How should I be positioned? with Steve Chiavarone (Federated Hermes) and Jason Draho (UBS CIO)
Lead — This commentary suggests a cautious but optimistic outlook for investors navigating the complexity of today's financial markets, particularly through the lens of macroeconomic dynamics and AI capital expenditure trends. Per the full note , both Steve Chiavarone from Federated Hermes and Jason Draho from UBS emphasized the importance of positioning in light of the Federal Reserve's ongoing monetary policy adjustments and potential risks to market stability. Given the current macroeconomic landscape, which includes a projected increase in AI-related investments, the duo portrays a forward-looking stance on equity market performance. Their insights could signal shifts in portfolio allocation strategies among institutional traders.
What the desk is arguing
The desk interprets the dialogue between Chiavarone and Draho as a call for strategic portfolio adjustments in response to macroeconomic indicators and shifts in technology-driven sectors. They highlighted that the central banks' actions, particularly those of the Federal Reserve, are integral to market movements and portfolio positioning decisions. This is crucial, especially with speculation surrounding the timing of further interest rate changes impacting equities and overall market risk appetite.
The supporting evidence revolves around the anticipated surge in capital expenditures related to AI technologies, which Chiavarone identified as a key growth driver. Notably, investment in AI is projected to grow significantly, potentially reshaping traditional asset allocations and leading to increased equity performance in sectors poised to benefit from these advancements.
Conversely, an alternative read would suggest that inadequate Fed communication or missteps in policy adjustments could dampen investor confidence, prompting a risk-off approach among traders. This presents a counterpoint to the optimistic positioning suggested by Chiavarone and Draho, illustrating the delicate balance between growth opportunities and market volatility.
Where it sits in our coverage
Our consensus target currently sits at 1.075 for the EUR/USD pair, with a range forecasted between 1.04 and 1.12. Leading firms in this projection include: - JPMorgan: Targeting 1.10 by March 2026 - Bank of America (BoFA): Forecasted target of 1.04 by March 2026
The desk's outlook aligns closely with the upper end of the consensus range, suggesting that if growth in sectors influenced by macroeconomic indicators and AI capital expenditure materializes, we could test these higher levels in the currency market.
How other firms see it
Several firms echo a similar sentiment, particularly those leaning towards a positive outlook on growth driven by technological advancements. For instance, JPMorgan supports the thesis of increased equity performance aligned with macroeconomic stability. Conversely, Bank of America (BoFA) presents a more cautious stance, emphasizing potential downturns should economic indicators fail to meet bullish expectations.
Watch the EUR/USD trajectory closely, especially as it mirrors influential factors such as Fed policy decisions and changes in capital expenditure commitments within the AI sector. These intertwined elements can significantly influence market movements and investor sentiments.
What the calendar says
No high-impact events are scheduled for the next 30 days, suggesting a quieter period for macroeconomic catalysts that could sway trading decisions. This also indicates a clearer runway for traders to interpret signals from the ongoing discussions and adjust their positioning accordingly.
01Cautious optimism regarding macroeconomic indicators and AI capital expenditure.
02The importance of strategic portfolio positioning in light of Federal Reserve policies.
03Potential risks loom if Fed communication does not align with market expectations.
04Investors should track the projected surge in AI-related investments as a key growth driver.
Market implications
Traders should monitor the EUR/USD at levels around 1.075, with potential catalysts for movement stemming from macroeconomic shifts or unexpected Fed policy changes. Positioning towards growth sectors influenced by AI may yield favorable outcomes in 2024, but vigilance is needed as stability remains fragile.
Risks to this view
A key risk factor is the Federal Reserve's ability to communicate effectively while adjusting monetary policy; any misalignment could cause market volatility or a loss of investor confidence. Additionally, failure of anticipated growth in the AI sector to materialize could challenge current optimistic projections.
ubs
Hi everyone, Dan Cassidy here. Welcome back to How Should I Be Positioned on the UBS Market Moves podcast channel. On this podcast, we like to catch up with our industry colleagues and thought leaders to exchange views on the market and macro environment along with thinking when it comes to asset allocation.
