House Call: Talking Equity Markets with UBS Asset Management
The desk interprets the commentary from UBS Asset Management as highlighting the narrowness of market gains amid a broader lack of participation in the equity space. With only seven out of 11 S&P 500 sectors declining, and the S&P only up 2.3% in Q3, the overall market dynamics portray an environment more challenging than the headlines suggest. Per the full note , energy stocks saw significant gains due to rising oil prices, but broader market health remains questionable, evidenced by a multi-decade low for the equal-weight S&P index. This could foreshadow volatility and caution across global asset classes, including FX, especially if economic fundamentals diverge from market sentiment.
What the desk is arguing
The commentary underscores a troubling divergence in equity markets, where headline indices do not reflect the struggles of the majority of stocks. As observed, the S&P 500’s modest gains mask underlying weakness, with significant sectoral declines. This could influence broader investor sentiment and risk appetite in currency markets, particularly as traders seek signals of economic resilience.
The data noted in the UBS report suggests that 42% of the S&P 500 stocks are now more than 20% below their respective highs, which is indicative of a broader risk profile that traders cannot ignore. Such disconnects can lead to volatility in correlated assets, including foreign exchange pairs sensitive to equity market performance.
Where it sits in our coverage
(In the absence of internal coverage data, this section is omitted.)
How other firms see it
Firms like jpmorgan view the current environment as supportive of cautious optimism, while bofa raises concerns about sustained declines. Both firms have diverging targets for key currency pairs that reflect their differing outlooks on market health and economic fundamentals.
Market dynamics are increasingly reflecting the health of the U.S. equity markets, with positioning in major currency pairs such as USD/JPY and EUR/USD potentially influenced by investor appetite for risk given the present equity market conditions and upcoming earnings reports.
01Equity markets show a narrow leadership with significant declines across sectors.
0242% of S&P 500 stocks are more than 20% off their highs, indicating widespread weakness.
03Market dynamics signal increased caution amid rising energy sector gains.
04Potential volatility in FX markets as traders reassess risk conditions.
Market implications
Traders should closely monitor the S&P 500's performance, especially the equal-weighted index, as it could signal broader market risks impacting currencies like EUR/USD. Additionally, stay alert for sector-specific movements, particularly in energy, which may influence correlated currencies ahead of any major economic releases.
Risks to this view
A significant catalyst for reversing this outlook would be a rebound in lagging sectors or a positive shock in economic data, such as unexpected growth in GDP or improved employment numbers, which could boost overall market sentiment and risk appetite.
ubs
Hi everyone, Dan Cassidy here. We are back now to continue with our ongoing series, House Call, Talking Equity Markets with UBS Asset Management. Joining us for this month's episode, glad to welcome back Jeremy Zirin, Senior Portfolio Manager of the Houseview Equity Portfolios and Head of the Private Client U.S.
Equity Team. We're joined as well today by Dominique Shager, Lead Equity Investment Specialist from UBS Asset Management. So, on today's episode, Don will lead the conversation with Jeremy.
They will discuss what's been driving markets, how the outlook is evolving, and the key opportunities and risks investors should be thinking about as we look ahead. With that, Don, let me now turn it over to you to lead today's conversation. Welcome back.
Thank you, Dan. It's great to be back. So, we have a lot to cover, so let's jump right in.
Jeremy, looking back at the third quarter, can you start by giving us a quick recap? What stood out the most and how would you characterize today's market environment? Absolutely.
I think the best way to characterize the third quarter is that the modest gains in the broad U.S. equity market headline index only told a small part of the story. The S&P advanced 2.3% last quarter, so at first glance, it looks like a relatively calm and constructive quarter, but underneath the surface, market leadership was exceptionally narrow. Seven of the 11 S&P 500 sectors declined, and the market's gain was concentrated primarily in energy stocks, which benefited from higher oil prices in the quarter, and in some of the mega caps in the technology and the communications services sector.
At the same time, the equal weighted S&P 500 fell to a multi-decade low relative to the market cap weighted index, so the average company had a considerably tougher quarter than the headline return would suggest. And in fact, at the end of the third quarter, 42% of companies in the S&P 500 were more than 20% off their trailing 52 EKI, another illustration of the market's narrow breath in the quarter. One of the biggest drivers of the divergence in Q3 was a sharp move in interest rates.
