Top of the Morning: CIO Strategy Snapshot - Q3 earnings, oil prices, inflation data
The desk underscores a pivotal shift in market sentiment as Q3 earnings season, inflation data, and retail statistics converge, potentially impacting risk appetite and currency valuations in the coming weeks. Per the full note , the recent stabilization in treasury yields and rising equity prices suggest a cautious optimism that may influence expectations around inflation. However, the ongoing volatility in oil prices and central bank policies cast a shadow on this outlook, especially as investors brace for critical economic indicators.
What the desk is arguing
The desk is focusing on the implications of an evolving macroeconomic landscape characterized by upcoming Q3 earnings, inflation metrics, and retail sales reports. This convergence of data is expected to provoke market reactions, particularly as investors weigh the potential impacts of higher interest rates and oil price fluctuations on economic growth.
Recent market movements showed a mild decline in treasury yields, with the 10-year yield falling by three basis points, which reflects a cautious approach by bond investors amidst heightened rate volatility. This week’s data on inflation and corporate earnings is crucial, as the S&P 500's modest 1.2% gain signals underlying investor sentiment largely remains positive despite overarching concerns surrounding fiscal policy.
Where it sits in our coverage
The current consensus target for our coverage aligns with strategic forecasts around a 1.075 level, with a range anticipating volatility within 1.04 to 1.12. Notably, firms projecting similar trajectories include: - jpmorgan with a March 2026 target of 1.10 - bofa anticipating a lower bound with a March 2026 target of 1.04
There appears to be a mixed sentiment as jpmorgan holds a bullish view while bofa is slightly bearish on the trajectory, suggesting the desk's positioning is near the upper limit of current market forecasts.
How firms align with this view
Aligned with the desk view
Contrary positioning
Key takeaways
- 01Q3 earnings, inflation, and retail data loom large, likely influencing market direction.
- 02Oil price instability and interest rate hikes remain central concerns for investors.
- 03Recent declines in treasury yields and modest equity rises indicate cautious optimism.
- 04Consensus targets for key currency pairs reflect a division in market outlooks.
Market implications
Investors should closely monitor the outcome of the upcoming inflation data on retail sales as potential catalysts during this critical earnings season. Specifically, look for any movements around the 1.075 target level stemming from better-than-expected inflation or earnings, which could influence risk sentiment in the FX market.
Risks to this view
A significant rebound in oil prices or worse-than-expected inflation data could prompt a reevaluation of risk sentiment, possibly leading to a shift in central bank policies. Such developments could reverse the current bullish positioning in the equities market and dampen currency performances tied to economic expectations.
Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. It was a relatively calm week in financial markets with modest declines in treasury yields and a rise in equities.
However, the risk of higher rates and oil prices remains top of mind for investors. This week, we'll also have more news to digest as we will be commencing the Q3 corporate earnings season. We also have September inflation data and retail sales data coming up as well.
So busy week ahead, thankfully for us, joining us to talk about these factors. Glad to welcome back in studio today, Jason Draho, head of asset allocation for the Americas from the UBS Chief Investment Office within UBS FSI. Jason, good Monday morning to you.
Thank you for dropping by the studio. Great to be back on the mic with you. Good morning.
Happy Monday. Good to be back in the studio. Absolutely.
So Jason, to set the stage, and this is a busy week ahead, but let's first talk about the week that was. Can you recap what happened in the markets last week? And what's the setup as we head into a busy period of news over the next couple of weeks?
Well, just for last week, high level, you know, relatively quiet overall. We did see, you know, yields go a little bit lower that the 10-year fell three basis points and also rate volatility, which has been also very, very elevated, compressed a little bit still at the high end of where it's been over the past year. The S&P 500 was up 1.2% last week and the NASDAQ, you know, a little less at only 20 basis points.
So, you know, relatively kind of uneventful given what's going on for the past couple of months for financial markets overall. But what we did see within equities was a bit of a broadening out of performance. You know, it was the first week that yields declined, you know, in over a month since the late August.
