With the war on inflation being won and central banks now actively cutting rates, the case for an economic soft landing is becoming more palpable. A combination of robust economic data, fading inflation pressures and easing financial conditions motivated us to lower our recession odds to 25% from 30% several weeks ago, and down from 40% in the prior quarter. Although a negative outcome remains possible, we expect that a downturn would be minor in magnitude and relatively short-lived.

Investors remain highly optimistic and equity markets have rallied to record highs, with the gains broadening beyond the small group of mega-cap technology stocks. The S&P 500 Index is expensive and vulnerable should the outlook deteriorate, but a soft landing could support double-digit profit growth that justifies higher valuations, and other stock markets outside of the U.S. large-cap space are not unreasonably priced. That said, a variety of risks complicate the outlook, whether it be rapidly evolving geopolitical tensions in the Middle East, China’s economic challenges or the imminent U.S. election. Uncertainty is elevated and the range of possible outcomes spans a wide range, though our base case looks for moderate growth and modest inflation this year and next, roughly in line with the consensus (exhibits 1 and 2).

Exhibit 1: Weighted average consensus real GDP

Growth estimates for major developed nations

Note: As of September 2024. Source: Consensus Economics

Exhibit 2: Weighted average consensus CPI

Inflation estimates for major OECD nations

Note: As of October 2024. Source: Consensus Economics

The economy and labour markets are holding up

Supporting our view that the economy is on a solid footing is data that has been reasonably strong and better than expected. Citi’s economic data surprise index has been rebounding since July, and it just turned positive for the first time since May, indicating that data releases, in aggregate, are now coming in ahead of economists’ estimates (Exhibit 3). Leading indicators have also improved. In September, the ISM services PMI rose to its highest level since March 2023, signalling a healthy level of economic activity, (Exhibit 4) and the Atlanta Fed’s forecasting model, which has provided accurate predictions in the past, suggests real GDP growth for the fourth quarter will be 3.2%, a strong reading that is inconsistent with the economy is falling into recession (Exhibit 5). It is worth noting that the intense U.S. hurricanes of the past several weeks could distort economic data over the next quarter, but looking through any potential volatility in the data, the overall trend is positive.

Exhibit 3: United States

Citi Economic Surprise Index

Note: As of October 15, 2024. Source: Citigroup Global Markets Inc., RBC GAM

Exhibit 4: U.S. ISM Services PMI

ISM Non-Manufacturing Index

Note: As of September 30, 2024. Source: Institute for Supply Management, RBC GAM

Exhibit 5: U.S. GDP

Real seasonaly adjusted quarterly data

Note: As of October 15, 2024. Source: Bureau of Economic Analysis, Federal Reserve Bank of Atlanta, RBC GAM

The labour market is also in relatively good shape. The unemployment rate at 4.1%, while off its recent lows, is situated near the lowest readings  of the past 70 years (Exhibit 6). Monthly job gains have been steady, averaging between 150,000 and 200,000, which was the range that former Fed chair Janet Yellen suggested was needed to keep unemployment from rising meaningfully (Exhibit 7). Weekly fillings for unemployment claims are also stable near the lowest levels they’ve been in the past three decades (Exhibit 8). While the pace of improvement has slowed and some metrics have arguably worsened marginally, our view is that the labour market is moving away from the overheated conditions that existed earlier this year to one that is in better balance. We would become more concerned about the labour market if the unemployment rate started rising significantly.

