How should I be positioned? with Dr. David Kelly (JPMorgan Asset Management) and Jason Draho (UBS CIO)

Hi everyone, Dan Cassidy here. Welcome back to How Should I Be Positioned on the UBS Market Moves podcast channel. On this podcast, we do like to catch up with our industry colleagues and partners to discuss the market and macro environment along with thinking when it comes to asset allocation.

Joining me here from the UBS Chief Investment Office, glad to welcome back Jason Draho, Head of Asset Allocation for the Americas. We're also excited to welcome back to the podcast from JPMorgan Asset Management, Dr. David Kelly.

Dr. Kelly serves as Chief Global Strategist and Head of the Global Market Insights Strategy Team for JPMorgan Asset Management. It has been a couple of years, Dr.

Kelly, but it's great to have you back here at the table. Very glad to be here. Jason, nice to have you back with us as well.

It's good to be here. Thank you, David, for coming in. So a lot going on in markets and the macroeconomic environment.

Perhaps a good starting point. Dr. Kelly, we'd love to hear your thoughts on the U.S. economy overall.

How would you assess the current health of the economy? What might be some areas of concern, strain, and what are your expectations for growth as we look towards 2026? So I think that the best word to describe the U.S. economy this year is resilient.

We came into this year, I sort of, I characterize the U.S. economy as being like a healthy tortoise. I don't think we're early cycle, or mid cycle, or late cycle. I think that's behind us, and we're sort of just moving forward slowly.

I think inflation was heading down towards 2%. I think the unemployment rate's fairly stable, about 4%. And I thought the economy would avoid recession.

And that is actually what's happened for the most part. But as the year has gone on, particularly because of tariffs and also a dramatic change in immigration policy, we're seeing the economy probably slowing down a little bit towards the end of this year, and then heating up in terms of inflation. I think you'll see more, I think as we go into 2026, I think you'll see a little bit more inflation as tariff effects feed through.

But the economy should speed up temporarily. I think the OBBA, which is quite important in this, it has telescoped a lot of income tax refunds into the first quarter and first half of next year. I think that's going to push up consumer spending, and then the economy is going to slow down again.

So by this time next year, I think we're still looking at a 2024 economy, inflation running at about 2%, growth running at about 2%, still avoiding recession, unemployment about 4%. So it's still a kind of a boring economy, but it's not bad. I think most people would take boring.

The word resilient, I think I used that two years ago as kind of the word of the year in economics and finance, because people thought we'd get a recession when the Fed was hiking rates, it did not happen. I would agree with you, things have been better than we expected, if we go back to early April. Thinking about maybe the inflation point, and tariffs in general in terms of the economic impact, it hasn't been as material thus far as people expected, given what was announced in early April.

Do you think that it's just a case of it's still coming in terms of more inflation impulse, one with that inflation impulse peak, one with a growth drag peak? Or is it kind of happening now and it's going to be not maybe as bad as we all kind of feared back in April? I sort of lean towards it's coming camp on this one.

So what we've seen, we do have good data, even with the government shutdown, we have good data on how much revenue the Treasury Department is taking in. And we know that in the month of October, they're taking in about $32 billion worth of tariff revenue, that's up from 29 the previous month. And it's basically $30 billion plus in tariff revenue every month.

And what's happened so far is it's not being paid by foreign producers, it's not for the most part being paid by US consumers, it's being paid by US companies. And so the Walmarts and the Home Depots of the world are paying the tariff to get the stuff on the trucks and onto their shelves. But they're reluctant to some extent to pass those increases on.

I think the reason for that is because consumers are actually pretty constrained. The richest consumers are doing fine. But the great mass of low and middle income American consumers are pretty paycheck to paycheck and I think retailers think for right now, they can't pass it on.

But what's going to happen is early next year, we're going to have this huge flood of income tax refunds. This year, the average income tax refund is about $3,200. We think that it's going to be over $4,000 next year.

