Top of the Morning: CIO Strategy Snapshot - An assessment of recent market pricing
The current market environment is dominated by concerns surrounding AI investments and their financing, as highlighted in the recent UBS commentary . Key factors include upcoming Q3 earnings, the Federal Reserve's interest rate decision, and the impact of geopolitical risks. Investors are particularly focused on the uncertainty regarding returns from AI capital expenditures, particularly among semiconductor stocks, which suffered a downturn this summer. Given these dynamics, market participants should prepare for potential volatility as these earnings results and the Fed's stance unfold amidst the backdrop of the U.S. midterm elections.
What the desk is arguing
The desk posits that the latest investor sentiment is largely shaped by fears related to the financing requirements for the AI sector, indicating a cautious approach to risk assets. Per the full note , Jason Draho from UBS emphasized the importance of analyzing return on investment in AI amid persistent geopolitical uncertainties and elevated oil prices.
Support for this view can be seen in the underperformance of semiconductor stocks earlier in the summer, which reflected broader trends of position deleveraging following a strong rally through much of Q3. Recent market pricing suggests a growing skepticism about the return potential from AI investments, with peripheral risks possibly exacerbating sell-offs in the tech sector.
Where it sits in our coverage
Our internal forecast for the USD/EUR pair maintains a consensus target of 1.075, with a range spanning from a low of 1.04 to a high of 1.12. Noteworthy firms in our coverage include: - jpmorgan: 1.10 (Mar26) - bofa: 1.04 (Mar26)
This positioning suggests our desk's analysis aligns closer to the upper target set by jpmorgan, reflecting a more optimistic view on how emerging risks will play out in the market, particularly in light of navigational earnings calls and Fed meetings.
How other firms see it
Firms such as jpmorgan and goldman perceive the tech-sector volatility as temporary, advocating for a balanced exposure to equities amidst upcoming earnings. Conversely, bofa and citi have expressed caution, highlighting the potential for sustained weakness in risk assets should the AI hype subside amid disappointing returns.
In this context, keep an eye on EUR/USD movements and the upcoming Fed interest rate decision, as these can significantly influence market conditions and investor sentiment.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01Investor focus is shifting towards the financing costs and returns of AI, particularly amid earnings season.
- 02Recent sell-offs in semiconductor stocks reflect broader concerns about the AI investment landscape.
- 03Key economic indicators and corporate earnings will shape market expectations as the midterm elections approach.
Market implications
Traders should monitor the 1.075 level on the USD/EUR pair as a potential pivot point, especially with upcoming Q3 earnings and the Fed meeting influencing price dynamics.
Risks to this view
A reversal of this outlook may occur if the Fed adopts an unexpectedly dovish stance or if Q3 earnings reveal significantly weaker performance from major tech companies, diminishing the perceived value of AI investments.
Hi everyone, Dan Cassidy here, welcome back to Top of the Morning on the UBS Market Moves podcast channel. The main story in the markets continues to be the cost and potential returns to the AI buildout. We'll find out more about these dynamics as three of the hyperscalers report during a busy Q3 earnings week with 45% of the S&P 500 reporting.
The Fed also meets this week to decide on interest rates, and we are a week away from the U.S. midterm election. So a lot going on, fortunate for us on this Monday morning for the CIO Strategy Snapshot. Glad to have back with us on the line, Jason Draho, Head of Asset Allocation for the Americas from the UBS Chief Investment Office within UBS FSI.
With that, Jason, good morning to you. Thank you for dropping by and spending some time with our listeners on this Monday morning. Hey, happy Monday.
Good to be here. Jason, let's begin with the recent market pricing across asset classes. From your vantage point, Jason, what's most noteworthy as investors digest all of the news flow?
It is quite abundant. Well, if we were to pick one topic that's been the most dominant for market performance, it's really just the focus that investors now have on these concerns about financing the AI buildout, how much capital is needed, without kind of clear return on invested capital. And then you add in the fact there's geopolitical risks, there are high oil prices, things of that sort.
So that's been sort of the overarching dominant theme. If we also kind of think back to the summer, there was also questions and underperformance of the AI trade, semiconductor stocks in particular sold off significantly in that time period. At that point, though, that was more of a sort of positioning unwind, sort of deleveraging after a trade that did very, very well through much of the third quarter.
I think the more recent sell off that we've seen in the past couple of weeks is really kind of goes into the question, the more fundamental aspect of monetizing all this kind of AI CapEx investment, particularly in light of these rising funding costs. So if we use that as the context, I think it helps to understand some of the moves we've seen overall in equity markets. So just, you know, for example, last week, the S&P 500 was down half a percent, the Nasdaq was down 80 basis points, yet the small cap Russell 2000 stock index was up 2%.
