Focus continues on the timing and depth of central bank rate cuts as they try to engineer soft landings for economies across the globe. Central bank balance sheets and QT end timing in different jurisdictions have become increasingly topical as well. How do equity markets navigate this uncertain environment?

Participants:

• Simon Deeley (Desk Strategy), Canada Rates Strategist
• Izaac Brook (Desk Strategy), US Rates Strategy Analyst
• Michael Reid (Desk Strategy), US Economist
• Peter Schaffrik (Desk Strategy), Head of UK/European Rates & Economics
• 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.

Simon Deeley:

It's clear that it is a clear hold for the BOC on Wednesday with stable messaging likely but a higher risk of a hawkish than dovish tilt given data in the INTERM meeting. This has included firmer core inflation measures last week and only a slow normalization of corporate pricing behavior and inflation and wage expectations. In the business outlook survey, the NPR is likely to show lower headline inflation and growth projections with the former driven by lower oil price assumptions. Messaging should continue to emphasize that it's too early to be discussing rate cuts. We do see a tail risk that an end to QT will be announced this week, but think around the next meeting on March 6th is more likely an important development in Canada to start. 2024 was a further rising Cora to rate the BOC targets with its policy rate. It is set at five basis points above target for much of January prompting the BOC to add one day liquidity through overnight repo operations.

So March meeting announcement again seems like the most likely timing to us. January meeting is likely too early for announcement though it is a risk, but we will be watching the press conference closely for any hints or guidance on the balance sheet given the above developments when QT is ended. We think the BOC will emphasize that it is not a signal of pending rate cuts with considerations for the latter. More on macro developments than the market functioning and liquidity considerations discussed above for the end of QT as well. They'll likely stress that as a return to normal balance sheet operations and not qe. Now we'll shift over to the border to Isaac Brook on the Fed.

Izaac Brook:

Also notably, while repo pressures triggered the QT discussion amongst fed officials, repo markets had persistent upward pressure and notable volatility throughout much of QT one suggesting the fed's tolerance for more volatility on that front before they actively consider ending the current QT program. So overall based on the indicators, the FED is likely monitoring and recent comments from fed officials. It's hard to justify calls that QT will end soon. The recent pull forward of QT end expectations just seem wrong given current market conditions and even when the Fed does taper, we think that taper announcement will not include an end date, meaning QT could run even longer than many. We're envisioning ahead of the increased focus so far in 2024, so we've adjusted our call for qt, we're shifting back the start from May to July, but then more importantly we're also envisioning a longer runoff at a lower pace post taper.

Simon Deeley:

Great, thank you very much Isaac. Very insightful. Now over to Michael.

Michael Reid:

That relates to household formation. Where we see the risk for job losses continues to be in those consumer related sectors. So when you look at wholesale trade, retail trade and non-durable manufacturing, we do see their margins coming under pressure here at the start of 2024 and that would put around a million jobs at risk pushing up the unemployment rate to around four and a half percent by mid-year. Now where that balance could be tipped to the downside in terms of the unemployment rate is within leisure and hospitality, they still have the ability to absorb some of those workers and that could help keep the impact on the unemployment rate rather muted if they are able to absorb those workers that are shed from retail and wholesale trade for example. However, if you do see a meaningful pullback, especially among spending from that 65 plus cohort with regards to leisure and hospitality, the risk to the unemployment rate is to the upside.

Thinking about some of the headwinds for consumers, we did see a strong consumption growth in Q3. There is a bit of a downshift in Q4 as we expect here on Thursday, but again looking ahead, looking at revolving credit as it relates to the ability for consumers to pay back non-mortgage interest payments continue to be a concern as a percent of disposable personal income that is still near an all time high at 2.8% and at some point that debt and that interest needs to be paid. So we do see that pullback really impacting that younger cohort of consumers moving forward here still we are not calling for a recession. We do think that the prospects for growth remain largely driven by that older demographic as well as the tailwinds that we will continue to see in the CapEx space driven by investments from the CHIPS Act and the inflation reduction act.

Simon Deeley:

Great, thank you. Michael. Peter is up next on Europe.

Peter Schaffrik:

Europe. Well, when it comes to Europe until we record the next edition of macro minutes, we're going to have two very crucial central bank meetings, the ECB and the Bank of England and in both cases what will be really interesting to see is how the language will be conducted, particularly when it comes to the ECB who's going to meet on Thursday this week. We have seen already a bit of a shift in the language by central bank officials including Central Bank President Legarde who has indicated that interest rate cuts could be coming towards the summer. Now in the meantime however, we've also seen as the data releases have been slightly stronger and of course what the central banks have also done. Walking a bit of a tight rope I would say is pushing back against early rate cuts and I think that's really going to be the key.

Will we be seeing the same kind of thing where they're pushing back against the march april implied rate cuts but allowing the possibility of rate cuts later in the year to stand? That's the most likely outcome and how will the market take it? Because when you look at it, we still have around about 130 basis points priced in terms of rate cuts starting much earlier than summer indication that we've already seen. We do think, and I'll come back to that in a second, that the market will have to probably price out more and fair value we think is round about 80 to 90 basis points implied for this year rather than the 130. Now turning to the Bank of England, the situation is even more tricky. First of all, when you look to the Bank of England meeting in December, what we've seen is still three members who have voted for rate hikes.

