Eric Savoie, Senior Investment Strategist, RBC Global Asset Management Inc., provides an overview of the risks and opportunities in the current market environment. He shares his outlook for interest rates and fixed income markets as well as an overview of equity market valuations.
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What is your outlook on interest rates?
Eric Savoie
Well, in the current macro backdrop, I think it's a very tough situation for central bankers, for sure, given there's so much uncertainty on the policy front, particularly stemming from the U.S. administration with their trade policy. The Fedhas a dual mandate, their role or their goal really is twofold.
One is to ensure price stability, and the other is to ensure maximum employment. So if you think of the impact of tariffs it sort of applies pressure in opposing directions on both of those fronts. So on the employment side, tariffs sort of slow economic activity. They act as a headwind on the economy, sort of a sand in the gears kind of situation.
And then on the price side, tariffs might raise costs for companies that will then ultimately be incentivized or inclined to pass that through to the consumer. So higher inflation potentially in the near term and a softer labour market. And so what does the central bank do in that environment. Well, Powell gave us a little bit of insight, on what he's thinking a
few weeks ago in a speech that he did recently, and he suggested that he would place greater weight on the softening labour market, rather than any sort of near-term pressure on inflation. So, with that in mind, the Fed sort of signaled that they'd be more willing or their bias would be toward interest rate cuts over the months and quarters ahead.
And so the market liked what it heard. The fixed income market started to price in interest rate cuts as soon as September, with further easing priced in later this year and into 2026. That view aligns with our own. We're forecasting four interest rate cuts over the year ahead. The market has priced anywhere between 100 and 125 basis points over the next 12 months.
So, we're fairly comfortable with our forecast, that the U.S. is going to resume a interest rate cutting cycle, with several cuts over the next 12 months.
What is your outlook for fixed income?
Eric Savoie
On the fixed income side, we've seen fairly narrow volatility in bond yields over the past year. Yields have been sort of fluctuating in this fairly narrow range as a variety of forces have been impacting yields. Weighing on yields has been sort of a little bit of softer economic data, a weakening labour market and the Fed being a little bit more dovish in its commentary suggesting that rate cuts lie ahead.
On the other hand, we've had some forces that are sort of lifting bond yields, and that has to do with some concerns about inflation. But more so concerns about highly indebted governments, in the U.S. but also around the world. In the U.S., that concern is exacerbated by the fiscal spending bill, the one big beautiful bill act, which promises increased spending over the year ahead.
And so, when you already have these highly indebted governments adding further spending, brings on greater concern of a fiscal health situation, within the U.S. in particular. And so you've had those push and pull forces and bond yields have been relatively stable over the year so far. But actually, as yields have started to climb a little bit recently in some areas, not just the U.S. but all around the world, our models would suggest that that actually means that fixed income investors can earn a higher return in this environment.
Importantly, our models would suggest that that latest increase in yields has been coming from real interest rates rather than major concerns about inflation. So fixed income investors are really being offered a higher after inflation yield on sovereign bonds. And so we think that's a good thing for investors in this environment.
Our view is pretty favourable on government bonds at this point. We think investors can receive a decent return potential in the mid-single digits. But importantly, with fairly minimal valuation risk, as long as inflation doesn't surge in a major way. And so that's not our view. Our view is that inflation will maybe firm up a little bit in the near term, but then moderate into 2026.
And so we think at 4.2% in the U.S. 10-year yield, we think that investors can receive that coupon income with very little downside risk and even the potential for higher returns should the economy actually stumble.
What is your outlook for equities?
Eric Savoie
So the stock market has been quite exciting so far this year. Earlier in the year, we had a big sell off given that investors were quite concerned about the tariff threats. And we saw major drawdowns in almost all of the major markets around the world. Since then, as we've seen some calming on the tariff narrative. We've seen a little bit more clarity, investors are more comfortable with what that might look like.
The tariff headlines have sort of lost their ability to shock the market. And we've seen massive rallies in major stock markets all around the world. The S&P 500, for example, climbed just over 30% from its low, reaching an all time high. And markets all around the world are also climbing to at or near record highs.
