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:
Welcome to the December 3rd edition of Macro Minutes entitled, different Trajectories Being Recorded at 9:00 AM Eastern. I'm your host Simon Deeley. We are approaching final Central Bank decisions at 2024 with uncertainty about ultimate outcomes, but clear differences across jurisdictions on where economies are headed. In Canada, soft growth data has solidified our expectation for a second consecutive 50 basis point cut despite firmer inflation data last month. While US economic exceptionalism has markets pricing and material possibility of a skip on the 18th across the Atlantic, the ECB is debating between 25 basis points and 50 basis points while the BOE looks at to pass at its final meeting of 2024. Meanwhile, FX and equity markets have been impacted by the central bank pricing volatility, incoming Trump administration and the threat of US tariffs. We are fortunate to have RBC experts across the world to provide insights on the situation in their respective regions and sectors.
I'll kick off by reviewing the lay of the land in Canada. Blake will follow with the situation in the US and Peter will discuss the Euro area and UK Elsa joins to provide the latest on FX market and Lori will give an update on US equities as we approach year end kicking off with Canada. It has been an interesting time with pricing for the December meeting, fluctuating between 30 and 40 basis points of easing by the BOC currently around 38 basis points. There is no clear direction from the market on whether the BOC will deliver a second straight 50 basis point cut or downshift back to 25 basis point increments. We have seen a 50 basis point cut in December since our forecast change in early October and continue to think it's the most likely option next week. Data since October has been admittedly mixed with the loan CPI release showing core inflation metrics around 0.3% month on month and ticking up on three month annualized rates.
Out of 10 inflation reports for 2024, we view seven as consistent with inflation moderation and three on the more firmer side including last month. Overall the disinflationary trend seems very much in place and the BOC themselves have noted that the inflation data could be choppy. The bank's focus on growth since July meeting is a return to their output gap centric mentality that they have historically followed. They see the Canadian economy as currently in excess supply and we agree the Q3 GDP report on Friday was another below potential print at plus 1% annualized with consumption strong. But investment week and final domestic demand boosted again by the government sector upward back revisions were material but peaked in Q3 2023 and so largely left the softer growth profile of late intact. We think this balance is off against the firmware inflation report and incrementally increased our conviction for another 50 basis point cut on the 11th. Going forward, we continue to see the bank extending cuts well into 2025. Given the weaker domestic macro outlook and downside risks to inflation, we think the bank cuts to just below their two and a quarter to three and a quarter percent range with our terminal forecast at 2% reached in July. Consistent with this view, we think yields can move lower across the curve and see trades like received two year, one year and April meeting OIS as well as cross market longs against the US and modest curve steepening as making sense going forward.
Finishing off on the Trump tariff threats on November 25th, president-elect Trump announced across the board 25% tariffs on day one of his administration for Mexico and Canada. If they did not take appropriate actions to stem the flow of migrants and drugs into the us, such an outcome would be very damaging, but we don't expect it to come to fruition. The Canadian reaction has been to placate Trump with additional border resources likely to be announced in the future on the back of Prime Minister Trudeau's productive visit to Florida to see Trump and now over to Blake to discuss the situation in the us.
Blake Gwinn:
Thanks that. So there's really kind two big topics of conversation in US rate markets right now. The first tariffs, and Simon you already mentioned this a bit, I'll follow up on some of the comments you made generally the same mind. That conversation has really heated up over the last week, particularly around Trump's comments on potential tariffs on Canada, Mexico, which you mentioned. The second is the potential for December, skip from the Fed. Now I'll say there really is kind of a third, which is a potential technical adjustment to the Fed's overnight RP rate, but admittedly that's a pretty niche topic. So I'm going to go ahead and punt on that conversation given that this is kind of a more macro forum and just focus on those first two. So starting with tariffs, I'll just make somewhat of a broad comment to start off with. I think over the next few years there's going to be a lot of attempts to game out what various Trump statements are going to imply for policy delivery and then in turn what those policies equate to in terms of economic and market impact.
But if I remember back to Trump's first term, a lot of this did end up being noise. I think one thing that both ends of the political spectrum generally can agree on is that with the left kind of criticizing this factor and the right seeing it more as a virtue is that Trump is widely unpredictable, especially in terms of international relations and trade. Moreover, I think he really views tariffs as a stick to carry into negotiations even on non-trade related issues. And I think what you were talking about there, Simon, just a second ago is a perfect example of that. The Mexico and Canada headlines where really the tariff threat is just a means to make a statement and try to pressure some type of action on the drug crisis and drugs coming into the US across the border. And lastly, I would just say where Trump does intend to move forward with implementation on tariffs, I do expect he's going to face major blowback both from inside his own party and also I think a lot of the various business leaders who do have his ear.