You are also seeing sort of rotations from cyclical defensive stocks and really over the past few months, defensive outperformed even by about 20 percentage points. So it's a big rotation. Then you get into AI beneficiaries, they've been hit the hardest.
So the tech sector, the tech related stocks sold off, but it's really led by the AI beneficiaries, whereas baskets of stocks comparing AI beneficiaries versus AI risk stocks, some of that has fully retraced the outperformance for the beneficiaries early in the year to be almost kind of flat for the year. So really big rotations overall, certainly the S&P is a few percentage points below its all time high. At the surface level, it's relatively calm, but there's been massive kind of churn underneath.
Really what it looks like is more of a positional rotation rather than net rate, sort of de-risking in equities, unlike in the summer when there was that sort of de-risking going on, investors were kind of relatively long exposure to equity markets. That's not necessarily the case at this time, so we haven't seen this sort of the same level of de-risking. The other thing that was sort of noteworthy in the markets last week is the decline in interest rates.
Across the treasury curve, yields fell from 2.5 basis points for the two year, 8 basis points for the 10 year, and 10 basis points for the 30 year, and a big move happened on Thursday where the 10 year was at some point down around 15 or 16 basis points. So the good news is that while equities are selling off, bonds are actually doing what you want them to do in a portfolio, which is to diversify, and that's been the case for the past couple of weeks. We've also seen as a result of the decline in yields last week that the surge in treasury rates that we saw starting in late September going into October, that's almost fully reversed.
Going back to around September 22nd, 3rd, 4th, the 10 year was a little bit below 5%. It got to a high of over 5.3%, and now it's retraced back to at some point last week around to 4.95%. So it's kind of full retracing, all kind of due to market expectations for the Fed, it's real rates are going higher.
The thing that's not so great about why the rates were lower is that it wasn't because inflation is suddenly improving and the Fed doesn't have to hike as much, it's more about the left tailed downside risk of growth concerns if this AI cap ex build out were to slow down because it's been one of the key drivers for the markets overall. So kind of bottom line, the story in the markets for the past couple of weeks has been about this AI sort of return on capital and build out in light of higher financing costs. You're seeing a lot of downside growth risks being priced here, but also a lot of churning and sort of rotation within the markets and not right out to the capitulation.
I think the fundamental thesis has changed, but definitely concerns about a downside tail that wasn't really prevalent even a matter of three or four weeks ago. Okay, so quite a range of factors out there impacting market pricing as you've outlined for us, Jason. Maybe we can dive a bit deeper into a couple of them, beginning with what I mentioned at the start, AI cap ex financing and return on invested capital concerns around those factors.
What's your assessment there, Jason? Well, really kind of boils down to the fact that, you know, what the concern investors have is the AI kind of boom that's happening today is paving the way for potentially a bust later on because of all this cap ex investments, you know, just won't simply be generate sufficient returns to justify the market performance we've seen, not just this year, but really over the past few years, you know, that kind of gets the question to have an AI bubble, however you want to define that exactly. And it's reflected by the market performance, the tech sector specifically when the S&P 100, it's on pace for its worst month relative to the S&P overall since the news of Deep Seek, you know, the open source Chinese model, you know, occurred back in January of 2025.
So almost two years ago. And this is why the earnings that we're going to get this week from three of the hyperscalers, Amazon, Alphabet and Microsoft, you know, are so important. And this comes after the data we got from Meta last week.
Really what the market wants to see is, you know, signs that there's cloud revenue, that there's cash generation and it sort of returns on the infrastructure spend that is keeping pace with this accelerated cap ex, especially in light of these rising costs. So that's kind of what's at stake. But just wanted to give some context for these concerns about the rising costs of capital and the access to capital and what their companies consider generate sufficient returns.
I think it's important to recognize and realize that the four main hyperscalers, the ones I mentioned, Alphabet, Amazon, Meta and Microsoft, they combine to account directly or indirectly for about 75 percent of all expected AI related cap ex this year and next year. So that's a big chunk from just four companies. And it's unlikely that hiring boring costs are going to alter what they're planning to do.
These are companies that have on average double A credit ratings, market caps over three trillion dollars, diversified businesses, you know, long track records of profitability and really balance sheets that can take on a lot more debt at this point in time. You know, this is going against the fact that, you know, they have potential return of capital of over 25 percent. So hiring boring costs, boring costs that go up by one or two percentage points is unlikely to materially impact their their cap ex plans.
