House Call: Talking Equity Markets with UBS Asset Management

Hi, everyone, Dan Cassidy here. Welcome back to House Call, Talking Equity Markets with UBS Asset Management. For this month's episode, I'm glad to once again be joined by Jeremy Zierin, Senior Portfolio Manager for the Houseview Equity Portfolios and Head of the Private Client U.S.

Equity Team, along with Dominique Shager, Lead Equity Investment Specialist, joining us today from UBS Asset Management. So Don will guide today's conversation with Jeremy. They will focus their time on recent market developments and how they're shaping UBS Asset Management's thinking within the Houseview Equity Portfolios.

So with that, Don, let me now turn it over to you. Great. Thank you, Dan.

It's great to be back, and we appreciate you having us on. So Jeremy, there's a lot going on, so let's get started. After a strong May and a volatile start to June, U.S. equities continue to move higher, pushing back towards record highs.

From your perspective, what has been the primary drivers of the rally, and what stood out the most to you? Thanks, Dom. I framed the rally as a market that's been climbing the proverbial wall of worry, largely due to strong underlying equity fundamentals.

We've had a lot for investors to digest, whether it's geopolitical disruption, concerns around oil supply, higher bond yields, questions about AI-related parts of the market, whether they move too far too fast, yet equities have been remarkably resilient. And the main reason, in my view, is that the earnings backdrop has been strong enough to offset a lot of those concerns. U.S. companies just reported the fastest earnings growth in four years in the first quarter, with S&P 500 earnings up roughly 20% year-on-year, and that marked the sixth consecutive quarter of double-digit earnings growth.

And that sustained fundamental strength and helped support investor confidence, even as macro uncertainty has remained elevated. And at the same time, forward earnings expectations have moved significantly higher, reinforcing the view that earnings, not just sentiment, has been supporting the rally. Just quantifying this a bit, the rolling 12-month forward consensus earnings estimate for the S&P 500 started this year at $311, and today it stands at $364, only 17% higher in under six months.

At the end of the day, Dom, earnings drive stock prices, and forward-looking earnings estimates at a market level are one of the best gauges of the health of the earnings cycle. The second market driver has been continued enthusiasm around AI, including the infrastructure build-out, increased AI utilization and enterprise penetration, and clearer signs of productivity gains accruing to users of AI. And what's important here is that it's not just a sentiment story.

You can really see the earnings for semiconductor companies and other AI-linked areas of the market, like energy, industrials, and tech hardware, where a real step function higher in demand for AI is driving a lot of those positive earnings revisions. And what has stood out to me also is that the economy has been able to absorb higher oil prices from the Middle East conflict, higher bond yields, much better than people had expected. But it really shouldn't come as too much of a surprise if you do the math.

I think we've spoken about this on prior calls, but the rule of thumb from econometric models is that every $10 increase in oil prices, if sustained for several months, shaves off about 0.1% of GDP. So if we've seen a $40 jump in oil prices, mathematically that should shave off about half a percentage point of GDP. The economy has been running between 2% to 2.5% GDP growth, so shaving off a half a point certainly isn't large enough to derail the economic expansion, just to modestly slow it down a bit.

So my bottom line is, we're in an earnings-fueled bull market that appears set to continue given the health of the earnings cycle, but we also need to recognize that risks do remain, whether they are related to geopolitical events, valuations, Fed policy, or potential technology changes. So while I expect the bull market to continue, it's unlikely to be a linear path higher and investors should be prepared for the bouts of volatility along the way. So Jeremy, if we step back from the markets for a minute, a big part of the story still comes down to the broader economic backdrop.

So how would you characterize the current state of the U.S. economy, and if you look ahead, what signals are you watching most closely? Yeah, I'd characterize the U.S. economy as resilient, but still very K-shaped. At a headline level, growth has held up better than investors expected, as we just talked about.

The labor market weakness we saw in the second half of last year and the early stages of this year seems to have passed, and we've seen a bit of a re-acceleration of job growth in recent months. And as I mentioned, corporate earnings have been strong, which is typically a very good leading indicator for the labor market. But beneath the surface, the sources of that economic growth are uneven, hence the K-shaped, and that's a key point investors need to understand.

So what does this K-shaped economy really look like? For consumption, which is the biggest part of our economy, the high-end consumer is really driving much of the growth, and that's been fueled by healthy balance sheets, rising asset prices, whether it be housing or financial assets, and solid income growth. But the lower-end consumer continues to be under pressure after several years of elevated inflation that has outpaced wage growth.