Overall, I think the gap between what we're going to see in tweet form and then what actually gets implemented much like during Trump's first term is going to be pretty large. So I'm going to generally do my best to kind of avoid going too far down the rabbit hole on any particular Trump tweet on tariffs and trying to game out what the specifics might look like, what products are going to be hit to what degree, what different numbers are going to be put on those, what the outcome might be on inflation data or growth data or even markets. And really just try to have a bit more of a broad look at least until we have some specific proposals that are outlined on paper and presumably seem to be moving forward through the bureaucracy towards some type of implementation. So to that point, the broad thing I would say stepping back from some of the noise and volatility over the last few weeks, I will say that I expect actual tariff implementation is going to look somewhat similar to what we had under Trump 1.0 or even I would say what we had under Biden, which is relatively narrow tariffs probably focused a lot on China and targeted at specific product sets such as autos or steel or other types of things rather than a completely broad across the board type of tariff that he was really kind of talking about on the campaign trail.
So moving on to the second topic, which is the potential for a fed skip market rumbling about this has been increasing in the last few weeks and I think at some point last week we were pricing a December cut closer to 50 50 yesterday we had Governor Waller suggesting that his base case is still for a cut that's pulled pricing a bit closer to that 70 30 level. I would still actually put it at probably something like 90 10. I'm particularly focused on Powell's comments the last time we heard from him he said we are approaching the upper range of reasonable neutral estimates. It's that use of the word approaching rather than ad or close to that range of neutral. So he does still think in my mind there's a bit more room to cut to even get inside of the range of what you might think would be a reasonable range for terminal.
We're going to hear from Powell again on Wednesday. We will be watching for any kind of indication that he is kind of pondering or setting up a skip, but we assume that those comments are largely going to mirror what we last heard from him and that it does sound like they are still on pace to cut in December. Overall, I do think fed speakers over the last few weeks have been kind of mentally preparing markets for an eventual slowdown to a quarterly pace. I just don't think that preparation's really being done with December in mind. Markets are still probably going to look to this Friday's NP report as a potential catalyst for Skip, but I think the bar is extremely high and I think you'd need something much stronger than we've got 200 K consensus right now. I think you need a much stronger print than that to get the Fed to actually deliver skip.
That's partly because I think the skip or slowdown is really much more keyed around inflation than it is labor. I think labor market resilience, the continuing strength we've seen in that data was enough to take away some of the that led them to start off with 50 basis points in September, but it's going to take growing upside inflation risks to really get them to slow or stop altogether. We've gotten some upside surprises to inflation prints, but I still don't think we're quite there yet. We will get one more CPI print before the fed announcement that could theoretically convince the Fed to skip in December, but it does come during the FOMC blackout which really could make for another messy communication process like we had around that 50 basis point cut. If markets are priced for a cut into the CPI print, I think the fed's going to be pretty wary of going through this whole press leak song and dance again for even a relatively modest beat.
So it's really going to take a kind of blowout CPI type number for them to I think go through that process again and try to move markets during the blackout period. So that 10%, when I say it's 90 10, that 10% is really around the possibility that we get some type of blowout CPI number and they do decide to kind of move that around during the blackout period. I'll say that just looking ahead, we do think those inflation tailwinds are going to start to grow into the January and March meetings and as a reminder we do have December and January cuts with March being the start of an extended fed pause. So what does all this mean for rates? Probably not that much, at least for right now. I think rates have come off the mid-November yield highs. Curves have generally drifted a bit flatter.
That's largely what we had expected into year end and if you look across the curve yields are generally within five basis points or so from our year end targets. I still think even with this drift lowering rates, this is really just oscillating inside of these wider post-election ranges. I think markets are just waiting for a new catalyst, whether that's clarity on fed's attention for slowing the pace of cuts, some confirmation of a higher terminal rate that we're expecting that's currently been price sent to markets a shift in the data trajectory or some kind of concrete development on the Trump policy front. But I think at least with that last one we're really going to have to wait until after inauguration in January. So for now kind of chopping around inside of those post-election ranges waiting for a new catalyst.
