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. We are back with the CIO Equity Pulse, a monthly review of CIO's investment views and positioning recommendations for U.S. equities.

We also outline a performance update and outlook for the asset class and touch on thematic points of interest. This monthly conversation aligns with the release of the monthly UBS House View. The latest UBS House View is now live and available, including the investment strategy guide.

Today, we will also tie in a recent blog authored by our featured guest. That blog is titled The Narrowest Rally in Decades, and these resources, of course, all available for you now up on UBS.com slash CIO. Joining me here for the conversation today, glad to welcome back Head of Equities Americas from the UBS Chief Investment Office, David Lefkowitz.

David, thank you for dropping by as always, great to have you back here on Top of the Morning. Yeah, my pleasure. Thanks for having me, Dan.

So, David, as I mentioned, the UBS Chief Investment Office just released the latest House View publication suite, and within, I see that you and the equity strategy team have raised the earnings estimates and price targets for the S&P 500. So, to begin, David, can you walk our listeners, our clients, through the thinking behind the changes? Yeah, most certainly.

So, yeah, you're right, Dan. So, we did make some changes to our price targets and earnings numbers for the S&P 500, and yeah, I mean, the punchline is that the earnings season was just really strong. But also, we had been seeing the strength even before the earnings season, and frankly, we were a little bit reticent.

We wanted to see a little bit what was going to happen with the situation in the Middle East before making some changes, and obviously, that's still a little bit uncertain. But bottom line, we have enough conviction now, just given the strength of how the first quarter panned out, that we are making that change. So, we're moving to, for 2020, for this year, we're now expecting 20% earnings growth.

That's a pretty big increase from the 11% we have been expecting, and we're introducing for next year that we think growth will continue at around 12%. And so, because of that increase in those earnings numbers, as you and many listeners probably know, I mean, the trajectory of corporate profits is one of the key drivers and variables for the overall equity market. So, that prompts us to increase our year-end price target. as the earnings upgrade, so we're now at $7,900 on the S&P for the end of this year.

So, that's about 6% higher than where we are today, which is actually a pretty normal return for a roughly six- or seven-month period. So, I would say we're expecting kind of normal-type equity markets, which doesn't mean a straight line, by the way. It just means normal-type returns.

Of course, equities tend to be volatile. And then, more broadly, Dan, I would say we think just the bull market drivers that we've been focused on for the last few years, we think they're still intact, that we have a resilient economy, we have a central bank, the Fed, that I would say is supportive, and then, obviously, the AI story, we think, still has some runway. So, the drivers, we think, are still in place, and the earnings are coming through better, and that's what prompts our target upgrade.

So, David, it's interesting from hearing that thesis, it sounds like you still have a positive outlook despite the continued disruption in energy flows from the Middle East. How are you thinking about that risk? Yeah.

So, I mean, I do think this is clearly a near-term risk, and it could be a source of volatility in the near term. I mean, I think the longer this goes on, the more of a headwind it's likely to become. I think, as evident so far, the U.S. economy, U.S. consumer can largely handle the rising gasoline prices that we've seen so far.

It's been about a buck and a quarter per gallon across the country. But the longer this goes on, I think we're going to continue to see further increases in energy prices and gasoline prices, and that probably, as I mentioned, will probably weigh even further on consumer spending and the cost of doing business for many businesses. So, it is definitely a risk.

That being said, I do think, and this is our base case, our base case is that any difficulty in the economy as a result of higher energy prices probably does prompt more of a focus on ultimately finding a resolution. So meaning, further pain may be what's needed to actually get the energy flowing and getting the two parties to come to an agreement about how to move forward. So, and I think that's especially true considering, you know, we have elections coming up in November, and so there's going to be a pretty strong incentive for politicians in the U.S. to really, you know, maybe make the concessions that are needed in order to get the energy flowing.

So we'll have to see how it plays out, but it certainly is a short-term risk, but we think that's a risk that would likely prove to be somewhat temporary and wouldn't derail the story that we expect to play out over the balance of the year. Now, David, outside of geopolitical considerations, another consideration top of mind for many being interest rates have been moving up, and the market has shifted from expecting two Fed rate cuts this year to now looking for a half a hike. So another consideration being as well, Fed Chair Kevin Warsh being sworn into office today.

Does that, David, have any implications for equity markets? It does a little bit, Dan. I think, you know, as you point out, we've seen a pretty big shift in Fed expectations.

You know, that being said, I mean, we ourselves within CIO here, we are still expecting the Fed to cut. We have now one cut in December and then another one in the first quarter of next year. But that could get pushed out if the energy situation doesn't start to improve in the coming weeks and months.

So I do think that it is a risk. But I also think there's a – the likelihood of the Fed hiking still seems pretty low in our opinion. I mean, a Fed hike doesn't really resolve the energy shortage problem, right?

So it's not clear it would really be beneficial to do that. But if the Fed were to start hiking, I do think that's one of the key risks. I mean, if we look at history, you know, especially in the context of investment booms like we're currently seeing, usually it's Fed tightening that leads to some trouble for those investment booms.

You know, that in this particular moment in time is definitely a risk that is worth watching. But again, not one we think is likely at this point. The other thing is that, you know, the longer-term interest rates have also been moving up.

I mean, partly – or we think mostly because of this change in Fed expectations. And I think it's just important to remind everybody, we're now in a regime really that started since COVID, whereby higher interest rates are generally a headwind for stocks. And I think the reason that that is the case is that we're in an environment where nominal economic growth is running hot.

So the market is more worried about inflation than, say, deflation. And this is actually a really big change from what we saw after the – you know, really in the couple decades – the first couple decades of this century, you know, roughly from 2000 to COVID. And so it's just – yeah, it's another risk factor that we need to monitor.