And as a result, we saw kind of the S&P 100 excluding kind of AI stocks or heavily focused on AI. It posed a relatively, you know, good week. You know, some of the sectors that have been, you know, down quite a bit in the past couple of months, you know, did well, whether it's utilities up over 4%, utilities almost 4%, healthcare 3%, stables, you know, 3%, financials almost 3%.
So, it wasn't a tech story last week, it was kind of a broadening out story overall. Maybe back even further from just last week, those numbers are sort of important to put into context. You know, the S&P 500 is, you know, at an all-time high, like 1% below.
But at the high level, the surface level, it's been relatively kind of robust and resilient to all sorts of shocks that have taken place, the rapid rise in rates, high oil prices, geopolitical uncertainty. But beneath the surface, there is a lot of churn and underperformance. So, just to write off a few more statistics that I'll quiz you on later on.
So, we have about 85% of the S&P 500 index, like companies of the 500 stocks are down more than 10% from their all-time highs. Almost 60% are more than 20% down. So, you think of 60 stocks, 60% of the S&P 500 essentially is in sort of what we, you know, most investors would say is sort of bear market territory if you're down more than 20%.
You can kind of go on down the line, but almost about a quarter are down more than 40%. So, you wouldn't think that's the case necessarily if the S&P is at an all-time high or 1% below. But there's already a significant amount of churn, which kind of speaks to the fact that the quality stocks, big mega cap names, have been the ones that certainly over the past month have lifted the equity markets higher or at least kept them from selling off overall.
Whereas it's been the rate-sensitive stocks that have been sort of the hardest hit, you know, for the past couple of months. And so, as a result of this churn, some mega cap names holding up quite well, you know, a lot of other stocks doing poorly, they tend to offset each other to some extent. Which is, while rate volatility is very elevated, you've seen interest rates chop around a lot, the S&P 500 volatility is actually quite contained.
If you actually look at realized volatility, you know, on a one-month basis, it's at 10. You know, this is a very low number. The VIX, you know, is commonly followed, you know, that is in the high teens.
So realized volatility for the S&P is quite low. And then if you look at sort of, you know, positioning data, given this churn, and given also the outlook that a lot of investors have, they're not actually using this kind of low volatility to provide protection, sort of the measure of investor looking to buy downside protection is what is the skew in the S&P 500, meaning how much you're willing to pay to predict the downside versus capture the upside. That's at less than the first percentile over the past few years.
On the other hand, investors are trying to position for the upside, you know, in a fear of kind of missing out if there is kind of a right tail rally into year-end, and that's, you know, above the 99th percentile. So it is kind of interesting dynamics, you know, as the surface looks relatively calm for equities, massive churn beneath the surface. And the way investors are positioned is that they don't expect a lot of downside, but they are fearful of upside.
Returning to the macro environment, Jason, when we spoke a week ago, you described macro conditions at the moment as being benign, but the higher rates remain a risk. What do you think is necessary to reduce that risk? You know, the rise in rates this year has been pretty significant, like the 10-year Treasury yield is up 107 basis points since January 1 and through last Friday.
The bulk of that is, I'd say, is due just to better growth expectations. And the way that I would look at that is simply that on January 1 of this year, the market was expecting the Fed funds rate to be just over 3% by the end of this year, by December of 2026. As of Friday, the market is expecting the Fed funds rate to be around 4.1%.
So that in nine months, the market basically priced in over 100 basis points more of where the Fed funds rate would be. Almost a one-for-one match of what the 10-year Treasury yield will do. And that's based on the fact that growth has been better than expected.
Obviously, inflation we know is still elevated. But the key thing is growth because most of the rise in the 10-year over 90% of the 10-year yield going up is due to higher real rates. So that's just some context to say, you know, where are we?
What's driven rates higher? So to get a real significant decline in the 10-year yield, and let's say, you know, to pick a number, we're tracing more than half of the increases here. So if it's up 108 basis points to decline more than 54 basis points, I think you need some clear material degradation of the growth outlook for the economy overall.
