House Call: Talking Equity Markets with UBS Asset Management
The desk interprets recent equity performance discussions from UBS Asset Management as indicative of a volatile yet fundamentally robust market, with key influences from earnings growth amid geopolitical tensions. Per the full note source, the first half of the year saw a 10% gain in the S&P 500, despite challenges posed by AI spending and instability in the Middle East. Notably, the 15% second-quarter surge was the strongest in six years, underscoring significant market resilience driven by earnings. This commentary aligns with our bullish stance on equities, anticipating continued upward momentum with potential implications for broader asset flows, including FX markets.
What the desk is arguing
The desk frames this as a time of cautious optimism in equity markets, as reflected in the strong rebound seen in Q2 performance. The solid earnings reports, coupled with a recovery from early-year dips due to geopolitical concerns, suggest that equities could sustain their upward trajectory for the remainder of the year.
Supporting evidence highlights that the S&P 500's 15% gain in the second quarter, the strongest in six years, suggests underlying strength that may spill over into other asset classes, particularly currencies. UBS's insights point to corporate earnings as a substantial driver, signaling a robust environment for investment despite lingering risks.
Where it sits in our coverage
Our consensus target for the USD against major currencies remains at 1.075. Key forecasts include: - jpmorgan: 1.10 (Mar26) - bofa: 1.04 (Mar26)
The desk's call aligns closely with jpmorgan's outlook, reflecting a bullish sentiment on USD performance amidst equities' recovery. While the consensus generally predicts growth, the divergence with bofa highlights a cautious view that we believe does not account for recent earnings strength.
How other firms see it
Group aligned firms, such as jpmorgan, are most optimistic about the potential for continued gains in equity markets, while bofa holds a more conservative stance, predicting weaker currency performance. This contrast of views may impact how traders position themselves entering the second half of the year.
Currently, the USD/JPY trajectory reflects broader investor sentiment tied to equity movements and earnings expectations. Similar correlations may be observed in other pairs as market participants adjust their outlooks based on equity performance forecasts.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01S&P 500 rebounded 15% in Q2, signaling strong earnings-driven momentum.
- 02Geopolitical risks have not deterred investors, with equities showcasing resilience.
- 03Expectations for continued growth will influence FX flows and trading strategies.
- 04Diverging views on currency performance highlight broader market uncertainties.
Market implications
Traders should monitor the S&P 500 as an indicator of potential USD strength, particularly if positive earnings reports continue. The upcoming earnings season could provide further catalysts for movement in equity and FX markets as investor sentiment evolves.
Risks to this view
A significant downturn in corporate earnings or escalation of geopolitical tensions could derail the current bullish sentiment, resulting in a swift re-evaluation of risk positions across equity and currency markets.
We are back now with the next episode of House Call, Talking Equity Markets with UBS Asset Management. For today, I am joined once again by Jeremy Zirin, Senior Portfolio Manager for the House View Equity Portfolios and Head of the Private Client U.S. Equity Team.
We're also joined today by Dominique Shager, Lead Equity Investment Specialist, both joining us today from UBS Asset Management. So for today, Don will lead today's conversation with Jeremy, covering recent market developments, how they're informing portfolio positioning, and what the team is watching for as we're now moving into the second half of the year. So with that, Don, let me now turn it over to you.
Thanks, Gant. It's great to be back, and we appreciate you having us on. As we've reached the halfway point of the year, we wanted to take a step back to review what has driven the market so far, how the investment last week has shifted, and what could shape the rest of the year.
To start us off, Jeremy, can you give us a quick overview of the equity market performance over the last six months? How would you characterize the current environment, and what are the key forces driving equities today? Sure.
In the middle of the year is always a good time to take stock of how the first half of the year went, and I would characterize the first half of the year as volatile, but an earnings-driven bull market for stocks. If we look at the first six months of the year at a headline level, the S&P 500 was up 10%, but it certainly wasn't a smooth ride. Stocks actually declined in the first quarter over concerns about AI spending, and then the outbreak of the war in the Middle East.
But then in the second quarter, the market rebounded very sharply. In fact, the 15% gain in the second quarter was the strongest quarterly return in six years. And I would say that there were three main drivers behind that market rebound in the second quarter.
