Lori Calvasina
Welcome to the latest edition of RBC Strategic Alternatives Podcast please listen to the end of this podcast for important disclaimers. I'm Lori Calvasina, head of US equity strategy at RBC Capital Markets, and I'm joined by two of my macro partners at RBC Capital Markets, Head of US Rate Strategy, Blake Gwinn, and Equity Derivative Strategist Amy Wu Silverman. With 2024 winding down, all of our outlook reports out, and too many December investor meetings behind us to even count, we thought it was a good time to come together and discuss our thoughts for the year ahead. We hope you enjoy the discussion. So Blake, I want to start with you and the recent Fed meeting. What were your main takeaways from the meeting, not just the decision, but the SEP the press conference and the reaction in financial markets?
Blake Gwinn
I think most of the attention has been on the SEP. But I think what really stuck out to me was that the Fed definitely seems a bit rattled by inflation. Powell actually used the words ‘fallen apart’ with regards to their year-end inflation forecast for this year in the SEP we saw upward revisions to the median case there. 2024 core PCE increased by two tenths. 2025 moved up by three tenths. But even more than that, I think the thing that jumped out to me most was that they actually give the balance of risks around those inflation forecasts. As to the market reaction, we were expecting that markets were pretty well prepared for a hawkish outcome, but this, clearly came as a bit of a surprise, and I think we've sold off in rates a bit more than we expected. We've broken out of those kind of post-election ranges. We're trading above 4.50 in 10s. So clearly, a bit more of a kind of violent reaction than at least we were expecting. This was a much more hawkish outcome than even markets were set up for given, you know, given how much yields have sold off.
Amy Wu Silverman
Blake, you've been warning us all for some time that the Fed was in a short and shallow adjustment cutting cycle and was poised to pause in January. And I'm just wondering, you know, did anything change for you in terms of how you're now thinking about the outlook for 2025?
Blake Gwinn
Yeah, so as you mentioned, I mean, it has long been our call that the Fed would cut in December. They'd cut in January, but by the time we got to that March meeting, the balance of risks would have shifted enough that it would have been easy for the for the Fed to pause. And what I mean by that is we're getting farther and farther away from some of those downside concerns, the hard landing concerns we had, largely driven by the labor market in early summer. Labor markets have clearly kind of stabilized. People are starting to look ahead to what the Trump administration means. Those upside inflation risks are starting to bubble up a little bit. So by that March meeting, you know, we thought with the Fed presumably by that point, having cut 1.25 basis points, and that balance of the risk shifting back to the upside on inflation, it would be pretty easy for them to pause. As we've seen in the past couple years, the Q1 data has been coming in very strong, and if we saw a repeat of that, and, we're heading into that May meeting with that very strong Q1 data, our view is that it would just be very hard to start cutting again, and that skip would basically become a long hold that lasted for the rest of the year. I'm a lot less convicted on the fact that they're going to cut in January. I mean, clearly there's a bias here to slow down. We had one dissent from President Hammock. We get one more inflation, one more labor market print, NFP print, before that January meeting, certainly some possibility that we see that same kind of strength in that print, and we go into that January meeting with another stubbornly high inflation print in the pocket. So that's certainly a risk. I'm still pretty close to a tossup on January. I haven't really changed our call for right now. The base case is still a cut in January. But, it's only going to take a stiff breeze to knock that thing over. As far as what that means for the rest of the rest of the horizon, I think we basically just take everything we were forecasting for the rest of the year, starting in March, and we just pull forward to January, because I think the same holds true, which, which is that if they don't cut in January, with this potential strength in Q1 data, it could be very hard for them to start cutting again in March. So what initially starts as a skip of January, may very well just become a hold.
Lori Calvasina
Blake, you know, I always bug you for numbers. Remind us what your numbers are for year end 2025 on 10-year yields in particular.