So that's an $800 – it's kind of like an $800 stimulus check. Well what happens if you give an American consumer a stimulus check? What happens if you give them a mass of cookies, one of glasses of milk?

Is that a trick question? I think they spend it. They will spend it.

And so that is going to be the precise time when the retailers are going to figure out, okay, now is when we can pass this on. Because that's really what kind of happened in the pandemic and I think that's what's going to happen too. So I think that tariff inflation is actually not going to peak until about June of next year on a year-over-year basis and then it fades.

Then if you don't have any further increases in tariffs or if some of the tariffs go away because of Supreme Court rulings or whatever, then I think the inflation rate fades. So I do think it fades in the second half of next year. But I think we have some tariff inflation still to come here.

Then going from inflation to growth, I got you right and sort of picking up on the stimulus point. So growth accelerates early next year, slows down in the second half of next year, but still the 2% to 2.4% I think you said, which if we think of trend as roughly 2%, that's still like – Well, yeah. Let me be clear.

Let me be clear. I think it will slow down to – I think we'll average about 2% next year, maybe a touch above. But I think it will start faster than that and actually end slower than that.

So I think it may end sort of 1.5% to 2% in terms of growth in the second half. But I think the unemployment rate will actually be down to 4% because we've got no labor supply. So it's one of those unusual economies where you're going to have a slowdown in the fourth quarter of 2025, then a pickup in growth, then a slowdown again.

But because there's so few workers entering the labor market, that could keep the unemployment rate actually coming down in the second half of next year I think to about 4%. So it's a slow economy but it's an okay economy. The real question, the first question I'm sure you grapple with too every day is, does that justify the sort of champagne and sparkle stock market that we have here if you've got an economy that's just kind of trudging forward?

We're going to come back to the markets and these kind of questions of bubbles and froth. But the macro you laid out, so inflation continues to rise at least year over year to middle of next year. It's a little bit delayed.

Growth is strong first half of the year because of this fiscal impulse and then moderates from there. Labor market actually tightens because of lack of supply. That's a tricky cocktail to stir if you're the Fed.

So we're recording this on Wednesday at noon on October 29th. Before the decision. Before the decision which is very likely to be almost certainly to be a rate cut in October.

Still likely for December but it's data dependent and I think we'll probably not get much guidance. Next year it's very much a wide open path with market pricing. The dot plot from FOMC members in September had a range of like 2.5% to 4%.

With that macro environment, if you told me inflation continues to go higher, growth is strong in the first half, unemployment goes lower, the Fed is done. But then maybe in the second half of the year they would potentially resume. What is your kind of view of how the Fed is going to play all this?

Is it other factors like is it QT or balance sheet or? Well, I think they'll quickly wrap up quantitative tightening right now because they're reaching the point where their ample reserves may not be ample enough. But I think that's kind of a sideshow for most investors and for the economy.

I think the Fed is in an interesting position. I don't think they're really scared about inflation in the long run and I don't think they should be because I think this is not a very inflation prone economy and the inflation will go away. I equally don't think they should be that scared about recession.

But what I think they'll hang their hat on is the idea that the neutral rate is 3% of the federal funds rate. Right now, as we're recording this, we're at four to four and a quarter. So they can say, look, we've got some room to run here and we can cut rates.

So long as we think that inflation will come down in the second half of next year, well, maybe we cut rates. To be honest, I also think part of this is they don't want to get into a fight with the administration. I mean, the administration is pushing very hard for them to cut rates and they very much value their independence.

I think they want to bend rather than break here. And so I think that there is a political element to this which will cause them to cut more, even though the macroeconomics may not exactly say they should be. Now, do I think they should be cutting?

No, but it's not because of inflation. I don't think they should be cutting because we have got some very bubbly, frothy markets. The animal spirits are running wild and if you visit the zoo, they say, don't feed the animals.

And I think we really shouldn't be feeding the animals here by feeding this market even lower rates. And so I think the Federal Reserve – the problem of the 21st century has been asset bubbles. Don't feed another asset bubble here, which unfortunately, I think they're doing.

