House Call: Talking Equity Markets with UBS Asset Management

Hi everyone, Dan Cassidy here. Welcome back to the UBS Market Moves podcast channel. We are back today with another episode of House Call, Talking Equity Markets with UBS Asset Management.

For today's episode, glad to welcome back Jeremy Zierin, Senior Portfolio Manager of the Houseview Equity Portfolios and Head of the Private Client U.S. Equity Team. We are also joined today by Dominique Shager, Senior Equity Investment Specialist, both joining us today from UBS Asset Management.

So with that, Jeremy, Dom, thank you both for dropping by to spend some time today with our listeners and our clients. Dom, let me now pass it over to you to lead today's conversation. Welcome back.

Great. Thank you, Dan. And as always, we appreciate you having us on the show.

So let's start with the big picture. Markets have had a very eventful year, from strong gains in parts of the tech to a few surprises and cyclicals. So Jeremy, what do you see as the main drivers of equity performance so far in 2025?

Yeah, at a high level, I'd say that three forces stand out. First, it's very clear that artificial intelligence or AI has been a big driver for the stock market this year. And what stood out to me, other than the large and growing capital commitments from the hyper scalers on AI infrastructure, is that AI has moved from the experimental phase to the mainstream.

And certainly that's true for consumers. And increasingly, that's true that companies and enterprises are utilizing AI to boost productivity. And that's becoming table stakes for most companies.

If you look at consumer adoption, you know, open AI, chat GPT, now has over 800 million weekly average users. And at the enterprise level, we're just hearing more and more companies are now prioritizing AI within their IT budget. And because of this, there's been an explosion of spending on AI infrastructure, from the chips that power the compute, data centers, networking, and software that enable use cases.

That has really supported the stocks of many mega cap tech leaders. But it's also boosted, you know, the so-called picks and shovels around them. The power systems, great upgrades, cooling, industrial equipment, investments, all of these have boosted, not just tech sector companies, but many industrials, energy and utility stocks as well.

And, you know, the good news here is that this doesn't appear to be a quarter to quarter phenomenon. It really looks more like a multi-year investment cycle that will steadily ramp and supports the earnings for both the providers of the digital and physical infrastructure related to AI. You know, the second market driver has been the fact that the U.S. economy has been more resilient than expected.

You know, despite the tariff shock that we had in early April and high interest rates, consumer spending has been, you know, reasonably steady. Labor markets have cooled, but they haven't pulled over, meaning we've seen a slowdown in hiring, but we haven't seen a lot of layoffs. And most companies are focused on productivity rather than simply cutting back in their labor force.

You know, that backdrop has supported, you know, parts of the industrial sector, you know, particularly strength in automation, aerospace and defense and logistics companies within the sector have done well, as well as the financial sector, you know, that continues to benefit from, you know, just strong capital markets and fee income. And, you know, consumer discretionary stocks also contributed, especially those catering to the high end consumer or those that are benefiting from, you know, the lower to middle end consumers trading down in their purchases. And then there's the old adage, don't fight the Fed, would probably be the third market dynamic that has supported equity market gain so far this year.

You know, the Fed delivered its first rate cut in about a year in September, and markets expect more easing as we head into the end of the year in early 2026. Historically, you know, soft landing rate cuts tend to support equities, and we're really seeing, you know, that playing out. Since the first rate cut, markets are higher and cyclical about performed defenses.

So putting it all together, the combination of AI or resilient economy and Fed rate cuts, I would say, have been the three big drivers of market performance. Thank you, Jeremy. That's very helpful overview.

So now switching gears for a minute, with Q3 earnings season just beginning, what are you watching most closely this quarter? And are you expecting earnings to grow to broaden beyond just the top heavy names we've seen so far? First, what are we focused on?

Broadly, we're focused on the resiliency of revenues and earnings growth overall and index level. And then within the market, we'll be listening for what companies are saying about the outlook, especially as it relates to what I just talked about, continued spending on AI infrastructure. You know, what companies are saying about the state of the industrial economy outside of AI, and the impact of tariffs on margins and ultimately on business confidence.

And then if you take a step back at a market level, earnings momentum coming into the quarter has been strong. In second quarter, S&P 500 earnings grew at 11% year on year. Consensus estimates call for roughly 8% year on year growth this quarter.

But keep in mind, companies typically beat by 3% to 4%. So if we get the normal beat rate for earnings this quarter, this will be another quarter of 10 or 10 plus earnings per share growth on a year on year basis. Digging in by sector a little bit, within the technology sector, as I mentioned, the big question is just what will the guidance look like from the hyperscalers in terms of AI CapEx?

