What's takeaway 1 on Top of the Morning?

Expect ongoing market volatility driven by Fed decisions and geopolitical tensions.

What's takeaway 2 on Top of the Morning?

Stable performance in the S&P 500 contrasts with underlying market risks.

What are the market implications for Top of the Morning?

Traders should monitor the EUR/USD pair around the 1.075 target level closely, especially as commentary from the Fed becomes available. Be alert for shifts in investor sentiment regarding infrastructure investments and geopolitical developments that could influence capital flows.

What are the risks to this view on Top of the Morning?

A marked shift in Fed policy, particularly if inflationary pressures mandate more aggressive rate hikes, could invalidate the current market assessment. Conversely, a de-escalation in geopolitical tensions may lead to a reevaluation of risk assets, impacting currency valuations significantly.

Top of the Morning: CIO Strategy Snapshot - Midsummer market assessment

What the desk is arguing

The desk highlights the upcoming challenges investors face, particularly the looming possibility of Fed interest rate increases amidst geopolitical volatility. According to UBS, this multifaceted risk environment has maintained relative steadiness in the S&P 500, with the broader market showing resilience despite external pressures.

Moreover, Jason Draho's insights suggest that while the equity market remains stable, traders should closely monitor how these risks might shift capital flows in FX markets, especially with tariffs and AI investments influencing investor behavior.

Where it sits in our coverage

Our consensus target for the EUR/USD pair is 1.075, with a range between 1.04 and 1.12. Notably, jpmorgan has set a target of 1.10 for March 2026, while bofa forecasts a lower target at 1.04 for the same tenor.

The desk's analytical perspective suggests that current market positioning aligns closely with this outlook, as risks from the Fed and geopolitical incidents could compel traders to reposition their strategies in the FX arena. As such, the prevailing stance sits comfortably within the overall consensus range.

How other firms see it

Firms aligned with this view, such as jpmorgan, emphasize cautious optimism regarding macroeconomic stability, while bofa presents a more bearish outlook, reflecting concerns over inflation and growth risks. This divergence highlights the complexity of market interpretations surrounding evolving central bank policies.

Traders should observe EUR/USD movements closely, particularly in relation to Fed rhetoric and developments in US-China trade policy, as these factors could trigger significant shifts in currency valuations.

Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. As we approach the middle of the summer, investors continue to deal with a number of pesky market risks, including the prospect of the Fed hiking rates, a resumption of hostilities between the U.S. and Iran, a new wave of tariffs, and ongoing concerns about AI CapEx spending.

Yet through all that, the S&P 500 has been relatively steady. So joining us here on this Monday morning to talk about those market risks and the market outlook from here, glad to welcome back Jason Draho, Head of Asset Allocation for the Americas from the UBS Chief Investment Office. Jason, great to be back at the table with you.

Thank you for dropping by. It's good to be here. Happy Monday.

Let's begin with the Fed because the FOMC meets this week, timely that we're covering this topic and the Fed will be deciding whether to hike interest rates. What are CIO's expectations? Well, you know, going into this meeting, I'd say there's an unusual amount of uncertainty.

You know, normally the Fed provides enough guidance that there's expectations either they will hike or they don't hike. This time I think it's relatively uncertain. The FOMC committee members have been split recently.

If we go back to the June FOMC meeting, it was almost 50-50 in terms of those who thought we should, you know, that they should hike at least once this year and the other half basically saying like we should stay on hold. In addition to that, we have, you know, Fed Chair Kevin Warsh. His views are a bit of a mystery still.

He's kind of refusing to provide kind of forward guidance. And also we've had this re-escalation of the U.S.-Iran conflict really during this blackout period. Oil prices have gone higher.

We have not had any real comments from officials, you know, since it's really kind of escalated to get a sense of how they interpret this overall development. So a lot of uncertainty. It's reflected in market pricing.

As of Monday morning, it's roughly about a 33% chance of a hike this month but also one full hike priced by September. Normally either you're going to be high like 80-90% or you're going to be low like 10-20%. So it's not quite 50-50 but pretty close to that.

In terms of what we expect, ultimately we think the Fed is going to be on hold this meeting. The inflation data we got for June, you know, sort of stepped down. So an improvement in inflation data.