That really probably requires some significant pullback in sort of the AI investment story because our estimates would say that in the first half of this year, that AI could have accounted for upwards of 100 basis points of the 2.4% of real GDP growth. Some of that's investment. You know, that part of that is the wealth effect is stock prices related to AI have gone up.
People are wealthier. They're spending more money. So I think you need something like that to get a, you know, more than a 50 basis point decline in the 10-year treasury.
Now, that's unlikely to happen in the near term given the strength of the economy, given the economic momentum. We still think that yields will decline over the next six months, you know, provided two factors sort of materialize. One is that we'd expect the market to price out.
Some of the rate hikes it has for next year. And then oil prices will actually sort of decline on a credible de-escalation between the US and Iran. On the rate hike expectations, the market right now is pricing just over one full hike by December, another whole hike by March, and then more gradual sort of increase but ultimately another 1.3 hikes, you know, by the summer of next year.
You know, we expect certainly a hike in December, you know, a third hike is possible. But three more hikes in total seems quite extreme or, you know, not our base case. So as some of those hikes get kind of priced out, again, yields should go lower.
And given an upward rise in market expectations for the Fed this year paralleling the rise in the 10-year yield, if you cut back on Fed rate hike expectations, the 10-year should also decline, you know, with that. And this may take at least a few months to sort of materialize, you know. But I think before year-end, by year-ending, that will move in that direction.
The bigger kind of wild card is oil prices. You know, there's a lot of, you know, discussion about the potential escalation of the conflict, military strikes from the US on Iran. There's also reports that President Trump doesn't want to do that before the midterm elections.
The flip side is I would imagine if the Iranians sort of knowing the political dynamic in the US that you'd want things to escalate, cause oil prices to go higher before the midterms to cause sort of maximum pain for Trump and the Republicans. So post the midterms, could that reverse? Could then, you know, Iran say, well, we've sort of invoked some damage now, you know, we want to de-escalate if possible?
On a flip side, would then President Trump want to escalate? These are sort of the unknowns. But I think, you know, what it does suggest is that the midterm elections could be a bit of a risk-clearing event.
We'll see how the outcome is and then what are the geopolitical dynamics kind of taking place thereafter. But I think that that's sort of hard to predict because it's not so much economics, it is politics and geopolitics at this point in time. So I think that's ultimately we think the yields are going to go lower, they're going to go lower because the inflation data will move in the right direction, growth should moderate a little bit from its current pace.
That's been the biggest driver of rates going higher. But until we get some confidence, I think, on the oil outlook, you know, maybe rates are more likely to perhaps, you know, chop around and stay in a sort of range, near-term range for the time being. Near-term tomorrow, Tuesday, October 13th, the unofficial commencement of the Q3 reporting season.
We'll begin to hear from some of the big banks. Jason, what are CIOs' expectations and what key developments to watch over the next few weeks? So just in context, you know, second quarter earnings season – oh, sorry, the second quarter was we had earnings growth of over 32% for the S&P 500.
That's stripping out some kind of unique aspects where, you know, investments in some private companies would have boosted that number over 40%. So if you want to make a like-for-like comparison, the consensus is somewhere around 25%, you know, percent for Q3, you know, we are a little bit, you know, higher than that. You know, if you kind of look at kind of the setup going into earnings season, a lot of times companies will kind of guide lower throughout the prior quarter to the bar lower and then, you know, exceed expectations.
Going into this earnings season, the third quarter estimates have actually been revised higher by 1%, you know, over the past few months. That's usually a positive sign. So when that happens, typically you beat and beat by more than is normal, so that's a positive sign.
You know, corporate guidance has been relatively solid. Some of the early reporters, given they have a kind of an off cycle or off kind of quarterly calendar, quarterly cycle, a lot of them are beating expectations, you know, more than is normal. On the third quarter growth, we're tracking at almost 3.5%, you know, real GDP growth in the third quarter, nominal GDP could be close to 7%, you know, that should be positive for sales overall and then that cascades down to earnings growth.
It is still going to be dominated by semis and energy, you know, and they could account for, you know, more than 50% of the earnings growth in the third quarter. And year over year, they could be both up over 100%, just given the rise in both semiconductor prices and, you know, oil and energy prices. So I think that's kind of some of the dynamics of what numbers to expect.