The initial rally was led by big cap tech stocks within the U.S. But we've seen more of a broadening of the participation in the rally, not just in those big cap tech stocks, but also stocks around the world - Europe, Canada, emerging markets and Japan as well. And so where do we go from here? Our view is that the stock market can continue to go higher as long as investors remain optimistic, as long as the economy continues to grow, allowing for corporate profits to rise.
But we do have some concerns with some pockets of the market that have reached fairly extreme levels of valuation, particularly within the U.S. equity market. But it's not the whole U.S. equity markets, it’s really a small portion of stocks that are very richly priced. And so that concentration risk is a little bit of a concern to us. Within the S&P 500, for example, just 10 stocks account for 40% of the weight in the Index.
They're very successful companies. They generate a significant amount of profits. But really there's so much dependency now on the S&P 500 in this group of stocks continuing to do well, that should they stumble for whatever reason, it could pull the broader Index down. So outside of that group of stocks, though, the U.S. market is not all that expensive. If we look at an equal weighted version of the Index, it's more reasonably priced.
If we look at small caps within the U.S., they're also more reasonably priced. And then if we look outside of the U.S. entirely, into emerging markets or European markets, we see actually quite good value in those parts of the market. When we look at the broad global equity market, we conclude that the overvaluation in some parts of the market really is concentrated to a small group of stocks.
But more broadly, the global equity market seems more reasonably priced. So while valuations are important, the ultimate true driver, sustainable driver of stock markets over the long term is the sustainability of corporate profit growth. And profits have actually been very strong so far this year. Within the S&P 500, profits are up 13% year over year in the second quarter.
That's much better than what was expected at just around 6%. Profits continue to exceed expectations. The impact of tariffs seems to be relatively minimal. Perhaps companies have found ways to mitigate the impact of tariffs, or they found ways around it or to sort of operate in this environment. And I think, when you look at these companies, it's quite impressive the ability for corporate America to continue growing their profits in the face of significant macro challenges.
On the one hand, we are quite encouraged by the corporate profit outlook. When we take all of that together, though, a lot of that optimism is already priced in, particularly in the S&P 500. So for those reasons, for the S&P to continue to deliver strong returns, we need two things to happen.
One is for optimism to remain in place and for those earnings to continue delivering very strong gains. If that happens, the stock market can continue to go up. But we would just caution that that risk reward is not as appealing in the U.S. as it is elsewhere around the world. In our view, we can expect as a base case, something like mid-single digit returns in the S&P 500.
But in other parts of the world, we could expect maybe higher single digit returns in the 8 or 9%, for regions like Europe or in emerging markets.
What is RBC GAM’s recommended asset mix in the current environment?
Eric Savoie
When we're considering our asset allocation, we consider a wide variety of potential outcomes for the economy and financial markets. We recognize that things could play out better than we expect as well as worse than we expect. And so we're sort of trying to balance all of these potential outcomes within our broader asset allocation.
Our base case scenario is that the economy is likely to grow, continue growing at a modest pace, over the year ahead. And we expect that inflation might firm a little bit in the near term, but ultimately moderate into 2026. So we think that those conditions will allow central banks to deliver monetary easing, through rate cuts over the months and quarters ahead.
This should be a boost to not just fixed income assets, but also equity assets as well. On the fixed income side, we can expect something like mid-single digit returns over the year ahead. And we think stocks can do a little bit better than that. So we're looking for a mid to high single digit returns out of most major equity markets over the year ahead.
Importantly, within that equity mix, we're a little bit more concerned with heightened valuations, particularly within the U.S. market. And because of that, we expect greater return potential to come from regions outside North America, particularly in Europe, Asia and emerging markets. And so over the past quarter, we decided to add one percentage to our equity allocation, increasing our overweight exposure slightly.
We sourced that 1% from fixed income where we have a modest underweight. And so we're currently sitting at a 62% equity allocation relative to our neutral for a global balanced investor of 60%. And we have a 37% weighting to fixed income, relative to a 38% neutral. We think that's a good setup for asset mix at this time, given the risks and opportunities that exist, slightly favouring, stocks away from fixed income at this point.
