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.
Jason Daw:
Hello everyone and welcome to this edition of Macro Minutes called Ready, set, go Policy Divergence. I'm Jason Daw, your host for today's call, which we're recording at 9:00 A.M. Eastern Time on May the 28th. So two develop market central banks have already cut, the Ricks Bank and the Swiss National Bank. And the Bank of Canada, ECB, and Bank of England should follow suit over the next couple of months. But the higher for longer theme is dominating the US rates market amid growing skepticism that the Fed will even cut this year. The divergence in macro and policy is something that we have discussed in this forum and our publications over the past couple of months, and it continues to be one of the main themes in the rates market. The other important theme is that despite Fed cuts being largely priced out for this year, risk assets continue to perform well.
The S&P is making new highs, and credit spreads are at cycle tight. So to discuss these cross-country dynamics and the outlook for the equity market, I'm joined today by Peter Schaffrik, Isaac Brooke and Lori Calvasina. Now I'm going to kick it off today with a discussion on Canada. From a very high level perspective, the Canadian economy has so far experienced what I would say is a perfect soft landing. The downside risks are minimal and excess supply in the product and labor markets does indicate that the policy setting is clearly too restrictive, which is very different than what the US is experiencing. And this provides a setup for the Bank of Canada to embark on an adjustment rate cutting phase, one that we think will bring the policy rate from restrictive to less restrictive levels. But a far cry from the ultra easy policies that markets we're used to between GFC and COVID.
Now we think the easing cycle starts next week at the June 5th Bank of Canada meeting. We have had four stellar inflation reports in a row. The unemployment rate remains on an upward trajectory, and wages are showing signs of moderating. Now, if it wasn't for high and sticky inflation in the past, the Bank of Canada would've probably started cutting interest rates back in September of last year when the economy moved into excess supply. So they've already waited a long period of time compared to past cycles, and with the confidence that inflation will remain subdued should spur them into action in the near term. Now, the difficulty in forecasting the timing of the first cut, i.e. June or July, is that there's no urgency. There's no hard landing risks. There's no crisis to respond to. So if the bank did choose to skip June and go in July, it wouldn't surprise us.
Consensus. It seems split on June versus July for the first cut, the market is shading in the direction of a June cut pricing about a two-thirds chance. For what it's worth, we are closer to an 80% chance for a June cut. And it really comes down to whether the threshold has been crossed with four good CPI prints. Now, if they wait until July, the bank would get another CPI report, but I don't see why they need to see five good prints instead of four. They would also get the business outlook survey before the July meeting. But the trends there are unlikely to change from less favorable versus what we've seen already. So the question is why wait and that leads us to believe that June is the most likely outcome. Now we get a lot of questions and a lot of skepticism about how many times the Bank of Canada can cut before the Fed.
We think that they can cut up the four times before the Fed pulls the trigger, maybe it's only three times, but we don't believe that Fed inaction is a limiting factor in the early days of a cutting cycle. And history supports this idea, that the bank can forge its own path when domestic conditions warrant it. Another thing investors are skeptical about is multiple Bank of Canada cuts and the currency impact. We think there the bar is quite high for the currency to stop them from cutting. Dollar Canada probably needs to get above 1.40 and closer for 1.45 for that to be an important factor. So with that, I'll turn it over to Izaac to fill us in on his views on the US.
Izaac Brook:
Hey, thanks Jason. Yeah. So I figured since the last time we were on the podcast talking about our Fed view, it was about a month ago, since then we've had a lot of important developments. We had the May FOMC meeting, we had NFP and CPI releases, we had lots of tier two data, and a heavy dose of Fed speak. So with all that in mind, I wanted to start off and say that nothing has changed on our Fed view. We still see a December 1st cut and just two more in 2025. On the top tier data prints that we saw, April's NFP print was weaker than expected, but it certainly wasn't weak. And while the lack of an upside surprise in the April CPI data was welcome and took some heat off the reacceleration concerns, that 0.3 month over month core number isn't likely to meet the Fed's good data test.
