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The bones of this economy are still ‘very strong’, strategist says

Lori Calvasina, RBC Capital Markets Head of U.S. Equity Strategy, joins Yahoo Finance Live to breakdown how markets are faring on Friday, S&P 500 forecasts and China's Evergrande crisis.

Video transcript

BRIAN SOZZI: Investors have had to digest a lot this week besides the debt ceiling debate. FedEx dropped an earnings warning, Nike cut its sales outlook last night, the Fed signaled its long-awaited bond tapering program, China's Evergrande is hanging by a thread. Lots going on for sure this week. Let's get a pulse of the market with all this volatility in mind.

Lori Calvasina is the head of US equity strategy over at RBC Capital Markets. Lori, Good Friday morning to you. Lots for investors to digest this week. What's your current thinking on the market?

LORI CALVASINA: Sure. Look, we've been looking for a short-term pullback in the market late this year for quite some time. I know a lot of other strategists are starting to make that same call as well. But you know, this is something frankly we had expected to happen simply because we were seeing earnings growth decelerate off these unbelievably kind of crazy highs that we had in the second quarter. And typically when you come out of a recession and that happens you do see stocks sell off a bit. You tend to be down modestly on a six-month forward basis after that peak rate of change in S&P 500 EPS growth.

Now, the other things that are happening right now is that we've got a lot of uncertainties abounding on other issues, whether it's in the governmental side, whether it's in terms of the COVID backdrop, a lot of uncertainty still about the Delta variant. And then supply chain issues obviously, are becoming a big topic, not just with the early reporters this week but we heard a lot about that in the post-Labor Day industrial conferences that happened around the Street. So there are just a lot of small things that maybe on their own could be manageable for investors that are starting to really sort of chip away to the downside here. But again, I don't think this is anything to be overly alarmed about. We typically have a pullback right around this time in recovery trades anyway.

JULIE HYMAN: Hey, Lori, it's Julie. So just to be clear, a lot of the folks that we were talking about sort of are echoing what you're saying in that they were looking for some kind of a pullback but most of them expect then a recovery. Your target for the end of the year I believe is still 4,325. So that implies that we're not necessarily going to see a recovery here. What sort of keeps-- what are the weights, the persistent weights you think on stocks continuing to go up here or rebounding here?

LORI CALVASINA: We did actually recently pull our number up to 4,500. And so we've said you know, expect sort of a 5% to 10% drawdown from the highs that we saw earlier this year, which is a little bit above where our target is. But look, I think as we sort of get a little bit deeper into this, right? I think the question is, what do you do with it, and does it have the potential to be something more nefarious than a 10% drop? And of course, that possibility is always out there on the table, right? True growth scares end up kind of taking markets down kind of 15%, 16%, 17%, right? So that's not an unreasonable assumption if we really start to anticipate something really bad economically. I don't think we're going to do that.

But look, I think the question going forward is what kind of economy do you think that we are going to have next year. And what I think is very comforting to me is that as I've looked around the Street and I've seen some of the economists who have pulled their numbers down for this year, it's not really affecting forecasts for next year. So we've seen US GDP in real terms go as low as about 5.9% or so for this year, if you're just averaging up the consensus annual numbers around the Street, and that's a big dip from where we had been, which was kind of like a mid-6% type number. But we haven't seen any of the quarterly numbers go anywhere sort of below trend. We have not seen sort of next year's numbers really even take a big hit. Next year expectations are still for a 4%-plus type economy, and that's well above trend.

So I think that as long as the consumer can hold up, as long as the corporates can hold up. And with these supply chain pressures that are being discussed, we are also hearing a lot about how strong demand is. So we do think that the bones of this economy are very, very strong. We have to digest some of these short-term issues like supply chains that were perhaps underappreciated but I think the sort of strong consumer backdrop, the strong corporate backdrop, the strong demand is going to pull us out.

BRIAN SOZZI: Yeah, I'm glad you mentioned supply chains, Lori, because it's something Nike talked a lot about last night. And frankly, their commentary was rather disturbing, inflation in the supply chain, and also they just can't get a lot of their goods. Is that one of the biggest risks in terms of the supply chain, is that one of the biggest risks for this quarter in terms of economic growth?

LORI CALVASINA: I think it's a risk more to earnings. And if you think about it from a margin perspective, right, like sort of any big hit that we make to profit margins can pull your EPS growth numbers down pretty significantly. But I have to tell you, Brian, like we were reading through transcripts back in August, and while I'm not going to disagree with you that the tone on supply chains has gotten a little bit more alarmist here recently, people who were paying attention to the commentary that came out in August, sort of late, mid-August, and kind of the later reporters, we were getting a glimpse of this.

