Top of the Morning: CIO Strategy Snapshot - Keeping it straight
Lead — The desk believes the current U.S. tariff announcements are likely to escalate market volatility and have significant ramifications for currency flows, particularly in relation to the USD. Per the full note from UBS, the markets are reacting negatively with S&P 500 futures declining around 1.5% immediately following the announcement. This negative sentiment is compounded by uncertainty surrounding AI investment trends due to developments related to DeepSeek. As traders assess these factors, positioning in key currency pairs may shift, reflecting broader risk aversion and liquidity constraints.
What the desk is arguing
The desk posits that the new tariffs announced by the Trump administration signal a more aggressive trade policy that could amplify the risks of a trade war, particularly with respect to China, Canada, and Mexico. Per the commentary, these tariffs are layered on top of existing tariffs, suggesting a sustained period of trade tension that the markets will need to navigate.
Key evidence from the commentary includes a new 25% tariff on imports from Canada, Mexico, and additional tariffs on specific sectors like semiconductors and aluminum. The desk forecasts potential for a broad-reaching impact on risk assets, as the market calculates the implications of these moves.
The alternative read would be that these tariffs are selectively enforced and do not escalate to a full-blown trade war, possibly leading to a more measured market response than anticipated.
Where it sits in our coverage
Our consensus target for the USD/CAD pair stands at 1.075 with a range from 1.04 to 1.12. Key firms in our coverage include: - jpmorgan: Target at 1.10 - bofa: Target at 1.04
This viewpoint aligns with jpmorgan's more favorable outlook on USD strength versus CAD while contrasting with bofa's bearish outlook, which is at the lower end of the target range.
How other firms see it
Several firms share a cautious outlook, with jpmorgan and citi adopting a more hawkish tone on the USD, suggesting that underlying economic conditions favor a stronger dollar in response to trade uncertainty. Conversely, bofa and hsbc hold a contrasting view, indicating that the potential for economic slowdown might weigh on USD strength.
Related currency pairs to watch include USD/JPY and EUR/USD, as these may reflect broader market sentiment and respond to the fallout from tariff announcements.
What the calendar says
With no upcoming high-impact events scheduled in the next 30 days, focus remains on the evolving landscape surrounding tariff announcements and their potential to reshape investor sentiment and positioning in the FX markets.
01Expect heightened volatility in FX markets due to new U.S. tariffs.
02Watch for shifts in positioning related to USD as risk appetite changes.
03DeepSeek developments could alter AI investment sentiment, impacting tech-related currencies.
Market implications
Traders should closely monitor USD/CAD as tariff impacts play out, especially the 1.075-level, which may prove to be pivotal. Additionally, any shifts in risk sentiment could lead to speculative opportunities in other commodity-linked currencies.
Risks to this view
A reversal in this call could be initiated by any signs of diplomatic progress on trade negotiations or stronger-than-expected U.S. economic data that might mitigate recession fears, leading to a stabilization in risk appetite and thus impacting FX flows differently.
ubs
Hi everyone, Siobhan Chapman here, and welcome to Top of the Morning on the UBS Market Miss podcast channel. Last Monday morning, the markets were dealing with deep-seek news. Today investors are dealing with the announcement of new tariffs and the risk of a trade war.
Markets are reacting negatively this morning with the S&P 500 futures down about 1.5%. In addition to tariffs, investors are still assessing the implications of deep-seek for the AI investment thesis. Here to discuss all of this and these issues is Jason Draho, Head of Asset Allocation Americas.
Jason, good morning. Good morning, Siobhan. Happy Monday.
Good to be here. Perfect. Let's get started.
On Saturday, President Trump announced tariffs on Canada, Mexico, and China. Can you take us through the details and what CIO expects next? All right.
So Trump signed an executive order to apply a 25% tariff on imports from Canada and Mexico. In Canada, there's only a 10% tariff on energy imports, like oil and gas. And there's also a 10% import, applied to imports from China.
These tariffs are on top of the existing tariffs. So for China, when there is already a tariff supply to 25% on certain goods, this will be incremental to that, whereas for Canada and Mexico, these are generally all new tariffs. In addition to these tariffs on these three countries, Trump has also said last week and even reiterated last night that tariffs are coming soon to the EU, the European Union, as well as specific goods such as semiconductors, steel, copper, aluminum, and pharmaceuticals.
Like our base case, at the start of the Trump administration, it was that tariffs would be aggressive, but they would be directed primarily at China, meaning that the tariff trade could go up to 60% on some goods. And outside of China, a tariff supply would be more selective in certain areas and certain products, not across the board. We also expected that the moves would be a little bit more delayed or elongated.
