Top of the Morning: CIO Strategy Snapshot - In the Knick of time

Hi, everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. This past weekend was quite exciting for sports fans with the World Cup starting and the New York Knicks winning their first championship since 1973.

However, investors also got some good news with reports that the U.S. and Iran have agreed to a deal that will reopen the Strait of Hormuz. All that sets the table for a constructive market response this week. So joining me here at the New York podcast studio, glad to welcome back for the CIO Strategy Snapshot, Head of Asset Allocation for the Americas from the UBS Chief Investment Office, Jason Draho.

Jason, great to be at the table with you. Good Monday morning. Happy Monday morning.

It's a fantastic start to the week. Absolutely. We were talking about the Knicks last week.

It was truly historic. So let's get into it, Jason. A lot to catch up on.

I mentioned that we did see a reported U.S.-Iran deal. So what does that mean for the economic and market outlook? I know more to come with that perhaps later in the week with the signing.

Well, it appears to be more of a memorandum of understanding rather than a concrete deal at this point in time. It's expected to be signed on Friday, June 19th. That will lead to further negotiations of a fully-fledged deal that would do things along the lines like negotiate Iran's nuclear capabilities, any sort of unblocking of frozen Iranian assets, and sanction curbs.

There will definitely be probably some pushback domestically from President Trump. He has the details sort of come to light. So there is a chance that this does fall apart between now and Friday.

But as of Monday morning, the markets and investors are sort of taking it pretty much as a done deal. So you can see oil prices are down 5%, interest rates are lower, equities at the moment, the S&P is up about 1%. And we saw across the board that it can overseas equity markets up even more.

So very kind of positive reaction to that. From a market perspective, we've been sort of moving in this direction. A few weeks ago, there were already reports of a deal being close and it's taken a while to sort of get to something that's more confirmed by both sides that a deal is now close to being signed.

So the market you could say was already pricing in this outcome, but it does further reduce sort of the tail risk of oil prices spiking higher. That causes inflation to be sticky, that would cause rates to be elevated. So a positive development, but one that was sort of somewhat anticipated at this point in time.

So Jason, outside of geopolitics, the other big market event this week is the Fed's FOMC meeting culminating on Wednesday. So what are you expecting from this meeting and what do you expect the Fed to do going forward? Well, let's just set the context by talking about what the market is expecting at this point in time.

As of this morning, the market is pricing still for one full FedRide hike by next March, and cumulative 1.2 hikes by the second quarter of next year. This is down. Ten days ago, after we got the May payrolls report, the market was pricing a full cut or hike by December and 1.7 hikes by June.

So we've already seen a decent dolling back of that. In terms of what to expect for the FOMC meeting that culminates on Wednesday, any change in the Fed policy rate is very, very unlikely. No cuts, no hikes.

I think that would be a true shock if that happened. What is pretty widely expected is that the Fed statement, the FOMC statement, will drop its easing bias to be more balanced, indicating that the next move could be either a hike or a cut. The summary of economic projections, including the dot plot, will be updated.

It's expected that the median member will expect no cuts this year. So the focus is more on next year. That could entail, again, the median will have one or maybe even no cuts, but there will probably be multiple members, not a majority, but at least a handful, who would actually want to have a hike next year as the next move.

Now, in the ballpark, it could be extreme one way or another that could be new information for the markets. But I think what's really going to matter for the markets is what Kevin Warsh says in his first press conference as the new Fed chair. Kevin Warsh is sort of on the record as saying he's not a fan of forward guidance.

So he might actually downplay some of what comes out of the economic projections, saying this is not an official forecast, the dot plots are not meant to be a guide. Something that Jay Powell said, but he might be even more adamant about that. He'll be asked, certainly, questions regarding the Fed independence, what the path is on that.

And he'll, I'm sure, reiterate what he said during his Senate testimony, believing strongly in Fed independence. So the real focus and the thing that could move the markets most is, what does he say in answers to questions regarding views on, how does he think about inflation, does he focus more on these trim mean measures on core? Because depending on which inflation measure you choose to focus on, you're going to alter your path on what you think the Fed should be doing.

He'll be asked questions about AI and productivity, and that can be disinflationary, should that justify cuts? So however he chooses to answer these questions, markets will be trying to glean, what does he actually really think? And even though that may not influence Fed policy this meeting or even the next couple of meetings, it would indicate how he's going to try and steer future conversations with the Fed.

And that can indicate how strongly he might be trying to push for cuts or no cuts or even potentially hikes. So that's the key thing to sort of take away is, how will the markets interpret Warsh's comments? And given it's his first press conference, I'll be subject to interpretation, I'm sure.

So all eyes will be on the Fed within a couple of days with that press conference in particular. So Jason, as you pointed out, the market is still pricing for the Fed to hike rates. But in your latest blog, which is titled, In the Nick of Time, great name, you argue that the economy is unlikely to overheat and is actually much better positioned.

So Jason, what is your current assessment of the economy? I'd point out Nick is spelled with a K. That it is.

To clarify that. So look, there's certain concerns certainly a couple of weeks ago of the US economy kind of overheating. What happened after we got the payroll reports, you know, bid expectations in the prior two months were revised higher.

So the three-month average of job growth was $188,000, whereas most investors and the Fed itself would expect that somewhere maybe in the neighborhood of $50,000 is the break-even rate that you need to have that job growth to keep the unemployment rate stable. So if this job growth stays at those levels, then this leads to a tightening labor market. It can lead to faster growth than expected.

