Top of the Morning: CIO Equity Pulse - Monthly performance update & outlook
The desk interprets the recent UBS commentary as a bellwether for volatility in US equities and its potential implications for FX markets. Per the full note from UBS, the outcome of the September FOMC meeting raises concerns surrounding the trajectory of interest rates, which directly impacts capital flows and risk sentiment in currencies. With AI adoption featuring prominently and the cloud of US midterm elections looming, positioning becomes crucial for traders, especially in light of trends in the equity markets that can influence currency pair dynamics.
What the desk is arguing
The current dialogue suggests that the US equity performance is intricately linked to broader economic sentiments shaped by interest rate forecasts. Specifically, the commentary highlights that the FOMC's hawkish stance has induced a cautious atmosphere among investors, which can translate into volatility for currency pairs due to shifts in risk appetite.
UBS's analysis notes that heightened interest rates could deter equity investments, consequently affecting the dollar's strength against major currencies. As interest rates remain elevated, this could translate into a stronger USD as capital flows to higher-yielding assets, affecting positioning in the FX space.
Where it sits in our coverage
Our consensus target for USD is 1.075, with a range between 1.04 and 1.12. According to our internal coverage, aligned firms include:
The desk's projections indicate a potential preference for a stronger dollar in contrast to bofa's more bearish stance, positioning us near the upper end of the expected range.
How other firms see it
Aligned firms view the potential for a stronger USD correlating with forthcoming economic indicators and investor sentiment. Conversely, bofa presents a more cautious outlook, anticipating that economic headwinds could undermine the dollar's strength.
With the intersection of US equity markets and different central bank policies, traders should monitor the implications of US monetary policy on FX pairs like USD/EUR and USD/JPY, where shifts could reflect broader market trends.
02AI adoption is crucial for future investment themes.
03US midterm elections present uncertainties for markets.
04Positioning will be critical amid changing risk sentiments.
Market implications
Watch for volatility in USD/EUR as the implications of equity performance unfold, especially following the September FOMC meeting outcomes. Should equity weakness persist, expect shifts toward safer assets, impacting currency flows across the board.
Risks to this view
A significant risk to this outlook would be a dovish pivot from the FOMC, leading to a sudden reversal in interest rate expectations. Additionally, unexpected positive economic data could bolster equities and weaken the dollar, invalidating currently aligned positioning strategies.
ubs
Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today, we are continuing with our monthly CIO Equity Pulse conversation, which does correlate with the monthly release of the UBS House View.
Joining me for these conversations today at our 12.85 podcast studio here in New York, glad to welcome back Head of Equities Americas from the UBS Chief Investment Office within UBS FSI, David Lefkowitz. So David, great to be back at the table with you. Thank you for dropping by today.
Yeah, great to see you, Dan. So David, heading into this week, very timely that you're joining us. Of course, we will spend some time discussing the UBS House View, your current thinking when it comes to equities, but equally as timely, the FOMC meeting, a lot of anticipation heading into this week because we did witness on Wednesday afternoon, a pretty substantial adjustment or change from the Fed now that they have commenced hiking.
So David, following this 25 basis point hike from the Fed, how are you thinking about this hiking cycle and the impact of the equity market? Yeah, sure. Obviously, you know, very topical point of conversation.
So yeah, look, I think just in terms of bottom lining it, you know, we thought this was a hawkish hike. You know, you saw strong support for two hikes this year. We thought there may have been some dissents.
There weren't. The statement and in the press conference, they also talked about the economy being pretty strong. So it's kind of an upgrade to the growth outlook and also highlighting that inflation is not really moving down enough.
So on the heels of this, interest rates, the initial reaction was interest rates moved up and not surprisingly, stocks moved down. Equities have been very sensitive to interest rates. So when interest rates rise, that tends to mean more Fed hiking and stocks tend to sell off a little bit on that and that's why we've seen some valuation compression this year.
All that said, what we did is we actually put it – we also put out a report earlier this week and we looked at prior Fed hiking cycles and how they tend to impact the stock market. Let me just start with the – one of the bottom lines is that when we did this analysis, the 12-month returns after the Fed starts hiking are actually fine, right? Usually on average, the 12-month return is about 10%.
So that's pretty good and the worst result over a 12-month period was only – was a negative nine, right? So not a disaster. Obviously nobody likes negative nine, but it's not negative 30, right?
So I think that should relieve some of the concerns and that was an outlier. But also what was very clear from the analysis, what really drove the returns was how economic and corporate profit growth behaved after the Fed started hiking and one of the measures that really helps give a signal here is something called the ISM Manufacturing Index, just sort of a gauge of manufacturing activity. So that's I think the clear message here.
It's not the Fed hiking itself. It's what's the impact on growth going forward. That begs the question, David, with that historical context, what is your outlook for growth?
