Top of the Morning: CIO Equity Pulse - Monthly performance update & outlook

Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. For today, we are actually launching a new monthly equity-focused conversation with the UBS Chief Investment Office.

Joining us for this conversation, which will tie in on a monthly basis, the latest equity views, a positioning, thinking from the UBS Chief Investment Office. Glad to have with me on the line today, David Lefkowitz, Head of Equities for the Americas from the UBS Chief Investment Office. David, thank you for dropping by on this Friday morning for what is the first of what will be an ongoing monthly series of conversations.

Nice to have you with us today. Yeah, great to be here, Dan. Thanks for doing this.

Absolutely. So, David, as I pointed out, on an ongoing basis, our conversations will tie in the latest published equity views from the UBS Chief Investment Office as published within the CIO Houseview series. And with that, the monthly letter for the month of May came out just last night.

The title, Investing in a Fast-Changing World, which for you, our listeners, is available now up on ubs.com slash CIO. But just going through the Houseview, David, I did see that CIO is maintaining its attractive rating on U.S. equity. So can you begin, David, by walking us through the thinking behind that positive outlook despite so many unknowns and uncertainty driven by geopolitics at the moment?

Yeah, sure. Happy to do that, Dan. So I think it's really helpful, and this is the framework we always try to use when it comes to formulating our opinions.

I think it's really helpful to try to look at the big picture and stay focused on that. And what I mean by that is there's been three, I think, three pillars to this bull market that really started in late 2022, and we think all of those three pillars are still in place. And so those pillars are a resilient economy, which is leading to solid earnings growth.

We have a supportive Fed and AI adoption. And so all three of those are, in our view, still key market drivers that are going to propel equities higher. And just to give some perspective on how important or just how meaningful, I would say, these market drivers are.

So for instance, when usually any given month the S&P is up nearly 1% on average. But what's been happening over the last couple of years is that the Fed has been lowering interest rates at the same time that we don't have a recession. So that's a little bit unusual.

Usually the Fed's not cutting interest rates while the economy is doing fine. And so when you get that combination, Fed cuts and a resilient economy or growing economy, usually your monthly returns are twice as better as normal. And we think this year, while the Fed cuts are delayed because of the war in the Middle East and the rise in energy prices, we do think that we will see some further Fed rate cuts later this year.

So that combination, good growth, especially good earnings growth, and a supportive Fed, that's a really favorable backdrop. Again, your monthly returns are usually twice as good as normal. And then layer on top of that just what's going on with AI and not only the really blistering piece of build-out of AI infrastructure, but now also we're starting to see, and this has just happened in the last few months, more clarity and more signs that companies and consumers are willing to pay for these AI tools.

I mean, the coding tools that are coming out from the private labs, the AI labs, have really gotten the market's attention. We're seeing some very rapid revenue growth, some of the most rapid revenue growth, really, for companies of the size that we've seen at the top of the list. So I think the three pillars are all still very much intact, good growth, supportive central bank, and certainly not a hawkish central bank, and AI adoption.

And we think that is going to continue to be driving equities higher over the course of the year. Okay. So quite a few factors there, David.

I do want to focus in for a few more moments on the ongoing geopolitical concerns, unknowns out there. I'm curious, how do you explain the market resilience we've seen, and how does CIO account for potential risks stemming from the conflict ongoing in the Middle East? Yeah.

So, yeah, right. So, obviously, the war in the Middle East has obviously driven a fair amount of volatility in markets. We saw about a 10% correction in U.S. equities, and now we've seen a very sharp rebound.

So in our base case, we do think that the energy flows will resume soon, in the coming weeks. But I think at this point, the market is also making a similar, sort of a similar assessment. And so if there's any setback to that, then that is definitely a risk.

And so that's obviously, you know, that's something we're monitoring closely. But I do think, you know, I've been getting a lot of questions, does this market rebound make sense? I think it really does.

I think, you know, things have, you know, things have improved, right? We're seeing, we have a ceasefire, so that's an improvement. And we're not getting the further degradation and destruction of energy infrastructure.

So that's encouraging. And then, you know, earnings, we started earnings season, that's been coming in pretty solid. And positioning was really light.