Simon Deeley:
Thanks Blake. Now over to Peter to discuss the situation in Europe.
Peter Schaffrik:
Thank you Simon. So I thought today I'll talk about two subjects. One is I will speak about the upcoming ECB meeting and whether there is a probability of a 50 basis point cut after all short spoiler, we don't think so, but before that I'll probably spend a few minutes on the implications of the French situation and that has clearly rocked markets lately. So where are we just to get us back on the same page. And it's difficult to say that because by the time this gets published we might already have moved on because it's a fast moving situation. But nevertheless, so the current government in France has proposed a budget that didn't really find a majority in the assembly that the parliament in France and there is an option to push it through by degree defacto. But that comes with the caveat. And the caveat is that there should be a sensor motion as they call it, or a vote of no confidence in the government.
And despite some horse trading, it seems very likely by this time that the government will fall and this is probably going to happen later this week. So the question is what does that mean? And clearly markets have reacted, the euro is weaker, the OAT bone spread is wider. In fact at its widest levels it has been since 2013. But the question still is what's the plan going forward? What's the path? Now first and foremost, and particularly for those listeners who are listening from North America, I would stress that there is a huge significant difference between how these budget standoffs play out in the US and how they play out in France. So in the US what we had on multiple occasions we had government shutdowns and that clearly had raised questions about how the government is going to act going forward. But in France the situation is different because there will not be government shutdowns.
The government will stay open, everything will continue to function, public services will continue to be delivered because the process is that the current budget, the one for 2024 will stay in place until a new one has been agreed even if that is quite far into the future. Now clearly that's not an ideal situation because the French budget deficit is very wide and the key proposal was to reduce it, which is now not going to happen or at least not in the near term, but that is a story for the more medium term. Now what's also going to happen is that some kind of a new government will then probably be put in place and that will be done by the president of the Republic Macron. And it's quite plausible that this new government will be a different shade of gray of the current one and as a consequence it seems much more likely that we'll get a muddle through scenario for the time being, which is not great over the medium term as I said, but still doesn't pose any existential risks in the very near term.
So therefore we think it's quite plausible that going into Christmas the spread might calm down a bit, certainly not go back to anywhere of the tightest levels that we've seen earlier this year, but might calm down a bit and certainly does not necessarily have to widen substantially further. And certainly at this stage we don't see a near term crisis developing. Now last but not least, there's a good segue into the ECB one of the questions that we're getting a lot. Could the ECB intervene? Well in principle of course they could, but we don't think that the necessary preconditions would be there for them to intervene and therefore this seems very, very remote at this stage in particular as the mechanisms that have been developed for the ECB to step in are basically predicated on a much wider spreading crisis throughout the your area, which clearly doesn't seem to be the case at the moment.
It looks relatively isolated in the case of France. That all being said, what will the ECB do? So they will meet next week and the question is whether they're going to cut rates by 25 or by 50 basis points. Although the question we think has predominantly been answered by a whole barricade of speakers who have not really endorsed a 50 basis point move, we don't think that they will go so far. We don't think that the economic preconditions are there to accelerate even further. And keep in mind we have seen the ECB accelerating after they did a cut, skip cut pattern and now moved into subsequent cuts and we think that's probably as far as they are willing to go at this stage. Now furthermore, I would highlight that even if we do get only the 25 basis point cuts, the market has been pricing a significantly lower terminal rate lately also in wake of the French situation I've just outlined. And I would highlight and as we've discussed in the previous edition of macro minutes, we are still ought to believe that the inflation and taming that the ECB has already declared victory over is maybe not as clear cut as the ECB will have us believe and we maintain that the terminal rate might be quite a bit higher than what the market is currently pricing. We put it at two and a quarter, whereas the market is pricing at somewhere between one 50 and 1 75.
Simon Deeley:
Thanks Peter. Now we'll move to the FX market with Elsa.
Elsa Lignos:
Thanks Simon. So I just spent the last two weeks visiting clients in North America, west Coast, east Coast, US and Canada. If I had to summarize the views on aggregate, it would be that people are generally long dollars, but their risk allocation is on the lighter side. On the other side of the long dollar trade, the most popular short is short euro. Short Swiss. A number of clients have short cad, a lesser number of clients have short yen and generally people have been trying to stay clear of the very negative carry trades like long dollar Brazil and Long dollar Max, even though both in parts have worked pretty well. But what that points to is that the hurdle for further incremental dollar gains is high. It can absolutely happen and our forecasts do have some further dollar strength baked in for 2025, but it's clear that we need new news to drive it at this stage.