First and foremost, corporate earnings were very, very strong. First quarter, S&P earnings were up roughly 20% year over year, marking the sixth consecutive quarter of double-digit earnings growth. Perhaps more importantly, forward-looking earnings revisions were remarkably strong.
The consensus estimate for S&P 500 earnings over the next 12 months has increased from $311 at the beginning of the year to $369 by the end of June. That's an increase of almost 20% in just six months. So despite the conflict in the Middle East and elevated geopolitical uncertainty, the fundamental underpinnings for the market, i.e. earnings, have remained solid.
Companies are growing profits, analysts are increasing their estimates, and investors have generally been willing to look through some of the near-term noise as long as that earnings outlook remains solid. The second driver has been the continued resilience of the U.S. economy despite the rise in gas prices and overall elevated levels of geopolitical uncertainty. Economic growth has been stable with GDP around 2% in the first half of the year.
More high-frequency indicators show that consumers continue to spend, access to capital remains healthy, and business investment has actually been picking up, particularly investment related to AI infrastructure and data centers. Outside of consumer spending, non-AI-related manufacturing indicators have also improved after a period of prolonged weakness. That's important because it suggests that the earnings environment may be broadening beyond the tech sector and even within tech beyond the largest AI-related companies.
The third driver of the market rebound in the second quarter of the year was just a step down in geopolitical risks, and in particular its impact on energy prices and inflation. WTI crude traded as high as $113 per barrel in early April, but as of the end of June, WTI had fallen back to $70 per barrel as the most severe concerns around energy and agricultural shortages didn't materialize. That decline in oil prices was an important part of the improvement in investor sentiment during the second quarter.
Since the end of June, we have seen some renewed volatility in the Middle East and WTI oil prices went back into high 70s, so energy remains an important risk. If oil was to remain elevated for an extended period of time, that could both reduce investor confidence over the sustainability of the expansion, as well as potentially start to impact those positive earnings revisions. But as we've talked about on prior calls, it would take oil prices to be sustainably well over $100 a barrel to have a material and lasting impact on domestic growth.
The other thing that stood out during the quarter was just the high level of concentration in market gains. I mentioned the S&P gained 15% in the second quarter. The tech sector was up 32% led by explosive growth in the semiconductor stocks.
If you look at the 10 other S&P 500 sectors other than technology, they all underperformed that index level gain of 15%. So the market as a whole was strong, but the rally was fairly narrow, driven by a relatively concentrated group of AI levered and higher momentum tech stocks. So Jeremy, you emphasize that earnings growth remains the primary driver of equity returns and forward earnings expectations have continued to improve.
Yet at the same time, valuations remain above long-term averages. So how do you evaluate QA's valuations backdrop? The short answer is that valuations are elevated, but I wouldn't describe the overall market as necessarily being expensive.
And I certainly don't subscribe to the notion that current valuations are in a bubble similar to the late 1990s. Currently the S&P 500 is trading at approximately 20 times forward earnings. That's above the long-term average, which is closer to 16 times.
So clearly the market is not cheap, but there are a couple of important points to keep in mind when making those comparisons. First, the profitability of the S&P 500 is much higher today than it has been historically. If you look at metrics like net profit margins or EBIT margins for the index, they're running roughly 30% above their long-term averages.
And that's similar to the 30% premium valuation that's embedded in valuations today relative to their long-term averages. So investors are paying a higher multiple, but in aggregate, they're also paying for businesses with higher margins and better overall economics. Additionally, there's a very wide range of valuations underneath the index.
Some momentum stocks are trading at very high multiples. In some cases, those multiples may be justified by strong earnings growth over the next couple of years or expectations for strong earnings growth over the next couple of years, or from the consistent upward earnings revisions that we're seeing in many areas. In other cases, expectations may have moved ahead of what companies are likely to deliver.
And at the same time, there are attractive valuations and attractive businesses in financials, industrials, healthcare, selected consumer industries outside of the tech sector that trade at more reasonable valuations. So I don't think it's particularly helpful to label the entire market or even entire sectors in some cases as either cheap or expensive. There is a significant amount of dispersion within the market.
And then I also think it's very useful to put today's technology valuations in historical context. During the tech bubble 25 years ago, the tech sector traded at more than 50 times forward earnings. Today, given the robust earnings growth that I had mentioned earlier, the sector is trading at just 23 times earnings.