Joining me here today at the 1285 Podcast Studio in New York, glad to have back from the UBS Chief Investment Office within UBS FSI, the Head of Asset Allocation for the Americas, Jason Draho. Jason and I are joined today on the line from our partners at Federated Hermes by Steve Chevron. Steve is the Chief Investment Officer for Global Equities and a Portfolio Manager at Federated Hermes.
Steve was also recently named as a member of the UBS Research Advisory Board, and for a bit of context, the UBS Research Advisory Board brings a wealth of expertise and diverse perspectives to help you evaluate the current macroeconomic and geopolitical environment, navigate today's increasingly complex financial markets, and anticipate what lies ahead on the investment horizon. The RAB is at the forefront of market news and trends, whether navigating geopolitical shifts, understanding the impact of AI, or debating the timing of the Fed policy decisions. So with that, we are very excited to have Steve on the Research Advisory Board here at UBS.
And Steve, Jason, great to be back with you both. Thank you for dropping by and for spending some time today with our listeners and clients here on How Should I Be Positioned. Well, thank you, Dan.
Great to be here, Dan. Yeah, I think this, Steve, is your first time on the podcast. I can assume like WFAN, this is your first time call, but long-time listener to the podcast.
I can assume that. You've got it. I've spent some time with Dan over the years, but I'm excited for today's conversation.
And I'd also say, you know, it really is an honor and quite an opportunity to be a part of the Research Advisory Board. UBS, I think, has done something pretty special there in bringing together a wide-ranging and impressive group of folks from the street. I think your clients will benefit from the insights.
And I think for those of us that are participating, you know, we're benefiting from the insights of our colleagues around the industry. So congratulations to you and UBS for having this initiative, and, you know, I think it's going to be a great benefit to your clients. So congratulations.
Well, thank you. We're very happy to have you on the RAB, Steve. A lot to talk about given today's markets and macro environment, Steve.
We are coming off of a great hike from the Fed last week, and there's a lot of speculation as to what this all means for the course forward for U.S. economic activity, monetary policy. What's your view, Steve, on the overall macroeconomic environment in the U.S. as it currently stands? Yeah, you know, it's interesting.
We always come up with our earnings forecast and our price targets for the S&P 500, you know, in the early fall. We did it earlier this year, and we published them, you know, the first half of September. And we go out two years.
We don't just look at where we think the market's going to be kind of at the end of 27. We look at where we think it's going to be at the end of 27 and 28, which is a little bit different from how I think a lot of firms do it. But we released it earlier this year because we wanted to plant a flag in the ground on what we see as a very bullish macroeconomic environment, you know, certainly through next year and into 28.
And we wanted to do that before the emergence of some volatility that we could see potentially pop up in the coming weeks. And so, you know, what really underlies that bullish medium-term outlook? Well, you know, we've got the infrastructure build that's happening right now around AI, but it's not just AI, it's grid modernization, there's reshoring, there's new domestic manufacturing that's also occurring, is the biggest infrastructure build since the railroads.
And it's the biggest infrastructure build, you know, outside when you think globally since China industrialized, you know, let's call it 25, 30 years ago. That's a big story. It's driving up employment, obviously employment's been much stronger this year than last.
Consumer spending has been buoyed by it as evidenced by the most recent retail sales data and earnings, right? We're seeing earnings grow at a rate that's really unprecedented unless you're coming out of a recession. And so we see 15% earnings growth in each of the next two years, and we see markets headed higher.
And it's based on a consumer that's strong, corporate investment that is, you know, one of the strongest periods we've seen in this kind of incredible infrastructure build out that's driving a lot of economic activity. So, you know, as we look out, we feel pretty bullish. We know that there's some things that the market is contending with and likely to worry about over the coming weeks, but we would view that as an opportunity to buy, not reasons to sell.
Jason, from hearing Steve's outlook, it sounds like a lot of factors contributing to what is a resilient U.S. economy with room to run. We spoke about this recently on the latest CIO Strategy Snapshot. Jason, your thoughts on the current state of the U.S. macroeconomic environment and how do you see that progressing from here?
Well, I would echo a lot of what Steve said in terms of like the investment that's taking place. Like it is a capex investment cycle that we've not seen in the U.S. You know, you have to go prior to the GFC.