So that's one of the first indications whether or not something is changing in the central bank. Secondly, in contrast to the Fed or the ECB Bank of England members have been relatively quiet and they have not when they've spoken, embraced the idea of rate cuts earlier or later. So they've been pushing back against their theme by simply saying not very much. Now at the next meeting they will have to speak and we'll have to get some kind of an indication and the question really is whether they're going to embrace the idea at least that rate cuts could be coming as well. This is also interesting against the backdrop of how we've been pricing the bank because whilst the market has been pricing rate cuts for the Bank of England as well, we have priced much less than in case for the Fed or in case for the ECB, which particularly in comparison to the ETB we think is a bit curious given that the Bank of England tends to be a bit more nimble.

Last but not least, in terms of the uk, we've also seen data releases coming out on the strong side, particularly as it pertains to inflation. The latest inflation print was much stronger than expected. So these are really the key things to watch out for these central bank meetings. Now finally, what do we expect for the market? As I was alluding to earlier, we've already priced out some of the rate cut fantasies, particularly the early ones and we think there is more to come, particularly if both of them pushed back against these early rate cut implications that the market has already priced 10 buns currently trading a little bit north of two 30. We think there is a little bit more room for the upside. Two 50 seems to be a reasonable target and we reckon that over the next two, three weeks we could get there and we'll take it forward from there.

Simon Deeley:

Thanks very much Peter. We'll finish up with Lori on the equity market.

Lori Calvasina:

Good morning everybody. A quick update from me on what we're seeing in the US equity market. I did want to start out with our overall outlook. I believe this is my first appearance on macro minutes this year. As far as year end in the s and p we're looking for 51 50 and we do take a quantitative approach to our targets. We have the average of five different models. I think it's worth flagging the most bearish one at the moment just given Mike's comments on GDP. One of the models that we use in our targeting process simply looks at how stocks do in different GDP environments and typically zero to 2% you see a flat to slightly down US equity market and of course real GDP if you look across the consensus forecast is expected to be about 1.3% this year and then 1.7% next year.

So we look at multiple economic cycles for clues on how the PE should behave in this one and we do continue to think that we're very early on in the post covid era of investing and it's really dangerous just to rely on post GFC pre COVID rules. At any rate, this valuation model was very bullish last year. It had been consistently pointing us to 4,700 to 4,800 on the s and p and a PE of over 22 times on a trailing basis. So what's the model saying for this year? It's starting to look for 23.2 if inflation moderates interest rates come down and GDP rebounds in the back half of the year and the fed cuts a little bit, which is really all part of the consensus forecast at this point in time. Now all that sounds pretty good near term. We do have a sentiment problem in the US and this is something we've been talking quite a bit about recently.

I would also just add on the institutional side, the CFTC buy-side positioning data on a notional basis for US equity futures contracts is also sending us a short-term caution signal as well. Positioning in US equity futures has gotten back to the 20 18, 20 20 and is above the 20 21, 20 22 highs. So for both institutions and retail sentiment does look a little bit stretch. Next thing I wanted to touch on very quickly is earnings, which are really ramping up in the US this week. I'm looking for 2 34 on 2 24 for the s and p versus a consensus number of about 2 44 to 2 45. If you talk to investors, I'd say there's a divide in Europe and the US European investors have been very focused on the lofty profit margin expectations for expansion that are embedded in consensus forecasts. That's not something I've heard a lot of concern about from US investors, but it is something I've worried about in my own modeling and is really generating a below consensus forecast on our model.

The fact that we're looking for flattish margins as opposed to margin expansion. I think this is really the key thing to look for and the earnings reports that come out this week and next is pricing, sticking our costs coming down, what kind of guidance are companies giving about margins because I think some concern in the equity community has started to emerge but it's not fully felt in US markets yet. And I'll wrap up quickly with some positioning trades. If you think about the positioning in the US equity market value and small cap stage to fierce comeback and took leadership away from mega cap growth at the end of last year, that really coincided with the peak and 10 year yields that we saw and as yields retreated leadership in the market broadened out. The exact opposite has happened so far in January. Mega cap growth is leading again as value and small cap have taken a backseat at least up until yesterday and that's really coincided with yields moving up.

So we think it's going to be a long year for the rotation trades. We do think that if you look through this on a small cap lens, the trade really seems to be middle innings and I can see the rationale even beyond the move up in yields for it. Taking a bit of a pause, but we do look for the leadership to broaden out again later this year. But I would tell you on small cap, and I think this is really the important barometer here. The PE is back to average. It's not cheap, but it's not expensive yet either. Small caps still look very cheap versus large, and if we look at positioning data, CFTC, small cap futures contracts are back to three-year highs but not all time highs. So we actually see more room for the small caps to run to ultimately then the bigger cap parts of the market.

I would just add on small caps. Every meeting I had in November and December, people were bullish on small caps and wanted to talk about 'em. It's about the most consensus I've seen that trade get in my 20 plus years as a strategist. Many of those were spent as well as a small cap strategist. It does make sense to me in light of just the consensus view that developed around the broadening out and the small cap trade in particular that we needed to take a little bit of a breather from it to start the year, but I do expect it to resume down the road. The last comment I'll make is just on the mega cap growth trade, the top 10, top seven names in the market, however you want to slice it, there's still intense investor focus there. Those stocks tools do look extremely expensive and crowded to us, albeit for good reasons.

They're having another moment in the sun as interest rates move back up. I do think though, if we take it back to GD and some of the comments Mike made and the release that's coming out, I think that for small cap's value to start leading again for mega cap growth, to really break its dominance in the market, we need to see more improvement in economic forecast. Typically when GDP is below trend growth and mega cap and large cap lead, when GDP is above trend and you've got really a lot of excitement about the cyclicality of the US economy, that's when small caps and value tend to shine. We're not there yet. We're making some progress, but there's still a lot of wood to chop.

Simon Deeley:

Thank you very much Lori, and thank you to our listeners. We'll talk to you again in two weeks.

Speaker 6:

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