As Peter said earlier, if we look at the situation in France, a voter of no confidence is widely expected and yet we're still just above 1 0 5, not lower in Euro dollar market is already short euros. And for the most part the crisis is not really a Euro story. Euro vol did pop higher, but it will have a hard time sustaining that move without material blowout in spreads and something which is not the core base case for most people at the moment. So where does that leave us as we go into year end? I think there is a certain bias for positive carry trades. The long dollar flows will persist and certainly on any pop higher in Eurodollar or pop lower in dollar card, dollar yen, dollar Swiss, we're seeing people buy into that. But to give some context for where positioning sits at the moment, obviously's positioning, monitor tracking, interbank observed trade data puts Euro dollar right now at 76% net short against the dollar.
CAD is not far behind with a 58% net short CAD position against the US dollar. And in first place, actually the most crowded short in G 10 is actually the Swiss Franc where the market is 84% short against the US dollar. Yen has actually lightened up a fair bit, helped in part by some of the comments from U Aada around the potential to hike rates. But also more generally, I think there is still some hesitation out there about the risk outlook and some look to yen as a bit of a hedge against that and now sitting around 56% still net short against the dollar, but as I just said, lighter than Euro, CAD and Swiss. And then the lightest of the positioning is in some of the commodity currencies, Noki basically flat against the dollar Sterling short, but not very much. There is some short Euro positioning on the crosses as well.
So we see short euro, sterling short euro cad, short euro, yen, and some long positioning though light in dollar x dollar, Brazil dollar in Y and as I said, for dollar x and dollar of Brazil in particular, the negative carry really working against people sitting in those trades. The one trade we really like and we've been watching for a while, we dipped into it in October, we got caught out with a very tight stop and market moved against us, but now think it's really ripe to be back in and we've been looking at it for the last few weeks and recommending it is short Swiss yen. It's currently testing long-term rising support level sitting where it is right now. We still think it has room to the downside. If you think that we were at one 20 just over a couple of years ago, we did test 180 earlier in the year and got up to the mid high one seventies again in September, October. But now as that breaks down in the high one sixties, we think there is further room to go there.
Simon Deeley:
Great, thank you Elsa. Now we'll finish up with Lori on the US equity market.
Lori Calvasina:
Thanks Simon. So what I wanted to do today was just review our early thoughts on the 2025 outlook for the US equity market as that's really been the focus of our research over the past week. So let's go through a few highlights and I would say the first highlight is our year end 2025 target, which we're setting at 6,600. We do consider that to be our base case. Now, at the time we froze our data, which was on November 22nd, that was about an 11% gain. Obviously that number has changed a little bit now, but as a reminder we do tend to use this target as a signaling mechanism and we consider it to be a compass as opposed to a GPS. We get to the 6,600 through our quantitative process. We have five different models that we use based on sentiment, valuation, earnings, the economy, politics, and the cross asset dynamic between stocks and bonds.
And the range of the outputs is from 6,200 to around 6,700. And we think that's a good summary of the path that the equity market is currently on. Overall, the story that we're seeing in our data is that another year of solid economic and earnings growth, some political tailwinds and some additional relief on inflation, which should keep the s and p five hundred's PE elevated can keep stocks moving higher in the year ahead. Now our 6,600 price target does bake in the idea that the s and p 500 will experience a five to 10% drawdown before too long and we've been flagging that as a concern in our research in recent weeks. Seasonally though the thing we really emphasized in this report is that stocks tend to be strong in November and December if you look over the past five years or so, but they are more prone to weakness in January and February.
We've also caveated that there's still a fair amount of fog in the outlook as we head into 2025 and we found it interesting as we were going through our process this year that some of our models are actually getting close to levels that are typically worrisome for the direction of stocks or have sort of briefly touched those levels recently. And so in addition to outlining our 6,600 base case, we've also spent some time going through a fair case where we estimate that the s and p 500 could end 2025 at around 57 75. So one thing we've caveated in our outlook report is that there is still a fair amount of fog as we head into 2025. And one of the things we found really interesting as we were going through our process is that some of our models are actually pretty close to levels that are typically worrisome for the direction of stocks going forward or have briefly touched those levels recently.