So we're talking at least, you know, almost 20 or 20 years ago, if not back into the 1990s. You know, constructive certainly on the U.S. economy, you know, let's call it, you know, next 12 months, but even like through the end of 2027, you know, I've been using the term sort of like, you know, the U.S. economy is sort of relatively benign. You know, there's a lot of risks going on.
People are kind of worried about it. They have flag all these things, but ultimately, you know, U.S. growth has been, you know, resilient. But the latest data we have would suggest it's almost even, you know, more than just resilient given, you know, where retail sales were really strong for August.
Third quarter GDP growth was tracking 3%. Labor market is probably re-excited a little bit. So all those things suggest, you know, kind of really, you know, positive macro conditions going forward.
You know, inflation is sort of the wild card and that, well, we think it's going to go lower. You know, if it doesn't, you know, the risk is instead of a nice kind of let's quote unquote soft landing, but something where it's just kind of, you know, persists to be somewhat reflationary. And so that, in my mind, is like one of the, you know, multiple risks kind of going on is inflation just doesn't want to come down because there's a perpetual series of supply oriented shocks.
And if demand is too strong, that further exacerbates it. So that kind of, you know, going back to you, Steve, you know, I'm very sympathetic to that view. You know, we've talked about on this podcast before, like a roaring 20s type of scenario.
So having a couple more years of very strong growth is consistent with that. But you know, there's always risks. And so what would you say is, you know, given the framework you've laid out, what are the risks that you think are the most potentially disruptive?
Is it, you know, a policy error from the Fed? Is it inflation can be sticky? Is it, you know, the AI Catholic story suddenly halting because concerns about return on capital?
Something else? You know, what's kind of keeping you up at night as it were? Yeah, what I would say is that the market seems to want to form a wall of worry here.
And if you wanted to put together, you know, your list of, you know, things that the market's going to choose to be nervous about, at least between now and the midterm election date in the U.S., you know, let's put together that list. Inflation is certainly one. The Fed starting a hike cycle, which I'm sure we'll talk about in a second.
Long-term treasury yields being higher, you know, the 10-year pushing up towards that 5% has a lot of people's attention. Obviously, tensions in the Middle East, what's happening with energy prices as we head into the kind of fall and winter, particularly as it relates to Europe, where stockpiles are quite low. And then I'd say the midterm elections themselves, you know, which always bring some element of uncertainty.
What I would say in terms of our view is that we believe that all of those concerns are going to be resolved in time. And that's going to provide, let's call it, the fuel for equity markets to move higher as you get through them one at a time. So as an example, I thought last week's Fed meeting was an example of exactly that.
A lot of concern about Fed rate hikes coming in. You know, had Morris painted himself into a corner, what would happen if he didn't hike? And he delivered, I thought, one of the best, you know, performances at the press conference that we've seen in a while.
He delivered unanimity of the committee. So it wasn't as though he was just backed into a corner. He clearly had won over the committee and built a consensus there.
The dot plots, which I know he's not the biggest fan of, you know, seem to ring fence what a hike cycle might look like. One or two, maybe three hikes, not something more severe than that. I thought his term, you know, removing a dose of accommodation was so important because it wasn't saying that we need to tighten conditions and slow down the economy.
It was simply saying maybe we're a little bit more accommodative than we need to be and neutrals a little higher. And then I thought his comments on the rise in long term yields were so constructive because he tied it to higher growth. And I think that that's right.
If you think about the environment between the great financial crisis into covid, it was very low growth, very low inflation, very low policy rates, very low market interest rates. We're not in that world anymore. GDP growth looks like it's trending more towards three inflation, two and a half that needs higher policy rates and higher market rates.
And that's a good, healthy thing. And I think he spoke to that. So I think that's an example of something that we worry a lot about.
And then ultimately it resolves to the positive. I think we did that on the rate hike cycle. I think as a consequence, we'll see that on inflation.
I think we will see that on rates. Less certain when you're talking about geopolitics. But I do have to believe that once you get past the midterms, the leverage on both sides of the Iranian and the American side changes and perhaps gives you another window for some resolution.
And all of that, again, is against this backdrop of really strong earnings growth. Just 30 seconds on that. When you look at margins, even if you strip out some of the one-offs this year, margins are expanding or growing at about a 9% growth rate.