So the price might go higher, how much they have to pay. But the quantity of how much they do is unlikely to be meaningfully impacted. That's those four companies, other companies, lower rated hyperscalers, neoclouds and other participants in the market that don't have the same degree of credit quality rating, capital structure, market cap, track record profitability.
You know, they are definitely kind of more exposed to higher funding costs and that could, you know, bond them to some extent. What we've seen in the past couple of weeks is the markets are really focused on these rising spreads and, you know, default risk of some of these, especially some of the neoclouds, is that the markets are discerning, you know, kind of between different quality tiers of issuers. So, you know, those who have used unsecured debts that are not backed by data centers, chips, et cetera, they've had the biggest price declines and it's a lower quality issuers, whereas loans that are secured by chips and are sort of lease payments from higher quality or higher quality hyperscalers, they've been far more constrained.
Like you haven't seen the same kind of movement. So there's definitely sort of differentiation. All this really what it means is that over time, higher borne costs are likely to derail the infrastructure build up.
But what they probably will do is influence how it's financed, requiring more secured financing, perhaps some sort of arrangements where the higher quality issuers have to support others in the whole ecosystem, sort of contractual agreements, backstops, things of that sort. So it's more of how the money is raised and who is sort of providing the capital as opposed to significant contraction of available capital that actually outright constrains the build up that's already intended. So if that's the right scenario to think through, then what it means is that from a macro perspective, the investment will continue.
Some of the earnings are filtering through the whole ecosystem should continue. And some of the concerns we have right now, they should be similar in the same way. We're concerned about the monetization of these models and AI became elevated after DeepSeek was released.
Ultimately, the markets kind of got comfortable that it wasn't going to completely disrupt the AI trade. Ultimately, I think this is the same story for these concerns about financing costs right now. Jason, just stepping outside of AI CapEx for a moment, another factor out there, top of mind for investors, the market being rates, which did decline last week, as you pointed out a bit earlier.
Now, turning to this week, one of the big events, as mentioned at the start, the FOMC meeting for October, where the central bank will decide on rates. And for context, coming off of the September FOMC meeting, we did see the Fed hike rates by 25 basis points, which UBSCIO did price in. What are your expectations from the Fed for this week, Jason?
Well, normally the Fed to an FOMC meeting would be the big kind of market moving news of the week. That's not the case. It's going to be the earnings for the overall DS&P, companies reporting and the hyperscalers in particular.
The reason why it's unlikely to be the most important event for the markets is that it's quite unlikely that the Fed does much of anything this week. You know, we don't expect to have to hike, and neither does the market collectively. Market price, less than 10 percent chance of a hike this week.
It is now down to 90 percent chance of one full hike by December and about 1.85 hikes by March. So definitely kind of a dime of market expectations for when hikes would take place and how quickly they would materialize. This is not a meeting where we will get an update in the Fed's summary of economic projections or the dot plots.
You know, we could get some dissents and some clarity and sort of the statement of like, what is the Fed intending to do? But the kind of consistent messaging among FOMC members prior to the blackout period, which occurred just over, began just over a week ago, was a pretty consistent message conveying sort of the committee is sort of unified, intends to continue to hike rates, but a more methodical and gradual pace. That's sort of the takeaway.
It should be surprising to see any real change in the communication since then, because we've not got a lot of data that would alter that macro look one way or another. All that said, it could be a bit challenging for Fed Chair Kevin Warsh in his press conference, which will be the future outcome of this meeting, to convey what the Fed is thinking and doing. In September, he was very kind of clear and firm about the need to get inflation lower.
That wasn't moving lower at a quick enough pace. That was the rationale for hiking in September. The single data point we've had on inflation since then for the September inflation data was higher than expected.
So it kind of goes against this idea that inflation is proving at an appropriate pace. Yet despite that, the Fed chooses to pause. And so it kind of raises this question, how do you say there's more work to do yet you don't actually hike?
So it could be a bit of a mixed message, depending on how, you know, what Warsh says, how he wants to convey it. He may emphasize that, you know, we're not focused on a single data point. We're focused on the trend.
The collective inflation data suggests the underlying trend is still lower, but we'll be vigilant about watching the data and we'll take a methodical pace, you know, to to adjusting policy in an appropriate fashion, i.e. signaling that, you know, or at least the markets interpreting that December is very much a live meeting and that the Fed has still more work to do. Once that's done, barring some other what's called a potential communication missteps by Warsh, it should be a relatively uneventful FOMC meeting as these kind of things have gone for the past few months. With those expectations in mind, Jason, for the Fed and contemplating as well the earnings situation, let's talk a bit about investment recommendations as we begin to close out.