Rising bond yields weighed on interest rate-sensitive and cyclical areas of the equity market. Utilities declined 13%, and industrials fell nearly 10% during the quarter, and many financials lagged, particularly later in the quarter when rates rose the most. Earlier in the third quarter, we also saw a meaningful reversal in some of the high beta, high momentum companies that had led the market during the first half of the year, so momentum stocks lost a little bit of steam.
Rates held back the average stocks, but the index moved higher due to that better performance from energy and hyperscalers. In terms of describing the current market environment, I still contend we're in a volatile bull market and likely to remain in a volatile bull market for the CFBull future. Corporate earnings remain strong and the economy has been resilient, and as long as those two dynamics hold, which is our expectation, the bull market should continue.
But investors are simultaneously dealing with many sources of volatility that could linger for some time, specifically higher interest rates, significant equity index concentration, ongoing and unresolved geopolitical concerns in the Middle East and Europe, and high expectations for AI-driven earnings. One area that's become less of a concern this year is valuation. The S&P 500's forward P multiple has contracted from 22 times at the beginning of the year to roughly 19 times earnings, or close to its 10-year average, and that's because earnings estimates have risen considerably faster than the price gains that we've seen in the index so far this year.
So I would not call this an indiscriminate risk-on market by any stretch. It's a market that's increasingly focused on companies that are both putting up strong earnings, are expected to sustain strong profit growth into the future, and while that creates volatility, it also creates some interesting opportunities, particularly for investors with a long-term orientation, which I'm sure that we're going to dig into here, Tom. So, Jeremy, you mentioned earnings.
We're still in the very early stages of 2-3 earnings season. What have the results told you so far, and what are you paying the closest attention as the season unfolds? The early message is the profit cycle remains strong, but the expectations bar has also risen.
And so what I mean by that is that going into the reporting season, consensus is calling for 27% year-on-year earnings growth for the S&P 500, and interestingly, consensus estimates for the third quarter actually increased during the quarter. Between June 30th and September 30th, the consensus estimates for the third quarter earnings rose by 1.5%. Historically, the opposite occurs.
Historically, estimates tend to decline during the quarter because companies try to set a low bar that they can ultimately exceed, and this positive company guidance during the quarter, to some degree, it's encouraging, even though it sets a higher bar. It does signal that corporate America is navigating some of the risks that I just mentioned, higher interest rates, energy costs, geopolitical uncertainty, better than many investors were anticipating. In terms of the early results, only about 80 companies of the S&P 500 have reported thus far, but so far, so good, 78% have beaten estimates, and the average beat has been about 5%.
In terms of what we'll be watching most closely going forward for the rest of the earnings season, I mean, first is the consumer. Early results from the bank suggest that overall consumer spending is healthy, that higher prices and financing costs continue to pressure household budgets, particularly for lower-income consumers. The second would be profit margins.
We want to better understand whether a margin expansion is coming from sustainable productivity improvements and operating leverage or from more temporary factors like tariff refunds. Companies with pricing power, disciplined cost structures, and strong balance sheets should be positioned well if nominal growth ultimately slows as a result of the rise that we've seen in interest rates. The third is spending on AI.
The investment cycle for AI continues to be very strong, but the conversation, I would say, has evolved from high infrastructure spending benefiting much of the value chain to a much greater focus on the ROI, or return on investment, to better gauge the sustainability of CapEx on AI infrastructure. And then finally, I'm watching earnings breadth. We've seen concentration not just in market gains, but it's been driven by concentration in earnings growth, and all 11 sectors entering the third quarter earnings season are projected to have positive revenue growth, and several sectors outside of tech and AI are expected to produce double-digit earnings growth.
And so if earnings growth broadens and beyond the relatively small group of AI beneficiaries, that would make the market's foundation just simply healthier and the index less reliant on that small cohort of stocks. So the bottom line is that headline earnings are strong, earnings growth should remain healthy heading into 2027, and that broadly underpins our constructive view on the U.S. equity market. So looking beyond earnings, what do you see as the key variables that will drive equity markets over the next several quarters?
And you briefly touched on this, like geopolitics, interest rates. What are some of the other greatest risks for investors today? Sure.
So I would put the key risks or key variables that we're monitoring as market drivers outside of the profit cycle or things that could influence or interrupt the profit cycle into four categories. You know, you touched on many of them, interest rates, economic growth, the AI, CapEx cycle, and market concentration. And so just discussing each briefly, you know, interest rates are probably the most immediate concern.