A few weeks ago, the administration, before they even took office, had issued an executive or memorandum of understanding, directing certain agencies such as the Treasury Department, Commerce Department, Trade, to look at trade practices, issues, and then report back by April 1st. So the initial market reaction was, this will take some time before tariffs move forward. So the announcement on Saturday and the potential for more tariffs, even in a matter of a couple weeks in other countries, is certainly more aggressive than we expected.
The way I think we would classify it is, relative to our base case, it's trending more towards our bear case, which is a universal tariff on all imports of at least 10%. If you put a 25% tariff on goods from Canada and Mexico, more than 25% on goods from China, the three biggest trading partners, you're already covering a big chunk of imports into the US. So it's trending in that direction.
There's going to be an economic cost, because ultimately, tariffs typically apply this way, and then sort of semi-aggressively and quickly. This is directly stagflationary, meaning it's negative for growth and negative for inflation. There's a wide range of estimates.
It depends on what models are used and what assumptions are made exactly. But if assuming these tariffs are implemented and maintained for the full year, you could see, relative to a baseline expectation or forecast, assuming there are no tariffs, that inflation could be half a percentage point higher, give or take a few tenths of a percent, maybe up to as much as one full percentage point. And growth could be reduced by half a percent, and again, it could be a little bit less than that, but these estimates could suggest that you go up to one full percentage point.
For context, the consensus forecast right now for the US economy is growth this year around 2.4%, 2.5% of GDP growth. So you're talking about below 2%, 1.5% type of growth, if these tariffs are fully implemented and maintained all year. And likewise, inflation instead of going down to 2.5% or lower, it could easily go back up over to 3%.
Now, we assume right now that these tariffs on Canada and Mexico, they actually won't be sustained for a long time, in part because there is these economic costs. You'll see various industries being impacted, potentially auto plants, which are one of the most impacted areas, potentially shutting down in a matter of weeks just because the cost of these tariffs on goods going back and forth across the border would basically make it uneconomical for these companies to produce in certain cases. We're also likely to see US industry groups, you know, represented impacted companies filing court challenges and lobbying for the removal.
And so ultimately, we think they won't be sustained for a long period of time. It's also, you know, what we've known, it's been announced, is that Trump will be speaking to Justin Trudeau, Prime Minister of Canada, and Claudia Schoenbaum, the President of Mexico, today. So depending on how the conversations go, there is a chance that the tariffs aren't actually implemented because the executive order was signed Saturday, but they're supposed to take effect starting tomorrow, February 4th.
But whereas a lot of the motivation that's been, you know, that's aligned to why these tariffs are applied, you know, meaning, you know, trying to curtail imports of, you know, fentanyl into the US from those countries, curtail the illegal immigration. You know, those are certainly factors, but Trump has also linked, you know, the tariffs to the fact that there's trade deficits with both countries. And those aren't easy to remediate quickly, you know, versus you can demonstrate progress on immigration, on fentanyl, et cetera, into the country, but trade deficits, those could take quarters, if not years, to alleviate.
So it's certainly possible that it might be a little bit too optimistic to think these tariffs will be removed quickly. So for the near term, it feels like, you know, the trend is that they're more, the tariff situation will get worse before it actually gets better. But it's very fast moving, and a lot of it comes down to what President Trump wants to do.
And of course, today, you know, based on the calls, you know, the tariffs, there's a possibility that they're not actually implemented. So a lot going on, it's moving very quickly. It's more than what our base case assumes.
It's turning more towards our bear case. But the situation is very fluid. And things could slip around in a matter of hours, if not days.
So last week, we also got more important economic data on growth and inflation. What does that say about the state of the US economy? So we kind of lost a little bit a lot of headlines last week with some more economic data.
And kind of this is the silver lining of the whole story. The US economy is in good shape. And it really supports a constructive medium term, like, you know, 12-month outlook for financial markets.
It's perhaps also why given that the US economy is in good shape, why, you know, Trump and the administration feel somewhat confident about moving forward and even potentially having a negative cost to the economy, because it's in this position where it can absorb it. So the data we got last week was both on growth and inflation. The specific growth data was Q4 GDP, which came in at 2.3%.
But this actually understates the strength of the economy and what the number could have been, because consumption grew 4.2%, one of the strongest quarters in a few years. And what dragged down GDP growth at the very last minute was import data for December. That was kind of higher than expected.
And this contributed to inventories actually subtracting 0.9% from GDP. What it appears like is that companies anticipating the implementation of tariffs, typically from China, they're front running that, they're importing more. That actually goes into inventories.
And so it actually looks like, you know, that was sort of dragged down growth, even though sometimes it's not really reflective of what's the underlying economic activity. So overall story that's consistent with other data we've gotten in recent weeks is the US economy is in good shape. It's growing at a 2.5% to 3% range.
The consumer is healthy right now. You're seeing pickup in manufacturing activity. Again, this assumes no disruptions from tariffs or other factors.
