Certain uncertainty – RBC Wealth Management

The first half of 2025 is mostly in the books. Following is our look at
equity market expectations as they stand for the rest of this year and for
2026.

Over time, the value of businesses grows in step with corporate earnings,
which in turn are largely determined by the direction and magnitude of GDP
growth. Looked at from the negative point of view, major stock market
retrenchments have typically occurred around periods when corporate
earnings are stagnating or in outright decline.

The worst and longest-lasting of such market declines, for all the world’s
major markets, have been associated with U.S. recessions, which leaves
open the question: Is a U.S. recession likely to arrive in the coming
18 months?

Just a couple of months ago, surveys of consumers, businesses, and
investors offered up a deeply pessimistic “Yes” to that question. The
overwhelming view at the time had the U.S. entering recession by the
second half of this year or by early next year at the latest. That extreme
low point for sentiment coincided with a scary low for stock prices—the
S&P 500, for its part, had fallen almost 19 percent in just six weeks,
from which it has largely, but not yet completely, recovered.

The same was true for the MSCI indexes for the UK and Europe as well as
Japan’s TOPIX. Surprisingly, Canada’s S&P/TSX, after falling by a
shallower 15 percent, sprinted to a new all-time high, the only major
index to do so as yet. All the more noteworthy because the heavyweight
Energy sector (approximately 20 percent of the TSX Index) was laboring
under weaker oil and natural gas prices over much of that interval, while
as the largest trading partner of the U.S., Canada’s economy has been
contending with massive trade/tariff uncertainty.

Meanwhile, those sentiment surveys cited above have all improved somewhat
but are still, on balance, set at pessimistic readings—that is to say, a
long way from the extended over-optimism that often spells trouble for the
stock market. It is also true that surveys require careful interpretation.
In this case, despite the extremely downbeat moods of both consumers and
company CEOs, spending by both households and businesses has remained
resilient.

Importantly, in our thinking, “market breadth” in the form of the
so-called advance-decline line for the S&P 500 has recently set yet
another new all-time high, suggesting the index won’t be far behind in
following suit.

With breadth readings like this, we think there is room for the major
global equity indexes to go on moving higher for some time yet, but there
are caveats.

Recession needs to be avoided

The negative GDP data in Q1 reminds us that there continues to be great
uncertainty about the potential impact of tariffs on the U.S. economy and
those of all its trading partners. The unwillingness of most companies to
provide forward guidance underscores this. We believe another sustained
up-leg in equity markets requires a catalyst which opens a plausible path
to continued growth without recession.

The most welcome would be a trade deal between the U.S. and one of its
notable trading partners—the EU, China, Canada, and Mexico represent about
60 percent of U.S. imports. So far, no such deal has emerged. With
postponed tariffs set to take effect in the coming month, the impact on
inflation and Federal Reserve policy could unfold over the second half of
the year. At the moment, the U.S. central bank looks to be wary of cutting
rates ahead of a price shock it assumes will be coming. The same looks to
be increasingly the case for other central bank policymakers.

Rich valuations require constant reassurance

Consensus earnings estimates for the S&P 500 remain unreservedly optimistic. This year is currently expected to come in at $265 per index share, up by 7.5 percent, with next year forecast to advance by a booming 13 percent to $300. And investors look to have embraced these estimates wholeheartedly: today the index trades at 22.8x this year’s earnings estimate and 20.1x next. (At the market’s February high, which we think will soon be surpassed, those valuation multiples lift to 23.2x and 20.5x.)

RBC Capital Markets, LLC Head of U.S. Equity Strategy Lori Calvasina notes that there is usually some erosion in consensus estimates over the course of the reporting year. Reflecting that factor and the firm’s forecast of soft GDP growth, her 2025 estimate is a more-sober-than-consensus $258. Applying an average “erosion factor” from here, 2026 earnings might turn out to look more like $273 per share, still up a respectable six percent. Using these “eroded” estimates, price-to-earnings (P/E) ratios at the S&P 500’s recent all-time high come in at 23.8x and 22.5x, respectively.

Here it should be noted the broad indexes in Canada, Japan, Europe, and
the UK are at comparatively much less demanding multiples—the mid-to-high
teens for the first three and only 13x for the UK. The P/E gap for all
four vis-à-vis the U.S. would narrow to some degree if one adjusted for
sector weight differences; the U.S. market has much higher exposure to the
high-P/E Tech sector and much lighter to the low-P/E Materials and
Financials groups. What valuation gap remains is largely attributable to
the preponderance of mega-cap growth stocks such as the “Magnificent 7”
(Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla)
found in the S&P 500.

Markets, even high P/E ones, can withstand some near-term earnings
disappointments, like those that might arrive in the wake of full-on
tariff (and counter-tariff) imposition in H2, as long as investors can
remain confident of a 2026 full recovery. However, in our view,
“withstand” does not mean “ignore.” A rocky H2 for earnings, should it
arrive, could be expected to take a periodic toll on investor confidence
and produce bouts of downside volatility along the way. And, while
forecasts of a 2026 U.S. recession, so prevalent two months ago, have
largely faded away, they could come back on the table just as rapidly.

Other risks abound

Earlier in the year, we argued that catalysts were needed to make a
sustained path higher for stock markets plausible. Our first choice was
“some significant improvement on the trade front” and it still is.
However, we also thought “a Ukraine truce would be helpful.” Regrettably,
the Ukraine-Russia conflict has escalated in the interval, diminishing the
prosects for a negotiated ceasefire or path to a peace settlement. Now, an
already highly fraught Israel-Iran relationship threatens to transmute
into outright war, perhaps pushing any possible U.S.-Iran nuclear deal
into the ditch along the way. And still lurking on the sidelines is the
until recently, very hot confrontation between nuclear powers India and
Pakistan.

Invested, but watchful

Markets are often said to “climb a wall of worry.” If that’s so, there
looks to be lots of climbing left to do. But stock markets shouldn’t be
thought of as infallible oracles that correctly divine the future. Rather,
they are the collective view of investors about what lies ahead. Those
all-too-human investors can and do change their minds—often abruptly.
There may be plenty of reasons presented to do just that in the coming
quarters.

We expect major equity markets to post further new highs in the months
ahead. But we also believe something more than “the trend is your friend”
thinking will be required. Good investment decisions are that much harder
to make when being pressured by either fear of missing out, or just plain
fear.

We advocate for a cautious, watchful approach.