So we'll get to that still. I want to tease the audience a little bit, picking up on the neutral Fed funds rate, which is not the most glamorous topic. But I wrote a note very recently and I titled it, The Two Most Important Numbers in Economics.

And I argued that one of them is the neutral Fed funds rate because of what it could mean for policy next year and how people interpret it. You said 3%. I think that's the Fed.

Most members would say around 3%. Stephen Myron, who was appointed by President Trump to join the FOMC right before the September meeting, dissented. Thought they should cut 50 basis points, 150 this year.

His dot implies a neutral Fed funds rate of 2.5%. And I've heard him make an argument and kind of labor supply story and so on and so forth. We can have a long conversation about the merits of that view.

The thing that I'm sort of thinking of is like, suppose he nominates a person, and there's down to five candidates, who subscribes to that view. And kind of then they try to use that as an intellectual basis. I agree with you.

I think that our official view is they'll cut October, December, once in Q1, and then they're done. But the bias will be for political pressure and maybe sketchy economic arguments that they'll cut more. How much do you think that is a real risk or do you think there'll be enough institutional pushback to keep them from going to like 2.5% and it'll stop around 3%, 3.25%?

I think it will be hard for the Fed to resist calls to cut rates all the way down to neutral. They say 3% is neutral. Now, let me be clear.

I don't think 3% is neutral. I'm going to say something very unorthodox here. I don't think there is a neutral rate.

And the reason I don't think there's a neutral rate is that a neutral rate implies that if you raise the rate from the neutral rate, you will slow the economy down a lot and reduce inflation a lot. And if you cut it, you're going to speed the economy up a lot or push inflation up a lot. And I think the whole message of the 21st century is, guess what?

Monetary policy doesn't work that way anymore. The Fed keeps on raising rates to slow the economy, it doesn't happen. If they cut rates after the great financial crisis to speed up the economy, that didn't happen either.

And you can go into the workings of all the ways interest rates are supposed to affect the economy in asset prices and interest expense and interest income. If you go through all of this, it's a very close call and that means a neutral rate could be almost anything. I mean I think it's actually – our star to me is an imaginary star.

It doesn't exist. But it makes it good because I'm never wrong. Well, it's unobservable.

But I do think that if the Fed – the big danger is that the Fed cuts short term rates down to a level which yet again feeds asset bubbles and that causes greater inequality and the problem about bubbles is eventually they burst. So it's not the economic punch bowl I'm worried about. It's the market punch bowl.

Well, that's – so kind of the punch line, literally the last line of the note is like whether you ascribe to this view or not, I think we have an administration in general that is biased towards wanting to run the economy hot through various policy measures. And if they want higher growth, I think they can get higher growth by like even today President Trump talking about maybe they reduce the defense and all related tariffs on China. So we can have tax cuts just through like a tweet basically.

And we'll get to the bubble kind of question for us. But the next one that kind of really leads into this is AI. And there is a discussion, a debate and this kind of feeds into the whole market bubble question is that is the US economy and US financial markets essentially just one big quote, bet on AI at this point in time.

It certainly is a lot of hype. There's certainly a lot of investment going on and every day the numbers seem to get ramped up. I think it's a little bit of a stretch to say it's all AI related.

But how do you think about AI in this whole kind of macro market story right now? Well, it is a huge driver of the US economy. I mean I think the – it's a driver both because of capital spending but also because of what it's doing to the stock market which is generating wealth effect among consumers.

So a lot of this economy depends on it. And I do think there are a lot of parallels to the late 1990s. I think that one difference is it is really about mega cap companies because any little company could be an internet company.

But you have to have massive spending on data centers in order to be a player in the AI space. So it really is these hyper scalers that are driving this. Look it's going to change the world.

I think AI is going to change the world just like the internet changed the world. If you go back, what were the lessons in the 1990s? It wasn't that the internet is all hype.