How are you thinking about that right now? So I think in order to answer that question, I think we first have to think about, well, how much is the Fed likely going to hike, right? So – and we think a lot of the inflation overshoot at the moment – and just to put this in perspective, say inflation is running around 3%.
The Fed's target is 2%. So this is a very different situation than where we were, say, in 2021, 22, when inflation was running at like 9. It peaked at like 9, right?
So very different situation and we think that the overshoot – we think temporary factors really are a big contributor to the overshoot. So tariffs, which are already starting to have less of an impact on the inflation rate and then higher energy prices, which obviously are very hard to predict given the uncertainties about the war in the Middle East. But reasonable assumption – our assumption is that we're not going to see a further spike that's sustained at very high levels.
A lot of these things are policy – somewhat policy choices, right? And I think that's – so we don't think that's going to be likely. So we think a lot of the tariff and the energy impacts will eventually fade.
So in that context, we don't think the Fed has to hike very aggressively and if we look back at history, recession risks don't appear elevated if the Fed is hiking less than six times or less. So that would be like 1.5 percent, right, cumulatively. And so we've never – in our study, we didn't see the economy go into recession when the Fed was hiking 1.5 percentage points or less.
So we don't – at this point, I don't think that's very likely that they'll have to hike more than that. But we'll have to see. The other thing I would also point out is that right now, growth is on pretty solid footing, right?
We have a recovery in the cyclical part of the economy. The ISM Manufacturing Index, which I mentioned, has now been in expansion for eight months. Usually it stays in expansion for three years.
So I think we're still pretty early in that manufacturing expansion. Hyperscaler CapEx, which is driving profits for the picks and shovels providers for the data centers, that we think is on solid ground. We think that's going to grow further in 2027.
We're penciling in 30-plus percent growth. It could even be more than that. And I would say with corporate profits really strong, I don't think you're going to see layoffs, right?
I mean look, we got the layoff announcements this week, one of the lowest in years, decades, right? So if you don't get layoffs, consumer spending will remain fairly good. So I think growth is in good shape and – yeah, so putting that all together, right?
Growth is in good shape. It probably doesn't have to hike aggressively. Ultimately think this bull market has further to go.
Bull market remains intact and we still are comfortable with our 8400 on the S&P for June of next year. Yeah, it's a pretty healthy return now given where we are currently in markets. But look, I mean the inflation and growth data that we get over the coming months and quarters could drive some volatility.
So be prepared for that. But in our base case, again, we think the bull market is still intact. Sticking with the integrity of the bull market was supporting that, David.
As our loyal listeners know in the past, you've talked about three pillars of the bull market. But as a refresher for everyone, those three pillars are a resilient economy, AI adoption, and a supportive Fed. Now, David, with the Fed now hiking rates, is it fair to assume that monetary policy is no longer a tailwind?
I think that's fair. Yeah, I think that's fair. I don't think it's a tailwind anymore.
But I'd make a couple of observations. First, the market already is pricing in a decent amount of hiking. I mean basically four hikes even though the Fed dot plot is only suggesting two.
The market itself is pricing in four, almost four, basically through next summer. So there's a decent amount of hawkishness already priced in. The other thing is that I think the way – if growth is on pretty solid footing, I think the way you're seeing the interest rates and the Fed expectations impact things is through valuations.
So interest rates have moved up pretty substantially this year. Look at the 10-year, up almost one full percentage point this year, not quite. And we've seen – I think where you've seen that play out is that valuations have compressed in the equity market.
We were at 22 times to start the year. We're now down at 19. So in order for it to be a further headwind, you'd have to see even higher interest rates coming or expectations of even more hiking from here.
Now that's possible and so it could be a little bit of a headwind. But I would say it's not likely to be a strong headwind. But I think it's fair to say it's not a tailwind at this point.
But that said though, what I would say is that we still feel pretty comfortable about the other pillars of the bull market, right? That economic growth is going to be resilient and we are still going to get sort of positive equity market implications from the AI rollout. With the AI rollout, David, we have seen some rocky conditions in equity markets in recent weeks due in part to concerns over AI safety, pushback on data center build out.
How are you thinking about that AI's impact on equity markets as of late? I think just to bottom line this down and these – yeah, obviously this is a fluid situation first of all, right? But I mean it does seem like we're moving into – we're probably going to see some sort of regime that gives consumers and just citizens more confidence in the safeness of AI and it's not going to run amok and cause problems.
That ultimately could slow down the cadence of how quickly new models are released. But I don't think it's going to slow down the adoption. In fact, in some of the sort of remedies they're talking about, it actually could require even more compute, right?
So I think the key question for equity markets is will there still be the same amount of demand for the picks and shovels, right? The semiconductors, the networking equipment, the power generation equipment, the HVAC equipment, all this stuff that is required in order to build new data centers. At this point, I don't think everything we've seen, safety concerns, data center buildout, a lot of local areas don't want them.