So if you weren't willing to hike when inflation was higher in June, then the inflation data has not sort of gone in the direction that would sort of, you know, make it even more adamant you need to hike, you know, right now. There also is the case that, you know, the Fed generally doesn't like to surprise the markets, you know. And again, this is a different Fed under Kevin Warren, less focused on forward guidance or doesn't really want to provide it.

So perhaps that's not a – the past is not a kind of prologue in this case. But typically, the Fed does not like to surprise the markets. And there also – there's not going to be any updated economic projections, dot plots.

There will be a press conference that's been kind of confirmed, you know, but we don't know or if the Fed does change rates, we won't know like what is the policy framework, what's the details that was going to justify the hike at this point in time. Assuming they don't hike, then we'll probably see an FOMC statement that acknowledges that the risks to inflation posed by these renewed geopolitical, you know, events are there and that they're also likely to be at least one if not more descents, which would be not surprising but also kind of speak to the fact that the committee is still somewhat divided on this. In some way, it really does kind of depend on Warsh.

There are people who probably do want to hike who are more adamant about hiking versus those who want to stay on hold. If Warsh is in the camp of wanting to hike, he could probably convince those who'd be on hold to go in that direction versus those who want to hike. It'd be harder to kind of get them to say, no, we need to hold.

But we just don't know exactly where, you know, his kind of thinking is. Now, some of his rhetoric has been relatively hawkish. He's made in just in the past couple of weeks comments that, you know, inflation is a choice, you know, that they could choose to accept inflation above 2% or they could take action.

I think there's a risk that if they keep talking really tough and they don't take action, then they lose some credibility. So these things would suggest to perhaps that Warsh would lean in that direction. But he's given no indication.

And so if he wasn't willing to do it in June, given the inflation data, one would think that perhaps they don't want to do it in July. So that's where we would come out. They were going to.

They won't hike this time. The market is leaning in that direction. But it is not a toss-up close to it.

A bit of a commercial. Your colleague Andrew Dubinsky will be joining me on Thursday morning for a post-FOMC takeaway top of the morning. So coverage on both sides.

One factor, Jason, that could influence the Fed's decision is the rise in oil prices because of the resumption of fighting between the U.S. and Iran, which you mentioned a few moments ago. Do you see this as a factor that could impact the Fed's decision? It's possible.

I think not necessarily this time. And again, we don't know, given the blackout period, how they're interpreting this. Typically the Fed will look through these kind of oil price shocks.

And if you want to assume, I think it's a fair assumption, that the situation is sort of an unsteady equilibrium between the U.S. and Iran. You'll get some escalation, then some de-escalation. Not necessarily a clear, sustained truce.

Because of that, and we've seen over the weekend a couple of days of somewhat more muted military action on both sides, you've seen oil prices come down as a result, kind of validating that conjecture for the markets and perhaps for the Fed as well. Now that would be the normal sort of circumstances. But I think there's enough commentary from FOMC officials that they would support if the inflation news doesn't improve and higher oil prices for longer could tip them in the balance in that direction.

Obviously there's relatively little margin for error on inflation given how high it's been above 2% for now for five years. And any persistence in the conflict that keeps oil prices higher will matter for rates because it just increases concerns about, are these supply shocks just going to be kind of perpetual? Now even if the Fed has somewhat a limited ability to address supply-side shocks, and the reason rates is more about curtailing demand, they can't really address supply problems, the committee members, the FOMC, the Fed overall, they feel that they have to respond in order to avoid the perception among the public, the investors, that they're not really credible, that they're willing to tolerate high inflation even if they're limited to what's something they can do, and the impact is somewhat ineffective, again just for credibility, like they will do what they can.

So there's that possibility. They may also be just thinking that the longer inflation stays higher, for longer it is going to unanchor inflation expectations, but it's also sort of difficult to know in real time if that's happening. So far, that hasn't been the case, but if you want to err on the side of caution, you'd rather say, well, let's avoid that possibility, and again, this could sort of cause them to hike.

Under normal circumstances, you'd say the Fed would look through these oil price rises that are inflationary. Given where the inflation dynamics have been for the past five years, there's probably less intolerance for that, and they're more willing to take action even though the policy response may have limited impact to deal with what's going on in the Middle East. Something else to account for another inflation risk and challenge for the Fed is the announcement of new tariffs.

