Top of the Morning: CIO Strategy Snapshot - Sentiment drivers

Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. The string of nine consecutive positive weekly returns for the S&P 500 ended last week, with Friday being one of the worst days all year after the release of the May jobs report.

Joining me here today in studio to talk about recent price action, jobs data, the market response and what it all means for the investment outlook, glad to welcome back from the UBS Chief Investment Office, Head of Asset Allocation for the Americas, Jason Draho. Jason, good Monday morning to you. Thank you for joining us.

Great to be back at the table with you today. Good morning, Dan. Happy Monday.

Good to be here. So Jason, let's begin with that market performance on Friday. It was not a good day, but can you provide more color on what exactly happened?

What drove investor sentiment? So I think we've taken a step back. It's just helpful to understand what happened, but also looking at the setup going into this.

And say it was sort of a kind of a technically challenged setup prior to going into Friday. Just some data points here. The S&P 500 had rallied 15% in the two months prior to Friday.

That puts it at the 99th percentile of two-month rallies since 1980. So very, very strong performance. And if you think about volatility was relatively mutant, so if you measure it versus kind of a total return versus realized volatility, that ratio is almost like a 4 to 1 ratio.

That's about the strongest in the last 50 years. So really strong performance. Investors were sort of almost chasing the upside, and you can look it up as they use puts and calls to kind of get exposure.

Normally people are buying puts. That's downside protection versus calls to get upside protection. In fact, what we had is essentially is inverted.

People are paying more to get the upside than they were at the downside. So there was a lot of sort of chasing of this performance. And then just the SOX Semiconductor Index, it was trading at 76% above its 200 moving day average.

That's the highest since March of 2000. So just that's the context going into Friday. And it wasn't just a jobs number, like for those of us in the U.S., you get the jobs numbers come out.

You think that's what was the key driver. It certainly was a factor. But even prior to that, kind of overnight, there was weakness in semiconductor stocks starting in Korea.

Korean equities were down nearly 7% overnight coming into Monday morning. Earlier in the week, Broadcom, one of the major U.S. semiconductor companies, was already trading down like 13% on fine numbers. But of course, the market expectations have become quite high.

So you had sort of weakness in semiconductors that sort of further manifested. So that SOX Semiconductor Index, it was actually down 10% on Friday. So it had performed very well.

So even without the jobs number, there's probably some weakness we would have seen there. If we turn to the markets overall, the S&P was down 2.6%. But an equal weighted S&P 100, this sort of equal weights every constituent of the index, was down 1.45%.

NASDAQ was down over 4%. So a pretty kind of narrow market, heavily skewed towards semiconductor stocks like the MAG 7. It was down 3.6% on Friday versus the other 4.93% down 2.5%.

And just another, I'm barraging you with some stats this morning, but I'll give you one more statistic. Since 1999, there are 284 days in which the S&P 500 is down at least 2%. In 282 of those 284 days, the advanced decline ratio, meaning like the number of stocks that are advancing versus declining, was always below minus 155, meaning far more stocks were down than up.

On Friday, it was only minus 21, meaning it was almost a close to a balance of those who were actually positive versus negative on a day that was negative overall. So it just tells you it was a really kind of concentrated, narrow sell-off, but also had been a pretty narrow rally on the upside. So those are the conditions.

Obviously, the jobs data, we'll get more into that, was a key factor. We saw interest rates kind of across the yield curve going higher. The two-year went up 10 basis points.

Five-year was up eight basis points, the 10-year up five basis points. So clearly, investors worried about a strong economy, inflation, higher rates, and that was kind of called the further catalyst that caused the sell-off on Friday. But the setup was challenging, and the semiconductor sector was also kind of a key driver.

And then sort of the cherry on top was that jobs data that caused a repricing of rates. Well, I'm sure many of our listeners appreciate a good stat. It was very helpful to paint the picture, provide some context, well-needed, just given that move on Friday, Jason.

Though let's dig into this a bit deeper. You did mention that weakness in semis already began before the jobs report came out on a Friday morning. But what were the details of that May jobs report that amplified the move?

