. And that was another time where we had this unexpected shock from Liberation Day that introduced a lot of two-way risks, meaning they're getting challenged potentially both on the inflation side but also on the labor side of the mandate, pulling them in two different directions.

And we had a number of meetings last year in the middle of the year where they were just saying, "Hey, look. We don't know which way's going to win out," and it was pretty boring. And so I think we're entering into a similar position now, where they just don't really know which way to take it. I think the risk around Iran, aside from being two-sided, where you don't really know... Is it going to be a bigger upside inflation problem, or is it going to be a bigger demand destruction, drag on growth, something that actually turns them dovish? Aside from that, they also don't know the timeframe. And I think even if you had a perfect beta, if you will, if you had a perfect estimate of what a certain oil shock, price shock would do to US economic data, even if you had that, there's still this time component.

It matters a lot whether that impact is one month long or two months long or six months long. And so the Fed can't know that right now, and so I think they're kind of stuck. They're just going to watch, see how things come in. I think seeing this thing start to wrap up is going to be an important part, where then they can move on and start saying, "What is the lasting shock from this going to be?" Is it going to be more of a growth hit, more of an activity hit? Is it going to be downside, or is it going to be filtering into some of these inflation metrics that they probably care a bit more about? Is it filtering into the core measures? Is it starting to push up longer run inflation expectations, et cetera? So it's going to be a while, I think, for them to really figure that out.

You also got to consider we have Warsh coming in, and there's probably going to be a little bit of a transition period. I doubt he's going to hit the ground running. And you saw from the last FOMC meeting quite a bit of disagreement on the committee. So clearly, this committee's not really aligned in action in either direction. I think what we're going to see over the next few months, the next few meetings, is you're going to see this Fed messaging and the bias. It's going to continue to become more balanced, which means they're just continuing to pare back this very light dovish bias that they have still had up until this time. And that was what... The dissents that we had in the last FOMC meeting, it was three people basically saying, "Hey, look. We don't want a cutting bias anymore. We want it to be two ways." So I think it's going to keep moving in that direction, not towards hikes necessarily, but really just becoming more two-way.

Now, unfortunately, back to the point of your question, I don't really think those shifts are enough to pull all of the attention back to the Fed and really flip the market dynamic on your side away from this AI story, away from the tech story, away from Iran, and back towards “what is the Fed going to do?”

Lori: Can we dig into the idea of transitioning to the Warsh Fed a little bit deeper? Putting aside the question if they get more dovish, more hawkish, just thinking about process approach, press conferences, the dots... I know the dots, some people love them, some people hate them. I'm a data nerd, as you know, and so I love the data dependency of the Fed, but do things like the dots, data dependency go away? How does this Fed operate going forward?

Blake: Let me say upfront — I’ve been on this podcasts before saying this, so this shouldn't be something new to people who listen to this regularly, but we really don't see... We see Warsh coming in and being able to deliver these uber-dovish outcomes, especially with everything that's happened in the data with Iran risks. This is really not a case that he's going to win there on cuts. So I almost take that right off the table. A few more questions around what he might be able to do with balance sheet and that conversation has been heating up. We've gotten different papers released — Miran put one out, Lori Logan at the Dallas Fed put out a paper, and we saw one from the G30 — all going through options for getting the balance sheet lower. We’ll see where they go with some of that stuff.

But I think what you're asking, more on the process side... And I think this is one of the interesting things about the last meeting, was that we had four dissents, the three that I just mentioned. We also had Miran dissenting for cut. And I think what we're entering into with Warsh taking over is really more of a, for lack of better word, democratic Fed, which is that they're going into these meetings without a real consensus decision that's already been essentially decided before the meeting. We're seeing more dissents. We're seeing decisions that actually take place at the meeting as a product of debate. I think we're going to see more dissents. I think seeing four dissents... We haven't seen that since the '90s, but this is something that's going to, I think, probably become a bit more normal. And we're just going to see a lot more dissent, a lot more disagreement, and decisions aren't going to be nearly unanimous, or at least nearly unanimous, with one, maybe two dissents.

I think that's going to be the new normal. As far as changing some of the communication, are they going to do away with press conferences? Are they going to do away with the dots? Certainly possibilities. We've heard Powell say that they've looked at the communication policy, and there really wasn't enough support on the committee to really get over the hump and actually make any of those changes. So we'll see what Warsh can do. He clearly wants to reevaluate some of those things. He wants less forward guidance. He probably wants to get rid of the dots, go to the fewer press conference meetings. It just depends on what he really can build a consensus for. Powell seems like that consensus was not there, but he left the door open to maybe the next chair being able to deliver that.

Lori: One follow-up question on that. If there are more dissents and there are more decisions made in real time, does that mean we're gearing up for more difficulty for investors to price the Fed ahead of time? Are we looking at more volatility around these meetings?

Blake: I think so — and I don’t think that’s necessarily a bad thing. And we see other central banks around the world that do have those types of setups, where meetings are not foregone conclusions. You get surprise announcements. You have a lot of differing views coming out from various people on the committee. So this is not something new for global investors. Maybe a little bit new in thinking about the Fed that way, but I do think it does mean more volatility in some of that front end pricing, especially getting rid of the dots. The dots have been a huge anchor for rate markets. It's not that the dots are always right, or they necessarily are going to tell you accurately what the Fed's going to do in a year or two years, but they have served as an anchor for markets to trade around. And so you remove that anchor, and I would just expect things to be moving around more, particularly in and out of Fed meetings, where if it's not a foregone conclusion and we could see surprise meetings, yeah, that absolutely means some more volatility.