Blake Gwin
Yeah, sure. So, I mean, I'm gonna kind of work myself out to 10 years start at the beginning. You know, Fed funds rate, as I was just mentioning, we see this 4.0 to 4.25, type of terminal level. Obviously, there's a little bit more risk that that's 4.25, kind of 4.50, range, if they do end up skipping in January. So I think, markets have largely come to terms with that higher terminal rate. If you look at very front end pricing, it's pretty much in line with that kind of higher for longer type of environment. And the reason I mentioned the front end yields is because it really has implications for what's happening at the back end. I really don't think we're kind of breaking out of these post-election ranges, at least kind of in the near term as we go into that Fed hold. Now, I say that on a day when we are trading slightly above those ranges, but I do think, as we head into year end, there's inevitably going to be some pullback on this very positive data narrative we've had over the last few months. So I do think we kind of pull back into that four to 4.50 type of range for 10s, and that that at least persists until the shift in the market thinking around what the next stage looks like, when there actually starts to be some acceptance, the next phase of the economic and Fed narrative may be another expansion, you know, a renewed hiking cycle. Once that starts to be priced in, that's where we really see yields kind of breaking out of those ranges. But I will say, you know, our 10 year yield forecast is probably not as exciting. I do think as we get a more hawkish Fed, we price more in at the front end, and front end yields are really rising. That is going to keep things a bit subdued at the long end, because those longer run growth and inflation expectations are going to be somewhat dampened by the fact that we are having a more hawkish Fed. So we really see this as kind of a bear steepening the yield curve moving higher, but it's really more driven by the front end
Lori Calvasina: So Amy, let's turn it over to you now, the VIX spiked pretty sharply on the date of the last FOMC meeting, not getting quite as high as we did back in August, but a definite breakout from what we've gotten used to. Is that move a sign of things to come in the year ahead, from your perspective?
Amy Wu Silverman
So I like to say that the only law that is consistent in the markets is Murphy's Law. And by that, I just mean the last time we were sitting here with this kind of VIX spike in August, arguably, it was higher, was my first day in Hawaii, and I'm about to leave for Hawaii. So of course, you know, we're gonna get a VIX spike because that's Murphy's law. But more seriously, I think this is essentially the structural problem we're going to see in derivatives, and I'll get into this a little bit later. But one thing I said in my Outlook last year and is essentially true for my Outlook in 2025 is there's just simply going to be more volatility potholes while you're driving along, which is a funny analogy for me, because I don't know how to drive, but you're going to see these fits and starts, which are often related to the illiquidity in the market. It's no coincidence that the August 5th spike was during a period where most people were on vacation or heading on vacation, very low liquidity. You didn't have your typical market makers in play. And so of course, when there tends to be some sort of multi-standard deviation drawdown, the inherent reaction is to just bid up prices, and I think that's what we saw. The other thing you see is there's a rapidity in the decline, which you saw as well, towards normalization. And so for folks who are trying to play volatility instruments like the VIX, it really comes down to timing. It's not that you cannot monetize them, it's just you simply have to do it quicker than you used to.
Lori Calvasina
And one of my favorite things that you say, Amy, is when you describe the stock market as a paddling duck. Is that still how you're thinking about things for 2025 and can just tell us, what is the paddling duck? What does that mean, and why should investors care about it?
Amy Wu Silverman
Yeah, you know, I love that analogy, because I find it's like one of the few that doesn't make investors eyes glaze over. What I mean when I say paddling duck is, it's a market that may look calm on the surface, really smooth, you know, that's your index level volatility, but underneath there's really severe rotations. You know, two really simple examples of that is when RFK became the cabinet pick, you saw severe drawdown in healthcare. But similarly, when we got our treasury pick Besant, you got a rally in Financials, particularly on the regional side. The issue is, when you net those out in S&P returns, that tends to cancel itself out. And so on an index level, that volatility kind of belies how much rotation there was underneath. So you know, the fancy term we use in derivatives is the dispersion of the market. We think that's going to be very high next year, and when that's very high, it really has implications of how you think about index volatility, because it does look artificially damp, even though those duck feet are paddling under the water.
Blake Gwinn
So you know, if I think about the last three years, markets have just really been dominated by the Fed narrative. We went from a hiking cycle right into a cutting cycle. And I think because of that, a lot of the volatility has largely been driven by shifts in Fed expectations and also data prints that are ultimately going to drive the Fed decision. I think this may be a very stable year from a Fed and data perspective, but at the same time, we've got a president coming in who is very active on social media and really loves to make waves. So how do you see the volatility landscape shifting into 2025 you know, as those factors driving inflation start to kind of shift?
Amy Wu Silverman
Yeah, there's, there's definitely many cross currents, and that's really important. Just going back to that term dispersion I was talking about. So one thing I discussed in our 2025 Outlook is when you think about volatility. You essentially have to stop just relying on VIX and S&P, and you have to get much more thematic, and you have to really drill down to the sector level. So I'll just give a very simple example, because Blake, you're completely right. It's been a volatility market, whether that's rates volatility or equity volatility, but it's completely been driven by the Fed and the Fed path. So Lori, I know you've been traveling for the past two weeks talking to investors. What's your sense of how equity folks have been thinking about the 2025, outlook in the US, and how does that compare to your own thoughts for the year ahead?