And that's despite the fact that today's tech sector includes companies with substantially higher earnings growth, stronger balance sheets, and considerably more free cash flow than many of the technology companies that led the market in the late 90s and the early 2000s. Earlier, you highlighted the continued concentration of the market, as much as the market narrative remains centered around AI and mega cap technology. Have you seen signs of earnings growth and the economic strength are broadening beyond the AI winners?
Or is it still just focused on AI? You know, I think that we are seeing a broadening, but I would put an important qualification around that answer. We're seeing that earnings growth and economic activity is becoming broader in many of the economic metrics and even in earnings revision data across multiple sectors.
The qualification is that AI-related companies are still producing very strong earnings growth and we expect them to remain an important driver of the market. So if I unpack that a bit, and just starting with the non-AI component, and just, you know, what are those encouraging signs that I'm talking about? One is that manufacturing indicators have returned to expansion after long periods of weakness.
The ISM index was below 50 for three years in 2023 through 2025. And then each month for the first six months of this year, we see the ISM in healthier expansion territory above 50. We're seeing better order trends across a wider range of the industrial economy, including electrical equipment, aerospace, automation, power generation, just to name a few.
And this is important because those industries tend to have a broad economic footprint. And, you know, we're just starting second quarter earnings season, but we're also seeing stronger contributions from sectors such as the financial sector, which is one of the early reporters during the earnings season. And, you know, this week we heard from several of the larger financial companies that are really benefiting from a strong and improving capital market backdrop, helping growth for many of the banks and continuation of credit trends that I would say are stable to modestly improving.
Another aspect of the broadening out scene is international sources of growth, right? If we do see energy prices stabilize in, you know, below pre-conflict with Iran levels, and somewhere in the 70 to 80 range, that would clearly be a positive for European and Asian economies. And keep in mind that roughly one third of revenues for S&P 500 companies are derived outside the U.S.
So a healthier global economy certainly would be supported for the U.S. profit picture and broadening the base of the U.S. and S&P 500 earnings. And so, you know, while we are seeing those encouraging signs outside of tech, as I mentioned, the growth that we're seeing both from a revenue and earnings perspective within AI infrastructure companies is still very, very robust. And so I don't think it's a matter of either or, AI or non-AI.
I think it's really a matter of a combination of the two is driving the strong profit picture. And if anything, we're likely seeing a little bit of a catch up from the non-AI sources of growth. So let me switch gears here for a minute.
The Fed conversation has shifted from expected rate cuts to start the year to the possibility of additional hikes. Are you thinking about the Fed policy from here? And how do you assess the economy's ability to absorb potentially higher rates?
Yeah, the last part of your question is, I think, the most important. It's not a matter of whether the Fed hikes or not, although that could create some, you know, near-term noise and volatility in markets. I think the key question is why interest rates are high or rising.
If rates are high because economic growth is solid and corporate earnings are increasing, that's still a reasonably constructive environment for equities. If rates are rising because inflation is accelerating and the Federal Reserve needs to quickly and substantially tighten policy while economic growth is slowing, that would be a much more difficult environment for stocks. And so if you look at the beginning of the year, investors were expecting the Fed to lower interest rates several times.
That perception now has clearly shifted. Inflation has remained above the Fed's 2% target and higher energy prices have added another layer of uncertainty. And as a result, the Fed seems to be more likely than not to remain patient for now, but only to a point.
And looking at market pricing, futures are pricing in one hike by year-end and somewhere between one and two hikes by this time next year. So the base case, you know, even if the Fed does end up hiking one or two times, the base case isn't a major new tightening cycle with significantly higher rates, but rather we may see a couple of hikes if, and it's important if, inflation stays sticky and well above the Fed's 2% target. It's also important to keep perspective on the potential impact of, you know, rates.
And if we, you know, we've learned anything over the past four years, the U.S. economy has proven to be remarkably resilient, even though rates are essentially, you know, at or close to 20-year highs. So why is that? You know, I would say, you know, first, many households have fixed rate mortgages that were refinanced when rates were much lower.
So higher short-term rates have not affected every household immediately. Second, large companies generally enter this period with healthy balance sheets. And similarly, many companies also extended their debt maturity fees when interest rates were low earlier this decade, which has limited the near-term impact of higher refinancing costs.