So a good situation. And barring policy errors or some unexpected shock, there's not a lot of reason to think it's going to slow significantly this year. On the inflation front, on Friday, we got December PC inflation, which is what the Fed focuses on.
It was generally aligning with expectations. You know, the core PC measure that the Fed really focuses on rose 0.16% on a month-to-month basis. That is basically 2.8% year-over-year, which was what expected.
But if you actually look at the three-month inflation, right, like how much PC, core PC has increased in the last three months, and you annualize it, it's down to 2.15%. You take the last six months of core PC inflation, how much it's increased, and you annualize it, it's 2.26%. So like, you know, 2.25%, less than 2.8% on a year-over-year basis.
So what it's telling us is that as you get sort of more kind of higher frequency data in more recent months, that the core inflation is actually trending lower. So fears of inflation re-accelerating, it's certainly not evident in the data. So you add it up, it's a good picture for the U.S. economy with growth being strong, inflation still generally moving in the right direction, disinflationary.
In the economy, that certainly is positioned to be able to absorb potentially, you know, a hint of growth, you know, in higher inflation from tariffs, but certainly not completely, you know, immune to it at this point in time. Turning over to AI, a week after DeepSeek News rolled markets, what is the assessment of how this development will impact the AI investment thesis? Well, in some way, that was the big story last week, and even reading, you know, sort of your various research over the weekend, it seemed to be that a lot of investors in the markets were still very much focused on DeepSeek and AI, and then how this could impact, you know, the markets overall, how it could impact the companies, which is, you know, understandable because the biggest performers or the strongest performers in the markets for the past couple of years have been these mega tech companies, NVIDIA, you know, driving a lot of the market higher.
So as you get this new AI model, that can be, you know, have very good results, but at a, you know, develop at a fraction or apparently at a fraction of the cost, you know, could disrupt or certainly challenges the whole AI investment thesis and, you know, the investment case for a lot of these companies. But as the week went on and investors started to kind of, you know, ask more questions and understand more of like how the model was developed, what are the implications, where does this fit in the overall picture? I'd say three kind of key points have emerged from it.
You know, one is that these emergence of lower cost models like DeepSeek, you know, already kind of aligns with the industry cost trends and does not necessarily change the overall growth outlook for the industry. So the development of these large language models, it was getting more efficient, cheaper, you know, think of it as a cost curve and where DeepSeek sort of aligned to it is kind of consistent with those costs trends. So, again, it seems like a big change in terms of the cost to develop these models.
But for those who have been tracking this closely, I suggest that this is, you know, where we expected this model development to go anyway. And there are some questions about whether it was as cheap as DeepSeek suggested if they were already building these models or their model on existing models and perhaps using some technology that they sort of understand it or more than that actually suggests to the cost. But that's the key point is that the cost aspect wasn't shocking given the overall trends in the industry.
So that's the first point. The second point is that there's been enormous CapEx spend to build out AI data centers to both test the models and develop these models, but also for inference. And that still seems to be for a lot of industry, a lot of investment is going on towards developing large language models, but to have data centers to be able to run inference.
So whether individuals go and do queries, ask questions, create problems using the AI tools. And by the end of the week, it was clear from that, especially after earnings for some of the mega cap companies, that among the big tech companies that are most focused on AI, which includes Alphabet or Google, Amazon, Meta, Facebook and Microsoft, there's still likely to increase capital spending by complying 25% this year up to $280 billion. There was no indication that they're going to dial this back.
So that trend still seems very much in place despite the developments and seeming sort of like new step change forward in the AI technology that DeepSeeker demonstrated last week. And a third sort of key takeaway was that if you have cheaper large language models that actually democratizes AI, it makes it easier to and justifiable to develop tools and applications for companies to make investments. So there can actually also be more demand for AI tools such that the overall revenue of the industry could actually increase.
And last week, the term Devon's paradox was tossed around a lot for something that people may not have heard before. But the basic idea is that it's actually suggesting as the cost comes down, the demand can increase enough that the overall revenue, the total adjustable market could actually go higher. So the end of the week, that sort of seems to be where the industry sort of took away this news is that DeepSeeker is consistent with declining cost trends.
This wasn't sort of a complete surprise and game changer. The CapEx spend for these big mega cap companies is still very strong in terms of investing and I think that's across the board. And this just actually cheaper AI models means that the demand and the adoption could actually increase and grow even faster and sort of reinforce the overall end-to-end investment thesis.
So a very choppy volatile week, but the end takeaway is that the view that our team at CIO has is that the AI story remains very much intact. The way to play the position for it, of course, can evolve over time, but as a general theme, it's still very much in play at this point in time. So we are coming to the end of our conversation, Jason, and I want to bring this all together.