And it can fuel kind of those inflation concerns. You also have consumer spending data that shows continued sort of resiliency. We will get May retail sales data later this week.

But higher frequency credit card data indicates that consumers continue to spend. Now the World Cup has started, you know, we can see a bit of an uptick, you know, related to tourism. You know, not dramatic, but something that, again, near term is directionally more positive for consumer spending.

So again, all that suggests growth is holding up. None of this should be particularly surprising. You know, back in the beginning of January, you know, the expectation was growth would accelerate in the first half of the year, kind of peaking in Q2 because of the fiscal stimulus that was passed last year, because of tariff effects would fade, financial conditions are easing.

So getting growth accelerating, getting a strong job market in the middle of the second quarter, that shouldn't be surprising. I think investors were perhaps overestimating the negative impact of higher oil prices, higher interest rates. And that's reflected in these various economic surprise indices.

Some of them are at three-year highs, indicating, again, that people did not, investors did not expect the data to be quite as strong. Again, that's sort of fueling some of these inflation concerns. There's also details, you know, recently in the past couple of reports suggesting that AI-related demand is helping to be, you know, sort of adding to inflation.

You know, there are some shelter components that have been sort of also distorted by the government shutdown last fall. Looking forward to where we have more comfort in the, in this overheating not being likely is that, you know, these growth impulses that were positive, they should fade in the second half. So we could see growth sort of moderate in the second half of this year rather than accelerating.

The inflation data we got for May, if you look at the details, it does indicate that sort of tariff-related inflation is coming down, assuming that the deal that, between the U.S. and Iran, does lead to a sustainable opening of the Strait of Hormuz, that oil flow starts to normalize, the oil prices gradually go lower, and that gives confidence that, you know, at least the headline numbers will kind of moderate and probably even peaked in with the May data. So again, that gives comfort that the direction of travel is that the economy is not going to overheat, that inflation is going to come down, which is, I should add back regarding the Fed, is why we actually expect the Fed to cut rates twice. We did push back our timing of that to be March and June for next year.

Look, even if the Fed chooses not to cut, it's further along the line. So like the timing-wise, the bar for hikes is quite high. You know, you need to see growth above, I think, 2.5% sustainably.

You need to see the unemployment rate continue to tick lower towards 4% or less, and we're around 4.3%. And for inflation expectations to kind of continue to drift high, that gets the Fed worried. We don't think any of those are sort of likely to happen.

Inflation is likely to go lower, and therefore the Fed, you know, is likely to sort of believe that it should be kind of cutting rates to get to more sort of a neutral territory. So all that suggests no overheating, at least that's a low risk. And that path towards a nice kind of soft landing as we go into next year, that still seems like it's on track.

So Jason, at this point now that we have a better understanding of CIO's outlook for monetary policy, thoughts on the integrity of the U.S. economy, let's end as we typically do with asset allocation. In light of all of these developments, Jason, what are you recommending that investors do right now? Well, if you think about this overheating concerns, if you look at where rates are, like the 2-year, the 10-year today versus just even sort of like roughly 10 days ago before the economic data started to come in quite strong, they've kind of essentially fully unwound where they were.

The S&P as of before the market opened was still below its all-time high by about 2.4%. That gap will close to some extent today. If you look at equity market performance over the past 10 days or so, even though the S&P is down slightly, what we've seen is a broadening out of performance.

Some of the more defensive sectors, but also cyclical sectors like financials have actually outperformed. We've seen small caps kind of outperform over this time period. Same thing with kind of an equal weighted S&P of 100 index.

So what we've seen is a bit of a rotation and some of that is it's twofold. One is investors get comfortable about the macro environment that inflation perhaps the economy won't overheat. You'll see a sort of broadening of performance.

Investors willing to go into the more economically sensitive or cyclical parts of the markets like financials, like consumer discretionary, like small caps. We can see outside of the U.S. European equities tend to be more kind of tied to the economic cycle and they're bouncing quite a bit on Monday morning as a result of this deal news.

The second factor is there's been a very strong performance for U.S. equities in the two months prior to all this. So basically in April and May, heavily concentrated, led by the tech sector, led by kind of AI related investments, semiconductors like the SOX index was up like 80%. So I think some sort of rotation taking some chips off the table is sort of understandable.

If this deal holds, sustains, I think this rotation is likely to continue, which is why sort of the kind of the broadening out should persist and why we would continue to say can diversify across equities, including things like favoring other sectors like financials, healthcare discretionary and other parts of the world, especially kind of Asia, which would benefit again from easing oil prices, more access to energy supplies because some of that part of the world was definitely impacted by the closure of the Strata Formos. Jason, always helpful to hear your macro, your market insights and guidance when it comes to positioning to begin a trading week. So thank you for dropping by for top of the morning and I do look forward to picking back up with our conversation again soon.

Well, I also look forward to that and seeing you at the next parade on Thursday morning. I know you love it. Oh, I don't know about that.

I'm sure I'll be able to be there in spirit. But good stuff. Jason Draho.

Thank you very much for dropping by. Again, I want to highlight the blog from Jason Draho, which we have been referring to on today's episode in the nick of time is available now up on UBS.com slash CIO for clients of UBS. Please be sure to reach out to your UBS financial advisor if you would like to receive a copy of Jason's blog directly from UBS studios on Dan Cassidy.

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