It was are you really sure that these are the companies who 10 years from now we're going to be talking about? And are you sure that every dollar being spent in different internet technologies is the right dollar to spend? And that's what I kind of worry about here.

I mean I got the – as I play around with AI, I put in a question of what's the best recipe for a blueberry tort and I realize that there are super computers whirling away in the desert sucking resources out of the earth in order to come up with that answer for me. And it's not very economical. There are certain AI – things that AI can do in places like healthcare.

Eventually I think in contributing to self-driving vehicles, there are certain things it can do that will make a big difference in productivity. But those are very selective, sort of a general being able to find you any answer at any time with this superhuman intelligence. I think first of all, I think it's a long time before we get to superhuman intelligence.

But also, it may not be the most productive use. So I'm afraid that there are going to be people who've got stranded assets. They spent a whole pile of stuff and it was just the wrong AI bet.

So you have to be careful about that because people are – anything that says AI gets money right now and not everything that says AI deserves money right now. Well, like during the dot-com era, companies that would put on like change their ticket to like dot-com including like some lawn care companies in Long Island. I was talking about something up to 10 percent.

That was true kind of euphoria and also there was someone that said around that time like, we wanted flying cars and we got 140 character tweets and maybe we want humanoid AI powered robots instead of we'll get blueberry torte recipes. Just that one example, I mean the imagination of Hollywood has always been about humanoid robots. But if you actually think about, we live in an age of robots, but the robots that run our factories are one just long arm that does this or one something else which does that.

I mean they are specialized and they're not – building humanoid robots is fun but I don't think anybody could afford the incredible expense of doing that with an all-purpose robotic AI ability to make sense. So we get to kind of this bubble topic. In asking whether it's a bubble or not, it's almost sort of not the right question.

It's more along the lines of like clearly there's parts of the market that feel euphoric and could be overstretched. You could also – people started talking about bubbles in 1996 and went on for a number of years. Talked about a housing bubble in 2004 and it went on for a number of years.

So given that there is this dynamic of worried about bubbles, that there is a lot of hype that hasn't fully been justified by kind of returns on capital at this point in time. Given that policy could be supportive in fueling asset bubbles as opposed to economic growth. How do you kind of think about it then from a market's perspective?

How do you navigate that? Is it something like you have to – maybe we make it a bubble but you have to kind of participate or do you like – how are you sort of thinking through this? Well, first of all, I think it's – I think we have to recognize that if this market has bubbly tendencies, there are good reasons for it and I would call it the broken valve problem, which is that a lot of people – it's easy enough to put money into the market.

But if you're in a taxable account, the moment you sell a stock, you pay capital gains. You write a check to Uncle Sam. Now, the way our laws are written, if you just held on to the stock, pass it on to your heirs, they don't have to pay it ever.

It never gets paid. So do you want – if you think the market might be over-expensive, you sell right now. You're immediately writing that check.

If the market bounces back 20% in a few weeks, you feel like a complete mug. So it's like the Hotel California. You check in.

You just can't check out. But also if you look at institutional investors, it used to be we had massive defined benefit pension plans who would eagerly rebalance every – every quarter they have to rebalance a portfolio. People aren't rebalancing the 401Ks.

I mean if they're overweight large cap US equities today, they're going to be even more overweight next quarter. And so you've got all this money that is flowing into this bet. It's very hard to get the money to come out of the bet.

So people have to be genuinely scared that this has gone too far and it's not going to recover before you see that huge correction. And that's a high watermark. It's happened to us.

It happened to us, the dot-com bubble. It happened to us, the great financial crisis. It happened to us very briefly with the pandemic.

But it's easy to see how a bubble can keep growing. It's hard to see the shock, the psychological shock that will break it. And therein lies the dilemma.

I mean as an investor, what I'd say is look, spread it around. There are better international investments that are going to do better than US – or international equities are going to do better than US equities this year. How much do you have in international?

Have some money there. Have some money in alternatives. You don't just have to diversify stocks with bonds.

