Welcome to RBC’s Markets in Motion podcast, recorded June 16th, 2025. I’m Lori Calvasina, Head of US Equity Strategy at RBC Capital Markets. Please listen to the end of this podcast for important disclaimers.

The big things you need to know: First, the conflict in the Middle East comes at a complicated time for the US equity market, as our sentiment and seasonality work has been suggesting stock prices could keep moving up, while our valuation/earnings and GDP analysis has been suggesting that the stock market has gotten ahead of itself. We highlight the three potential challenges we see for the US equity market from this conflict, which we are monitoring closely. Second, we revisit our four tiers of fear framework, which helps us map out potential downside in US equities from the conflict, particularly if conditions escalate and broaden out. Third, Energy and Materials seem most likely to outperform if the conflict results in a sustained oil price spike, while Consumer Discretionary and Communication Services seem most likely to underperform. We’re also keeping an eye on Utilities and REITs as potential, tactical outperformers.

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Now, let’s jump into the details.

Starting with Takeaway #1: What the escalation means for US equities broadly…the conflict in the Middle East comes at a complicated time for the US equity market, as our sentiment and seasonality work has been suggesting stock prices could keep moving up while our valuation/earnings and GDP analysis has been suggesting that the stock market has gotten ahead of itself, keeping us on guard for a pullback

• As we’ve discussed recent developments in the Middle East with RBC’s Commodity Strategy and MENA research team, two key risk factors for US equities have come into focus for us: their view that the conflict could take some time to play out, and the risk that it evolves into a broader, regional conflict.

• The broader the conflict becomes and the longer it lasts, the more problematic we think it will be for US equity markets. We see three potential challenges for the US equity market, which we are monitoring closely.

1. First, historically, heightened uncertainty on national security policy tends to put downward pressure on stock market valuations,

2. Second, we’re worried the situation in the Middle East could derail the sentiment recovery that’s been underway, as seen in a number of recent investor, consumer, small business, and C suite surveys – we think this issue matters a great deal as the recovery in sentiment has been one of the most important drivers of recent stock price action, and

3. Third, we are obviously watching oil prices – a major, sustained spike could impact headline inflation - which our Econ team notes could muddle the Fed’s inflation outlook, and which our own modeling suggests could put downward pressure on equity market valuations. It could also add to angst over growth at a time when tariffs impacts may be starting to hit.

Question #2: How much could stocks get hit?

• To answer this question, we found ourselves looking back to the “Four Tiers of Fear” framework that helped us navigate tariffs in March and April.

• Tier 1, a garden variety pullback of 5-10%, seems on the table. We’ve seen this kind of reaction around big episodes in this conflict before. The October 7th attack came in the middle of a 10% drawdown, sparked by a surge in 10 year yields, with half of the decline coming after the attach. In April 2024, there was also a series of strikes in this conflicts which occurred against the backdrop of a 5% decline in the S&P 500.

• Tier 2 and Tier 3 our “Four Tiers of Fear” framework are not our base case, but risk scenarios that we’re monitoring.

o Tier 2 is a growth scare, or 14-20% decline which is what we went through in April. If recession fears start to percolate, a retest of the April lows is reasonable to anticipate. Also, we’ve run a new inflation stress test on our valuation model – if we bake in 4% inflation on PCE, just 2 cuts from the Fed, and 10 year yields around where we are now, our modeling points to 4800-5200 on the S&P 500 as fair value, depending what earnings are used, which is basically the tier 2 range.

o Tier 3 on our framework is a recession type drawdown of 27-32% (median/average) vs. peak. Major wars in recent decades – the US invasions of Afghanistan, the US-Iraq wars, and the Russian invasion of Ukraine in 2022 involving the U.S. have been associated with recession or looked like them in terms of stock market pricing.

Wrapping up with Takeaway #3: What do we buy if conditions in the Middle East escalate further?

• We took a look at the relationship between sector performance and oil prices since 2010. It suggests that Energy and Materials are the most likely to outperform if the current situation in the Middle East results in a sustained oil price spike, while Consumer Discretionary and Communication Services are most likely to underperform.

• Two other sectors to keep an eye on in this scenario are Utilities (which was the second best sector performer in 2022’s oil price spike; it’s also a sector we’ve been overweight in 2025 as a defensive hedge, earnings revisions have also been strong relative to other sectors)….

• …and REITs (we’ve been cautious on this sector, but funds flows are improving).

That’s all for now. Thanks for listening. And don’t forget to vote!