Lori Calvasina
Yeah, so look, I will caveat my answer by saying I've mostly been talking to non-US investors in both Canada and Europe. A few US folks sprinkled in, but this time of year, I really like to go to Europe in particular, because I think we really just get great perspective on the US and the big picture macro view from that community. In terms of what I was hearing on my trips, I would say it was generally a pretty cautious and concerned tone. In general, people think that we're going to continue to see the momentum in markets last for a bit longer, but there is concern that a pullback is going to happen sooner rather than later. A fair number of people I was talking to peg the January, maybe early February timeframe is when we might get that peak. In terms of specific concerns, I would say valuations and sentiment were front and center. There were also a lot of questions on tariffs and tax policy and whether equity market pricing is currently taking too rosy a view of those outcomes. At the same time, you know, I had a number of clients tell me, ‘Look, we're worried about all these things, but so are a lot of other people, that feels too consensus, and the consensus is usually not correct. So, you know, I do think people are sort of twisting themselves into a pretzel a little bit here at the end of the year. In terms of my own view, we're at about 6600 which at the time, which was about a 10% return on the market for a year. And I would say I do share a lot of the worries that my investors that I've been speaking with have had. And so we felt compelled to put out a bear case as well at 5775 and, we think that we're still on a good path for equities, and really see that 6600 as a strong base case. But we do think that a few of our models are sort of on the cusp of misbehaving, or have been misbehaving recently, and so we thought it was prudent to kind of put out that 5775. And I'll tell you, Amy, there was, you know, a lot of interest in exploring that bear case in the meetings, you know. We tend to take the median for both the bear case and the base case. If I just focus on the base case, I look at sentiment, I do think we still have a modestly constructive sentiment set up on a 12 month view. If we look at AAII net bulls, there was, though, I will tell you, a fair amount of time in my meetings devoted to looking at the CFTC data on US equity futures positioning for S&P in particular, which is hitting new highs. In terms of valuation, my work there is the most conservative in my base case, I can only really get to about 6200 on the S&P. And bottom line, our modeling is telling us that we really shouldn't see any multiple expansion in the year ahead, but we are looking for really kind of a flatish multiple. I do think the earnings outlook remains supportive of further appreciation in the S&P500 in the year ahead, but there are a few hurdles that need to be overcome. My cross-asset modeling, you know, it's probably one of the most interesting things we've talked about on the road the last few weeks. The current earnings yield gap is still in a range that's predicts, you know, kind of 12% - 13% type returns in the S&P500 over the next 12 months. But if we were to see 10 year treasury yields move to 5% we would see it flip into a negative range for stocks.
Blake Gwinn
So, Lori, it's really interesting, I think there's almost a bit of a circular logic problem. If we have higher rates, if the Fed's hiking and rates are moving higher, because the economy is going absolutely gangbusters, you know, me and my simplistic rates world would think, okay, that's probably good for equities, because the economic side outweighs what's happening on the rates. The rates are just responding to the strong economy. But it sounds just like there may be a bigger impulse from those higher rates that even if those rates are moving higher because economic growth expectations are going up, that it still might actually be negative for equities. And as a rates guy, I always have a hard time wrapping my head around that. So I'm just wondering, you know, how do you kind of see those two factors, and if rates are going up because the economy is doing well, how do you kind of think about that in terms of equity valuations?
Lori Calvasina
Yeah, I think it's a great question Blake, and the answer is that you can't, sort of give the determinative answer up front. You really have to do monitor the math in real time. And it's a question of degrees on these things. If I'm looking at, you know, 10 year yields really higher interest rates, are going to dampen PE multiples. And my assessment of the damage is generally more limited because I do take a much longer view of history, right? So I go back to the 1960s in our modeling. And just to back up, you know, our PE model basically takes PCE, Fed Funds, 10 year yields. So you know, if I say all other things being equal, right, a higher 10 year yield is going to dampen your PE, but at the same time, 10 year yields are much lower than they were back right, in, say, the 70s, right? So, you know, on the one hand, I think that higher yields are going to put some pressure on PE multiples, but at the same time, you know, we recognize that things are still whole lot better than they were many decades in the past. So I generally look for things in the low 20s, where a lot of my competitors tend to look for things in the teens. Now, putting that aside, you know, if you just sort of say higher interest rates negative for PEs, let's go look at your assessment of the hot economy, right, that's causing that to occur. That really comes into play in the earnings expectations, right? And that comes into play in the revenue line in my S&P500 earnings model. So, you know, we can assume that that hotter economy, frankly, is going to boost the revenues in the S&P500, it is probably, going to enhance the margin line, although I would caution you that margins are very tricky to forecast these days, but a traditional analysis would tell you that if we're ramping up GDP, that should help margins at the end of the day. Now, there would be from the 10-year yield itself, some dampening impact on the interest expense line. That tends to be sort of a smaller component of an earnings forecast than, say, the revenue side or the margin side.