And so even as inflation has moderated from its peak, just that cumulative increase in prices and above-average or above-trend inflation has weighed heavily on households that are not benefiting from rising asset prices as they have less flexibility. My nuanced perspective on the K-shaped economy is that it also applies to the business spending component of GDP. And most people discuss GDP, and they say that consumer spending is two-thirds of the economy, and that's true, but it's that business spending segment, which, while it's only 15 to 20 percent of the economy, tends to be more cyclical and more directionally consistent with whether the economy is accelerating or decelerating.

And there we also have a K-shaped economy. The top of the K is AI infrastructure, and that's been a major growth engine, supporting demand across semiconductors, power, data centers, networking, and other industrial-related supply chains. The bottom of the K is more traditional manufacturing and broader capital investment, and that's really been slumping for much of the past three years under the pressure of higher interest rates, policy uncertainty, and geopolitical risks.

I would say that the good news there is that, while we're not seeing a lot of improvements in the bottom of the K in the consumer spending landscape, we are seeing green shoots in the bottom of the K in business spending, whether it is the stronger ISM readings that we've seen this year, or a number of industrial companies just talking about improvements in markets that have been struggling. And so the bottom line on the U.S. economy, from my perspective, is that it's still on solid footing, but it's not a uniform story. And then you asked about the signals, and what am I watching most closely?

I would say, first, it's inflation. Because even though inflation is moderated from its peak, it's still running above where policymakers would like it to be. And the cumulative impact of higher prices is still weighing on lower-end consumers, as I mentioned.

I'm also watching whether the high-end consumer continues to spend at such a robust pace. Just putting some numbers behind this, the top decile of consumers by income represent almost half of all consumer spending. So consumers at the top of the K really drive the aggregate consumer spending data, and ultimately, the U.S. economy.

And then finally, I'm watching for confirmation whether there are early signs of improvement in the bottom of the K in business spending or traditional manufacturing and capital spending, and whether to see it stay broadened. And if that happens, the economy can be less dependent on that high-end consumer and AI infrastructure story alone, which would make the expansion healthier and more durable, in my view. Jeremy, I know the thing you were watching yesterday was Wash's first meeting as chair wrapping up yesterday.

As you mentioned, inflation is still running a bit hot. So what stood out the most to you from that meeting, and how does it shape your thinking on the policy path ahead? Lots to discuss in terms of the Federal Reserve change.

The headline decision yesterday of keeping rates steady was not a surprise, right? It was the fourth consecutive meeting where rates were unchanged, and it was Wash's, the new Fed chair's, first meeting, and the decision was unanimous. But the real story was not the whole.

The real story was the tone, and it was incrementally more hawkish than markets were perhaps expecting. The biggest surprise was the dot plot that then removed the easing bias from the statement, that that had largely been expected. What was more notable was that nine FOMC participants, so effectively half the committee, penciled in at least one rate hike in 2026, and six participants saw at least 50 basic points of hike.

And that's a meaningful shift. It tells you the committee's balance of risk has moved more firmly towards inflation and away from concerns about the labor market. And you can see that in the economic projections.

The Fed raised its 2026 core PCE inflation forecast up from 2.7% to 3.3%. It also raised its core PCE forecast to 2.5% from 2.2%. So that's higher than many of the Fed had expected.

At the same time, the Fed lowered its GDP forecast more modestly, just from 2.4% to 2.2%. And so the messaging really coming from the Fed is not a recessionary message. It's more of a growth is still solid, but inflation is too high message.

And then Chair Warsh's communication style was clearly a big focus yesterday. And I would say that had stood out to me. The statement was much shorter.

There was no forward guidance. And Warsh said forward guidance is not well suited for this market environment. He also didn't provide his own dot in the dot plot, which is a clear and notable departure from the prior communication framework.

And so in essence, what we saw yesterday was not just a policy message. It was a regime change and how the Fed or this Fed that's led by the new chair wants to communicate. And then maybe finally, you know, Warsh was very clear that inflation is still the focus.

That's why it was incrementally more hawkish. He emphasized that inflation has been above the 2% target for five years and said the committee is quote unambiguously and unanimously and quote committed to price stability. And he reiterated that the 2% target is not up for review.

