Top of the Morning: CIO Strategy Snapshot - Running it hot

Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. All eyes will be on the Fed this week as they meet to decide whether to cut interest rates.

The outcome isn't necessarily the last big market event before the holidays as critical labor market data will be released next week and a nominee for the new Fed chair could be announced. Equity markets are back near all-time highs and investors are wondering if this Santa rally can continue. Joining us here today on this Monday morning to discuss this all from the UBS Chief Investment Office, glad to welcome back Head of Asset Allocation for the Americas, Jason Draho.

Jason, good morning to you. Thank you for dropping by. Welcome back.

Hey, good morning, Dan. Happy Monday. Good to be here.

So, Jason, before we get into the Fed, we are getting more economic data, although it is a bit dated. What is it saying about the state of the U.S. economy? Well, we have, I think, most of the data we'd need or we'll get for September.

We got spending data last week, also income data for September. That allows us to have a complete picture for the data for the fourth quarter overall. The spending data in September was up a little bit over a month, over a month on a real basis after you adjust for inflation.

And then on a full quarter basis, some of the prior months have been revised lower, but there was still a solid 2.7% real spending growth, you know, kind of see, you know, angrily adjusted. So, a good number overall, and that was the last key data point we needed to estimate or for the estimates of GDP for the third quarter. The Atlanta Fed has a third quarter GDP now tracking estimate, it's at about 3.6%.

It's fluctuated around a little bit, but I think that's a reasonable expectation for what the data will be. And other economists are forecasting something around like 3 to 3.5% when we look at other more recent data, because that's, you know, now we're early December, so looking at September is a bit, you know, certainly backward looking. More recent data that we continue to get on the labor market data, so ongoing softness, some alternative data measures from, you know, private sector data providers, not the government suggest measures, the layoffs have begun to kind of rise, which is, you know, a potential risk going forward.

But other good news that we've gotten is on inflation. So we also got the September, you know, PCE inflation, it came in a little bit softer than expected to 20 basis points a month or a month, annualizing to just over 2.8%. There's also moderation core services ex-housing, that's down to 20 basis points a month or a month after rising 30 basis points the prior two months.

That particular measure, core services ex-housing, inflation is sort of a, you know, if you strip out potential impacts for tariffs on goods, where the tariffs are mostly applied to goods not to services, the fact that core services, once you take out shelter, is relatively contained is a positive sign. The underlying inflation predictors remain moderate. The shelter inflation has also been trending lower.

Combined that is roughly, you know, 60, 65% of the overall inflation basket. So if that's kind of going lower, once some of the tariff-related impact on goods inflation is alleviated, then the outlook for inflation going forward is better. So in a nutshell, what we have is an economy that continues to be resilient in growth.

Consumer continues to spend, and again, credit card data we see, and we got for, you know, over the Thanksgiving long weekend, indicates consumers continue to spend. So the official story that we have through September suggests a resilient economy, consumer holding up, labor market softness, inflation going lower, low recession risk, that still remains the picture that we have, you know, going into the end of the year. Okay.

So with that backdrop, Jason, let's now turn over to the Fed. The market's at this point pricing in for a high probability of a cut at this upcoming meeting. Aside from that, Jason, what are you watching out for from the Fed?

Well, you mentioned a high probability. The market's at about a 95% probability the Fed will cut, but it's also widely expected that it's going to be a hawkish cut. Now, the case for the cut, I think, is relatively solid.

You alluded to the fact that the economy overall is growing resilient, the consumption is good, but labor market softness persists. And right now, it looks like job growth is not keeping up with labor supply, and that's contributed to the unemployment rate rising, you know, for the last few months in a row up to 4.4%. Again, that's through September.

You know, if we've had some softness in October, November, which the Fed doesn't have that date yet when they will make that decision on Wednesday, if it goes higher, then that's a further sign that they need to be somewhat aggressive in moving towards, you know, cutting rates, normalizing policy to back to sort of a neutral rate. So the case for cutting sort of makes sense. The case for also being somewhat hawkish, and that's the perception, is also somewhat justified given inflation is still well above 2%.

It's also maybe necessary for Powell to appease sort of committee members who will likely dissent again. And so he might say things such as, you know, during the press conference that explained the views of other participants, you know, who opposed to cut, you know, where they're thinking. In October at the FOMC press conference, he did make the statement also that, you know, further cuts are not, you know, are far from a guarantee.

He could say some along those lines. If we look to last year, we recall that they cut 50 basis points in September, then once 25 each in October and December. And then in the press conference in December, Powell kind of guided the fact that it will probably take a bit of a pause.

So they could do something similar to that this year, you know, or in a statement from the, or an expression from the FOMC statement last December, where it was the extent and timing of additional adjustments, you know, maybe, you know, will be assessed, which the market would interpret as they're going to take a bit of a pause. So there's reasons they could be hawkish, but there's also limits to how hawkish they could actually be. You know, the Fed would never want to, you know, rule out definitively a cut in January.

They also just don't have a lot of the data that would be necessary to make a decision of whether they would cut in January or not. On the 16th, so next week, we will get the October and November payrolls numbers. We'll only get November unemployment rates.

Then in early January, we will get the December payrolls, which will be kind of the cleanest measure of where the labor market is after the government shut down and other distortions. So the Fed will have essentially three months of labor market data plus other spending and consumer data, other inflation data, before they make that decision at the end of January. So given how the data plays out and where the economy is, you know, they may well feel they need to cut or not.