We're going to need to see many more months of good data for them to get confidence on inflation's path lower. So shortly after the April CPI with yields near their lowest level since before that march CPI surprise, we had written that we were neutral on duration at that point. I'd also noted that the front end move post FOMC seemed a bit overdone given that the catalysts were really just the removal of near-term hike risks, one in line inflation print and some modest signs of swelling in the economic data. And last week we got a bunch of reminders of how those stories, no hikes, no inflation surprises, and weaker data can flip back in the other direction. So the FOMC minutes that were only last week were more hawkish than expected with a lot of attention on the line that various participants noted a willingness to hike again if needed.
Now that shouldn't come as a surprise, but it's just a reminder that hikes are only off the table as long as the data cooperates. And overseas, UK inflation data did not cooperate. UK CPI came in stronger than expected. Markets priced out about a full 25 basis points of Bank of England cuts. And that serves as a pretty stark reminder that over here all it takes is one upside inflation surprise and we'll be back to worrying about re-acceleration, no cuts or even hikes. And then lastly, last week, weaknesses seen in prior releases of lower-tier economic data faded, the focus was on the S&P PMIs which said that US activity rose at its fastest pace in two years. That has reduced the probability or possibility of sooner or faster than expected cuts based on an economic deterioration. And combined with some hawkish Fed speak last week that's really taken the already limited pricing for a July cut close to zero.
So all in all say last week's developments were firmly in the higher-for-longer camp and it's no surprise that the front-end led the sell-off last week. 2024 cut pricing is back to just about 33 basis points versus 50 basis points immediately post CPI, two-year yields are back above 490, duration is back near the top end of what's likely to be these new ranges. So I'm looking at four-fifty tens and four-sixty thirties and then curves bear-foughtened. I think overall though markets remain stuck in this choppy and range-bound wait-and-see kind of environment until the next set of top-tier data. Until then, signs of marginal strength and weakness in the economic data, positioning and technicals, and developments from abroad are going to determine how we trade in those ranges. And I think the developments last week certainly argued for yields moving higher. I do think that for this week the most likely outcome is a partial retracement of these moves.
So I lean tactically along in the short term. Think incoming data and Fed speak for this week is unlikely to change the narrative. The front-end is back near local highs, which makes for an attractive entry point as does duration, which is probably near the top end of these new ranges. And I'm also constructive on auctions we get this week, so we're getting USD supply in the form of twos, fives and sevens. So I guess overall the catalyst needed to propel us out of those ranges in one direction or the other is likely going to need to come in the form of top-tier data, and we don't get anything on that front until NFPs at the end of next week.
Jason Daw:
Okay, thanks a lot, Isaac. Next up is Peter to unpack the outlook in Europe.
Peter Schaffrik:
Thank you Jason. So before I speak about the Euro area in the ECB, I would like to quickly speak about the Bank of England. Particularly as Isaac mentioned, we had a bit of a repricing following the latest CPI number. So essentially, as Isaac has mentioned, the last inflation numbers were quite a bit above the market consensus but also above the expectations that the Bank of England had put forth. And as a result, the market has now reduced the expectation for June down to zero, which we always thought was probably going to happen anyway, but has also reduced the expectations or the implied probability for an August rate cut down to eight basis points. Now we think there's still a very decent probability, probably more than implied by the market, that the August rate cut will come and that this will be the first step for the Bank of England, mainly because we know that the bank is bound to cut rate.
They have an easing bias and they obviously have shifted in that direction in terms of their voting already. But we also know that as the summer progresses, the window of opportunity will get smaller. Mainly because the base effects that have driven inflation down will have run its course. And we know that the intrinsic part, the domestically generated inflation part, is coming down only much more slowly. So we think if they want to get started, this is probably as good an opportunity as they get. However, having said that, it's clearly not a slam dunk, but on balance we think that the risks or the odds favor going in August more than the market is currently implying. Also on the UK, because the general election date has now been announced, we probably won't be getting a lot of communication from bank officials because they essentially said or have canceled most of the set piece speeches.