And so we did spend some time outlining our bear case where we estimate that the s and p could end 2025 at roughly 57 75. That's not the path that we see stocks on currently, but it is a possible detour that we were able to outline. So moving on to our second highlight, just some of the more interesting nuances and takeaways in our model. And I'll just touch on a few of these, but first off on sentiment sentiment, if you look at a i net bulls, which has been the best star in the sky with which to navigate the equity market with on a short-term tactical basis since late 2022 is looking okay right now it's at a level where stocks tend to rise 8.5% on average over the next 12 months. It's between the average and the one standard deviation above the average mark. But back in October it actually briefly touched the one standard deviation mark for a few weeks.
And what we found is that when you're at that level, you tend to have a flat return in the equity market over the next three months and 12 month forward returns are a bit lower at six point a 5%. So the eight and a half percent went into the 6,600 base case in the six and a half percent went into the 57 75 bear case. If we think about valuations, I'll spare you the details here, but one of the things we've talked about is that if you're looking at PE multiples on a forward basis, the top 10 market cap names in the US equity market have been bumping up against an important ceiling and the rest of the market that's been playing a catch up trade is starting to look elevated as well. It has a little bit of room to run but not a ton.
Now in terms of thinking about our targeting and our models and our base case and our bear case, when we bake in RBC house views to our trailing PE valuation model on inflation interest rates and the Fed, that gets us to a trailing PE at the end of next year at around 22.7 times or a year end level on the s and p of about 61 61. That's the most conservative element of our forecast. If we think about our bear case, we've kind of put in some of investors' biggest fears inflation that reignites to 3% no fed cuts next year and 10 year yields that move up to 5%. That gives us a trailing PE at the end of next year of 20.8 times or 56 31 on the s and p. So that was sort of an interesting one to look at. And then the other one I'll mention here is the cross asset dynamic between stocks and bonds.
Our earnings yield gap model is still in a range that's seen favorable 12 month returns historically over the next 12 months of about 12.7%. And so that earnings yield gap has flattened, but it's still in a range where stocks tend to do quite well. And so we've baked that into our base case, but we did do one test here and found that if we see 10 year yields hit 5%, this model will be in a range that's followed by an average decline in the s and p over the next 12 months. So we did bake that into the bear case. And then the last thing I wanted to wrap up with today was just our thoughts on positioning. So this would be highlight number three and there's sort of three layers that we think about value growth sectors and small, large and on value growth.
I would say we give an edge to value in the year ahead, but we do think the trade is going to stay choppy. Reasons for rotation out of big cap growth include extreme crowding and growth on the CFTC data. If you look at NASDAQ 100 futures, valuations again for the top 10 market cap names in the s and p are hitting a ceiling and decelerating earnings growth in the MAG seven name keeps investor anxiety in play with those names. Reason for the choppiness though and why growth keeps fighting back is that longer term earnings growth expectations for the MAG seven or top 10 names are stubbornly high and superior to value. We're really not seeing any movement there. Earnings revision trends continue to be better in growth Stocks in the top 10 market cap names and GDP forecast for next year is still sluggish tracking it around 2% and that's usually not an environment in which value and cyclicality does well on sectors.
We did make a few changes recently. Our three favorites for the year are financials and energy where we've reiterated our overweight and comm services, which we just upgraded from market weight to overweight. We also have downgraded materials and healthcare from overweight to market weight and we're sticking with our underweights on consumer staples and REITs heading into the new year. And the very last point I'll make is just on small versus large. This was a very, very choppy trade during Trump's first term. We had several distinct small cap outperformance trays in 20 16, 20 17 and 2018 that ramped up quickly and sharply and then faded. And I feel like we're setting up for more of the same this time around. Small cap positioning and valuation currently are at or above the peaks that we saw in those 2016 to 2018 Trump trades. The valuation still has a little bit of room to run but not a lot if you look back to the 2016 highs. That being said, there are still good reasons to like small caps, they look cheap versus large and consensus forecasts are anticipating a better earnings growth dynamic in small cap than large cap next year. And so we think as investors get more faith in the strength of the economy and start to believe those numbers a little bit better, it will certainly put a floor under any underperformance we see in small cap and maybe give us some opportunities for outperformance.
Simon Deeley:
Thank you Lori, and thank you everyone for listening. Talk to you again soon.
Speaker 7:
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