Equity markets have gone up so quickly that they're highly vulnerable to a pullback if the U.S. economy slips into even a mild recession, according to Royal Bank of Canada's fund management arm.
The odds of such a downturn are still about 70%, says the chief economist of RBC Global Asset Management, despite increasingly-frequent predictions of a soft landing. Those calls are based on data that show inflation is cooling, suggesting the Federal Reserve and other central banks will soon be able to lower interest rates even as the economy continues to expand.
Rate cuts are likely to happen in 2024, but the global economy hasn't yet absorbed the full impact of almost two years of tightening monetary policy, RBC economist Eric Lascelles said in an interview. Historically, the average time between the first U.S. rate hike and the onset of recession is about 27 months, Lascelles writes in the firm's new investment outlook.
The Fed and the Bank of Canada first raised rates in March 2022, while the European Central Bank began that July.
"The risk of recession has gone down modestly, but the market's pricing suggests it's gone down remarkably," Lascelles said. The S&P 500 is poised to end the year up about 25% after a stunning 14% rise since the beginning of November.
"What's baked into the cake is a sizable jump in earnings, which is really only achievable in a soft-landing scenario," Lascelles said.
Many economists believe the U.S. economy is less rate-sensitive than the U.K., Canada and other countries where consumers are already dealing with higher loan payments because their mortgage rates reset more frequently. But there's a flip side to the U.S. structure of long-term mortgages: tighter credit from hard-hit financial institutions, Lascelles noted.
"For every 30-year mortgage holder in the U.S. who's sort of cackling at their 2.6% mortgage and they've got no problem until 2052, there is a financial institution that lent them that money at 2.6% that's feeling some stress here," he said.
Even if millions of American households have locked in relatively low mortgage rates, "any decision to buy a new car or to buy a new home or to build that new home or to build that new factory — those are all completely exposed to higher rates. The U.S. is no more protected from that than anyone else."
The firm's quarterly investment outlook says stock valuations look far more reasonable outside of the megacaps such as Microsoft Corp. and Nvidia Corp. that have been the biggest drivers of this year's big gains in the S&P 500.
"The dominating performance of U.S. equities for more than a decade could be ripe for reversal," RBC's Eric Savoie and Dan Chornous write.
RBC Global, which had about C$540 billion ($408 billion) under management as of Oct. 31, is entering the new year with a neutral positioning on stocks and has raised its recommended allocation to fixed income to 38.5%. That's up from 37% at the start this year, as higher yields have made bonds more attractive.
