House Call: Talking Equity Markets with UBS Asset Management

Hello, everyone, and welcome to UBS OnAir. I am pleased to welcome you to House Call, Talking Equity Markets with UBS Asset Management. Today, I am pleased to welcome to the show Jeremy Zierin, Senior Portfolio Manager of the House View Equity Portfolios and Head of the Private Client U.S.

Equity Team, and Dominic Shager, Senior Equity Investment Specialist with UBS Asset Management. With that, let me turn the call over to you, Dom, to lead us through today's discussion. Great.

Thank you, Siobhan, and thank you again for having us on the show. So with that, Jeremy, we have a lot to cover, so let's get started. Jeremy, stocks have had another solid year, but more recently we've seen a pickup in volatility.

Markets have come off their late October highs, and now the S&P is slightly down for the quarter. Can you talk about what's been causing the stocks to struggle more recently? Absolutely.

But for context, while the S&P has been generally range-bound or flat so far this quarter, keep in mind that the market was up 38% from its April lows to its late October high. So a 4% or 5% correction certainly isn't very extreme. And the fourth quarter actually started off pretty well with stocks rallying during the bulk of third quarter earnings reporting season, which takes place in mid to late October.

But we've seen a bit more volatility, as you mentioned, Dom, and a bit of a pullback over the last couple of weeks, and I think there are a couple factors at play here. First, from a macro perspective, we've been in a bit of a data vacuum. The government shutdown delayed and possibly postponed several key economic data releases, so investors have been flying blind to some extent.

And that lack of clarity tends to make markets more sensitive to alternative sources or macro data points from the private sector that usually aren't market movers. And while the overall spending in the economy still seems reasonably healthy, we're still hearing about economic uncertainty causing some hesitation in consumer and business decision making, especially for larger capital purchases. And I think that lingering tariff uncertainty is part of that overhang.

We saw market volatility lift a little bit in early October when U.S.-China trade issues escalated, but that ultimately settled down after Presidents Trump and Xi met in South Korea and agreed on a one-year trade truce a couple weeks later. And while that trade truce was initially well-received, the reality is that it only provided de-escalation in trade tensions, not a final resolution to trade terms between the two countries. So there does still remain some lingering uncertainty as to where the final tariff rates will land, and that's important to companies that are making long-term, multi-year, and in some cases, multi-decade capital investment decisions.

On top of that, we're still awaiting the Supreme Court's ruling on the use of tariffs in the President's authority under IEPA, which could keep trade uncertainty in the headlines for a while longer. And so while the overall economic backdrop has remained solid and U.S. GDP growth prospects and forecasts for U.S.

GDP for the year have actually been revised higher by about half a percentage point since May, there are still pockets of concern for long-term capital. And in the near term, we've seen slowing labor markets, lack of data releases, cost by the government shutdown, and that's not helping to provide a whole lot of clarity and providing a little bit of angst as to, additionally, as to just the ongoing debate about how much further the Fed will cut rates as well. And then the second issue that the markets have been wrestling with, particularly over the last week or so, has been the AI trade.

And so AI, or artificial intelligence-related stock, really ripped higher in the third quarter, and it's fairly normal to see some consolidation in any asset after such sharp gains over a short period of time. But over the past few weeks, there's been renewed concerns over the sustainability of AI infrastructure spending and whether or not the companies doing the spending, largely the hyperscalers, will generate a sufficient return on their massive investment to justify that spending. So, Sadam, to sum it up, to me, the more recent shopping that's in markets, one, hasn't been very extreme, two, it's really been driven by a combination of some cyclical concerns on the economy that have been exacerbated by the lack of some key economic data releases because of the government shutdown, somewhat less clarity on the next move by the Fed, and then more recently, renewed AI bubble fears.

But it's also interesting to observe that if you just take a step back and look at the quarter-to-date performance of the S&P 500 by sector, it does appear that the bigger issue is the economy, it's the economic trajectory, despite all the headlines about AI potentially being in a bubble. The worst-performing sectors quarter-to-days have been cyclical, specifically materials and consumer discretionary stocks, while the top two sectors have been healthcare and utilities, classic defensive sectors, while the tech sector has largely been flat. So, what the market is telling us is that investors are more concerned about the economy than AI bubble risk.

So, Jeremy, over 90% of companies have already reported third-quarter earnings season is pretty much complete. What are the key takeaways so far? Yeah, third-quarter earnings season has actually been quite encouraging overall.

We've seen S&P 500 revenue growth accelerate from 6% last year to 8% year-on-year in the third quarter. And earnings per share looks like it'll come in around plus 12% year-on-year, so very similar to the 13% year-on-year growth from the second quarter. And in fact, if you just look back over the last four quarters, this will be the fourth consecutive quarter of year-on-year S&P 500 earnings growth of over 10%.

So, at an aggregate level, earnings growth and earnings momentum appears quite solid. In terms of takeaways by sector, technology, which is the largest sector by market cap and by earnings weight in the S&P 500, was very strong. It posted 22% earnings growth led by AI infrastructure and cloud services.