Exhibit 6: U.S. unemployment rate

Note: As of September 30, 2024. Source: Bureau of Labor Statistics, NBER, Macrobond, RBC GAM

Exhibit 7: United States

Monthly change in non-farm employment (3mma)

Note: As of September 2024. Source: Bureau of Labor Statistics

Exhibit 8: U.S. initial unemployment claims filed

Four week moving average

Note: As of October 4, 2024. Source: RBC GAM

Inflation trajectory remains favourable…

Extremely high inflation, the major pain point for the economy for the past two years, has largely faded. Each of the six inflation metrics that we track to calculate price changes has been declining since mid 2022, and some are now within reach of the Fed’s 2.0% target (Exhibit 9). For example, U.S. headline CPI was 2.4% in September, down from a high of 9.1% in mid-2022. Although the pace of improvement from here will likely slow, we expect that inflation will continue on a downward trajectory into 2025 and get closer to the 2.0% level. Inflation expectations also remain well anchored around 2%, but they have crept up marginally higher since mid September, when the Fed delivered a 50-basis-point rate cut (Exhibit 10). While the increase in inflation expectations isn’t significant, it shows that central banks will have to carefully manage monetary policy as easing financial conditions could buoy prices and threaten the soft landing they are trying to achieve.

Exhibit 9: U.S. inflation measures

Note: As of September 30, 2024. Source: Bloomberg, RBC GAM

Exhibit 10: Implied long-term inflation premium

Breakeven inflation rate: nominal vs 10-year real return bond

Note: As of October 2024. Eurozone represents GDP-weighted breakeven inflation of Germany, France and Italy. Source: Bloomberg, RBC CM, RBC GAM

…although U.S. election outcome poses a risk

Even more critical than the effect of monetary policy on the course for inflation are government policies, which could see a meaningful shift following the U.S. election. In Exhibit 11, work by BNP Paribas outlines what the various election outcomes could mean for taxes and government spending plans. Importantly, both Republican and Democratic parties favour deepening the fiscal deficit, which could heat up inflation. At this time, the election remains too close to call as odds-tracking platform PredictIT suggests a marginal lead by Trump over Harris (Exhibit 12). Should Trump win, the tariffs proposed by the Republican party could cause inflation to rise to the mid single digits. According to BNP Paribas, if the tariffs are implemented to the full extent that they have been tabled, they would result in a tailwind of between 4 and 5 percentage points to inflation above the 2% baseline rate, meaning 6%-7% inflation in the first year the tariffs are imposed (Exhibit 13). Uncertainty will remain elevated until the election concludes, but a Trump victory could result in a level of inflation that would likely limit the amount of easing delivered by the Fed.

Exhibit 11: Main policy assumptions under post-election scenarios

Note: *Denotes provisions related to the 2017 TCJA that are due to roll of at yearend 2025. Subjective election odds are as of 3/9/2024 and subject to change over time. Source: CBO White House, BNP Paribas assessments based on candidate statements and media reports

Exhibit 12: PredictIt U.S. election odds

Question: Who will win the 2024 U.S. presidential election?

Note: As of October 16, 2024. Source: PredictIt, Bloomberg, RBC GAM

Exhibit 13: Impact on inflation in years one and two under US across-the-board tariffs and global retaliation scenario (with monetary policy response)

Note: Chart shows inflation impact relative to baseline in years 1 and 2 for the US, Eurozone, China and Japan following imposition of tariffs and tit-for-tat-retaliation. Source: NiGEM, BNP Paribas

Interest rates have begun their descent

Notwithstanding the possible impact of a new U.S. administration, central banks are focused on the fact that inflation is no longer a concern and that, for the time being, tight monetary conditions are no longer justified. As a result, central banks have begun cutting interest rates and are likely to continue lowering them toward a more neutral setting. Our own model suggests the federal funds rate is as much as 150 basis points above the upper range considered appropriate or neutral given the inflation backdrop (Exhibit 14). Pricing in the futures market also suggests rates are likely to continue to fall. Investors are looking for 50 basis points of further cuts this year, and another 100 basis points next year (Exhibit 15). These numbers are slightly less aggressive than they were a few weeks ago given that economic data has been relatively positive since then.