We've only ever seen that between 1995 and 1999. So again, when you look at the equity market fundamentals, here's what you see. You see some of the strongest margin growth any of us have seen in our lifetime on an equity market that's actually gotten cheaper this year, trading down from 22 or 23 times earnings to 20.
And we think that's very attractive. And again, we'd use any volatility around these concerns to add. So I want to kind of dive more into the equity view of the thought process and kind of almost methodically go through some different topics from rates, from the earnings details and so on.
Starting kind of with the rates kind of view, or at least the implications of rates for equities. And I think I would push back a little bit in terms of Warsh's performance at the press conference. Not that it was bad, but in some ways, I think the Fed's job last week to me was easy.
I mean, the market was pricing a 95% chance of a hike. The economic data is strong. Inflation is too high.
Sure, hike. You know, that's not a big deal. And even I think they can, our views will do one more in December.
I think that's another kind of easy call. Beyond that, I think it gets a little more uncertain. And I'm a little unclear because Warsh doesn't provide any forward guidance.
Like, what is he really thinking? Like, where in the heart of hearts is he thinking? Like, when he says a dose of accommodation is being removed, is that like a little bit of tweaking risk management or is that he actually thinks policy is really loose?
And so, I mean, that's a speculation game that's going to be over drinks. We can have that discussion debate. But as an investor, like, who's thinking about, well, you know, what, from a rates perspective specifically, like, you know, they've already raised a lot, they're priced a lot.
What would you think has to happen in rates that would get you more concerned, like, would cause breakage in equity markets, like, in terms of yield levels or speed? And is there something that, you know, like, what sort of combination of factors would make you think, like, this actually starts to become painful for equities? It's not sort of coinciding with good growth leads to higher earnings, but also higher rates and it's all okay.
Yeah. So, there's really kind of two questions in there. One is on the policy side.
One is on the market rate side. Let me start with market rates and then I'll go to policy. Look, I mean, again, if you think about the great financial crisis through COVID period, you had nominal GDP growth that let's call it was sub 4%, you know, with sub 2% inflation, sub 2% growth.
In that environment, you're not going to have high market-based rates. On a 6% growth environment or a 5.5 to 6% growth environment, that does necessitate higher rates because it means that the potential growth of the economy is rising. When you add in further the idea that, right, today's CapEx is tomorrow's productivity, is the day after's trend economic growth.
This is something that's been lost over the last generation where, you know, the focus was solely on consumption growth as opposed to investment, which leads to productivity, which leads to higher trend economic growth. And so, I think that's the primary driver because if you really look out, inflation expectations now are not materially different than they were three or four months ago. They might be slightly higher on certain measures, but not materially.
If you look at debt and deficits, which are also commonly, you know, the boogeyman brought out for higher market rates, again, the deficits in the U.S. are certainly smaller today than they were at the peak, you know, of COVID. They're still too high, but there's not a big change in that fiscal picture as there was from three or six months ago. And so, it really is, I think, the three things that Warsh called out.
One of them is higher nominal growth. The second one is more competition for capital. As part of this AI build-out, you've got the hyperscalers issuing a lot of debt.
And for a lot of investors, that's attractive relative to a government debt. And then thirdly, I think geopolitics. Certainly, oil prices have put a little bit more, let's call it a boil on them.
And I think if we see some resolution, you'll get some relief in rates from there. But we continue to think that the trend for rates is higher. There's a name for a period of time where you had high capital investment, surging productivity, strong equity markets, and higher bond yields.
And it was called the 1990s. And it was in a terrible environment. And so, the other thing that I would reject, I know a lot of people are worried about this, we've already seen a massive backup in long-term bond yields, right?
I mean, the 10-year has gone from, you know, I want to say it was 150 at its bottom during COVID, all the way up to 5%. And that has coincided with equity markets hitting all-time highs. I don't think there's something magical about going from 5 to 5.5 or 6 that really changes that.
I'd also point out that the big drivers of the economy right now are the high-end consumer and the consumer space, and the hyperscalers and some of the biggest mega-cap names in the corporate world. And they're the least rate-sensitive participants in the economy because of strong balance sheets, high cash positions. So, I think that that's durable.