So with inflation closer to 3% and the Fed reiterating the 2% target, you know, it's clear that their clear goal right now is bringing down inflation. So a little bit incrementally more hawkish, hawkish. I would say, you know, how does that shape my thinking?

I would say that investors need to be a bit more cautious around assuming that the next move is a cut. Well, I don't think that we're going to see a rate hike given that we are seeing declines in energy prices and that should bring down, you know, inflationary measures. I would say it's very unlikely that the Fed is going to ease anytime soon.

They're much more likely that they're on hold for, you know, a longer period of time. It certainly doesn't mean that hikes are guaranteed, but it does mean that there's a hurdle for rate hikes to move higher. And the Fed wants more evidence, you know, probably several months of evidence that inflation is decelerating, moving back towards its 2% target.

And then for markets, the distinction is important, right? A higher for longer Fed driven by resilient growth can be manageable. But if the Fed is forced to, you know, if inflation does not come down as expected and the Fed is forced to stay more restrictive, because inflation is either 50 stubbornly high or potentially be accelerating, that's a much, much, much tougher backdraft for equity markets, especially parts of the markets that are more dependent on lower interest rates or discount rates like stocks tied to housing or auto in markets.

And it would threaten sort of that broadening out in the lower part of the K or the industrial sector. So Jeremy, let's touch on a topic. That's been getting quite a bit of attention lately.

We're starting to see a large pipeline of mega cap IPOs coming to market. What does that signal to you? And should investors be worried about excessive investor exuberance, or are we seeing signs of a bubble?

Look generally a strong IPO market and healthy capital market activity is a good signal that investors view the economic expansion as sustainable. You know, companies see a window to come public. Investors are more willing to fund that growth and their conditions, conditions are supportive enough to absorb new issuance.

And that's like, you know, a healthy signal that regarding animal spirits and business confidence, and it gives investors access to new businesses and can broaden the opportunity set for investors. But, you know, to your point and the tone of the question, there have been times that very high levels of IPOs can also be a warning sign. You know, valuations are being driven more by hype or compelling narratives rather than by, you know, fundamentals, you know, regarding signs of a bubble and particularly most of the concerns today are, you know, are we in a, an AI bubble?

There certainly has been a lot of comparison to the current or comparing the current AI cycle to the internet bubble from the late nineties. And while I would say that there are some clear similarities, you know, such as investors being excited about a new technology and tech stocks leading the market higher, you know, there are many more significant differences that lead me to conclude that we are not likely in a bubble for, for AI stocks. What are those differences?

Well, first, even just related to IPO activity, right? Even assuming we see the two well-rumored frontier model providers, so public this year, that would put equity issuance this year, just about 1% of the $72 trillion market cap of the, of the U S equity market. And that's just about in line with, or maybe slightly higher than the long-term average level dollar value of IPOs relative to the market cap of the U S market.

Just for context, you know, the peak of IPO activity relative to the market cap of the U S market in the late 1990s was a little over 2%. So almost twice as large. So we're not really seeing bubble like behavior in terms of the magnitude of IPOs in aggregate coming to markets.

And then similarly, you know, valuations are not accepted in the way they had been back in the late nineties, early 2000s. Today, the tech sector trades at 24 times forward earnings, less than half of the peak valuation of 55 times earnings that we saw at the peak of the internet bubble. And then finally, more fundamentally, you know, bubbles burst when there's, you know, simply just too much capacity built up in a specific area after a meaningful overbuild and not enough demand.

And while capital spending on AI infrastructure has been rising rapidly demand for AI products and services is still outstripping supply. And that's really the key point. And the key difference from the late nineties, where we had an overbuild by Brock to cable where supply outstripped demand.

And so today, you know, the spending on AI should not be, you know, viewed in a vacuum. It is clearly being pulled by real consumer demand for compute data center capacity, you know, frontier models, software, and AI enabled services. And so, you know, overall, you know, I don't think it's likely we're in a bubble, you know, sure there can be pockets of exuberance, especially when expectations have moved up sharply higher where companies are being valued on very aggressive earning assumptions.

But my bottom line is that as long as demand continues to outstrip supply, I think it's just inaccurate to label the current build out in AI as a bubble. Jeremy, thank you again for joining us and for sharing your insights. This podcast is presented for informational purposes only and should not be relied upon as investment advice or the basis for making any investment decisions.

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