The Upside: December market moves with Denise Chisholm

[00:00:17] Jordan Chevalier: Hello, and welcome to The Upside. I'm Jordan Chevalier. It's all eyes on the Fed ahead of the latest rate decision announcement. If there is a rate cut how will that cut shape the markets, and are there still tariff related challenges to come? Joining us today to talk interest rates, U.S. equities, tariffs, and provide a sector update is Fidelity Director of Quantitative Market Strategy, Denise Chisholm. Hi Denise, it's great to see you.

[00:00:43] Denise Chisholm: Hey Jordan, it's great to be back.

[00:00:45] Jordan Chevalier: Let's start with your current read on the U.S. equity story. I think unsurprisingly that was the most common question coming in. Let's look at U.S. equities, mainly U.S. mega-cap tech. What's your view on the current valuation story? Is there still upside opportunity there? What do you see?

[00:01:03] Denise Chisholm: I do, despite the fact that they're expensive, think that there is upside opportunity. I think that investors think quantitatively that because the stocks are expensive that that shifts your risk-reward lower in terms of giving higher odds of the technology sector underperforming. But you actually see the opposite in the data over the last 20 years, meaning that if you had to pick between high growth and high valuations that actually has better odds than high growth with lower valuations. Historically speaking, valuations don't get in the way of outperformance, in part because earnings growth tends to be so strong. It's almost like valuation correctly predicts the durability of earnings growth. As we look into 2026 we're seeing exactly that. I think that there are a whole lot of drivers behind the overall SP 500, but in particular for technology, to make that earnings growth durable. We had a tax cut, we have a capex recovery that usually generates growth, we've got a friendlier Fed and we've got oil prices still sliding. All four of those things are really strong tailwinds for earnings growth, and the more durable earnings growth is, the less likely valuation is to be enough to offset it.

[00:02:21] Jordan Chevalier: Looking now at rate decisions, there's two rate decisions this week forthcoming, both in the U.S. and in Canada. Focusing in on the U.S. it's looking like there will be another cut announced at this month's meeting. What should investors expect from the Fed over the next year? I won't look to you for the crystal ball and sort of imminent decisions but throughout the year what are you seeing, what can investors look for from the Fed there?

[00:02:45] Denise Chisholm: I do think a friendlier Fed, a Fed that is continually cutting interest rates rather than being on hold or hiking as we look over the next year, in part because tariffs didn't create the kind of broad-based inflationary impulse that the Federal Reserve expected. Even when we started the year I think that they had expected that inflation was going to come in around where inflation is coming in despite the fact that we actually had tariffs in the middle of the year that was unexpected. Tariffs ended up more like a tax to the U.S. consumer that had some offsets. Certainly many prices went up but there were a lot of prices that were actually decelerating as well, creating a net out where you might see a more normalized Federal Reserve, meaning that as inflation continues to decelerate they can continue to cut rates.

[00:03:34] I do think one interesting twist that investors should always remember is that I think that as we enter the year where we say, hey, we expect the Fed to cut rates, maybe the market is pricing in three or four cuts and it only ends up being one or two, is that going to be a problem for the equity market? You should always remember that we've seen that movie certainly over history and certainly a lot over the last three years. To the extent that the Federal Reserve cuts less than the market expects if it is a function of growth the equity market has no problem with it. Definitely don't make the math think that, you know, to the extent that the Fed doesn't cut as much as the market expects that means that there will be pressure on equities because it's the opposite of what you usually see historically. If the Fed has to cut less usually that means growth has been stronger so it's not necessary, which is usually good for the equity market.

[00:04:28] Jordan Chevalier: Are there key indicators that investors can look for that signal maybe this sort of thing is coming to fruition, or this kind of shift is about to take place?