As it relates to policy rates, you know, the key phrase in its entirety was, removing a dose of accommodation to get to our target faster. And you're right, you do have to parse the words more with Warsh. It's more of a Greenspan-like interpretation than what we're used to over the last couple of Fed shares.
But what that signaled to me was, one, we don't think that we need to get too restrictive. We don't need to hurt growth. I thought that was a very positive signal to the market.
And two, to get to our target faster implies that we were getting there. And it acknowledges some of the disinflationary forces that I think we all observe in the labor market and the housing market. But it's saying it wants to get there a little faster.
So, if you're trying to put that into a rate hike expectation, there were three rate cuts last year that were viewed as essential because we were seeing a softer labor market. And I think this Fed wants to take back some or perhaps all of that. And that would imply, you know, one or two more hikes, but not necessarily anything more severe than that.
I don't see that as derailing the equity markets. I don't see that as derailing the economy. I think the momentum there is just too strong.
If the tone changed to inflation is a huge problem, it's running away, it's going the wrong direction, and we need to slow growth in order to get it in line, that would change my view. But I don't think we're there, and I don't think we're headed there. I like the 1990s comparison.
Something I've gone back five years ago would suggest, when people were worried about static inflation and looking at the 70s, I thought the 90s would be the better parallel. And so far, I think it's been pretty accurate. And also, you know, the language, I mean, you mentioned a VORSH versus Greenspan.
Again, Greenspan in the 1990s was notorious, infamous, however you want to have been, you know, a master of saying nothing with a lot of words. So you'd always have to parse it out. VORSH seems to be in that kind of vein.
Pivoting to another part of the equity story, like the earnings growth. You know, you mentioned, I guess you're forecasting about 15% earnings growth for the S&P for next year, 2027. It sounds like 2028.
We don't have a 2028 forecast, but for next year, we're at 14%. So all within, you know, the ballpark. After this year, it could be around 30% when it's all said and done.
So I think, you know, have comfort on the earnings threat. I guess the question kind of leads more to, like, you know, the valuation aspect. So one of the things that gives me comfort about the equity outlook is that the forward multiple on the S&P 500 has declined this year from over 22 early in the year down to about 19 now because earnings growth has just been so strong.
And like, you know, the multiple has actually contracted a bit, which would, okay, this is a positive, but I've also had, you know, sort of seen different views from different people suggesting, well, as a result, and I'm approaching this from a national allocation perspective, like, you know, stocks versus bonds, yields are higher, more attractive, but also the equity is premium by some estimates, hasn't changed because the valuation has come down. Other people would say, well, actually, you know, these, you know, we look at long-term trend earnings and these earnings are unsustainable. You should value it more like trend earnings and therefore, on that perspective, you know, equities aren't quite as cheap.
How do you think about, you know, this earnings story and how it kind of flies back to, like, you know, it's kind of the valuations and, you know, what do you think is an appropriate way to think about the combination of the earnings story and, like, how does it put a price on that for U.S. equities? That's a great question and I think we have a little bit of a differentiated view on it that has, you know, served us well up through now. So the first thing that you have to remember, you know, I think where people get themselves in a lot of trouble when they think about multiples is, you know, they observe maybe a long-term average multiple.
Maybe it's 16 times, maybe it's 18 times and they assume that it's a kind of static flat relationship and that you're always going to mean revert above and below that long-term average. We don't subscribe to that because the composition of the index changes, right? So if you were to go back, as an example, to 1990, you would observe in 1990 that over 50% of the S&P 500 was in manufacturing.
So, you know, things like industrials, materials, energy, utilities, and telecom. And you would see roughly only 15% of the S&P was in what we would call innovation sectors. So infotech, healthcare, comm services, and telecom.
Well, fast forward to 2026 and that's almost completely reversed. That manufacturing sector is down to 18% and the innovation economy is up to 52. And at the same time, the margin profile of the S&P has surged.
So I won't go all the way back to 1990, but if you were to look at, you know, profit margins on the S&P in 2009, you know, they were just over 6%. We're north of 15 at this point. So why would you pay the same price for a more asset light index with more shareholder friendly return of capital and higher profit margins?