Amy Wu Silverman
Lori, I want to turn it back to what you call your first professional child. So whenever we market together, particularly for hedge funds, small caps come up, certainly it's been a big topic this year. There has been a lot of exuberance we've seen that on the options trading side and IWM calls. Can you walk me through now how you're thinking about small caps in 2025?
Lori Calvasina
Yeah, it's a great question. Amy. When I think through our 2025 outlook, I think our work on the bear case has been one of the most unique parts of it, kind of value added for clients. But I think where we're also pretty contrarian, actually, at the moment, is on the small cap side. And you've got a lot of strategists out there right now arguing for broadening out of market leadership, and a lot of people making the case for small caps on things like NFIB, optimism is soaring, therefore must, we must buy smaller things. And what I'm saying now is basically, I would be neutral on small caps. I think that we are set up for a choppy trading range if you're looking at the small relative to large call in the years ahead. That's exactly what we saw in the first Trump presidency. And frankly, you know, that's kind of where we've been for the last year, year and a half or so. And I know a number of the meetings you and I have done together, you know, we've walked into hedge fund XYZ and we find out small caps are one of the things they're really focused on. And as I look back over that past year and a half, I think that they have been a key instrument to make trades regarding Fed views. And so when the dovishness is dialed up, that that is bullish for small caps, and when the dovishness is dialed down, that tends to be negative for small caps. And you know, it wasn't surprising to me after this last FOMC meeting, that we saw small caps get hit a bit harder than the rest of the market, just as some of that dovishness regarding the Fed was pulled off, and sort of more hawkishness was pulled into the forecast. If we put that aside, and we assume that something that's been a tailwind is no longer a tailwind, maybe even a little bit of a headwind in the new year. Let's look at some of the other things that matter for the small cap space. When I look at positioning, the CFTC data prior to the election Russell 2000 futures positioning was already back to the 2016 highs, and it has since broken out and then started to slip back a little bit. But we do think we've got a crowded trade on our hands again, and that's very different from this time last year when it was looking like a quite under-owned space. If you look at valuations, my recent weeklies, Russell, 2000 weighted median PE has been trading around 17 and a half times, and that's well above the average, which has been about 15 two and you know, we're just we're not quite at the tip top of the range. So we certainly haven't hit the ceiling just yet, but that ceiling is starting to be within sight. And you know, everyone always wants to look at small relative to large on valuation to make a call on this space. And I think that's the wrong thing to do, because small caps have been cheap relative to large caps since 2018 or so, and it just hasn't mattered. It's been more of that absolute valuation that has been triggering moves in and out of the space. If you believe bottom up consensus earnings growth forecast for Russell 2000 companies, the consensus data is showing faster growth for small caps than the S&P500 from an earnings growth perspective next year. So that is one thing you know that I think is making a case for small and we don't feel like we want to be underweight here, but I think the tie breaker is going to end up being the economy. You know, if I look at small large against monthly Non-Farm Payroll numbers, you really need to see an acceleration in job growth to get small caps outperforming again. And we're in a decelerating job growth environment right now. I'm curious to see if we get that just based on this whole idea of, you know, better vibes and animal spirits in the New Years, but we haven't seen it yet. So I think if we can get a return of really strong economic tailwinds and economic enthusiasm, then I think we could push those valuations up and that positioning up even more. But barring that, you know, this just feels to me like a crowded, overvalued trade at the moment that has some good things going for it from an earnings growth perspective, but is about to lose one of the big tailwinds that got it to this sort of overvalued and over owned point in time. So I'm happier with a neutral right now, and I've been telling people, I think you'll have a better time to buy this space.