Now moving on to the ECB, we just have changed in the latest update that we've produced our ECB for rate cuts in 2025. Now they will cut rates almost certainly in June, so next week. And the question for us is what comes thereafter and how do their forecasts shape up? And here I would really like to take a step back to digest or unpack what is embedded in their forecast that drives them to expect that inflation returns to target. Because the ECB have been surprised in terms of the magnitude of growth that we had, however, they always had a recovery of the economy embedded in their forecasts. So that doesn't per se come as a surprise. However, what they also have in their forecast is a relatively tight labor market. So we essentially do not have any increase in unemployment over the forecast horizon, but also a reduction in wage growth and therefore a reduction in CPI inflation.
So how can that happen? It can only happen if you assume that productivity growth, which is currently very, very low in fact negative, picks up and picks up quite significantly. That's indeed what they are expecting. They recently put out some writing about this as well and explained why that's the case. But when you really dig deep and analyze what the expectations are, it's very hard not to come to the conclusion that their assumptions are quite heroic in terms of how strong productivity growth will recover in order to deliver the perfect outcome that I've just described. So where does that leave us? So we do think that the ECB will start cutting rates and they probably will continue with moderate rate cuts, as they have coined it, from June to September and probably December as well, particularly if the Fed starts cutting rates in December as we currently expect.
However, the opportunities for them to do so as the economy keeps recovering and if they are not right or not entirely right about the recovery in productivity as we think is more likely than they, I think they will have to abandon the rate cutting path much earlier than what the market is currently implying. And therefore, we have taken down our expectations from six rate cuts, three this year, three next year, to only just four three this year and one early next year. That would leave the deposit rate at 3%, which is probably the upper end of where neutral can be seen.
Jason Daw:
Okay, great stuff, Peter. Lastly, Lori Calvasina is going to tell us why the S&P is making new highs and the outlook for the remainder of the year.
Lori Calvasina:
All right. Thanks Jason and thanks for having me on today. Look, the title of our latest weekly Pulse report that we put out this morning was called Stuck in Neutral for now, and that's increasingly the word that I'm actually using to express how I feel about the equity market at the moment when we think through year-end. We're basically at my 5,300 S&P 500 price target. And for those of you who aren't familiar with our work, we really take that target pretty seriously in terms of the timing and think about it as really articulating where we think the index will end up at the end of the calendar year. That being said, we also think it's a signaling mechanism and when I go through the body of my work, I keep coming up with that word stuck or that word neutral and I thought it was interesting that Isaac had a similar reference during his commentary as well.
And bottom line, what I've been saying in meetings is that I'm just having some difficulty making the math work to justify a higher number at the end of the year. I was in five different states in the US last week speaking with equity investors throughout the country, so this morning I thought I would share some thoughts on just a couple of things that were prevalent in my conversations. And when we think about our modeling, when we think about our analytics, we keep coming up with the recurring theme of conflicting crosscurrents. So I want to highlight just the two most important of those right now. I would say the first of these conflicting crosscurrents is actually investor sentiment. So one of the things we've been tracking quite closely is investor sentiment on the AAII survey and what we're finding is that it's not quite there, but it's getting pretty darn close to the highs that we achieved in late summer of 2023 and early of 2024.
Now we do point out that the data on net bullishness can be volatile week to week, but it did catch our eye in last week's update as it rose to 20.7%. And that's just shy of the one standard deviation mark of 22.1%. Just one standard deviation above the long-term average, which is essentially what we saw late last summer, kind of late July, early August, and then kind of late December into early 2024. We do typically see that when you hit that one standard deviation mark in terms of net bullishness on the four-week average. And we're not quite there yet, we're still tracking around 15% on that metric. But the S&P 500 tends to be flat on a three-month forward basis and up only about 6.5% over the next 12 months. So kind of positive but below trend type gains.