We've heard that recently from the Trump administration. How relevant of a factor is that, Jason, for inflation and the Fed outlook? I'd say the short answer is not very relevant for inflation, and therefore probably for the Fed.

What was announced last week was these new Section 301 tariffs that were sort of calibrated ultimately to be very similar rates for the expired 122 tariffs, and before that, the emergency IEPA tariffs. What that means in practice is that the overall effective tariff rates on US imports is essentially unchanged. If you actually do the math, maybe it is a plus or minus 10 to 20 basis points, but in all things considered, it doesn't make a major change.

What we know is that the sort of tariff-late inflation for the tariffs that were imposed last year, that is coming down. You can look at it by seeing which goods are being tariffed, look at the import prices, see the inflation on those goods. That's been declining, which was expected.

Tariffs are sort of a one-time price level increase. On a year-over-year basis, once you get past that one-year mark where the tariffs are imposed, inflation levels should drop. We're seeing that already.

If the effective tariff rate essentially remains the same, then you really shouldn't get any sort of knock-on effects overall. So ultimately, for the Fed, I think this is, of the pecking order of things that matter, this is probably relatively low, given it's essentially maintaining a status quo. Now, the one thing that is a little bit different with these tariffs just overall is that they are the result of months-long investigations.

And thus, they're kind of harder to remove compared to the 122, which had a 150-day expiration or the emergency tariffs, which the Supreme Court has struck down. So they will stay in place probably indefinitely. That doesn't mean, again, they'll be inflationary, but it just also means that there isn't – or it's probably a lower risk that some sort of ruling could be put into place or change some policy that would take them off that would be disinflationary down the line.

Another concern to be mindful of, the concerns seem to be piling up this morning, Jason. With AI CapEx spending and the return on investment, especially with the focus on open-source AI models, how much of a risk is this to the markets, Jason? Well, this concern about AI CapEx spending has been around for probably a couple of years.

It's a massive amount of spending, and you're seeing numbers continuing to ramp up as we go through earnings season. We'll get more of the hyperscalers reporting this week. As those numbers go higher, the question is, when will you get a real return on investment?

Compounding that is that if there are open-source models where – as opposed to closed-source where the proprietary Frontier Labs are introducing these models, charging various users for the services. Essentially, you have open-source where someone can take it and sort of download it on their own systems. The thought would be, well, then, how would you monetize this content if essentially you're giving away the product for free?

This is sort of added to it. There's a lot of developments even in the open-source kind of world in the past month or so. In some way, it kind of really boils down to, in my mind, does the release of these open-source models alter the demand for compute that is – and therefore, that would reduce or alter the demand for kind of the investment?

Effectively, I think the view that we have in CIOs that it's much more likely that these models will increase the adoption of AI and therefore the demand for compute. And it's going to be some sort of combination of like Frontier models where you pay for certain proprietary services and other models that you can apply specifically. If there's demand for compute actually goes higher, this is sort of the Jevons Paradox that you make something cheaper, you actually increase demand so overall revenue can increase.

Then more demand for compute, therefore, the suppliers for the compute technology, what semiconductors or semiconductor equipment actually kind of goes up. So, all that would sort of support that there will be some sort of return on investment. Another thing that's sort of from the tech companies, and this just gets into the market implications is that for a lot of the hybrid scalers, they view this as an AI sort of a winner-take-all and therefore an existential battle.

And if they don't invest, over-invest potentially rather than under-invest, the risk is that they will fall behind. They'll never be able to kind of properly catch up. So, even if the returns in the near term are low, ultimately, they'll keep kind of buying and investing because they think if they kind of establish a permanent presence and expertise, they won't kind of maintain that advantage.

That's a thesis that will be tested over time. But in the near term, companies will continue to spend, that will continue to reflect in different parts of the AI kind of value chain. And the final thing on this whole topic is that, and it goes back to kind of the open source models to some extent, they may allow also for the growth of agentic AI to be even more rapid and greater and more exponential.

And it's likely that by 2030, the vast majority of the demand for compute is going to come from agentic AI like applications that are being done. So, again, all these things suggest that the demand is going to grow faster than compute and therefore, that will generate an adequate return on investment enough that these concerns, at least in the near term, we've had them sort of linger than the markets have rallied. This will probably be the persistent dynamic kind of going forward.