[00:04:39] Denise Chisholm There are two overall indicators that I'm watching into 2026. One is credit spreads which we talk about a lot. That's just the yield that investors are demanding on high yield or junk bonds relative to the risk-free rate. There's usually a really good correlation between that and future bankruptcies or insolvencies. The bigger the credit spread you usually see, the more there's somebody out there concerned that there's going to be a lot of bankruptcies or that there might be an earnings recession. So far what we're seeing in the credit markets is the credit market's saying, yeah, yes, things are uncomfortable from an economic perspective but there isn't a whole lot of bankruptcy risk on the horizon. That usually means a very durable cycle.

[00:05:21] We're also seeing a capex recovery continue from 2022. Now, I'll define my terms. If you add up all the capital expenditures that we look at in the broader public markets, the Russell 3000, and you divide that by the sales that they generate, when that's upward sloping I'm calling that a capex recovery. That's something relatively rare since the financial crisis and it's a good thing historically speaking. When companies are investing in terms of capex relative to their sales base they usually create demand and create jobs. On a go-forward basis those are two things suggesting that the median earnings growth that we've seen finally inflect more recently joining the cap-weighted earnings recovery does mean that we likely have a very diffuse, durable earnings recovery driven by the fact that credit spreads are pretty narrow and the capex recovery continues.

[00:06:14] Jordan Chevalier: Looking now to tariffs, Denise. You've spoken a little bit about them but there seems to be a little bit of uncertainty maybe around investors, specifically around supply chain disruptions. It's a question just coming in now, can you speak a little bit about that relationship between tariffs, how they're being priced into the markets and if there's potential for supply chain disruptions and what that could mean?

[00:06:36] Denise Chisholm I don't think tariffs are going away even despite the Supreme Court, we'll get that decision soon-ish, I mean, certainly by the end of June. The variability around with tariffs that the administration has a bunch of other methodologies that they can use instead of the IEEPA tariffs that it's now under. I don't think tariffs are going away, which means that supply chain disruptions are not going away either. That doesn't mean that it's a headwind enough to offset all of the tailwinds that we just talked about for the equity market. When you think about how tariffs evolved even coming into this year, I think that the downside case that many investors expected was really onerous global trade situation and a really hefty tax on U.S. consumers and an inflationary impulse, none of which we saw given that the size of the tariffs were about a third of what were originally announced. As much as yes, these headwinds will still be around they are less onerous than the market digested during that almost bear market in April. The longer we go the more corporate profits grow, the more consumer real income grows, the more likely you are to be able to absorb the disruptions that will likely come your way. This is to say that it's not all good news as we approach 2026 but you don't need all good news for the equity market to actually advance. In some ways the market can climb that wall of worry and that's some of what we're talking about of late.

[00:08:05] Jordan Chevalier: There is that resilience that we've seen, everything that you're seeing sort of indicate that that will continue, at least in relation to tariffs and that story.

[00:08:14] Denise Chisholm Yes.

[00:08:15] Jordan Chevalier: This is a very interesting question, actually. Someone's asking, can you explain the VIX? They hear you mentioning the VIX and what that measures and what the sort of current VIX index reading is telling you about the equity story. A little bit of a broad question but I think a lot of people at home would love to hear your thoughts on that.

[00:08:34] Denise Chisholm The fancy definition is the VIX is an indicator of implied volatility. What that means in practice is that it's just basically looking at all the options pricing and the options pricing is contingent on market volatility. It's a whole bunch of investors predicting future market volatility. In some ways in that way you can call it a measure of fear because if people are betting on more volatility that means they are afraid of that downside volatility. That's why you get this contrarian indicator, the more fear there is the more upside there usually is in the market. We saw that very clearly in April, which is to say I think the VIX hit 50 which is in the top 1% of all historic instances since 1990, since we had the VIX being measured. That is usually what we call a hold your news and buy signal, which is not to say that it's the bottom of the market, although it happened to be on Liberation Day, but it is to say that if you take a long term view over 12 to 18 months you usually make money when the VIX is at top decile levels like that.