Well, it was definitely better than expected. So it was 172,000 new non-farm payroll jobs. The consensus was 88,000, so pretty basically like exactly double.

But in addition to that, the prior two months for March and April were revised higher by a combined 93,000. So if you kind of add it up, almost close to 200,000 sort of beats in terms of how many jobs were created. As a result of the May jobs report, if you take the three-month kind of average, moving average of how many jobs are being created, it is now at 188,000.

Prior to the jobs report, it was at 48,000. So a big jump in terms of the momentum and overall kind of job growth in the past few months. It was kind of skewed again more towards government but also leisure.

So a lot of thought that perhaps hiring before the summer, before the World Cup. There was some pickup in activity there. And it wasn't, let's say, a broad base of dip, but it definitely wasn't very, very narrow.

So a strong beat in terms of the overall headline numbers. The unemployment rate did tick down for basis points to kind of around at 4.3%. And that was driven more by sort of employment gains than sort of any sort of decline in the labor force.

So again, directionally another sort of positive development. But it was also the case that the average hourly earnings actually decelerated. That fell to 3.4% year-over-year.

The prior month, that was at 3.6%. So again, it's not really sort of strong job market in terms of leading to higher wage growth. But we do see a sort of broadening out of income overall.

So hours worked but also income going up means that it continues to run a little over 4% if you think about overall wage income. So strong report. This came after also a JOLTS job opening survey earlier in the week that also had beat sort of expectations.

That's very noisy. But still, the labor market data last week would suggest that not only we've seen sort of stabilization in the labor market but definitely looks like a little bit of acceleration from the softness towards the end of last year. So that covers the labor market.

If we focus in a bit on the inflationary environment, we will have some key inflation data coming out this week. Though, Jason, you mentioned the concern that the economy may run too hot. That could cause inflation to be sticky.

Is that a legitimate risk? I think we need to sort of think about the jobs data and the economic data we're getting. In the first week of January, if we were sitting here, the expectation was the economy would accelerate in the first half of this year because you had the stimulative benefits of the one big beautiful bill, the tax cuts, higher tax refunds.

There was also the headwinds from the tariffs from last year. That should be abating. So faster growth in the first half of this year, particularly in the second quarter when the full benefits would kick in, this shouldn't be surprising.

I guess it's surprising in the context that oil prices are up over 50%. So people, investors weren't assuming it but let's say the contours of growth are consistent with what we would anticipate earlier in the year. If we then look at some other economic data like sort of economic surprise indices, they have been moving higher.

In fact, there's a Citi economic surprise index that's widely followed. It's the highest it's been in over two years. So you're definitely seeing sort of a pickup in growth.

But as I mentioned, this is not surprising. There was a policy tailwind on the fiscal front. We also had an easing of financial conditions for much of last year and to the start of this year.

That leads into higher growth. The whole wealth effect of stock prices going higher, consumers will be able to spend. So again, an uptick in growth that we're seeing right now is not surprising.

The question is whether this can continue and what we have some conviction is that these policy support is going to ease. So for example, the fiscal tailwind is already probably going to pass its peak because a lot of that was predicated on higher tax refunds. Those tax refunds have occurred.

Consumers now, two months later perhaps from when they got it, have probably spent that money. So that sort of impulse plays out. The kind of impulse from easing of financial conditions, again, that sort of probably is peaking now.

So even if the markets stay where they are at these levels, the delta for financial conditions spurring growth, that starts to ease off again in the second half of this year. So policy won't be as supportive later in the year, which is why we'd also think that growth ultimately will slow later into this year. And even on the AI investment story, this is a key driver of a lot of investment that's lifting growth that is kind of cascading throughout some of the economy.

But there are also supply constraints in sort of like some of the semiconductors. So there's limits to how much that can actually physically can kind of ramp up. And so all that suggests that growth is more likely to moderate towards in the second half of this year and even looking into next year.

And so these concerns about overheating or running too hot, well, at least the policy environment is not sort of conducive. It doesn't mean that it can't stay relatively strong and resilient, but we just have to have the context that part of what we're seeing right now is a result of policy support. Without policy support, it's going to go away.