Exhibit 14: U.S. fed funds rate

Equilibrium range

Note: As of October 16, 2024. Source: PredictIt, Bloomberg, RBC GAM

Exhibit 15: Implied fed funds rate

12-months futures contracts

Note: As of October 16, 2024. Source: PredictIt, Bloomberg, RBC GAM

Sovereign bond yields rebound

Government bonds sold off in the past month to adjust for the fact that interest rates may not need to come down as quickly as previously thought. The U.S. 10-year yield climbed nearly 50 basis points from its mid-September low of 3.61% to as high as 4.10%, which is situated close to our modelled equilibrium level (Exhibit 16). Valuation risk is minimal as a result, and we recognize that the meaningful capital gains that were enjoyed through the spring and summer months are likely behind. Bond rallies have historically been concentrated leading into the first rate cut of an easing cycle, without much follow through to lower yields in the absence of a deep recession (Exhibit 17). As a result, we expect sovereign bond yields to remain relatively range-bound over the year ahead, delivering single-digit returns to investors in government bonds.

Exhibit 16: U.S. 10-year T-bond yield

Equilibrium range

Note: As of October 15, 2024. Source: RBC GAM

Exhibit 17: U.S. 10-year bond yield and the Fed funds rate cut

Implications for current cycle, following first rate cut

Note: As of October 16, 2024. Source: PredictIt, Bloomberg, RBC GAM

Credit spreads narrow to extremes

Investors remain highly confident that the economy will continue to grow and that companies will be able to fulfill their financial obligations. The spread offered on corporate bonds versus safe-haven government debt has narrowed to its tightest since just before the 2008-2009 global financial crisis (Exhibit 18). In other words, the extra compensation offered to investors for taking on the risk that they might not get paid is extremely low. With economic data relatively robust and borrowing costs falling, the environment for businesses is favourable, and fewer companies are failing to meet their obligations (Exhibit 19). This environment may also suggest, however, that investors are complacent and willing to accept lower returns because they deem the risks of a negative outcome minimal.

Exhibit 18: U.S. corporate bond spreads

Difference with U.S. 10-year Treasury yield

Note: As of October 16, 2024. Source: BofAML, Bloomberg, RBC GAM

Exhibit 19: U.S. high yield bonds

Distressed ratio and default loss rates

Note: As of October 11, 2024. The distressed ratio is the proportion of bond issues with spreads in excess of 1000 basis points.Source: BofAML, Credit Suisse, RBC GAM

Stocks extend gains, valuation risk is concentrated in U.S. large caps

Many major stock indices posted gains in the past month and the rally broadened beyond U.S. mega-cap technology stocks. The S&P 500 rose 4.0% since the Fed’s 50-basis-point rate cut on September 18, while the S&P/TSX Composite Index rose 2.8% and the MSCI Emerging Markets Index gained 5.2%, all in U.S.-dollar terms (Exhibit 20). The MSCI EAFE Index lagged, falling 0.5% over the same time frame, largely reflected a drop in Japanese equities on fears that domestic interest rates are set to rise. Although equity-market gains earlier in the year were high concentrated in U.S. mega-cap technology stocks, other markets have participated in the rally since the summer.

Exhibit 20: Major equity market indices

Cumulative price returns indices in USD

Note: As of October 15, 2024. Price returns computed in USD. Source: Bloomberg, RBC GAM

From a valuation standpoint, the S&P 500 is expensive. Up 22% so far this year and currently at record highs, the S&P 500 sits approximately one full standard deviation above our modelled estimate of fair value and, as a result, offers lower potential for returns (Exhibit 21). But the same can’t be said about the broader equity market. Our composite of major equity markets suggests global stocks are only 3.9% above fair value (Exhibit 22), and most of the overvaluation is coming from the U.S. large-cap market. If we exclude the U.S. from the composite, global stocks are as much as 15% below fair value, offering the potential for attractive gains should the economy and corporate profits continue growing.

