What are the main takeaways from the Fed meeting and the SEP release? What has been the market reaction?
Blake Gwinn: In the 2024 SEP, we saw upward revisions to the median projections, with the PCE inflation forecast rising by two-tenths and the 2025 forecast increasing by three-tenths.
The Fed appears a bit rattled by inflation. The balance of risks around these inflation forecasts has shifted from being nearly balanced to tilting toward the upside. Part of this shift is tied to the upcoming election. During the press conference, Powell acknowledged that some committee members had incorporated expectations around potential Trump administration policies into their outlooks.
Rates have sold off more than we anticipated, breaking out of the post-election ranges. We're now trading above 4.50% on 10-year yields, reflecting a more pronounced and unexpected market reaction than we initially expected. As we approach year-end, I don’t think there’s significant demand to counter the current price action or to step in and buy duration.
Does this change the rates outlook for 2025?
Gwinn: The 10-year Fed funds rate is expected to settle between the 4% to 4.25% terminal range. However, there’s an increased risk of it reaching 4.25% - 4.50% if the Fed ends up skipping a hike in January. Markets have largely adjusted to the idea of a higher terminal rate. This range will probably hold until there’s a broader shift in market sentiment and a clearer understanding of the next phase.
With a more hawkish Fed, we’re seeing increased pricing at the front end, leading to a notable rise in front-end yields, and keeping the long-end somewhat subdued. This dynamic points to a bear steepening of the yield curve.
“A more hawkish Fed is driving higher front-end yields, keeping the long end subdued and creating a bear steepening of the yield curve.”
Blake Gwinn, Head of U.S. Rates Strategy, RBC Capital Markets
The VIX spiked sharply following the FOMC meeting. Is this a sign of things to come?
Amy Wu Silverman: This is essentially a structural problem we’re going to see with derivatives. There's going to be more volatility potholes, we’re going to see these fits and starts, which are often related to the illiquidity in the market.
When there’s a multi-standard deviation drawdown, the typical reaction is to bid up prices, followed by a rapid move toward normalization. Successfully trading volatility instruments like the VIX largely depends on timing. While it’s still possible to monetize them, it now requires acting more quickly than in the past.
“Successfully trading volatility instruments like the VIX largely depends on timing. While it’s still possible to monetize them, it now requires acting more quickly than in the past.”
Amy Wu Silverman, Head of Equity Derivatives Strategy, RBC Capital Markets
How would you describe the stock market today?
Silverman: I love the analogy of the stock market as a "paddling duck." While the surface appears calm, there are significant rotations happening underneath, driving market dispersion.
High dispersion has implications for index volatility, as it can appear artificially subdued despite the intense activity occurring beneath the surface—just like those duck feet paddling furiously underwater. We believe this market dispersion will persist into next year.
How will the volatility landscape evolve as the drivers of inflation change?
Silverman: The S&P faces two key challenges: the "paddling duck" phenomenon, and the dominance of the Magnificent 7 stocks, which often act as a flight to safety.
This dynamic creates an issue with spreads, which have been trading at very low levels, signaling complacency, only to blow out during periods of stress. Portfolio managers focused on hedging and managing portfolio risk, will have to stop relying solely on the VIX and S&P to assess risk. They will need to get more thematic, and drill down to the sector level, leveraging instruments that effectively express those hedges, especially when the market is being driven by factors like interest rates.
How are equity investors thinking about 2025?
Lori Calvasina: Investors are increasingly concerned that a market pullback may occur sooner rather than later. Valuations and sentiment remain key focal points. Additionally, there are significant questions around tariffs and tax policy, with doubts about whether equity market pricing is overly optimistic.
“The earnings outlook continues to support further appreciation in the S&P 500 in the year ahead but rising 10-year Treasury yields and where the GDP forecast ends up will be critical in shaping equity market returns for 2025.”
Amy Wu Silverman, Head of U.S. Equity Strategy, RBC Capital Markets
The earnings outlook continues to support further appreciation in the S&P 500 in the year ahead, but several hurdles remain. Currently, the earnings yield gap suggests potential returns of 12% to 13% for the S&P 500 over the next 12 months. However, if 10-year Treasury yields were to rise to 5%, this dynamic would shift, potentially turning the yield gap into negative territory for equities.
Where the GDP forecast ends up will matter a great deal for equity market returns in 2025.
How do rates impact equity valuations?
Calvasina: Higher yields will pressure PE multiples, but the economy is in a much better place than decades ago. A stronger economy likely boosts S&P 500 revenues and enhances margins, as GDP growth traditionally supports profitability.
While higher 10-year yields may slightly dampen earnings via increased interest expenses, this impact is typically smaller than the revenue or margin effects. Ultimately, the key questions are how strong the economy is and how high yields will go, which requires ongoing analysis throughout the year.
What’s the outlook for small caps in 2025?
Calvasina: Looking ahead, consensus earnings growth forecasts suggest faster growth for Russell 2000 companies compared to the S&P500 next year, which supports maintaining a neutral weight rather than being underweight.
If we see a resurgence of strong economic tailwinds, there’s potential for small caps to benefit from higher valuations and increased positioning. However, the space is becoming crowded again, a notable shift from last year when it was significantly under-owned.
How are corporates approaching headcount and managing pricing pressures?
Calvasina: Consensus forecasts for S&P earnings next year show operating margin assumptions declining since mid-2024, reflecting a sharper focus on cost management from corporate America. In recent years, companies have taken pride in reducing costs without significantly impacting labor, which remains a strength for the labor market heading into 2025. However, this will be a key area to watch closely moving forward.
While pricing hasn’t been a major focus on earnings calls, companies across various industries have been quick to stress that any increased costs stemming from tax policy or tariffs would be passed on to end consumers.
Describe 2025 in one word for your market or asset class.
Silverman: Fatter tails.
Gwinn: Whipsaw. We’re facing significant risks that could emerge at any time. With the Fed essentially on hold, I expect we’ll be whipped back and forth between shifting economic narratives and evolving expectations around the new administration’s policies.
Calvasina: Tactical. Visibility for the year ahead is very limited, making adaptability crucial. There are significant upside risks, but also notable downside risks. Overall, it’s essential to approach the year with a tactical and adaptable mindset.