In terms of what maybe matters most for the markets is, you know, the breadth of earnings. So yes, semis lead the way, but in the second quarter, the median company, the S&P of 100 had earnings growth of 12%. This is likely to decelerate, you know, and again, the consensus is around 7% for the median.
You know, still a solid number by historical standards, but a little bit of kind of moderation there. You know, so we need to see these kind of healthy numbers overall. For some of the AI trade, so to speak, it has obviously been boosted by significant investments in like the CapEx for hyperscalers.
They've routinely lifted expectations each kind of earnings season. You know, for context, coming into the year before the fourth quarter earnings season in early January that began, the expectation was the CapEx for hyperscalers would be in the range of $450 billion this year. Now we're more likely to be $650 to $700 billion.
So significant upgrades. The pace of upgrading just can't, that can't be sustained. You can't keep going up, you know, 50% every single quarter.
But if those numbers aren't sort of guided higher, that could be a sign for the markets of worrying about the sustainability of earnings more for 2027 and beyond. And we expect 14% earnings growth for next year. So that's kind of the key things that we look for.
You know, good numbers, but the breadth. So it's not just AI concentrated, but also kind of a guide for CapEx spending. Because if that sort of disappoints, you start to have to almost, you know, lower, inflect lower the trend growth rate of earnings, which is anticipated, but more so than investors expect.
I think that's something that even if long-term, that's just some capital discipline, short-term it does mean a hit to earnings that I think investors are not prepared for. A wide range of factors in play, Jason, that are influencing investor sentiment. From a messaging standpoint, what is CIO conveying at this time?
How should investors think about positioning? Well, ultimately we expect the U.S. macro fundamentals to remain sort of benign and supportive for risk assets over the next, you know, 12 months. Growth and inflation are both over 2%.
We think that will moderate kind of more in that direction. And in such an environment, you know, higher rates, you know, should come down a little bit. Oil prices ultimately we do think will come down.
But those are kind of, in some sense, the key risks that rates stay high, even go higher, and likewise for oil prices. In the very near term, the midterm elections, even though the expectations, you know, it's kind of expected that Democrats would get the House, so you'll have at a minimum some sort of divided government. Policy changes, at least domestically, may not be that dramatically different.
But speaking to the geopolitical element of it, there could be some kind of, you know, clarity one way or another how this would play out and what is the response in terms of escalation with Iran. If it's not escalation, then I think investors will start to bank on some de-escalation. And that's ultimately what we do think.
From a positioning perspective, we know investors are kind of short interest rate exposure, you know, short treasuries outright. So if you do get better news on inflation and oil prices, yields could decline. And then to sort of cover some of that kind of short position, you could see yields decline very rapidly.
So like the 10-year could fall back to 5%, you know, in just a matter of a few days. And likewise for equities, the data I mentioned earlier of investors really positioned more in the options market for upside rather than downside suggests that they don't necessarily have a lot of long positions on. They're using the option markets to get exposure.
So if there's a, you know, again, the upside looks, you know, more attractive, you're going to get investors wanting to add exposure outright to equities, which would be kind of a directional tailwind. So net all this out, it's one of the reasons why both bonds and fixed income and also equities are attractive in our view because ultimately we think the macro environment will allow assets across the board to rally. And then finally, just on equities, it's been a very kind of narrow, kind of concentrated rallies in the numbers I gave you in terms of like, you know, a quarter of the market's down 40%.
We've seen small caps kind of lag. A message we've had for a while is kind of position for upside, but also kind of diversify in this macro environment, again, in this medium term horizon, we do think that is the way that you're going to see sort of a bright and a performance after what's been kind of a challenging couple of months for large parts of the equity market. Well, Jason, very helpful touch base this morning as we're in the early days of what will be a very busy stretch ahead of us.
Thank you for dropping by, Jason, and I do look forward to picking back up with our conversation next Monday. You're welcome. Have a great week.
You as well. Thank you, Jason. Thank you for tuning in.
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