Blake Gwinn
So, Lori, his year, you know, there was a lot of focus on labor market softening, but I think a lot of that weakness and kind of the rise in the unemployment rate that we saw came from a slowdown on hiring and also new entrants coming into the labor market. But layoffs have actually been very, very low. So I guess my question to you is, how are companies thinking about headcount into next year?
Lori Calvasina
I'll caveat it by saying, you know, I'm not an economist, I'm an equity strategist, and my primary input on this is going to be sort of my obsession with reading earnings call transcripts. To be honest, I am not seeing a whole lot of discussion about labor and the transcripts generally. So we've overall seen the last couple of quarters just more discussion of costs and productivity initiatives. And I would say, it's somewhat alarming on the inflation side, right? Because it seems to be input cost. It's not one thing across industries or across companies, but it's something that they have to use to produce the things they do. It is generally not labor, though. So I think that's the good news for this labor discussion. If you look at consensus forecast for S&P earnings next year, operating margin assumptions have been coming down since the middle of 2024 and that's coincided with this sort of higher focus on cost that we've heard from corporate America. Companies have really been taking a lot of pride in recent years over being able to suck costs out of the system without having to tackle labor. And so I think that's one thing the labor market still has going for it in the year ahead, but it is something we're going to have to keep a close eye on.
Blake Gwinn
No, that's great, and I appreciate your non-economist, I'm really asking for the bottoms up, like what you're seeing. How do you think companies are looking at pricing pressure?
Lori Calvasina
I haven't noticed as much of a pricing discussion coming up in the earnings calls themselves. But what I will tell you is that since the since the election, we have kept a close eye on what companies have been saying about political dynamics down in Washington, and that can be anything from the Department of government efficiency to tax policy to tariffs to deregulation. We've been keeping an eye on all these topics. And the tariff discussion has been front and center. We've seen it across a number of industries, a number of sectors, and companies have made it clear when they've been talking about the potential for tariffs down the road. To be fair, they've mostly been talking about the possibility of China tariffs, as opposed to broad based tariffs. But in the tariff discussion generally, they have been very quick to emphasize that they would pass any higher prices that they were forced to pay onto their end consumer, whether that's, you know, an individual consumer or a corporate consumer.
Blake Gwinn
Oh interesting.
Lori Calvasina
Okay, and so this has been a great conversation so far. I thought it would be fun for us each to give one word that describes how we think 2025 will turn out for our market or asset class. Amy, you're the most creative one among us, so I'm going to put you in the hot seat to go first. I think I know what your word is going to be, but, but I'm not going to say it. You go for it.
Amy Wu Silverman
Okay? It's fatter tails.
Lori Calvasina
Okay, I would have guessed potholes, but I liked fatter tails. All right, Blake…
Blake Gwinn
Wait, she gets two words.
Amy Wu Silverman
There’s a dash.
Blake Gwinn
Oh, dashes are ok.
Blake Gwinn
Whipsaw. Given the Trump administration, and given that we have these very big risks that can crop up at any time, with the Fed kind of on hold, I do think we're just going to be really kind of whipped back and forth on the economic narrative and kind of on expectations around administration policies.
Lori Calvasina
Yeah, and I'll wrap up with mine, you know, my word is going to be tactical. And, you know, it's outlook season, right? And one of the things that you know just keeps coming up in my client conversations has been we have very limited visibility on the year ahead. I think the key is to be adaptable. I think that being wedded to one view over the next 12 months and not being willing to change it, because that's what you said back in November or December, I don't think that's realistic in the year ahead. And I agree with you, Amy, you know, the fatter tails. I think we've got, you know, big upside risks. I think we've got some downside risks. And I think in general, we just all need to keep the idea of being tactical and adaptable in mind in the year ahead.
Blake Gwinn
Can I just say we didn't even plan that… but look how well that worked out because Amy and I seem to kind of give the conditions, and then Lori gave the response to those conditions. Those conditions, the fat tails and whipsaw. You have to be tactical. So that really worked out nicely.
Lori Calvasina
That's perfect. All right. Well, thank you both for doing this. This was a great conversation. I'm glad we were able to pull this together before the end of the year. And to all of our listeners, we are so grateful that you joined us today, and we wish you all a very happy New Year.
Lori Calvasina
That’s all for this episode, thank you for tuning in today. have been listening to Strategic Alternatives, the RBC podcast. This episode was recorded on December 19, 2024. If you enjoyed the podcast, please leave us a review and share the podcast with others.