The big question really is will they provide further either explicit guidance or signals that the next couple of years will be up years for AI infrastructure, given how much these companies have already committed? More broadly, we'll be looking to hear about AI adoption by companies. So you've already heard very early in earnings season so far this week, as of right now, but some of the biggest financial companies that have reported are already saying that they are seeing a significant return on their investment in AI in terms of stronger productivity and new revenue opportunities.

Within the industrial sector, we're going to really be looking at those CapEx plans given the resiliency of the economy and whether we're seeing an inflection point. Industrial activity has been very weak over the last couple of years, but given that we have new fiscal policy that has been signed that includes bonus depreciation and expensing provisions, we're going to be listening for whether companies are taking advantage of those provisions and whether that's providing sufficient incentives despite the uncertain global economic outlook to increase capital spending. And then the consumer, we're really going to be looking at are we seeing, we've clearly seen a step down in job growth.

We're going to see if that's translating into weaker consumer spending. All the data sources that we've looked at so far are showing that things have not really slowed down largely because of the strength of the middle to high-end consumer, but the tone for management on sort of end of year and holiday planning is certainly going to be important. And then to answer your question, do we think that earnings growth will broaden out beyond sort of the mega caps?

The answer to that is probably yes, but not yet. So, consensus has the tech sector EPS growing at about 20% while the S&P 500 excluding the tech sector is only expected to grow at about 3% rate. And I think that will narrow over the next few quarters, but I think it's a bit early to expect it to narrow in this quarter.

We just saw the Fed cut rates. We're still seeing more of a bottoming than an inflection point in some of the rate sensitive sectors within manufacturing, housing, and other sectors that have been struggling under the weight of high rates over the past couple of years. And frankly, tech sector earnings still look robust.

So, it's hard to see a narrowing in the actual third quarter results, but we may get some greater indication that we'll see a narrowing given the guidance that we'll be hearing from some of those non-tech companies. As you mentioned is yes, but not yet. Broadening of the market will be influenced by what happens next on Fed policy front.

So, as the Fed continues to walk this fine line between controlling inflation and maintaining growth, how has the shifting expectations around Fed policy shaped market leadership this year? And do you think the markets are still too optimistic about how quickly rates might come down? So, the Fed is clearly walking a tightrope here.

Inflation remains above their target. The main inflation gauge that the Fed focuses on, the core PCE, is around 2.9%, but the labor market is cooling, and that justifies a September 25 basis point cut. And markets expect another 75 basis points easing by early 2026, taking the policy rate down to about 3.5%.

And that's generally supportive for equities, as I've mentioned, don't fight the Fed, but there has been a catch. I mean, long-term rates remain elevated and the yield curve is steep and signaling that investors remain somewhat uncomfortable with both fiscal and inflation risks. So, are markets too optimistic pricing in the other another 75 basis points?

Possibly, right? If tariffs or wage pressures keep inflation sticky, the Fed may not cut as aggressively as priced, but we also have to remember that we'll have a new Fed share come the middle of next year. And it's very likely that the new Fed share will be aligned, at least directionally, with the President's view of interest rate policy and will want to lower interest rates.

And so, from that perspective, from a market perspective, lower rates should be a tailwind for some of those interest rate-sensitive sectors that have lags, like utilities and consumer staples, and should support the broadening out of S&P 500 earnings growth, because lower interest rates should translate into better earnings for some of the more cyclical factors. But a lot will depend on how the bond market interprets the cuts to short-term interest rates. If long-term rates don't come down because of fears of sticky inflation or fiscal sustainability concerns, it'll be less helpful for the economy, for markets, and for that broadening out trade.

Another area that a lot of investors are concerned around is around valuations, especially in parts of the market like AI and large-cap tech, which remain elevated. How are you thinking about valuation risk in this environment? So, relative to history, valuations are undeniably high.

The S&P 500's forward PE is roughly 22 times versus a long-term average of 16. The tech sector trades at 30 times earnings, which represents a 30% premium to the broader market, compared to its 10-year average PE premium to the market of about 20%. Does that mean investors should avoid the tech sector?

Certainly not. As I mentioned before, earnings growth for the tech sector is the strongest of all 11 economic sectors. Fundamentals for AI-related costs continue to look very strong.

Global AI capex figures, as mentioned, have been rising rapidly. By some estimates, spending on AI infrastructure could more than double from current levels by the end of the decade. There's been a lot of talk in the media over the past couple of weeks whether or not AI in particular is in a bubble, similar to what investors experienced 25 years ago in the dot-com boom-bust cycle.