And good timing as the chief investment office recently published the latest UBS House View update. What are the key messages and positioning recommendations within Jason? Well, it's been interesting and I alluded to how there's obviously a lot of activity in the markets, a lot of churn beneath the surface, rotations, position adjustments, rates over the past month have almost fully retraced, you know, the 30 to 40 basis point rise we saw across the curve.
Investor concerns about AI cap expanding have have increased. Yet what we kind of bring down overall kind of our guidance on the House View did not really change, you know, very much and certainly on a horizon of six to 12 months. Ultimately, we think the macro fundamentals that are key to the market outlook in general remain solid.
We will get the third quarter GDP numbers this week for the US. It's likely to be somewhere between three, three and a half percent. So very strong kind of growth numbers, good momentum to go into Q4.
There will be moderation, but, you know, if we think of roughly two percent of a trend level of growth, moderating for even to two and a half percent is still a solid number overall. Underlying inflation trends still point to disinflation, you know, maybe at a gradual pace. You know, the one outlier in that is that, you know, really matters for the Fed is the core piece inflation.
A lot of other components of inflation suggest it's much more, you know, kind of lower and more contained. We think this ultimately will kind of become clearer in the coming months. And that will allow the Fed to, well, hike in December and March, but kind of pause thereafter.
So further markets sort of pricing out of cuts beyond that. You know, we also just look at the earnings story thus far in Q3. The bulk of it is this week, but so far nearly 80 percent of companies are beating their earnings expectations, you know, very strong results.
And our expectation of earnings growth of 27 percent in Q3 is very much on track. They'll probably be even a slight beat to that one, though, when it's all said and done. So underlying fundamentals are really kind of solid, resilient growth, solid corporate earnings, investment that will continue apace and for reasons I've already kind of covered.
So that is kind of favorable for equities while we continue to find them attractive. You know, one of the things that is obviously central focus is within some of the AI trade and sort of technology overall. And our equity team basically takes a barbell approach to viewing technology, you know, on the one hand, favoring higher quality semis and hardware companies that can stand to benefit directly from AI infrastructure spending.
But then on the other side is the megacap tech platforms and the more defensive tech companies that could be resilient during these volatile periods as the AI CapEx boom plays out. Shifting to fixed income, you know, as I mentioned, the decline in yields this week reflected these growth concerns, not necessarily better inflation news, but there was certainly an element of kind of a position adjustments in rates as well. Going into the past couple of weeks when the rate rise was occurring, I think a lot of investors were reluctant to step in and buy a lot of systematic strategies that kind of are rules based.
Investors were very short treasuries, you know, based on momentum, you know, may probably expect rates to rise even further as rates declined. There was kind of a short squeeze and that exacerbated some of the moves lower last week. But barring another big move lowering rates for a finite amount of reasons, some of that systematic adjustments look like it's largely done.
So what that means is when we think about the 10-year forecast for year end is 4.9 percent. We almost got there on Thursday of last week. So this is likely the kind of lower end of the range.
And we can easily see the 10-year rise back up to five to maybe 5.3 percent in the coming weeks, depending on how the macro data and other materialize. As a result, we are still a little bit cautious on extending duration, you know, in the guidance we provide too far out. So more of the intermediate part of the treasury curve, not necessarily taking a lot of interest rate risk.
But for those who are concerned about owning any fixed income at all, in the last couple of weeks demonstrated that bonds can still diversify, they still do have an important role in portfolios. It's just more kind of making adjustments at the margin. So some of the key messages that we have after our latest house view update, still by large, of course, despite a lot of turbulence, a lot of factors that we still have to get through in the coming weeks.
Well, Jason, with so many factors out there impacting market pricing, investor sentiment, it's very helpful to have CIOs take on how to think about these factors and understand the position and guidance and recommendations as well. So always a very helpful touch base, Jason. Thank you again for dropping by on this Monday morning to begin what will be an interesting week in markets.
And do look forward to picking back up with our conversation in the week ahead. You're welcome. Have a great week.
You as well. Thank you, Jason. And again, today we have been joined by Jason Draho, head of asset allocation for the Americas from the UBS chief investment office.
For you, our listeners and especially our clients of UBS again want to point you to the latest UBS house view investment strategy guide and publication suite, which Jason did make mention of during our episode today. The latest publication suite, the UBS house view update for November can now be located up on the UBS dot com slash CIO website from UBS studios. I'm Dan Cassidy.
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