I don't think that's going to change anything in terms of – for instance, I don't think any analysts are going to be cutting their numbers for the picks and shovels guys. Now one other point on the data center stuff, I think it's important to recognize that there are a lot of data centers in the planning stages. What I would say is there's buffer there, meaning not all of those data centers have to get approved.
In fact, there's probably quite a bit of a buffer. Not all – a decent percentage of those don't have to get approved and you're still going to be adding sufficient capacity to accommodate the growth expectations that are embedded in the marketplace for those picks and shovels companies. In other words, the semiconductor companies that are selling the chips, there very likely will be – even if we get some data centers that are blocked, there still will be places to put the chips, right?
So I think – and that's really the lens I would look at this through from an equity market perspective. Will there be any cuts to say capital spending from the hyperscalers or estimate reductions for the semiconductor companies? I don't think we are likely going to see that.
Well, David, very helpful clarity. Before we get into positioning, if I may add in as we're speaking here in mid-September and we'll speak again before the midterm elections, though of course it is top of mind for many of our listeners. How is CIO thinking about the US midterms as far as a source of volatility leading up to them?
Any market implications of an outcome scenario to be mindful of? Look, if you look at the historical record, Dan, it's – you do tend to see kind of choppier markets ahead of the election and then more of a – more of an upward slope to markets for lack of a better word after the election. Once the dust settles.
Once the dust settles, right? And I think the logic here is that there's some policy uncertainty going into the election. Once the markets and investors get clarity on the outcome, then that uncertainty goes away.
That said, I don't know if there's that much uncertainty, right? I mean the president is going to still be the president. Democrats seem likely to take the house and you'll have divided governments.
So not much is going to get through on the legislator front. But not much is getting through today on the legislator front. The Republicans don't have 60 votes in the Senate, right?
So in my – I don't think policy really changes. I think the only maybe caveat to that is I think there's going to be a focus on how well the left flank of the Democratic Party does and, you know, how – is there an extrapolation to make about how that segment of the party could do in say 2028 and, you know, does that mean a very different business environment, a regulatory environment, things like that, a less business friendly environment. You know, so there could be a negative knee-jerk reaction if you do see very strong gains coming from the left part of the Democratic Party.
I think that would very quickly though – I don't think that would lead to sustained problems for the equity market because 2028 is a long way from now. The world can change tremendously in two years. Look, you know, we just had a presidential election two years ago and the world looks very different than it did two years ago, right?
So if I had a bottom line at Dan, I think sure, could there be some short-term volatility? Of course. Is there anything that's likely to change in a substantive way as a result of this election?
I really don't think so. So I don't think it's impediment to further gains. So David, as an equity investor, a lot to consider.
We spoke about the midterm elections, AI adoption, the Fed hiking rates, geopolitics and other consideration as well. So as an equity investor, what to do in terms of positioning? How is CIO recommending at the moment that equity investors position?
Right. So the message, Dan, has been pretty consistent that we think you want broad exposure to the equity market, right? Not just tech, not just, you know, AI.
And we've been expressing that in terms of from a sector. Let me talk about U.S. sectors. You know, we like industrials, we like financials, but we also like health care, we like utilities.
We also have talked regularly about how we like some of these innovation drivers. We like AI. We like power and resources, basically electrification theme.
We like longevity, health innovation. So I think there's – it's a message that is broad and it's not just in the U.S. We also – there's a number of overseas markets that we also like because this – these trends that we're talking about, AI, global manufacturing recovery, they're really true around the world.
The other thing I would also kind of highlight is that, you know, we're probably moving into a period when higher quality companies might become a little bit more appealing, especially now that the Fed is hiking rates. So that's something we're, you know, we're doing some more work on, doing some more thinking about. But if you look historically, usually sort of mid-cycle environment, yeah, you want to focus on companies that you can sleep well at night.
You don't have to worry about – you don't have to be concerned if there's a slowdown in the economy and things like that. And look, that's possible. It's possible we see that if the Fed is hiking.
So some food for thought I guess, you know, but the main message is broad exposure to equities. We think that's the way to express the opportunities there. Well, David, as I always say, this is a very helpful touch base to have these equity-focused conversations on a monthly basis, which do correlate with the release of the monthly UBS House View publication suite.
I do want to point out to you, our listeners, the latest UBS House View publication suite available for you now up on UBS.com slash CIO, though for clients of UBS, please be sure to reach out to your UBS financial advisor if you would like to receive a copy directly. Though again, we've been joined today for the CIO Equity Pulse Top of the Morning by Head of Equities America's David Lefkowitz. David, thank you again, and we'll speak again in October.
Sounds great. Thanks, Dan. Thank you for tuning in.
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