The financial sector actually had the highest growth rate, slightly higher and above that of the tech sector. Earnings were up 24%, with banks benefiting from stable net interest margins, still healthy credit quality, and investment banking, which has seen a marked improvement. On the defensive side, you still saw pretty good earnings growth from healthcare, which had 10% revenue growth, the highest of any sector outside of tech.

On the negative side of the equation, the energy sector, because of lower commodity prices, was the only sector to see down earnings. But even in the energy sector, the cash flow remains pretty healthy. And trends in the consumer discretionary sector were more mixed, where you saw travel and leisure was strong, and housing and auto-related segments were weaker.

I would say some of the key themes that we picked up across sectors was that within consumer spending, overall, consumer spending has been resilient, but we have seen meaningful shifts. So strong discretionary spending, as I mentioned, on leisure and travel, entertainment and luxury goods generally strong, but we have seen a moderation in big ticket items and housing-related categories. And then in retailers, you've seen the discount chains and e-commerce companies perform quite well or deliver stronger earnings.

While restaurants and traditional brick-and-mortar retailers continue to lag. In corporate spending categories, you have seen more of the same or sluggish growth in capital spending in the industrial sector or segments of what I'll call the old economy. But like I said, we saw 22% growth in tech, and a lot of that was on cloud and AI infrastructure and investments.

Across sectors, what we're seeing in terms of labor is that wage pressures are largely easing, which has helped profit margins. And that's why profit growth has been in the low double-digit range, despite revenue growth more in the mid to high single digits. And in terms of pricing power, we're seeing it evident in some pockets of healthcare and staples, but it did fade a little bit in technical sectors where companies are seeing pushback from higher prices.

So just putting a bow on it, overall earnings may not be quite as balanced as we'd like to see, but we've seen double-digit gains for four consecutive quarters in S&P 500 earnings. So Jeremy, as the slow economic data is set to be released now that the government shutdown has ended, as we look ahead of the Fed's December 10th meeting, what should we expect for the Fed over the next few months? At the end of the shutdown, it's certainly a relief for government workers, anyone who flies as well, and all of us market observers and investors who rely on timely economic data.

You and me both are experiencing that, right? The shutdown delayed some key economic releases, which we discussed has made it harder for the Fed and investors just to get a clear read on the economy. And just this week, we learned that the FOMC, the Federal Open Market Committee, will not see unemployment rates for October or November before the December FOMC meeting, which takes place on the 9th, with the decision being on the 10th.

So as it relates to what our expectations are for the Fed, it's looking more and more that the December 10th FOMC meeting is a close call. Like six weeks ago, markets were pricing in almost 100% chance that the Fed would cut. Now it's closer to 50-50.

At the last FOMC meeting, Chair Jay Powell noted that when it's foggy outside, you slow down, indicating that the lack of data coming from the government may make it more appropriate for the Fed to pause its cutting cycle this month and wait for the data releases to catch up to get a better read on the economy in terms of both growth because of the labor market data delays, as well as inflation because we haven't had the most recent CPI print. But if we look beyond just the December meeting, our view is that the Fed will remain in an easing mode. And the rationale is pretty straightforward.

While overall economic growth has been better than expected, the labor market is clearly showing signs of softness. And inflation pressures, especially those related to tariffs, have been more modest than feared. And it's important to remember that the Fed has a dual mandate, and that dual mandate is maximizing employment and price stability.

GDP and corporate profit growth are not part of the Fed's mandate. And so if labor markets are softening and there's some downside risks to job growth, the Fed tends to act quickly. And so while markets may remain volatile in December, and there could be downside risks if the Fed decides to pause in their December 10th meeting, the bottom line is that we expect monetary policy to remain accommodative, the Fed to cut interest rates anywhere from 50 to 75 basis points from current levels over the course of the next six to nine months, which should be supportive for risk assets over the course of 2026, as the Fed focuses more on sustaining job growth and managing downside risks.

So speaking of 2026, how are you thinking about the economic and corporate profit outlook for next year? Yeah, I'm glad that you separated those two, Dawn, because most people think about the economic outlook and assume that the corporate profit cycle is just mapped to the economic cycle. And in fact, there are several differences between GDP and the S&P 500.

The U.S. economy has much more exposure to services, while manufactured goods make up a higher proportion of S&P 500 revenues and profits. There are sectoral differences, too, with technology making up a much bigger slice of corporate earnings compared to its impact on GDP. And we know that GDP is a domestic measure, whereas about a third of S&P 500 revenues come from outside of the U.S.

So on the U.S. economic outlook, I'm lukewarm. Given healthy consumer and corporate balance sheets and no obvious imbalances in the economy, I think it's a fairly low probability that the U.S. flips into a recession next year. But slower labor force growth, lingering policy uncertainty, and the lagged impact of tight monetary policy probably means that we don't escape the one and a half to two and a half percent GDP growth channel that we've been in anytime soon.