You wouldn't. And so that allowed us to get comfortable. In fact, if you were to chart S&P profit margins and PE ratios over time, you see there's a pretty tight relationship.
As margins go up, so too does the PE. We actually took our PE number down coming into this year. So we had a fair value on the S&P of about 22 times that we had used the last couple of years.
We took it down to 20 at the beginning of this year because we observed a couple things. One, the MAG-7, who had been these huge free cash flow generators, very asset light, were becoming more asset heavy, right? A lot of capex, a lot of investment.
And then secondly, the bottlenecks. When you look at, you know, the names that have won so much this year, these AI bottleneck names that you see in chips and some parts of industrials are themselves kind of low multiple names. They usually pay high single digits, mid to high single digits for, you know, a semiconductor name.
And so we thought that that would weigh on the multiple a little bit as well. So we took that fair value down from 22 to 20 times. And, you know, we think that that's a fair place to be.
For folks who look at kind of trend earnings growth and, you know, expect multiple compression, history doesn't support that. If you look at the P-E ratio of the S&P through a cycle, particularly as you get to the end of the cycle, you never see, never see the P-E of the S&P slowly and in a linear fashion compress as you're getting closer to the end of the cycle and people are rationally expecting, you know, earnings to roll over. That never happens.
What you see instead is you get to a place of euphoria where people look at current conditions, expect them to accelerate forever and the multiple peaks right before a recession hits and things roll over. So we think we're actually quite conservative saying that we're going to be at 20 times and stay at 20 times. I think for folks who are expecting an orderly decline lower, that's a sign of another leg higher actually, not a sign of, you know, some impending problem on the earnings side.
Equity markets, for whatever reason, have never been able to forecast that well. So at 20 times, we think that's a fair value for the S&P. We don't, and think about what that implies.
We're at 8,500 this year on our S&P target, 26, 10,000 for next year. And I don't need the market to get more expensive. I just need earnings to come through.
And as you detailed, my 15% earnings growth is right around in line with consensus. So at consensus earnings growth and no multiple expansion, we can get the S&P to 10,000 by the end of next year. That's pretty good.
And if anything, I think there's probably a risk to the upside, not the downside. You know, you mentioned that, you know, euphoria, that's usually kind of the sign of the top and things roll over. There are a lot of, I'd say maybe more the general public as opposed to professional investors, suggesting like, you know, AI is a bubble.
It's about to burst at any point in time. You know, they've been saying this for a while, and this will probably persist, you know, similar to what happened in the late 1990s or during the, you know, the real estate situation in the 2000s. I think that's my seat, not a particularly, you know, useful conversation debate.
Is it a bubble or not? It's just I can want to get back to the fundamentals, like what could cause things to turn. So there is obviously an enormous amount of capital expanding.
It's been ramped up relative to the start of this year, like from the hyperscalers to like what they expected, like Jan 1, you know, to where we are now. Numbers are expected to go higher next year. I think there's good reason to kind of think about all that.
That is essentially translating to like one of the reasons why there's enormous earnings growth. You're seeing like semiconductors, like the earnings growth could be up, you know, 60% this year. A lot of it is due to price appreciation, not more quantity.
All this, the way we've kind of looked at it as a team, from a more of a macro, again, association perspective as opposed to individual stocks is there's like an AI flywheel that as long as, you know, AI applications are demonstrated, there's some sort of productivity benefits. There'll be demand for compute and tokens will go up as that is the demand is high versus what's available. So supply, that needs to more investment.
That sort of flywheel kind of continues. And so I'm always kind of looking for things of, you know, what signs of, are the gains not being there? Is the demand going lower?
Is open source models changing things? Because that could impact ultimately from a macro perspective, the investment and sort of part of the story you're saying. That's how I'm thinking about it.
I'm not saying it's the right way. It's just trying to like contextualize a lot of information out there. When you look at sort of AI and the investment, and that seems like it's a key part of your thesis, what are sort of maybe the markers or things that you're looking at to see, you know, we're not optimistic enough or too optimistic or as data points come in, that would suggest we need to adjust our assumptions.