So as far as how the Fed is interpreting this all, the market is pricing for a Fed rate hike as soon as December. Interesting. What actually, Jason, has to happen for the Fed to hike and how likely is that?

So before the jobs report, going back a week or so ago, the market was pricing in a fall hike by April of next year. That's been pulled forward, as you mentioned, to December. And now the market, as of Monday morning, is pricing in 1.6 hikes by June of 2027.

I'd say that the bar for them actually hiking is quite high, even if cuts become less likely or get pushed off further into the future. So in order for them to hike, we think some of the criteria has to be economic growth, GDP growth has to be running at 2.5% or higher. You have to have a decline in unemployment rates, so like maybe down to 4% from the 4.3%.

And then wage growth, as I mentioned, instead of 3.4%, it starts to tick back close towards 4%. And then also inflation expectations have to kind of move higher to the point where the Fed is getting concerned that could inflation expectations become unanchored. And at the moment, none of those conditions hold.

It's possible, but I'd still say it's quite unlikely. So we get, in nine days from now, the next FOMC meeting decision. It's unlikely they'll do anything, hike or cut.

What we should look for is any change in the statement from the committee, and it's likely to shift to a balanced tone. From April, it was more sort of like the bias was further adjustments, implying cuts. Now it's likely to say something that's kind of more balanced, meaning a hike or a cut.

So this is, and it's also, I'd say, that's more aligned into where the market price already is given the market's pricing for a hike. Now we get some other important key data. As you mentioned, inflation data for May this week, as well as retail sales, we'll get a sense of just how hot is the economy.

And that could influence some of the language that the Fed has officially. But also Kevin Walsh, this is his first meeting as Fed chair. Presumably he will give a press conference.

And again, his comments could assuage the market, he could sound hawkish. There's certainly some uncertainty there. So ultimately, I think our bias is still the Fed is going to cut rates.

We reassess as information kind of comes in. We're thinking December, that course could get pushed out potentially. But the key thing is that it's much more likely that the next move from the Fed is still a cut rather than a hike.

Even if a cut does not take place at some point into 2027, I think the bar is higher for them to want to hike than it is for them to want to cut. Well, helpful clarity, Jason, on CIO's view. Now even if the Fed doesn't hike, higher rates can still, of course, be a headwind for risk assets.

So with that, Jason, what do you think the latest move higher in rates means for the markets? Well, the move higher on Friday that I mentioned, they're down slightly as of Monday morning. It's consistent with some other episodes where we've had sort of like a – is good data bad news for the markets because is it a sign the economy is running too hot?

Is it overheating? Especially after other payrolls reports. So since 2010, there's been eight sort of episodes in which you got a hot jobs report better than expected in which either the job growth was higher than expected, wage growth was higher than expected, and it led to a situation where yields went up and stocks went lower.

And that doesn't count what happened on Friday. Now in six of those eight situations, ultimately, the equity markets kind of recouped those losses or traded sideways within the next couple of weeks. Only in two other episodes back in February of 2018 and June of 2022 did you actually get further declines in equities and tech stocks in the next couple of weeks.

Now when that happened, it usually was the case of a combination of you saw treasury yields go higher, but also you kind of had weak growth data. And particularly I mentioned the economic surprise indices have been trending higher at the highest they've been in a couple of years. In these prior situations where equities continue to suffer, it was – the data had been centrified to the downside.

So it was a little bit confusing. The data wasn't great. You got a jobs report that was relatively strong.

The data wasn't quite sure what to make of it. Rates went higher, but ultimately that proved to be more of a one-off. It does feel like we are more in the six of eight situations where the data has been relatively resilient.

You got a strong jobs data point and ultimately, again, the market sort of digested. Rates going higher because the economy is doing fine is not necessarily a bad thing for equities. It's a fundamentally positive story.

If rates going higher with the economy is bad because there's inflation, then that's the real concern. And that does not appear to be the case. So it will take data this week, the Fed meeting to kind of get a bit of clarity like maybe how this will play out near term.