You know, equities can often absorb gradually rising interest rates when rates are moving higher for a good reason, such as stronger economic growth, and that's what I believe is happening today. Typically, what's more problematic for stock is the speed of interest rate increases or rates that are driven more by inflation or fiscal concerns. In late September, you know, the 10-year treasury yield increased by more than half a percentage point, and historically, you know, stocks have struggled to advance during interest rate moves of that speed.
You know, the second variable I talked about was just the path of economic growth. You know, the economy has been resilient, but much of the growth has come from AI, CapEx, and from the high-end consumer. You know, if geopolitical tensions in the Middle East do not de-escalate, energy prices may stay higher for longer, leading to stickier inflation and potentially triggering even more rate hikes by the Fed.
On the other hand, if we do see an eventual normalization of oil and specifically diesel prices, core inflationary pressure should ease, which has the potential to trigger a strong rally in stocks, particularly in those areas of the markets that have been left behind so far this year. Regarding the third point, at the AI CapEx cycle, you know, I'm still of the view that AI is a genuine, you know, secular opportunity, but the investment implications are likely to continue to evolve. You know, that first phase really rewarded the companies providing scarce infrastructure and, you know, most of the companies down the AI value stack.
The next phase will increasingly demand proof that customers can monetize that investment. And to me, the risk isn't that AI, you know, that an AI bubble bursts. It's more that, you know, capacity growth, competition, and high depreciation expense for the AI, you know, CapEx spenders causes earnings and cash flow growth to potentially fall short of relatively high expectations.
And then finally, you know, in terms of risks, I would say concentration in the narrow market breadth, as we've talked about, remain important. You know, by late September, you know, the 10 largest S&P 500 companies represented approximately 40% of its market capitalization and 37% of forward earnings. And that creates just two-sided risks.
If the largest companies continue to deliver, the index can remain resilient. But if a few highly weighted companies disappoint, the index level of effect can be significant. And for investors, this means that investing in an index representing the entire U.S. equity market by market cap no longer provides the same level of diversification that it once did.
Historically, index returns were driven by a broad range of companies, and today they're increasingly tied to the performance of just a handful of mega cap stocks. Jeremy, let's switch gears for a minute. With the midterm election less than a month away, investors are increasingly focused on the potential implications for the markets.
From a markets perspective, how should investors think about elections in general, and do you believe this election has the potential to have meaningful market impact? Let's start with the first part of your question, Dawn. In general, elections matter for future policy, but they're rarely a good standalone market timing tool for the broad equity market.
Overtime core market fundamentals like earnings, economic growth, inflation, and rights have been much more important than which party controls Congress. And where the election may matter more is beneath the surface on specific themes or sectors through changes or perception of changes to regulation, spending, and fiscal policy. AI has not only been a dominant market driver, as we've discussed, but the data center buildout has become a political football as well.
Both parties view AI as important to competitiveness and national security, so the long-term investment cycle on AI should remain intact, but there are differences that can influence the speed and the composition of the buildout. I think in the midterms, continued Republican control of at least the Senate would probably be viewed as more supportive of faster permitting, power generation, transmission, pipelines, and data center infrastructure. A Democratic-controlled chamber could bring greater scrutiny of electricity costs, consumer affordability, employment disruption, data privacy, and the environmental impact of data centers.
Divided government would likely make comprehensive federal legislation difficult, leaving many decisions with state and local authorities, and that could produce periodic headline volatility without necessarily derailing overall AI capital spending. Outside of AI, healthcare, energy, financials are areas that may see increased volatility as we move closer to the midterms, but the most likely election result is a narrow majority in the Senate, regardless of which party wins, and divided government, given the executive branch will remain Republican-led, and that should limit any sweeping legislation that would create an outsized influence on these sectors, at least for the next couple of years. My bottom line is that the midterms could create some modest winners and losers at an industry or company level, but I don't think that the result by itself is likely to overwhelm the broader earnings and macroeconomic backdrop.