I do think that based on what we've been seeing the last few weeks, we're going to get a negative signal on this model again soon. And I would say kind of beyond that fact, there are a couple things that are bothering me. I would say number one sentiment has just bounced back so quickly on the heels of rising Fed optimism on cuts since the last FOMC meeting. And we did feel like that faded a bit, just in our client conversations last week, but still we saw net bullishness ease up just a bit. And I would say the second thing is really, again, we expect flat markets when we hit that level, and this has been a very good signaling mechanism from a tactical perspective over the last 12 months in equity markets. When you get to that one standard deviation mark, it's really indicating that it's time for the market to take a bit of a pause.
The other thing that's bothering me is that this model is not an outlier. When we look across the body of our investor sentiment work, particularly on the CFTC data sets, which also comes out weekly, we find that its data on US equity futures positioning is hovering a little bit above levels that were seen in early 2018 and early 2020. So in other words, we have other models that are also signaling short-term caution from a sentiment or positioning perspective. And then the second cross current I wanted to mention that I thought would be particularly timely given the other speakers that we have on this call is our valuation work for the S&P 500. And when I talk about how I'm sort of struggling in terms of the math and coming up with a more constructive view beyond that 5,300 number, this is really what I have in mind.
For those of you who aren't familiar with it, our valuation model is pretty unique on the street. It forecasts a trailing PE for the S&P 500 at year-end based on consensus assumptions for inflation and interest rates. We look at PCE, Fed funds, also 10 year yields and we leverage data going back to the 1960s. So we are able to get a lot of different economic cycles baked into the valuation work. We do update this model weekly and one of the things that jumped out to me on Friday as I was running through the updates is that consensus views on these inflation and interest rate inputs have shifted a good amount over the past week or so and they're not quite there, but they are starting to get much closer to the RBC US rates and economics team house view. So what we're seeing in the model right now is that it's projecting a year-end trailing PE of about 21.5 times.
That's down from about 21.8% a few weeks ago. And if you do the math with our earnings number of 237 or the bottom up consensus earnings number of 245, and both of those will be 2024 stats, it implies an S&P 500 price of 5,100 to 5,300 is fair value at the end of the year. So obviously we're trading right at the high of that right now. We do have a few stress tests that we're monitoring and one of the ones that we look at bakes in no cuts, stickier than expected inflation, and higher than expected 10-year yields. Though nothing disastrous. It does point to a slightly lower PE at around 20.8 times and a range of 4,900 to 5,100 in terms of S&P pricing at year-end. So we do look at that data and it tells us that if we sort of buy the consensus view that seems to be emerging right now of maybe one, possibly two cuts later this year, the market's pretty fairly priced. But if we don't get any cuts then there does seem to be some modest downside risk in the equity market. Though, again, nothing major.
It's worth noting in my travels last week that the equity investors I spoke with who were mostly in the long only camp generally are not expecting any cuts this year. So they're really in that kind of no cut part of the market. That's a little bit different than what I've observed in prior weeks where I was frankly talking to more hedge funds investors who were really more optimistic about cuts. Now, in terms of my conversations last week, what I was hearing is the idea that cuts aren't coming anytime soon didn't really seem to phase too many of the investors that I was speaking with as they also tend to believe that the US economy, and particularly their local economies, were quite strong. And I will say that everywhere I went, traffic was a bit of a mess because of all the construction that was going on.
So I could really see tangible evidence of what many of them were talking about. As we discussed last week what could drive stocks higher between now and year-end, it became clear to me that a focus on 2025 seems needed to take the stock market materially higher from here. From my seat at least, visibility is still a little bit limited. One investor did tell me that they think the November elections are starting to contribute to the fog. And I would say that while I've been having plenty of conversations with non US investors about the US election over the last 6, 9, 12 months, really US equity investors are slowly wading into this debate. But those conversations are starting to pick up just simply based on the fact that many of my US clients are getting more questions from their clients about that event and how it might impact their outlooks.
Jason Daw:
Okay, thanks a lot, Lori. Thanks a lot to Peter and Isaac and thank you to all our listeners for tuning into this episode of Macro Minutes. Monetary policy expectations, they've been a key driver of bond yields and curve shape and they can eventually have a larger impact on risk assets. So please reach out to your sales representative or us directly for further insights.
Speaker 5:
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