People had really de-risked because of the war. And so as soon as ceasefire happened, earning season started, it was, there was a lot of kindling to propel stocks higher because of the light positioning. And I think that explains, you know, why we've seen such a, such a powerful rally.

Now, look, I mean, I do think we need to see the energy flowing. I mean, the U.S. economy can handle oil prices where they are today, around $90 or so. But if we don't start to see the energy flowing, you know, relatively soon, you know, I think in weeks rather than months, you know, we probably are going to be looking at oil prices that are going higher, you know.

And if oil prices get, you know, above $120 or, you know, certainly if they get into the $150 range, I think that would certainly be a more of a challenging environment for the economy and U.S. stocks. So that is still the risk. But I think it's pretty clear that President Trump is looking for an off-ramp here.

They've made some progress on de-escalation. And our base case is that there will be further de-escalation. But if, you know, if that proves to take longer or more challenging to do, then, yeah, there would be some downside risk to U.S. equities.

Okay. So higher oil prices, that sounds like something we need to continue to monitor. Outside of risks stemming from the conflict in the Middle East, David, anything else out there in the way of risk that you're watching for at the moment that could perhaps derail the bull market or be a source of volatility?

Yeah, sure. There are a few things. I mean, the labor market, Dan, has softened up over the last, call it last 12 to 18 months.

So we're not producing that many new jobs at the moment. So we do want to make sure we don't slip further there. And then, and I think that's part of the reason why the Fed has been cutting interest rates and we think we're going to see further interest rate cuts later this year once inflation cools off a little bit.

You know, there also, we have to see how these AI, you know, does AI start eliminating jobs very rapidly? That's not our base case, but I do think, you know, there certainly are anecdotes where you see, you know, some pretty big headlines about job cuts. We're not seeing it, you know, related to AI efficiencies.

We're not seeing that in the broader economic data. We get weekly jobless claims. We haven't seen any pickup there in terms of people filing for new unemployment insurance.

But if AI tools really are rapidly adopted, you know, that could cause some volatility in the labor market. So, you know, that's something to watch. We do have these mega IPOs that are coming up.

You know, these large private companies that are in the AI space, they could be looking to raise, you know, $300 billion. I mean, this is a very large amount of capital that's going to try to be raised, you know, just for perspective, usually in a full year. A good year of IPO capital raising is about $75 billion.

So this is big. But the other thing I would say is also keeping perspective, I mean, the U.S. equity market itself, it's a $70 trillion market. So in the grand scheme of things, it's not a huge game changer.

Look, could it cause a little bit of short-term volatility? I think that's possible as people maybe reallocate some of their positions to accommodate some of these new companies that eventually might go public. That's possible.

I don't think that would be a lasting issue, though. You know, probably if we're really thinking about the other risks that I think, you know, could be more game changers, I would say if inflation, you know, really picked up or got worse than we're thinking, or if interest rates, I mean, if the 10-year Treasury, you know, was closer to five rather than closer to four, I think that would be a little bit more of a challenge. And I think the, you know, probably the biggest risk, which we don't think is really something to worry about right now, is are we going to overbuild AI data centers?

Right now, that does not seem to be the case at all. But that is a risk that we watch very carefully because if there is, if we do end up buying or putting in service too many data centers, you know, more than the demand, you know, that has pretty big implications for the whole AI infrastructure complex, which is a big part of the U.S. equity market. So a wide range of risk considerations there.

Putting that all aside for a moment, David, as you pointed out a bit earlier in the conversation, you highlighted a solid earnings growth that we're picking up on thus far as we're making our way through the Q1 reporting season. And that serves as one of the key drivers of the positive outlook for equities. As we're speaking today, we're roughly halfway through.

We're at the midpoint of the first quarter reporting season. From what you've picked up on, what would you identify as the key takeaways from Q1 reporting thus far? Yeah.

Great question, Dan. And yeah, this coming week, we're going to get all the, or a lot of the mega cap tech companies. So this coming week is going to be also pretty important.

But I would say in general, things have been solid and definitely better than feared. So just the bottom line, we're looking for 17% earnings growth in the first quarter. That's the fastest growth in four years.

So really pretty solid. I would say so far, so far the results confirm our expectations there that this is going to be, the numbers for the first quarter were quite good. I would say the other thing is that the guidance has definitely been better than feared.

