Equities and the economy

By Jim Allworth, Investment Strategist – RBC Dominion Securities

From late October to the start of the Iran conflict, most major developed equity markets—in Europe, Japan, the UK, and Canada—forged steep upward paths to a succession of new all-time highs. The S&P 500 by contrast barely inched higher over that interval. However, since Iran entered the picture the U.S. and Canadian markets have lost comparatively little ground, while economies highly dependent on imported oil and gas—Japan, much of Asia, and Europe—have endured more substantial pull backs.  

The future course of all markets depends to some considerable extent on how the U.S. involvement in Iran plays out. A cease-fire and resumption of unhindered oil traffic could shift investor focus back to the outlook for the domestic economies in the U.S., Canada, and other developed nations. However, if the current bombing campaign threatens to turn into a major, multiyear commitment of American forces to an Iranian conflict, we think it could produce an unsettling financial market outcome, potentially akin to the First Gulf War’s extended stock market pull-back, where the crude oil market would remain meaningfully affected.

Equities could benefit from the U.S. avoiding a recession

While we see a real possibility that the U.S. equity market could lurch into a more unsettling correction, and carry other global equity markets with it, we don’t expect the U.S. economy to be the cause. We believe the positive impulse of the 175 basis points (bps) of U.S. Federal Reserve (Fed) rate cuts over the past 17 months will go on providing useful stimulus for some months to come, as will the estimated USD$50 billion of additional tax refunds arriving this spring. Meanwhile, large and small businesses plan to hire more, pay more, and boost capital spending.

For now, policy uncertainty is receding as the tariff picture looks to be largely fixed as post-Supreme Court ruling levels out—perhaps beyond the midterm elections. Consensus U.S. GDP growth estimates are now sitting comfortably in the 2 percent to 3 percent range, a pace of economic growth which has typically delivered low double-digit S&P 500 returns.

Rising gasoline prices, especially if they don’t dissipate quickly, pose the biggest threat to this constructive GDP outlook. The bottom half of U.S. households, already contending with elevated food prices and utility bills, had been having difficulty making ends meet before Iran.

U.S. midterm elections

Historically, midterm election years have not always been the strongest period for U.S. stock market performance. In the 23 midterm years since 1934, markets have experienced a noteworthy downturn with an average peak-to-trough drop of over 20 percent, typically followed by a robust rebound that went on to set new highs.

On balance, we would be more concerned about the prospect for a market downturn in the coming months if the U.S. economy looked to be heading toward recession. However, easing monetary conditions, steady employment prospects, the continuing flow of largesse from the One Big Beautiful Bill Act (OBBBA), and solid capital expenditure plans suggest that any profound economic weakness is unlikely to materialize over the coming year.

The Canadian economy is faced with many of the same challenges as the U.S. and then some—trade and tariff uncertainty, soaring gasoline prices, falling property prices and the continuing burden of mortgage renewals at rates that squeeze household budgets. On the other hand, interest rates are much lower in Canada because our fiscal deficit is a fraction of being run across the line and our balance sheet is arguably more sustainably positioned. This leaves government in a position to provide long-term fiscal and policy support for major project developments—some of which could see shovels in the ground in 2027.

Fixed income

We expect both the Fed and the Bank of Canada (BoC) will “look through” the inflation induced by the disruption of crude shipments for at least a few months.

The bond market has a mind of its own, but both government and corporate yields have risen only modestly in response to the outbreak of hostilities in the Middle East. That said, we expect bond yields will move higher and yield differentials between lower quality and high grade debt widen further for as long as tanker traffic out of the Persian Gulf remains restricted. If that were to change, those expected higher yields could present an opportunity to lengthen term in portfolios.

Invested but watchful

We currently expect the stock markets will set more new highs later this year. However, there is a growing possibility that the Iran conflict will demand a longer U.S. military commitment, together with the unfortunate history of stock market corrections typically occurring during U.S. mid-term election years suggest that some more extended market pull-back may turn out to be part of the roadmap to eventual higher ground for the major indexes.

For our part, we think portfolios should remain committed to equities up to but not beyond an investor’s long-term targeted exposure.

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