Exhibit 21: S&P 500 equilibrium

Normalized earnings & valuations

Source: RBC GAM

Exhibit 22: Global stock market composites

Equity market indexes relative to equilibrium

Note: As of October 14, 2024. Source: RBC GAM

Signs of extreme enthusiasm in stocks

Aside from valuations, there are signs that investors may be too optimistic about the prospects for stocks. A composite of investor sentiment tracked by Ned Davis Research situates investor sentiment in territory that signifies extreme optimism (Exhibit 23). The composite consists of surveys and market-based indicators to gauge how investors are feeling about prospects for stocks, and it has reached upper extremes. Investors also became increasingly excited about equities in China, as evidenced by the Hang Seng Index experiencing one of its most intense rallies ever. The Hang Seng Index rose as much as 32.3% over a one-month period to a peak on October 7 for the biggest one-month rally in the past two decades, just eclipsing the 32.2% rally that came off the bottom set during the 2009 global financial crisis (Exhibit 24). This powerful move came after Chinese policymakers announced a series of measures to bolster the economy, such as reducing borrowing costs, easing restrictions on property investments, increasing government spending and incentivizing stock purchases. Time will tell if the enthusiasm can be sustained, but history suggests that equity markets tend to be more vulnerable to disappointment when excitement is elevated.

Exhibit 23: Ned Davis Research Crowd Sentiment Poll

Percent bulls

Note: As of October 8, 2024. Source: Ned Davis Research, RBC GAM

Exhibit 24: Hang Seng Index

Index level and 1-month rolling % change

Note: As of October 8, 2024. Source: Ned Davis Research, RBC GAM

Corporate profit outlook is bright

Further fueling investor enthusiasm is the fact that analysts expect rapid corporate-profit growth over the next two years across most equity markets. Exhibit 25 lists earnings-growth expectations for major stock-market indices in 2024, 2025 and 2026, based on a consensus of analysts’ estimates. Earnings for the S&P 500 are projected to grow 13% in 2024, 15% in 2025 and 13% in 2026. These double-digit growth rates are impressive and are a reason to support a high price-to-earnings multiples over 20 for U.S. large-cap stocks. But other areas of the market are expected to deliver even stronger earnings growth over the next couple years. For example, profits for the S&P 600 Small Cap Index are expected to rise 17.9% in 2025 and 15.8% in 2026. This is important because small and mid-cap indexes are trading at more attractive valuations with P/Es of 17.1 and 17.8, respectively, and an economic soft landing could motivate a sustainable broadening in the equity-market rally beyond U.S. large caps.

Exhibit 25: Major stock-market indices

Consensus earnings outlook

Note: As of October 14, 2024. Sorted by 2025 EPS growth. Source: Bloomberg, RBC GAM

Asset mix – maintaining slight underweight in fixed income, and neutral allocation to stocks

In our base case scenario, we look for the economy to continue expanding at a moderate pace, for inflation to settle near 2% and for central banks to continue lowering interest rates at a steady pace. Against this backdrop, sovereign bonds have already priced in a significant amount of monetary easing over the year ahead, and we think that the bulk of the capital gains that bond investors enjoyed over the past year are what they’ll get in this part of the cycle. We think yields are likely to fluctuate in a narrow range over the year ahead, delivering low single-digit total returns for bond investors. As a result, we are maintaining a slight underweight exposure to our fixed-income allocation. Equity markets offer more attractive upside potential than bonds, but we recognize that elevated valuations in U.S. large-cap stocks pose a vulnerability should the outlook deteriorate. Other parts of the equity market offer more attractive risk/reward should the economy continue to expand as we expect. On balance, our exposure to stocks is in line with our strategic neutral, with a slight tilt away from U.S. equities in favour of regions that are more attractively priced. We are maintaining a small cash balance of 3% to buffer potential volatility and provide opportunities to take advantage should it arise. Our current recommended asset mix for a global balanced investor is 60.0% equities (strategic: “neutral”: 60%), 37.0% bonds (strategic “neutral”: 38%) and 3.0% in cash (Exhibit 26).

Exhibit 26: Recommended asset mix

RBC GAM Investment Strategy Committee

Note: As of October 16, 2024. Source: RBC GAM