But the fundamental story is, again, suggest the economy is holding up relatively well. Higher rates because of an economy doing well is not necessarily a bad thing, especially on a medium-term outlook. So Jason, a lot out there for investors to consider at the moment as you laid out for us.

Let's end today on portfolio positioning. What is the investment outlook from CIO at this time and what should investors be doing? Well, first off, the good economic data, the good jobs data, that's not necessarily bad news over the medium-term.

In fact, I think it's generally not. It's going to ultimately be good news for the economy in the medium-term. And likewise, if we think about the fundamental story in AI and semiconductors, it's been very positive.

Recently, we've seen other earnings revisions going higher, other companies in the broader complex of kind of semis in AI, not just the Mach 7 also benefiting. So there's a positive long-term fundamental story. They just moved very, very quickly, rapidly, and probably got a little bit over their skis.

So I think that's kind of some context for what happened late last week. From a more medium-term outlook, ultimately, we think the main inflation data that we get this week, probably the highs, then they would actually start to kind of moderate, large part because the oil prices have not sort of gone further. So the kind of year-over-year, month-over-month numbers should start to kind of roll over.

Again, the fundamental story should be kind of positive for equities. And then say also investor positioning, broadly speaking, wasn't sort of extreme. So some of the technical indicators are just how far prices have run up.

That would suggest there's some vulnerability. But on the whole, in terms of investor positioning, it wasn't as stretched as it was as versus late February. And there are any sort of market pullback, I would suspect that there'll be investors who'd be willing to like kind of buy to upgrade.

If you miss some of this extreme run-up, here's a chance for me to re-engage. And as of Monday morning, you're seeing equities a little bit higher as a result. In terms of a kind of more specific guidance, one of the messages we've been having emphasized in a sort of diversity across equities, it was a pretty narrow rally.

I gave a bunch of stats at the top of the call to kind of indicating that that was a good chance to take some profits, kind of rebalance. And it's what happened in the past couple of days. It sort of reinforces that view.

One of the sectors that we like is healthcare. And on Friday, it was positive. Last week, it outperformed.

It has fundamental reasons, but also an indirect beneficiary of AI. So again, thinking about how do you play the scene that makes you less concentrated. There are other opportunities in healthcare in the U.S. is one of those examples.

And then just on fixed income, the overall message there is kind of stick with higher quality intermediate duration, five to seven year or less fixed income, because rates can back up very quickly. And so especially at the back end of the curve, you can see those rates going higher. No reason to take a lot of interest rate risk at this point in time.

Well, Jason, very helpful conversation this morning, just given everything out there that's influencing markets, always very helpful during these periods of volatility to have a good understanding as to the drivers and how to position accordingly. And of course, what the investment outlook is from the chief investment office. So thank you again, Jason, and I look forward to picking back up with our conversation next Monday.

Well, you're welcome. Have a good weekend and go Knicks. Go Knicks.

Thank you for tuning in. Be sure to visit UBS.com slash studios to view the entire UBS studios suite of podcast channels along with our video offerings, such as UBS trending. You can also follow us on Instagram for content highlights at UBS trending.

UBS studios is part of the UBS chief investment office within UBS global wealth management. Visit UBS.com slash CIO to view the latest research UBS chief investment office's investment views are prepared and published by the global wealth management business of UBS AG or its affiliate UBS. This material has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is published for informational purposes only.

As a firm providing wealth management services to clients globally, UBS AG and its subsidiaries offer both investment advisory services and brokerage services. Investment advisory services and brokerage services are separate and distinct, differ in material ways and are governed by different laws and separate arrangements. In the USA, UBS Financial Services Inc. is a subsidiary of UBS AG and a member of FINRA SIPC.

For information, please visit our website at UBS.com forward slash working with us. For a full legal disclaimer applicable to the independent investment views produced by UBS, please visit our website at UBS.com forward slash CIO dash disclaimer. Thank you for watching.

For more information, please visit our website at www.ubsc.com. For more information, please visit our website at www.ubsc.com.