Also, while we're likely to see an improvement in productivity from AI, we're still in the early days of AI adoption. And in past technology cycles, productivity gains often don't show up in the GDP data in real time and are more visible years later after benchmark revisions. And so UBS economists are forecasting U.S.

GDP growth of 1.7 percent for 2026, which is just a touch below trend, but still solid given where we are in the economic cycle. The economy continues to have crosscurrents and has aptly been described as K-shaped because there's been such a sharp contrast within different segments of consumer spending, with the high end being quite strong relative to the low end income cohorts, and even a K-shaped economy with an investment spending between AI and traditional enterprise spending. But I have been and remain more bullish on the corporate profit cycle relative to the economic cycle, and I expect that profits will once again outperform broad measures of economic growth next year.

And I see this coming from two angles. The last two years, we've seen capital spending on AI infrastructure far surpassed initial expectations, and I suspect that we'll see a repeat of that in 2026, given everything that we're seeing in terms of backlogs at some of the hyperscalers and what we're seeing with AI adoption by enterprises ramping higher. And the second angle is that we're likely to see a bit of a rebound in manufacturing as tax incentives and replacement cycles kick in in industries that have been quite soft for the last two to three years.

If you think about the ISM Manufacturing Index, it's been in negative territory for 34 of the last 36 months, and I think that there's greater likelihood to see some upside surprises and a bit of a rebound in that in broad manufacturing. And as I mentioned, S&P is more levered to manufacturing than in the broad U.S. economy. And so overall, CIO, our chief investment office, expects S&P 500 earnings to hit $295 per share next year with upside risks.

I mean, that translates to high single-digit profit growth. I think that's a reasonable estimate, and I do think that I agree that there are upside risks in that forecast. So Jeremy, valuation continues to be a concern for many investors, and there's been more and more chatter about the market being in a bubble, right?

I think we get this question all the time from our clients. So how are you thinking about high valuations as a market risk? Look, it's a fair concern.

Valuations, especially in U.S. equities and AI-linked stocks, are elevated by historical standards. But context is important. First, the current policy environment is different from past cycles.

Like typically, when bubbles have burst historically, one of the triggers has been tight monetary policy or tightening monetary policy. Today, we're in an interest rate cutting cycle, which tends to support higher valuations. Second, as I just mentioned, the earnings outlook is robust.

And so high valuations are more sustainable when they're backed by strong and growing profits. And that's what we're seeing, particularly in sectors benefiting from AI and innovation, where the valuations are the most noteworthy. And when we look specifically at the risks of an AI bubble, we're not complacent.

And certainly, we recognize that history shows that investment booms often come with periods of overbuilding and boom-bust cycles. But I think this cycle is very different from the internet boom-bust cycle from 25 years ago. First, valuations are not nearly as extreme.

The leaders in the TNT boom-bust cycle in the late 90s and early 2000s traded between 50 and 100 times earnings, while AI leaders today trade more in the 25 to 40 times gold return range. Plus, today's leaders have much stronger business models, more robust free cash flow generation, and overall healthier balance sheets. But the biggest difference to me is that currently, there simply is no supply glut of AI infrastructure.

Investment booms end when it becomes clear there is way too much supply. Today, demand for AI infrastructure is far outstripping supply. And we hear that companies can't get enough compute, can't get enough cloud services, can't get enough power to satisfy their customers.

So for now, we think the spending cycle on AI infrastructure is still in the early to middle innings. So Jeremy, to close out the call, given everything we just discussed, how are you positioned and where are you finding opportunities in this market environment? Given the widespread between valuations and recent performance between growth and value, we want to be positioned with a balance of secular growth areas, many of those lever to AI, traditional defensive market segments, and value stocks that should benefit the most if the economy or their end markets positively surprise in 2026.

And looking within each of those segments, technology stocks, many of which are AI infrastructure or AI usage plays are among our favorites in the secular growth camp. But we also see secular growth in areas outside of technology, like medical devices, cybersecurity, digital payments, and aerospace. Within defensives, we've become increasingly interested in the pharma sector, the pharmaceutical sector, given its low relative valuation, and what appears to now be lower policy risks than what faced the sector earlier this year.

And also within defensives, we still like industries like waste management, traditional defense, and utilities within those non-cyclical market segments. And then lastly, within value segments, we continue to favor financials, which still reasonably valued, particularly relative to the broader market. They're delivering very strong earnings growth, which I mentioned earlier, and they're benefiting from reduced regulation.

Perfect. With that, Jeremy, thank you again for all your insights. And we hope that everybody else can join us for the final call of the year next month. and brokerage services in its capacity as an SEC-registered broker-dealer.

Investment advisory services and brokerage services are separate and distinct, differ in material ways, and are governed by different laws and 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. For more information, please review client relationship summary provided at UBS.com forward slash relationship summary.

UBS Financial Services, Inc. is a subsidiary of UBS Group AG. Member FINRA SIPC.