What does the tariff AI and economic news mean for the economic outlook? Well, let's just start maybe from the economic outlook. You know, I alluded to like a good economy is the baseline, but clearly at risk now of being disrupted in terms of a negative impacts to growth or inflation.
And the magnitude is going to come down to just how long these tariffs are put in place and how broadly additional tariffs are applied. The longer and more, the worse the outcome overall, and that's, you know, there's no getting around that. We could certainly go from our base case of growth with tariffs to something that more like this is a tariff shock that really puts the growth trajectory at risk.
It still seems more of the risk case in the base case, but the probability is, you know, it's kind of been sort of shifted in real time and could shift back, you know, almost at any moment. From the market's perspective, it becomes a little bit trickier because if I look at market performance last week across equities, fixed income currencies, there's two kind of key takeaways that I would have from it. One is that there was a modest risk off tone to markets last week.
Understandable, given the newsflown aggregate was direction negative for the economy, but also earnings given the deep seek news and the market sort of to absorb that. So we saw last week that the S&P was down one percent of tech sector was down four and a half percent. The 10-year treasury yield last week saw eight basis points.
The dollar also rallied. But a second and perhaps bigger thing in terms of the outlook is that, you know, the markets and equities in particular had seemed to be relatively complacent on the macro risks of higher tariffs. You know, while investors are more focused on the micro risk of AI and sort of individual stocks.
So just think like last week, the VIX index, you know, the index for volatility in the markets or the kind of quasi fear gauge, you know, rose a little bit during the week, but it closed at a level of 16.4 on Friday, which was actually less than where it was for most of the first two weeks of January. So certainly, you know, relatively contained. In contrast, if you actually looked at the volatility of individual S&P 500 stocks that took the average last week, it was nearly 30 points higher volatility versus the volatility for the overall S&P 500 index.
It's rarely that high. The last time it was like this high was in November of 2020. And it's one of the top 10 biggest caps in the past 25 years.
What I was suggesting, there's a lot of movement on individual stocks, but I'm not for the overall market, because the investors think we're relatively complacent on the trade risks. The movements we're seeing on Monday morning before the markets open is clearly, you know, a different direction. We're seeing volatility.
You jump, we're seeing futures down, you know, over 1%, 1.5% for the S&P. So consistent with the market sort of, you know, adapting to this kind of new reality. In the near term, I guess like the, you know, is the market sort of a digest this news is still kind of news on what the tariffs are fully implemented, whether tariffs are soon implemented across Europe and specific industries.
The risk reward at the moment just feels like it's a little bit more skewed to the downside the next couple of days, weeks, maybe a couple of months, as this sort of plays out just because the implications for the economy have not been sort of priced in. In the medium term, the fundamentals still remain solid for the U.S. And ultimately, again, if the tariff situation doesn't fully escalate to our risk case, it kind of dials back to our base case that tariffs do go higher on China.
But for other regions, other countries, they're more contained and even maybe kind of dialed back. The ultimate economic impact is something that the U.S. economy can absorb, that corporate earnings for U.S. companies cannot dramatically impact and ultimately still see upside, you know, for year end. Again, driven partly because the EITC still remains in track.
But in the near term, that's the challenge, I think, for the markets. We think and would expect that as the markets pull back, as the S&P 500 pulls back, there will be buyers come in. We saw that last week.
You know, retail buyers are stepping in for the tech sector after it sold off. Something would probably happen similar to equity markets overall. But relying on a, you know, Fed or Trump put, I think there's probably more downtime before that actually gets materialized.
Big picture, though, you know, we see upside ultimately to year end for equities, given how I think the tariff scenario will play out. We still like the tech sector and the A.I. theme in general. For fixed income, you know, remaining up in quality because credit has also not been pricing in and a lot of kind of tariff risk and, you know, kind of growth risk there.
Given how much, you know, yields have pulled back even a little bit before the tariff news, we'll be cautious on extending duration, you know, too much because if this pulls back, there could be sort of also reaction for sort of inflationary news in the market. So you could see yields go higher. So being more in the belly of the curve, the five-year duration point is where we still target and be up in quality, higher quality corporate credits, agency MBS or areas that we like.
And then also just as a hedge, you know, gold as a kind of risk off diversifier is something we're liking this morning. It is up, you know, half a percent and it has sort of a fundamental sort of technical reasons why it could continue to go higher. So go for gold is also a key theme that we have overall.
But be prepared for volatility. Have a game plan of how you want to deploy capital still running the year. There'll be opportunities for pullbacks, but realize that, you know, the markets are going to be trying to assess what's the likelihood of this tariff situation escalating to be something that's more negative for the overall investment outlook because it's not sort of priced there.
In the news flow, as we saw last week, it changed very quickly, you know, daily or even hourly in some cases. Okay, perfect, Jason. Thank you so much for joining us.
You're welcome. Have a great week. Thank you for tuning in.
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