[00:09:35] The issue I hear people get wrong from a quantitative perspective is well, if high VIX is fear, and that's a contrarian indicator and I want to buy that, that must mean the symmetrical signal is to sell a quote, complacent, or low VIX. That's actually just not true historically. The signal is monotonic, meaning that the higher VIX is, the more fear there is, the more likely the market is to go up in your face, but that is to say that low VIX or a complacent market is the sweet spot for average equity returns, meaning that if you charted the secular bull markets and you shaded all the areas that had a bottom quartile VIX, which is I think what we are around now, we're certainly below average VIX levels so people would say it's complacent already, that's actually the lion's share of the secular bull markets. The two sweet spots for equity investors are when VIX is really high and people are already afraid, or when the VIX is quote, complacent, meaning that there's not a lot of volatility because maybe there's durable earnings growth or there's some durable story.

[00:10:39] The interesting part is both of those situations are the best probabilities of the equity market going up. In 2026 we just directly bounced between the two most of the year. We sort of, you know, got out of that muddy middle which is where you see a reduction in market odds. Remember that VIX signals are not symmetrical. Yes, elevated fear usually means there is opportunity, and for quantitative investors like me you sort of run towards that fear, but it doesn't mean that a complacent market should be sold and that mean equities will deliver below average returns either.

[00:11:13] Jordan Chevalier: Denise, I'm glad we asked that question because I think that's the most detailed and nuanced explanation of the VIX that certainly I've ever come across. I know investors at home watching will really appreciate that so thank you very much. We have a tradition here. We kind of end the show with a top three, bottom three sector updates. Let's move to that now. What kind of sectors are on your radar heading into 2026? Let's start with the bottom three and then we can shift to your top three.

[00:11:39] Denise Chisholm Bottom three I'd say consumer staples, utilities and energy would be my bottom three. It's all around, I would say, fundamentals, weak fundamentals. I still think that there is continued oversupply in energy. I think that the companies are over-earning relative to history which creates more downside potential than other sectors. Consumer staples still have margin pressure. This is not the stable sector that it once was in the '80s where it was offence and defence. That looks more like technology, which we'll get to in the top three. I think fundamentals will continue to lag as we go into 2026. Utilities has gotten a bid from a closet AI play but when you look at the data, yes, there are stocks within it that are power oriented but utilities as a broad-based sector, if you're owning the entire sector or the XLU or some broad-based ETF, that is very much a defensive sector. To the extent that the market delivers above average returns, above 8, that's sort of the average return historically, I think utilities are still likely to underperform.

[00:12:41] Jordan Chevalier: The top three, what are we thinking for your top three? Let's end there.

[00:12:45] Denise Chisholm Top three, tech, tech and more tech, because it is the dominant in terms of earnings growth. I do think that that earnings growth is durable. I'll also add in consumer discretionary and financials which are usually my big three. I think we talked about them last time so there's really no change there. It's all around the fact that I think both valuation and earnings growth are on your side for consumer discretionary. Financials is very similar. Relative price-to-book is bottom quartile for the financial sector overall, and specifically for banks, although brokers and capital markets tend to have the most upside as it relates to a secular bull market, which I still think we're in.

[00:13:22] Jordan Chevalier: Denise, thank you very much for taking the time. As always, it was great to have you and have an excellent rest of your week. We'll see you next time.

[00:13:29] Denise Chisholm: Yeah, you too. Thanks so much, Jordan.

[00:13:31] Jordan Chevalier: Thanks everyone at home for watching. Just a reminder that the Upside webcasts, they do air daily so keep an eye on your inbox so you don't miss your invitation to the next show. If you haven't done so already sign up for The Upside newsletter so you don't miss out on future updates. Video podcasts are also frequently released, both The Upside and Fidelity Connects. Just search Fidelity Canada on YouTube, Spotify and Apple Podcasts. Thanks for watching. I hope you'll join us again on The Upside. I'm Jordan Chevalier.