Certain uncertainty

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 labouring 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.