You can diversify stock bond portfolios with alternatives like infrastructure, real estate or transportation. So there are ways of diversifying portfolios, reducing risk while still acknowledging that the good times could keep rolling for some time further in equity markets. So I'm maybe trying to paraphrase, I can't be clear in your thinking.

It sounds like you're saying, yes, these are issues that are maybe elevated risks of these kind of bubble conditions of really evolving. But as an investor, they're hard to know when that psychology changes. If you have a diversified portfolio, kind of a long-term plan, don't get too cute perhaps on the timing.

I know a lot of people who – we have clients, I'm sure you've talked to people, sold their business. Now they have a lot of money, worried about buying at an all-time high. It's like figure out how you want to be allocated and start working towards that.

Don't worry so much about the level of – Yeah, and just invest in a diversified way. I do believe in valuations in the long run for long-term investors because sooner or later, something will happen that's going to scare everybody and I think we're all haunted by the fact that when the dot-com bubble burst, the overall equity market fell by 50%, the Nasdaq fell by 78%. And if you're overweightly overhyped at this stage, I mean you know not the day nor the hour but you do know the location and the location of a bust is always the place that was most hyped beforehand.

So if that's the case, as an investor, if you've got money that you can allocate without causing capital gains, you've got some new money or whatever, just rebalance, rebalance, rebalance. There are plenty of great opportunities around the world. You don't have to invest in the most expensive, hyped area of US equity markets.

So if you think of a long-term strategic asset allocation, it could be like globally diversified as your baseline across fixed income, then tactically there could be opportunities to tilt one way or another. Like gold is something that we've liked and it's performed very well this year. Are there areas relative?

Do you think like just assume your almost agnostic benchmark rate is your long-term allocation where you'd be tilting that allocation like even more international versus a benchmark, less US tech, you know, fixed income, like where is your preferred? Yeah, I would probably have a bit of overweight to international in general and a lot of that has to do with the dollar. I mean there is this very strong correlation with long dollar moves, you know dollar moves that go on for years and even over decades and international performance.

And if we do think the dollar is too expensive, we think that's actually one of the reasons why we've got a trade deficit rather than just everybody else's trade practices. But if the dollar does come down, and partly again because it was as federal reserve that is too easy. If the dollar does come down, then that will tend to cause international equities to outperform.

And so, you know, if I had a completely neutral portfolio to start with and an extra dollar, I'd probably put it into international equities generally, both emerging markets and developed countries. I would, you know, I feel pretty good about both of those areas right now. And then within fixed income, I probably would, you know, I think it's okay to have an allocation to fixed income.

Maybe I'd be a little underweight because I do think that a 10-year treasury at 4% is a little on the low side, but I wouldn't make a big bet there one way or the other. And then within US equities, I just put extra dollars into value and into mid and small cap relative to large cap. And again, I would put money into alternatives, add some alternatives which can add some stability to a portfolio.

Obviously, with alternatives, you've got to be careful about the manager too, of course. Gold massive run up into early October, then very quickly had almost 10% correction, sort of stabilizing as we speak. Do you think it's at a pause before the rally continues another 10%, 20%?

Or is it kind of like that's played out a little bit? Really hard to make this call. I mean, I used to be negative in gold and thought that it was a Bitcoin.

And then I realized what a truly speculative investment was. But I think I'm not completely negative on having a gold allocation. It's not my favorite asset in the long run because it doesn't generate a stream of income and it is really worth what the next person thinks it's worth.

But in a world where you've got populist governments pumping up government debt, the idea of having an asset which is of truly limited supply that people look at it as a substitute for government debt is somewhat appealing. And so I wouldn't mind having a small allocation towards gold as part of, again, just trying to achieve that very broad portfolio diversification. Well, with that, Dr.

Kelly, very generous with your time, a fascinating conversation. Have to have you back for a part two, perhaps in 2026. Would be great.

In the new studio, by the way. I would love to do that. Excellent.

Thank you again, Jason. You're welcome, Tick. Thank you for joining us today.

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