So less about like the view itself, like the mechanics of like how you sort of, you know, arrive at the view and what gives you conviction, what gives you sort of a pause for concern? Yeah, it's a great question. I think our thinking is probably more similar than it is different.
You know, we would think about AI really kind of in three groups, right? So you have the AI, let's call it the spenders, the developers, right? These are the hyperscalers.
These are the folks that are delivering the models or delivering AI, and they need infrastructure in which to do it. There's the AI infrastructure world, which, you know, a lot of people will call bottlenecks. So this is the hard asset piece where you have to build the data centers.
You need the chips. You need the power and electric. You need all of those things that are in short supply.
And then the third group will be the AI adopters. And those are folks that will use the AI solutions and, you know, ostensibly make their businesses more efficient or more profitable. The trade was dominated by the spenders early on as there was a proof of concept.
And so it was all about Mag7. It was all about AssetLite. And it was all about, you know, who could develop the biggest, the best model and the technology.
Over the course of this year, it's been dominated by the AI bottleneck companies because we don't have enough chips, and we don't have enough power and electricity, and we don't have a lot of things. When you think about the longevity here for a second, and you think about when you can start to worry about this slowing down, remember, this isn't a piece of software that comes out every year. The infrastructure needs are significant.
And if you've ever been on a union job site, you know, the day starts at 9, it ends at 5. There's a lunch break for an hour, and there's 15-minute breaks. And I don't care how quickly you need your data center.
You're going to go through that process. So it takes a while. Just because we have all these CapEx announcements doesn't mean that all of it is getting finished immediately.
It takes three years, three, four years to get these data centers up. So when you think about the demand for the kind of hard assets and the industrial goods needed to do this build-out, you know, you've got companies on the chip side that have already sold all the chips that they'll make next year. You've got companies on the heavy power side that are now taking orders for goods that they will deliver in 2031.
Forget about next year. And so it's one of the reasons why we feel as good as we do about earnings, because the visibility is higher. We know that a lot of these companies have sold products, you know, they've sold all of their inventory for the next couple of years.
And if you want to get the next incremental piece of inventory, which is going to come in 28 or 29 or 30, you're going to pay a higher price for that, which means higher margins. So that's the phase that we're in. Now, if we were to slow, if AI innovation were to slow, I think you would see the benefit go away from those bottleneck companies and back over to the spenders, because they're going to have a little bit better cash flow, a little bit less debt needs.
So there's a question of who wins, but not whether or not AI gets done. And then the big question mark is going to be on the other side of the build out, which companies are most effective in implementing the technology, you know, in order to create a competitive advantage. And we're really not at that part yet.
I think the market's tried to snip that out in certain places like software, but I think there'll be much more to come on that trade as we go. So when we look at this, it's three to five years to build a data center. It's three to five years to bring capacity online, right?
If you want to solve that chip shortage, you've got to build a chip fab. Well, that takes three years. And so we think that this looks pretty good through 28, I'll say that.
If we slow down, you might not have as much of an earnings peak in 27 and 28, but you might buy yourself another year of more demand and supply, which means you can kind of put a higher multiple on this. So we don't see this going away. What are we watching to make sure that it's not a bubble?
Well, we're watching for sanity. And we see that, right? If you look at the hyperscalers, the healthiest ones, they're able to finance themselves much cheaper than some of, let's call it the secondary players in the space.
That's a sign of rationality. We're seeing spreads on their debt move up modestly. That's also a sign of rationality.
In a bubble, everybody gets funded for cheap. And there's no distinction made between a strong borrower and a weak borrower. We're seeing rationality in terms of the build-out.
I don't subscribe at all to the idea of AI Armageddon. But it's good that we're having a discussion around safety and what the right pace is. Again, these are all elements of rationality in the trade.
And then when you look, I mean, the hyperscalers have underperformed this year in the face of stronger market interest in the bottleneck names. That's another sign of rationality. We're not just buying everything.
And so there's a kind of healthy rotation. The credit markets are being rational. We're having a kind of adult conversation around how this should play out.
That's all a sign of a boom. That's not yet a sign of a bubble. Well, we are not a union shop over here.
So we don't have the same quite time constraints. But we do kind of come up towards our time limit here. And I think that your comments at the end are kind of a nice segue to, you know, constructive, I'm constructive on equities, you know, for a multi-year view.