We're not seeing companies, companies are not, you know, it's always a mix, right? There's some companies that are doing better than others. But in general, we're not seeing any cuts in a broad-based sense to the outlook stemming from the conflict in the Middle East.

Now that's, you know, some of the travel-related companies, that's not true. They're coming under some pressure. But more broadly, consumer spending is doing just fine.

I think if we got, as I mentioned earlier, I mean, if gasoline went up another dollar, to say over $5 on the national average basis, that might be a little bit more of a concern. But so far a consumer is able to handle the current increase in prices that we've seen, which does make sense because also tax refunds have been better than normal or because of the One Big Beautiful Bill Act. So you know, I think the guidance has been actually pretty encouraging.

I would also say we're seeing signs of a cyclical improvement. So some of the areas of the economy that have been, you know, a little bit on the softer side look like they're showing some signs of life. You can see that in analog semiconductors, in loan growth from the banks, in non-residential construction.

So you know, that's all encouraging. And then the AI infrastructure story is just really strong. I mean, you can see this in semiconductors.

You can see this in power generation. You can see this in electrical components. So really strong results.

People are raising numbers as a result of these strong results in that AI infrastructure area. So when we put it all together, Dan, we think it's going to be a very solid earning season, and all the signals we're picking up suggest that that strength is likely to continue. And I think there's probably upside to our own estimates that we have for the full year.

And so we're looking for, I would say, pretty solid double-digit earnings growth for this year. With that, David, and it sounds like a lot of encouraging takeaways from the Q1 reporting, especially as it relates to AI infrastructure. And as you pointed out, we have another busy week of reporting up ahead of us as we get into Monday.

Let's end today on positioning, get a bit more detail there. Where do you and the team see opportunities at the moment within equity markets? Sure.

So just to, yeah, just real quick on sectors, I would say the way we're thinking about it is kind of a barbell between some cyclical areas like financials, consumer discretionary industrials, as well as some defensives like healthcare and utilities. Those are all the sectors that we have attractive views on. I also think thinking about tech, one of the things that we have really been trying to focus on is that we think it's really important that investors think about diversifying away from concentrated positions.

So a lot of tech companies have done quite well over the last five, 10 years. And in some client portfolios, some investor portfolios, those companies may now be very large. That's a good thing, obviously, but because of AI and because these markets are so new, we think the landscape is really changing and it's not clear who the winners and losers are going to be.

And so what we think it makes sense is to scale back some of those concentrated positions in tech and start diversifying and ensure you don't have too much risk in sort of the tech complex. And we think that also means sort of an active managed approach really makes sense. And that really is one of the reasons why we launched our TRIO series of publications.

These are our transformational innovation opportunities. What we've observed is that most of the value creation in equity markets stems from new innovation and companies that are riding, either driving or riding innovation cycles. And so we have three different TRIOs, as we call them.

One for AI, one is called power and resources, which is electrification, and it's related to the build out of AI infrastructure, obviously. And then the third one is about healthcare innovation, and that's called longevity. So we think those are the areas to be focused on.

And we also think, though, sort of an actively managed approach is even more important, just given how much the landscape is changing because of AI, especially for some of the mega cap companies that previously enjoyed strong and high market shares in secular growth markets, but now they're kind of all competing with each other. Well, David, thank you for dropping by top of the morning on this Friday morning for the first of, again, what will be a monthly series of conversations on equity markets, equity market positioning. And again, for you, our listeners, we will be tying these monthly conversations into the release of the House View monthly publication from the UBS Chief Investment Office.

But David, again, this was a very helpful touch base. Thank you for dropping by and look forward to picking back up with our conversation next month. Yeah, perfect.

Yeah, thanks, Dan. Happy to do it. Thank you, David.

And again, we've been joined today by David Lefkowitz, Head of Equities for the Americas from the UBS Chief Investment Office. With that being said, I do again want to point out the latest House View is available for you up on UBS.com slash CIO, the monthly letter entitled Investing in a Fast-Changing World. So for you, our clients of UBS listening in, please reach out to your UBS financial advisor if you would like to receive a copy of the House View monthly letter directly.

From UBS studios, I'm Dan Cassidy. Thank you for joining us. Thank you for tuning in.

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