Lori: So let's get back to this complacency argument we started discussing earlier from the equity side. What do you think rates investors are pricing in with regards to the Iran war?

Blake: I don't think it's as extreme as the equity side. Usually, when you hear this narrative, it's people pointing at the all-time highs in equities, et cetera. I think in the rate side, we've repriced a bit in the hawkish direction. I think maybe the better way to describe it is we've taken out some of the dovish bias, and now we are pricing something that looks a lot more like a flat distribution. I think that's correct. If you go back to what I was saying about where I think the Fed is heading and moving back to a more neutral, two-sided type of bias, and removing that dovish bias that was inherent in a lot of their communications, it makes sense that the markets front ran that a little bit. I think markets got a sense of that shift and have rightfully moved to a much more flat pricing for the Fed going forward.

We've been hovering around this spot where we're neither pricing hikes nor cuts in the next year. So I think that's accurate. I think that's right, because we do have these two-sided risks that, if this goes on a long time, if it gets really drastic, you start thinking about demand destruction, and then you start thinking about the Fed having to cut rates. On the other hand, if we see these pricing increases in oil and other goods just a little bit more stubborn, a little bit more persistent, start pushing up inflation expectations, it could push them to hike. And I think those two sides are pretty evenly balanced, and the markets are pretty well reflecting that. So I don't see things as unfairly priced. I think, looking at the range of outcomes and the skew in outcomes, things actually look pretty fair here.

And for what it's worth, if you look out the curve even away from Fed pricing, we are still somewhat inside of ranges that we've been in for quite a while. We haven't really hit new highs in yields. We really haven't moved to extreme levels. We're seeing chop around on some of these Iran headlines, but overall we're not pushing to any types of extremes that we haven't seen over the last year or so in terms of yields further out the curve. So I think things are pretty well positioned right now.

Lori: As we start to wrap up, I’m going to ask you a question with a little bit of twist — something someone asked me in a meeting last week, which is just, what's the most interesting question you've gotten in the past few weeks? And if you don't have an interesting question, is there an interesting chart, or is there just something stuck in your head that you're noodling over right now?

Blake: Yeah. Okay, I'm going to dodge this question a little bit, and what I'll actually say is an interesting shift in the type of questions. And I think what I mean by that is I've seen a lot of conversation, or gotten a lot of conversation, a lot of discussion with clients, et cetera, over the last week on more technical issues. And what I mean by that is balance sheet changes. We had a treasury refunding announcement this week where they talked about the TBAC. This is the Treasury Borrowing Advisory Committee. They gave a presentation to Treasury about potentially investing some of their cash that Treasury holds into repo. These are very technical things, but they matter for our markets quite a bit. And so I think what's interesting is we've seen a shift. These plumbing and regulatory and more technical questions, that has been quiet for a very long time.

Basically, since late last year, a lot of that plumbing stuff has been near silent. It's been very well-behaved. Nobody's really asked about it. Everybody's been more focused on Iran, Warsh transition. These kind of things have been where most of the questions have come in. And so to see that stuff quiet down, nobody's really asking us about impacts of Iran anymore. Nobody's asking us about macro space, but we're getting a ton of questions about a lot of these more technical market plumbing type of issues. So I guess that's how I answer that. I want to ask you the same question. I'm curious to hear. Have you gotten anything on the equity side? Is there any interesting questions that are coming your way?

Lori: I will say the interesting questions, I did struggle to answer that one when asked. So I probably shouldn't have asked that one of you. I did have in our latest report a new chart that I'm pretty excited about, and I will say it's gotten a lot of good feedback, because it's just talking about something different, I think. But one of the things... As we were going through our process recently in terms of updating our outlook and the various models that go into it, I stumbled across some data that looks at consensus forecasts for net income growth for not just the Mag 7, which is something we've looked in the past, but a broader basket of AI stocks. And so I was able to go in and compare Mag 7 versus the rest of the market, Mag 7 versus S&P, but now also just look at the broader AI theme, and be able to look at the earnings growth expectations for that basket against the Mag 7 and the S&P.

And that broadening trade had a nice start to the year and then kind of stalled. I think that traditional broadening trade, the cyclicals, I think that's the part of the market that's got some pretty stiff headwinds from the war in Iran. Even if it settles down tomorrow, all the lasting damage that the geopolitical analysts tell us to expect, that seems likely to hit things like industrials and consumer companies a whole lot more than AI-related names. But at any rate, what we are seeing, though, is just this shift within the tech cohort, which is the old leadership on AI versus the new leadership on AI. That's a new kind of broadening. I'm really interested to get this chart out on the road and talk to investors about it and see what they think.

Blake: Awesome. All right, thanks Lori. Let’s go ahead and call it there. I don’t know if we hit that 60/40 split between equities and bonds, but I was waiting all morning to make that cheesy joke. Thanks for joining. This has been great. And for all you listeners, please tune in to the next edition of Macro Minutes.

Speaker 4: This content is based on information available at the time it was recorded and is for informational purposes only. It is not an offer to buy or sell or a solicitation, and no recommendations are implied. It is outside the scope of this communication to consider whether it is suitable for you and your financial objectives.