With this inventory of risk considerations in mind and mindful as well that we're heading into August, a summer slowdown period of sorts. And I will note that we won't be having an episode next week. We'll be taking a bit of a pause just so our listeners can mark that down.

We need to refresh ourselves from all these risks that we're dealing with, Dan. So hopefully we end on a bit of a brighter note in terms of the market outlook, Jason, where we go from here, given these market risks, what does CIO recommend at this time? So on that point, these various risks we've talked about have been present in the past couple of weeks or even the past couple of months.

Despite all that, the S&P 500 has basically been in a range of 73.50 to 75.50, a pretty tight range. And so, as you could say, it's withstood these kind of headwinds, these challenges after obviously a very strong rally in the second quarter. Still good performance year to date.

We're looking at 9% total return to the S&P 500, a little bit past the midway point of the year. Good results overall. Ultimately, these are risks.

They're not the base case. Our base case is still that most of these things ultimately don't materialize in a significant way, that the Fed does not hike rates, that the situation in the Middle East stays kind of status quo or improves, and so the oil prices can go lower, that the flow of oil kind of normalizes. On the economic fundamentals that support all this, and that's part of why the Fed is potentially hiking, is that economic growth remains resilient.

We're seeing consumer spending continue to hold up. Inflation activity in the U.S. and globally is solid, so solid kind of growth that's contributing to some of these inflationary pressures, which is why the possibility of Fed hikes is even sort of being discussed. But the economic growth, that is supportive, and we think it will be solid going forward, that is supportive for risk assets overall.

Part of that's reflected ultimately by corporate earnings. We are only about a third of the way through the second quarter earnings season for the S&P 500, but the results are coming in very much in line, if not better than expected. Our team forecast 28% EPS growth for Q2 year over year, and we're tracking that, if not a little bit better than those results.

So very good kind of numbers overall. Equity markets to some extent are kind of shrugging it off. It's a little bit of the buy the rumor, sell the news, or arrive and travel and arrive, meaning once you actually get the news, it's like, okay, we expected it.

So you're not seeing a big market pop, but it's also good that it means the valuations are actually probably getting cheaper rather than sort of more expensive overall. Add this all up, this is why we look at equities as being kind of attractive globally in the U.S. The latest how-to-update about 10 days ago, we upgraded Eurozone equities to attractive, a little more cyclically based, and that does feed into one of the key messages of like kind of diversifying across equities, but in particular kind of leaning into kind of a cyclical rotation to some extent.

So sectors in the U.S. that we like, including financials, industrial, consumer discretionary that will benefit from this kind of relatively solid economic environment, that's kind of how we would lean into that direction. That also includes emerging markets, which has some of those drivers as well. On the fixed income environment, rates have been obviously kind of jostling around.

If the Fed doesn't hike as we kind of expect, and ultimately the path going forward under our flinching assumptions is that they would cut at some point early, middle of next year, you could see interest rates kind of go lower at the front of the curve. The intermediate part, the 10-year part, could still be very much range bound, which is why we tend to favor more, let's call it the belly of the curve, up to about five or seven years. That's why within corporate credit, we tend to favor more of the high yields relative to IG just because it has shorter duration and you're not getting this massive supply of longer duration from hyperscalers issuing debt to finance the CapEx build-out.

But generally, a diversified fixed income, kind of higher quality portfolio. So a relatively constructive view overall, and so again, these are risks that we've covered throughout this call, not the base case, and they will persist by the market so far. I've been able to kind of swat them away, and I like to think that, you know, mosquito season.

Sure. You know, it tends to kind of peter out as the summer goes on, so hopefully these risks dissipate, but they're probably going to persist into August, maybe even into late in the summer as well. Well, helpful to be knowledgeable about the scope of risks out there and to have a good understanding of how CIO sees the market outlook taking shape in the months ahead.

So always a very helpful touch base, Jason. Thank you for dropping by on this Monday morning. Enjoy the time away next week, and do look forward to regrouping here with our listeners in a couple of weeks' time.

You're welcome. Have a great week. Thank you for tuning in.

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