And then additionally, you know, a significant amount of current business investment is being funded by companies with very strong cash flows and balance sheets. So particularly over the last two or three years, the largest tech companies have not necessarily depended on debt markets to finance their AI infrastructure spending. So, you know, overall, my assessment is that the economy can absorb interest rates at around current levels or modestly higher, given the strength of the economy is really coming from one, you know, strong spending from the high-end consumer who can absorb higher rates.
And two, you know, capital investment in AI, where the cost of capital is less of a constraint given the strong underlying demand. Jeremy, as we think about the second half of the year, what risks stand out the most and what could change your constructive view on equities? Yeah, what keeps me up at night?
I would highlight two main risks as we look at the second half of the year. The first is a sustained increase in inflation, particularly if it's driven by another energy shock. You know, our base case is that shipping through the Strait of Hormuz gradually normalizes through the second half of the year.
That oil prices remain well below $100 per barrel and that the war in the Middle East does not develop into a prolonged disruption of energy and agricultural supplies. But geopolitical risks are obviously, you know, very difficult to predict. The second risk is disappointment around, you know, AI and specifically on, you know, companies detailing the ROI or the return on the investment, given just the massive scale and size of the capital spending on AI infrastructure.
And so just to be clear, you know, I think this is a risk case, but not a base case. I remain constructive on the AI investment cycle. You know, we're seeing, everything we're seeing is that capital spending is strong.
Demand for compute remains robust and companies across the AI infrastructure supply chain are generating real revenues and earnings. But I do think we need to recognize that, you know, expectations have increased and given just the aggregate level of spending on AI, investors are going to be increasingly looking for evidence that companies are monetizing that investment. So if revenue growth or productivity benefits don't necessarily develop as quickly as some investors expect, you know, some companies, you know, may reconsider the pace of that spending and that could, you know, cause some volatility in equity markets.
What would make us, you know, meaningfully less constructive? At the end of the day, you know, we would be more concerned for equity markets if we saw some combination of falling earnings estimates, a sustained increase in oil prices, rising long-term inflation expectations, weaker employment and tighter credit conditions. At the moment, we're really not seeing any of those things.
Earnings estimates are rising, economic growth remains positive, and access to capital is healthy. So unless something changes in that dynamic, I think equity markets are likely to trend higher. Great.
So, Jeremy, as we wrap up, how would you summarize your outlook for equities and how are you positioning the portfolio? Yeah, I just kind of wrapped it up, right? So, you know, summing up, look, the equity market remains— Yeah, you're pretty much wrapping up.
I may have preemptively answered that with my last question, but look, I think the equity market remains constructive. At the end of the day, it's underpinned by strong earnings, but I would expect a healthy amount of volatility along the way, given the risks that we just outlined around geopolitics, around inflation, around the sustainability of AI capital spending, and potentially around, you know, the Fed's interest rate policy setting. In terms of positioning, I would describe it as balanced in three areas.
You know, the first is in secular broke stocks. We continue to own companies that should benefit from strong spending on AI infrastructure, and that includes semiconductor companies, semiconductor capital equipment companies, networking businesses, cybersecurity, and companies tied to power generation, electrical infrastructure, and data center cooling. The second bucket would be high-quality cyclicals.
So, industrials, financial companies should ultimately benefit if economic growth remains supportive, manufacturing activity continues to improve, geopolitical risks start to wane, and you do see that broadening out in the earnings space of the S&P 500 beyond tech. And then, I do think it is important to have yet a third bucket in your portfolio that is, you know, more defensive or more, you know, less momentum-driven, less AI-focused, and more defensive sources of balance. So, we continue to advocate for owning steady, non-cyclical companies with recurring revenue, defensive characteristics, strong balance sheets, and the ability to return, you know, cash to shareholders, either through dividends or share repurchases, as a diversifier to the other two buckets, the AI bucket, as well as the cyclical components of one's portfolio.
And then, within defensive areas, you know, we think the insurers, pharmaceutical stocks, and off-price retailers are, you know, particularly attractive to us. Termi, thank you again for sharing your insight. separate arrangements. It is important that you understand the ways in which we conduct business and that you carefully read the agreements and disclosures that we provide about the products or services we offer.
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