Higher rates, you know, at the long end, probably a bit of a headwind. And then, yeah, I mean, new Fed chair Kevin Warsh, I think it wouldn't shock me if – you know, new Fed chairs sometimes need to find their stride, especially how they communicate with the markets. It wouldn't be shocking if there's some communication miscues and things like that.

You know, the market needs to get to understand how the new Fed chair is going to operate things and really, you know, have more confidence, essentially, in how the Fed chair would think about different variables. So yeah, that could be another source of volatility. But again, I think that's really going to be largely temporary.

So interest rates are definitely a risk factor. If I had to bottom line it, I would say the biggest risk would be if we started to anticipate meaningful Fed hikes. That would be a significant change or significant headwind, I would say, for stocks.

And also just generally, you know, higher long-term yields, that's also a little bit of a headwind as well, but not something that we think is in the cards from here. Okay, so now that we have an inventory of sorts of risk considerations being monitored by you and the Chief Investment Office, David, if we turn focus just to recent equity market momentum. Now, I mentioned at the start a couple of days ago, you put out a blog showing that the recent market rally was one of the narrowest since at least 1990.

So that's going back a ways. What are the implications of that, David? Yeah, so yeah, we were looking at the data.

It was pretty interesting. I mean, we had a six-week rally that ended last Friday, and it was the largest outperformance of the market cap weighted index versus the equal weighted index, you know, since 1990. That was the year that the equal weighted index started.

So really, in the history of the data, we've never seen anything quite this large. So we looked at other periods when we've seen fairly large rallies or large outperformance of market cap versus equal weight, and I'd say there's a couple of takeaways. One, narrow rallies don't always broaden out.

Sometimes they persist. Like for instance, really, since the launch of ChatGPT, I mean, we've had somewhat of a narrow market, and this is just a continuation of that. That was also the case in sort of the earlier stages of the dot-com bubble in 1998, for example.

But then eventually, you know, I guess the message is, if you think the investment boom that's driving the outperformance of the market cap weighted version of the index is at risk, then obviously that's a reason to be focusing more on equal weight. We don't think that's – and that's exactly what happened in, say, 1999 and 2000. We don't think that's the case yet.

As I said, I think the Fed is a critical variable here. We're still – the other, you know, more fundamental reason is that we're still very short compute in AI. We're still seeing, you know, very aggressive adoption, which has been a new story this year in monetization of some of these tools.

So you know, we think there's more to go in the AI trade. So we don't think it has huge implications, but for investors, we think still have some exposure to AI for sure. But if there are large positions that have become outsized as a result of market performance, we think this is a time to maybe scale those back a little bit, back to more reasonable allocations.

So David, in terms of factors that may drive market momentum as we look ahead, now, last time you and I spoke about a month ago, we largely focused on the Q1 reporting season, which is now over. So with that in mind, what catalysts should investors focus on in the coming months? Yeah, so next month, you know, there's a number of things.

I would say, first and foremost, we're going to get new Fed Chair Kevin Warsh leading his first post-FOMC meeting press conference. That's on June 17th. I think that's going to be a pretty important day for markets, so a lot of attention there.

You know, we get the typical macro data, labor market, and inflation. That's always important. Some of the large cap companies, mega cap companies in tech are going to have developer days.

That's when they introduce some of the new tools and sometimes new products. So those could be market moving. And we do have a smattering of earnings.

And then we're probably going to get a big IPO. Definitely a number of things to focus on that could move markets in different directions. OK, so a lot there to watch out for.

How should investors be positioned within U.S. equities at this time, given all that you've shared with us today? What I would say is that, so from a sector perspective, you know, this is not a bad time to look at some of the defensives that have underperformed. So two of them that we like, health care and utilities, you know, we think those are even a little bit more interesting here, especially considering, you know, we don't think we're going to see further increases in interest rates.

The other thing is that if we do get resolution on the Strait of Hormuz, you know, cyclical areas like consumer discretionary and financials are probably well positioned. It's a bit contingent on the energy situation improving, but we do think that will eventually happen. And then, you know, within tech, for tech, I would say on a pullback, there could be some opportunities.

I mean, the sector has done really well. So we're currently neutral, but if there is, if there are pullbacks, it's definitely worth taking a look at those. And then I, you know, I need to mention, we still think investors should be allocated to the major and the large innovation drivers that are out there.

We have portfolios that we call trios, are aligned to those. So those are the three are artificial intelligence, power and resources, which is an electrification story, and longevity, which is a health tech story. You know, we do think investors should have exposure to innovation drivers.

That's usually a very clear source of shareholder value creation. And we think those are very appropriate. But I think that, you know, the main message is, Dan, that we think the bull market is intact.

Because as always, we could see short term fluctuations based on Iran, based on the Fed. We don't think that would derail things. And we think markets will be higher by the end of the year.

Well, David, very productive conversation. Thank you for dropping by for this month's CIO Equity Pulse here on top of the morning. Again, for you, our listeners, CIO Equity Pulse is a monthly review of CIO's investment views and positioning recommendations for U.S. equities.

And we do tie in the views from the UBS House View monthly release, which, again, is available for you now up on UBS.com slash CIO. As is David's recent blog he had referenced a bit earlier, that title, again, The Narrowest Rally in Decades, again, available up on UBS.com slash CIO. Though we have been speaking with David Lefkowitz, head of equities for the Americas from the UBS Chief Investment Office.

David, thank you again for dropping by. Great speaking with you. Thank you so much, Dan.

Appreciate it. 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.

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