RBC Capital's Lori Calvasina on what’s at stake for investors and markets

Key Concepts

• Geopolitical risk (Israel-Iran conflict)
• Federal Reserve (interest rate decisions)
• Inflation outlook
• Market sentiment (consumer, investor, business)
• Portfolio strategy (energy, materials, communication services)
• Valuation modeling (rates, yields, inflation, earnings)
• Risk assessment (pullbacks, recession, war pricing)

Geopolitical Risk and the Fed's Response

The discussion begins with the escalating tensions between Israel and Iran and its potential impact on the markets. The upcoming Federal Reserve interest rate decision is also a key focus. Lori Calvasina from RBC Capital Markets notes that a sustained oil price spike, resulting from the conflict, could complicate the inflation outlook. RBC's economists were not expecting the Fed to move until September due to insufficient data on labor and inflation. The geopolitical situation is adding uncertainty to the market outlook.

Shifting Market Sentiment

The conversation highlights a shift in sentiment among consumers, investors, and businesses, with a move towards increased caution. Calvasina emphasizes the importance of monitoring sentiment gauges (NFIB, corporate surveys, consumer sentiment) to understand how the Middle East situation will affect them. The recent market performance has been significantly influenced by this positive shift in sentiment.

Investment Advice and Market Outlook

Calvasina acknowledges the conflicting signals from her models: sentiment modeling suggests further upside, while valuation, earnings, and GDP modeling indicate the market is overvalued. She advises investors to "hope for the best and prepare for the worst." In case of escalation, she suggests considering sectors like energy and materials, which tend to outperform during rising oil prices. She notes that the communication services sector, a significant part of the growth trade, could be negatively impacted.

Communication Services Sector Vulnerability

The discussion delves into why the communication services sector is vulnerable to rising oil prices. Calvasina explains that this sector is a mix of defensive and consumer-oriented components, including media, entertainment, and internet-related businesses. Higher oil prices can reduce consumer spending on discretionary items like streaming services, impacting the sector's performance. Communication services are more durable than consumer discretionary but less defensive than consumer staples.

Potential Market Pullbacks and Risk Scenarios

The conversation addresses potential market pullbacks in the event of an expanded conflict. Calvasina outlines a "four tiers of fear" framework. A garden-variety pullback of 5-10% has been observed in previous episodes related to the conflict. If the situation worsens and recession concerns arise, a retest of the April lows is possible.

Valuation Modeling and Fair Value Range

Calvasina describes a valuation model that incorporates rates, ten-year yields, and inflation assumptions. By keeping the ten-year yield constant, assuming two Fed rate cuts, and increasing the PCE inflation gauge to 4%, the model yields a fair value range for the S&P of 4800 to 5200. This range aligns with the growth scare low and a potential retest of the April low.

Recession and War Pricing

Calvasina mentions "recession or war pricing," referencing historical events like the Russian invasion of Ukraine, the invasion of Afghanistan post-9/11, and the Iraq wars. These events saw recession pricing in the US ranging from 20 to 34%. While she doesn't anticipate such a severe scenario, she acknowledges the potential for significant market impact under extreme circumstances.

Conclusion

The main takeaways are that geopolitical risks are clouding the market outlook, and investors should prepare for a wide range of outcomes. Monitoring market sentiment and considering defensive portfolio strategies are crucial. While the market has shown resilience, potential escalation of the conflict and its impact on inflation and economic growth could lead to significant pullbacks.