The question kind of comes down to, like, you know, how do you position foreign play? Like you alluded to some of the AI themes. But maybe, like, more broadly, you know, some high-level thoughts that you would have in terms of, like, whether it's the U.S. versus other regions, whether, like, in more cyclical or defensive buys, any particular segments, subsectors, things that you like in addition to kind of some of the AI themes that you've already touched on?
Yeah. So, I mean, I'll start, you know, we're overweight equities. And, you know, when you think about rebalancing, we're going to want to add to equities and remain underweight longer-duration fixed income until the risks to growth are greater than the risks to inflation.
So right now, there's more of a risk of inflation than there is a risk of a growth slowdown. And equities handle inflation much better than longer-duration bonds do. So we like equities kind of at the top of the stack.
Within fixed income, we do like the short end of the curve. When you think about that kind of zero to two-year part of the curve, you know, you're pricing in three, maybe four hikes in there. We think that number's two, maybe three.
And you're going in at, let's call it a 475 yield. So really good going in yield on a relatively flat yield curve with some opportunities for price appreciation and a strong view on the economy over the next couple of years, which supports credit on the short end. So within fixed income, everything from cash to ultra-short to that two-year part of the curve, we find to be particularly attractive.
On the equity side, you know, by region, the U.S. is the epicenter of this build-out, as is emerging markets. And so we tend to like both of those. We like the U.S. both on the growth and the value side.
You know, with the recent kind of index reclassifications, it's hard to tell what's growth and value. And you've seen sectors kind of flip, right? So semiconductors have been part of value.
Now they're part of growth. It's one of the reasons why value outperformed in the first part of the year. We would be agnostic from growth and value.
We would say we want growth companies and we want cyclicals. We think that those are at the top of the stack. But we're overweight, the U.S., and we're overweight both large and small, particularly as you get to what, as we get closer to the end of what could be a tightening cycle.
We think small caps, having gotten past that with an economy that's doing relatively well, you know, will be positioned to continue to lead. In international, so outside the U.S., it really is EM, whereas Europe, you just don't have as much of that. And so they're not quite as exposed also in Europe and other developed parts of the world.
You've got some greater energy concerns than maybe you do in the United States, where you have some more energy independence as we get into this fall and winter season. So we really like that. I would say, you know, digging into the parts of the U.S. market, you know, that we like.
We obviously like tech here. I think you could see a little bit of a slowdown on the CapEx on the margin. I think that would be really good for some of the mega cap hyperscalers.
We still are invested in the AI infrastructure play broadly. And that bleeds over not just from tech, but also into industrials and utilities and materials. And then on the cyclical side, it's really kind of that small cap trade, which also has some elements of AI exposure.
So overweight equities, overweight the U.S., overweight EM, underweight longer duration fixed income, but overweight the short part of the curve. And if anything, we would be buyers of weakness on the equity side. Well, thanks for that, Steve.
And, you know, I'm sure we'll be talking again next year. And it's a very fast-moving AI environment, policy environment, geopolitical environment. So, you know, we'll see how this all plays out.
And, you know, it's a dynamic environment. So I appreciate your perspective. Thank you for an incredibly thoughtful conversation.
I hope this is beneficial to your listeners. Jason, very productive. And, Steve, really appreciate all of your transparency when it comes to guidance, positioning around the markets.
And, again, honored to have you as part of the UBS Research Advisory Board and many more conversations to follow this one. Jason, Steve, thank you again. Take care.
Thanks so much. Thanks, Steve. Bye.
Thank you for tuning in. Be sure to visit UBS.com slash studios to view the entire UBS Studios suite of podcast channels along with our video offerings such as UBS Trending. You can also follow us on Instagram for content highlights at UBS Trending.
UBS Studios is part of the UBS Chief Investment Office within UBS Global Wealth Management. Visit UBS.com slash CIO to view the latest research. This material has no regard to the specific investment objectives, financial situation, or particular needs of any specific recipient and is published for informational purposes only.
For a full legal disclaimer applicable to the independent investment views produced by UBS, please visit our website at UBS.com slash CIO dash disclaimer.