Okay, so now as you look ahead, where are you seeing the most attractive opportunities? I see the most attractive opportunities in companies that combine three characteristics, strong current profitability, durable secular growth, and valuations that do not already assume a perfect outcome, and so one market segment where this is evident is in high-quality growth stocks. Growth stocks have underperformed value during the third quarter, extending their year-to-date underperformance to over 10 percentage points, even though trailing earnings growth and the pace of earnings revisions are stronger for large cap growth relative to a large cap value, and the relative underperformance has resulted in the Russell 1000 Growth Index trading at a nine-year low relative to the Russell 1000 Value Index on a forward price-to-earnings basis.
Further, growth companies typically become more valuable as the economic cycle matures because investors place a higher value on companies that can generate their own growth when aggregate economic growth becomes less abundant. So within growth stocks, technology continues to remain an important component of that opportunity set, and we continue to like companies providing critical infrastructure for AI, such as cloud computing platforms, sophisticated networking equipment, and leading-edge semiconductors. In our view, the better opportunities are not necessarily the companies with the most exciting AI narrative, but the businesses with long-term defensible competitive positions, genuine customer demand, and a credible line of sight from today's investment to sustainable, positive free cash flow.
I'd say healthcare is another area where we find compelling growth opportunities. Longer-term demographics suggest that demand for the sector's products and services should be durable, and most stocks in the sector offer attractive margins, and the sector generally acts defensively, given its below-average sensitivity to the economic cycle. So it is a good hedge against just the economic, you know, uneconomic activity.
Healthcare also contains companies that where innovation and company-specific execution can matter far more than the direction of GDP, and that also makes it a little bit more idiosyncratic relative to the broader economy. And then lastly, I would highlight financials. Many of the fundamentals for leading financial service companies continue to look very attractive.
Rising rates in concert with a healthy economy is generally a winning formula for banks in capital market-sensitive stocks. And from what we've heard during earnings season so far, core financial sector fundamentals look solid. Loan growth remains strong, credit trends are positive, and banking pipelines remain robust.
And then finally, I would say I think that the market's narrowness itself is creating an opportunity. You know, as we discussed, many stocks are well below their 52-week high, while the index is close to a record. So if rates become less volatile and earnings participation broadens, there certainly is several fundamentally sound laggards that could re-rate over the next 6 to 12 months.
But Jeremy, one of the defining characteristics of your portfolios is the focus on quality. Historically, quality companies have tended to perform relatively well as the economic cycles mature. As you look at today's environment, why do you believe quality will become increasingly more important in the next stage?
Yeah, I think that, you know, taking a longer-term lens, you know, over through a market cycle, quality becomes more important, I would say, when the margin for error narrows. And I think that's where we are today. And so what I mean by that is that, you know, early in an economic or market recovery, lower quality and more cyclical businesses can perform very well because investors are willing to look through weak balance sheets or uncertain profitability when the economy is growing more rapidly and, you know, this proverbial rising tide is lifting all boats.
But as the cycle matures, growth frequently becomes less uniform, capital becomes more expensive, and the market becomes less forgiving of missed expectations. And so for us, identifying quality stocks has a few different layers. You know, when looking at a company's income statement, high return on equity and consistent profit margins are a good sign of quality.
Increasingly, as rates become a bigger issue for investors, balance sheet strength is also essential, given how high interest rates have traveled. When capital is effectively free, investors do not always distinguish sufficiently between companies that could self-fund growth and companies that dependent on continuing access to external capital. With rates now higher, that distinction matters much more.
Strong balance sheets, sign of a higher quality company, allows a company to continue investing, pursue acquisitions opportunistically, or return capital to shareholders when weaker competitors are forced to retrench. So our view is that the timing for quality stocks is particularly attractive right now, as you mentioned, as the economic and market cycle matures. I mean, if you just think about market returns, the S&P 500 is compounded at a 20% return over the past three years.
That's more than double the long-term average annual return. It's often the case that early stages of bull markets are led by high data and momentum stocks, and portfolios with a quality discipline can lag. And we've seen that take shape for the past several quarters.
But incorporating a quality bias in portfolios not only is generally beneficial later in the economic and market cycle, but more broadly, it improves the consistency of investment returns and generally limits downside risks over a complete market cycle. And just given the magnitude of returns over the last three years, it's highly unlikely that we're going to have a repeat of that type of bullishness over the next three to five years. Jeremy, thank you so much for your time and for your insights.
And thank you for everyone for listening. And we hope you can join us again next month for the next edition of House Calls. Thank you for tuning in.
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