Welcome to RBC’s Markets in Motion podcast, recorded April 15th, 2024. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers.
Today in the podcast, we’ve got a lot to get through. Seven big things you need to know: First, geopolitical concerns are spiking at a time when stocks already seemed due for a pullback. Second, the rotation trade has just gotten a lot more complicated. Third, companies have been keeping expectations low on earnings. Fourth, our valuation modeling suggests some modest downside risk to the stock market if we don’t get cuts, and a more significant hit if we get more hikes. Fifth, Small Caps may be stuck in a holding pattern for a while. Sixth, Biden has closed the gap with Trump in betting markets. Seventh, US equity flows have fizzled.
If you’d like to hear more, here’s another 7 minutes. Let’s jump into the details.
#1: Geopolitical concerns are spiking at a time when stocks already seemed due for a pullback.
One point that kept coming up in our meetings last week was that equity markets have a tough time pricing in geopolitical risks too far in advance. Recently, equity investors appear to have been baking in rising geopolitical risks by buying the Energy sector, which has easily been the top performing sector in Large Cap and Small Cap in recent months. That seemed to change at the end of last week as the S&P 500 broke below its early-April low on Friday’s close. We reminded investors last week that sentiment has been looking frothy on a number of indicators including the weekly AAII survey and CFTC’s weekly positioning data in US equity futures. How bad could a pullback get? For now, our assumption is that it would be in the 5-10% range. The drawdown in the S&P 500 that occurred last summer and fall ended up being around 10%, and typically any drawdown beyond 10% involves a serious scare about economic growth. This assumption could change, however, depending upon how geopolitical risks play out and if the economic narrative takes a turn for the worse.
#2: The rotation trade has just gotten a lot more complicated.
One of the best questions we got last week was what the hot inflation data means for the leadership rotation in the US equity market that seemed like it was finally getting underway. Our answer: generally we think higher inflation and fears over higher interest rates are good for the mega cap growth stocks. Since SVB, the Large Cap Growth/Value trade and the performance of the top 10 names in the S&P 500 relative to the rest of the market have been moving more or less in sync with trends in 10-year yields. We think this is in part due to better balance sheets in the biggest cap growth stocks.
But it’s worth noting that other things besides interest rates and balance sheet fears could drive the rotation trade. GDP forecasts have been moving up quickly and stand at 2.2% for 2024. That’s still a little below average, but when GDP is trending above average Large Caps and Growth tend to underperform Small Caps and Value. A continued ramping of economic expectations, in other words, could keep the rotation in leadership going. Rising geopolitical risks also benefit the Energy sector, an important though not terribly big piece of the Value trade. Crosscurrents for the old leadership, much like the broader market itself, are simply complicated.
#3: Companies have been keeping expectations low on earnings. Earnings didn’t come up too much in our meetings last week, but it’s still worth taking a moment to highlight our thoughts as 1Q24 reporting season gets underway. The setup for earnings is interesting to us for a few reasons. For one thing, the decline in bottom-up EPS forecasts for the S&P 500 has been milder than what we typically see (cuts to bottom-up forecasts are the rule not the exception).
Additionally, downward guidance has far outpaced neutral and upward guidance in recent quarters. This has allowed companies to meet or even beat expectations. Though we like this setup for the most part, we remain a bit concerned that expectations for margin expansion in 2024 may not pan out given the cost pressures that many companies cited in the last reporting season. The anticipation of significant margin expansion is one of the key differences between the bottom-up consensus (which is tracking at $242) and our own EPS forecast of $237. Color on margins is one of the big things we’ll be looking for in the weeks ahead.
#4: Our valuation modeling suggests some modest downside risk to the stock market if we don’t get cuts, and a more significant hit if we get more hikes. Following last week’s hot CPI print, we’ve updated our valuation stress tests. As a reminder, our valuation model forecasts a trailing P/E for the S&P 500 at year-end based on the relationship between the trailing average S&P 500 P/E since 1962 with trends in PCE, 10-year yields, and Fed Funds, along with consensus assumptions about where each of those variables will be at the end of the year. We look at the projected P/E in the context of both our own below-consensus EPS forecast of $237 and the bottom-up consensus EPS forecast to come up with a gauge on where the S&P 500 could potentially be trading at year-end. When we bake in the updated views of the RBC Rates Strategy team for one cut in December, our model points to a range of 5,050-5,200 for the S&P 500. When we bake in a scenario involving no cuts this year and stickier inflation and higher yields than expected, our model points to a range of 4,900-5,000 for the S&P 500. When we bake in a scenario involving more hikes this year (and much higher inflation and yields than currently expected), our model points to a range of 4,500-4,600 for the S&P 500.
#5: Small Caps may be stuck in a holding pattern for a while. In the aftermath of last week’s hot CPI print, our views on Small Cap were in focus in meetings. We’ve liked Small Caps this year, and were impressed last week that even with several very bad days for the Russell 2000, the RTY/SPX ratio didn’t break its mid-November 2023 low. There’s still a lot we like about Small Caps. Balance sheets aren’t as bad as feared, in our view. Valuations are reasonable relative to history and cheap vs. Large. Positioning on the CFTC data isn’t extended for the Russell 2000 as is the case for the S&P 500 and Nasdaq. Small Caps also tend to outperform Large Caps when ISM manufacturing is picking up and when GDP is above trend. There are valuation and economic and positioning tailwinds for Small Caps to be sure. All that being said, we think Small Caps need confidence in cuts to be able to outperform in a sustainable way (Small Caps usually outperform after the Fed cuts), and that confidence seems like it’s a long way off at the moment. For now, our assumption is that Small Caps will stay in a holding pattern relative to Large Caps until greater confidence in an easing path emerges.
#6: Biden has closed the gap with Trump in betting markets. We’ve talked a lot about the shifting dynamics in the race for the White House over the last few weeks so won’t spend too much time here. But it’s worth noting, given how in focus the US Election has been for non-US investors, that Biden is now tied with Trump in betting markets. As we noted last week, this challenges a key assumption of non-US investors that Republicans will sweep this fall. Ultimately, we think it’s important to remind investors that stocks tend to go up regardless of which party controls the White House and Congress.
And finally, #7: US equity flows have fizzled. Something else that’s worth a quick mention – US equity funds are suddenly seeing outflows. Outside of the US, most major geographies remain weak, though Canada flows have started to improve a bit. Within the US, flows for Large Caps and Small Caps are both under pressure as are all of the major styles. Passive deterioration is noteworthy, while active is holding up much better. At the sector level, growth and defensive sectors are generally seeing the worst trends while cyclical and commodity sectors are seeing improving and/or positive flows.
That’s all for now, thanks for listening. And be sure to reach out to your RBC representative with any questions.