You know, what we've done on my team is try to figure out not just you know, why supply chains are so bad, right? Like I think we all sort of understand that freight costs are through the roof. There's a lot of port congestion. There are labor issues. There are plant shutdowns. There are semi issues, we get all those things but what gets us out of this?

And one of the things that we found on our team when we really tried to think ahead was that if you look at the relationship of global COVID cases, the rate of change and you compare that to the rate of change in shipping costs, global COVID cases have been a loose leading indicator for those freight shipping costs. And that's not to say that we're going to turn the corner anytime soon but we are seeing a good improving trend at the global level on COVID cases. It's been more of a plateau in the US but globally things are getting better and that does portend some improvement in freight costs down the road.

BRIAN SOZZI: Well, that raises my other question here, Lori. We've heard from a lot of strategists this week that the fundamentals of the market remain intact for stocks to go higher next year. But when I hear Nike call out higher inflation, I hear Costco call out of higher inflation. I saw FedEx really a terrible earnings warning from them this week. A lot of these concerns at least to me, seem like they will carry on into next year. So is the backdrop really fertile for stocks to go higher over the next 12 months?

LORI CALVASINA: I think that you can have a short-term period of digestion. But remember if you look at our target so we're at 4,900 for next year versus an ending point let's say of probably around 4,500, which is our target for this year. That's a 9% gain. That's very much in line with the average return over time. And when we look at our models, the GDP forecasts that we have, you know, whether we're looking at our own internal models or the Street, are telling us that that's about where the market deserves to end up from an economic perspective.

So the question is, are these short-term margin pressures going to damage earnings? Perhaps. Perhaps some of it's baked in, perhaps some of it still needs to come in but I will tell you again, Brian, that just because people are paying a little bit more attention now, does not mean that some of these issues were not well telegraphed. Like we saw in the last reporting season again, more the middle to the tail end, we saw companies talking about how 2022 might be the time that you would see an alleviation of the pressures on the supply chain. We saw some companies say that they simply didn't know. So I know that chorus has gotten louder but some investors were paying attention and already starting to digest this in August.

JULIE HYMAN: Hey, Lori, two things that I think we didn't mention in this conversation, one of them is the Federal Reserve interestingly enough, and the other is China. And some of the recent concerns around Chinese growth that Evergrande sort of highlighted, even though perhaps that's not really the actual problem that people are worried about. Are you concerned A, about tapering and rates going up, and B, about Chinese growth as pressures on the US?

LORI CALVASINA: So I'll take both the questions separately. I would say in terms of tapering, I really feel like a lot of this got priced-in in the second quarter. If you go back and look at the last tapering episode in markets. We did have some initial indigestion in the direction of the S&P when it became clear that that's what the Fed was going to do but it really didn't end up damaging markets. We saw stocks continue to climb higher through the taper.

What you did see was the risk trade took a bit of a hit. So we started to see growth leadership take back over, small cap leadership was ceded back to back to large caps. And we saw a lot of that already play out in the second quarter. And if you think back to March, April of this past year, we saw a lot of economists think the Fed was behind the curve and needed to taper and sort of made a strong impassioned case for why they needed to move their timetable up. So I think a lot of that has already played out, to be honest.

Now, when I think about China, I think the main sort of risk that our internal people have flagged, our FX strategy team has done a tremendous job monitoring the Evergrande issue but what they've told us to be most concerned about is the possibility that this leads to slowing domestic growth in China as opposed to some sort of big contagion event that could unravel financial markets.

And when I think about that as a US equity strategist I have two questions, one, how bad is it going to get? What is it going to cause the hedge funds to do? Is it going to cause them simply to move money out of China and back into the US? That ends up affecting the tech sector oftentimes.

Or is it simply going to-- this would be my second question, is it going to simply cause them to take money off the table and move back into cash? That latter scenario is what you worry about damaging US equity markets. If we simply have a situation where we've lost some appeal of non-US markets from a fundamental perspective and the US still looks like the best game in town economically, that actually can help boost and sort of bolster the S&P 500 and limit some of the downside.

BRIAN SOZZI: You, Lori, do a tremendous job. Appreciate the insights. Great stuff as always. Lori Calvasina, head of US equity strategy at RBC Capital Markets. Have a great weekend.