To be fair, there clearly are some things that rhyme. There's a new technological paradigm that promises transformational change. This time, it's AI before it was the internet.

We've seen rising valuations. We've seen greater market concentrations. To me, there are two main differences between the current AI cycle and what we saw 25 years ago in the dot-com era.

First, valuations are not nearly as acceptable today compared to what we saw at the market peak back in March of 2000. Back then, the leading internet companies and the largest companies in the S&P 500 traded at over 60 times earnings and in some cases, over 100 times projected earnings. Many of the leading internet companies didn't even have earnings and traded on new metrics such as price to eyeballs or price to clicks.

If you look at the leaders in the AI space today in the public markets, most of the gains have been driven by established tech leaders and the capital spending is coming out of their strong free cash flows. The PE, the price to earnings ratios for most of those mag seven stocks or just AI leveraged stocks that are market leaders or have seen rapid gains is closer to 25 to 35 times earnings. Big difference in terms of the valuation between now and then.

Secondly, and maybe just more intuitively, bubbles occur when there is a glut of unused capacity and the market suddenly realizes the mismatch between too much supply and not enough demand and that's what pierces the bubble. That's exactly what happened in the dot-com bust in early 2000 when investors realized that the massive spending on fiber optic cable and internet infrastructure far exceeded demand, especially near-term demand. The big difference with AI now is that at least what we see today and what we have some visibility on over the next couple of quarters, almost every AI-related company along the value chain talks about how much demand is outstripping supply.

New versions of large language models have to be gated because they require more processing power than the providers can supply. Some of the biggest cloud computing providers are turning away some business because they don't have the capacity to service the customers. This suggests to me that we're still in the early to middle stage of the AI build-out or at a minimum, spending on new capacity to meet current AI demand should at least continue over the next few quarters.

That doesn't mean that these stocks will go up in a straight line. We've already seen several 10 to 20% corrections in AI leveraged stocks over the past two years, but in my view, stocks across the AI value chain, whether it's the enablers, the intelligence layer, or the application layer, will ultimately see higher earnings over the next few years supporting further share price gains over time. So as you mentioned, growth has clearly led for much of the last decade or so, but we're starting to hear renewed interest around value stocks.

In your view, what's the case for value today and where might investors find underappreciated opportunities? Value stocks characterized by the Russell 1000 value index have lagged for much of the past decade and even this year with its outperforming value by about five percentage points. But I do think that there's a growing case for the value for patient investors.

First, the valuation gap is wide by historical standards, like U.S. large cap growth rates at an 80% valuation premium to value compared to a 10-year average of 55%. So some of the optimism clearly is parsed in. If inflation proves sticky or rates stay higher for longer, value sectors like financials and energy tend to hold up better.

And then finally, as we discussed earlier, if the Fed rate cutting cycle spurs a meaningful economic rebound in 2026 in some of the interest rate sensitive segments like manufacturing and housing, we get to see a narrowing of that earnings growth differential between growth and value, and that should be supportive of value as well. I mean, part of the reason growth has outperformed is because of the just gains we've seen in AI. Part of the valuation widening that we've seen between growth and value has been driven by a scarcity value of growth.

And since growth stocks, especially AI levered growth stocks, are growing revenues and earnings rapidly, and we haven't seen a lot of earnings growth outside of the tech sector, you get an even wider valuation premium because there's a scarcity value to that growth. If that scarcity value declines because we see earnings growth improve outside of the tech sector, that should be a fertile ground for value stocks to start to perform better. And then within value, we particularly like the financial sector because the fundamental backdrop for the financial sector, which includes healthy capital markets, still resilient consumer spending, and importantly, improving regulatory backdrop should reinforce that earnings growth, at least for the financials within the values category, value stock category, I should say, looks fairly attractive.

So before we close the call, as we enter the final stretch of the year, any words of wisdom for investors as they think about their precisioning for the remainder of a year and beyond? Yeah, I'll keep this answer a little shorter. But as it relates to much of this conversation, I think investors tend to think a little bit too much about growth versus value.

And my best advice would be to reshape and reframe that to growth and value. Right. You want to have a diversified portfolio between growth stocks and identify looking at categories within the growth stock universe that where growth can be durable and value, because if we do get a improved, broader economic growth backdrop within the U.S. economy and the global economy over the next couple of years, that could trigger a rotation to value.

And as I talked about before, we see good value in financials and other value oriented cyclicals within industrials, consumer discretionary, and even material sector could start to look a lot better if market breadth improves. Wise words. Thank you, Jeremy.

Thank you, as always, for your insight. Along with our video offerings, such as UBS Trending. You can also follow us on Instagram for content highlights at UBS Trending.

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