If they want to leave all options on the table, it limits to how hawkish they could be. Other things to sort of look for along those lines is how do they update the dot plot. So there could be some committee members who don't officially dissent, but kind of leave their dot that imply there would have been two cuts this year, not the three that actually took place.

So that could be a way of sort of, you know, silently dissenting. The dot plot could remain at, the median dot could remain at only one cut for next year rather than more aggressive cuts. So we're going to imply that it'll slow down, you know, from here.

In terms of updated economic projections, it's likely that growth for this will be taken up just because the data that we've had since September indicates the economy is stronger than was assumed. They may take up next year a little bit. The inflation picture looks better than expected or better than maybe they feared back three months ago.

So the inflation could actually be improved. So all of a sudden it suggests that their economic projections could be a little bit better on growth, a little bit better on inflation. It's also why the, you know, the need to cut more aggressively also, at least next year, you know, won't be there.

And that might be more the signal to, they just need to be cautious at this point in time. Like, you know, inflation still is a top target. So a lot of things to look for beyond the cuts, but in some sense, given the market setup, it's for a hawkish cut.

The bar is pretty high for Powell to out-hawk the market, given the flexibility that they're likely to want to retain. So Jason, it's interesting if we turn to the markets, the markets are rallying on rate cut hopes, but there's also this idea of running it hot that seems to be supporting the rally. What is this idea of running it hot, Jason?

So running it hot is kind of a scenario, maybe a narrative that's, you know, been floating the market certainly for a while, something that I've written about and we've talked about on podcasts earlier this fall, with the idea that ultimately you sort of run the economy hot, meaning you allow or you try to get growth higher, nominal growth higher, nominal GDP higher, with policy being supportive. And that's kind of a U.S. story, certainly, but I think there's elements of that that are applicable kind of globally with other central banks, other policy makers around the world. You know, a simple thing is, you know, if you're President Trump and you're looking at the midterms next year, you want a strong economy going into the midterms, it's probably easier to get growth higher through different policy measures than it is to get inflation lower or affordability, you know, solved in just the 12 months, because that's more of a supply side story.

By running it hot, you can also have the Fed cut rates more aggressively, and certainly that's been the thought that under a new Fed chair that Trump would nominate, this person would also look to cut rates kind of somewhat aggressively, allowing the economy to kind of grow faster. You might get other policy measures that are supportive for growth coming in from the Trump administration, such as, you know, maybe lowering tariffs, if the tariff, the IEPA tariffs are struck down by the Supreme Court, would they perhaps be more measured in the, you know, reimposing tariffs as a way to implicitly create some sort of, you know, tax cut. We also know that the One Big Beautiful Bill Act will start to kick in with benefits, you know, by Q1, later Q1, as tax refunds are likely to go higher, because some of those tax cuts on the personal side are retroactive this year.

So we're going to see a bit of a burst in growth, or should see some kind of acceleration of growth kind of relatively early next year, at the same time the Fed is cutting. So all these things are going to suggest, you know, this idea of kind of running it hot, where growth accelerates, it's elevated, inflation is still above 2%, you know, expectations will come down, but maybe at a slower pace if you're running the economy hot. The real risk to this scenario, in some ways, is if bond yields don't cooperate, and already, you know, we've seen bond yields kind of tick up a little bit, you know, there is concerns ultimately that the economy is overheating, and that the Fed and other central banks can't cut rates, and in fact, they might have to pivot to a point where they have to even consider rate hikes, or it becomes more balanced, rate volatility will go higher, that would certainly be disruptive for the markets.

But for the time being, the markets are treating this as a sort of relatively benign scenario of good growth, accelerate higher nominal GDP, that's certainly positive for equities. So that's kind of the narrative that's taking place in the markets right now. So with that, Jason, how is this view being reflected in market performance, and what should investors be doing right now in the way of positioning?

So we know that equity markets overall, like U.S. equity markets are close, you know, or near all-time highs, but what is noteworthy is that, you know, the performance in equity markets in the U.S. is broadening out. You're seeing equal weight indices outperforming, or at least holding their own against large cap, or the market cap weighted S&P 500, small caps are kind of picking up, cyclical stocks are kind of, you know, leading some of this recovery. So there's a bit of a broadening out that's occurring, because if investors have more confidence about the overall macro environment, and certainly on a relative basis, a little more questions or cautions about the AI thesis, then you can see this kind of broadening out, and I think that's, you know, one story that's reflective of this.

Interest rates going higher is another aspect of this story. If you look at it last week, you know, rates across the curve were up about 10 basis points over the prior five days, like most of last week. But it's also been led by real rates, you know, more so than the inflation expectations going higher.

So it may be consistent with the market thinking that if you run it hot, that it's less scope for aggressive rate cuts later on. There are also kind of along those lines reports that, with Kevin Hassett's name being sort of floated as the likely Fed nominee, there are also reports that the feedback from senior Wall Street officials or bankers and investors was that a little concern that if Hassett does get nominated, that he will have to cut rates aggressively, again, sort of running the hot narrative. And so I think that was a factor in terms of the markets pushing back on that, but suggesting that perhaps, again, the markets will force any new Fed chair's hand to not cut rates too aggressively.

But other parts of the market sort of consistent with this kind of running hot narrative, as you're seeing some commodities and copper as an example of, you know, really accelerating the breaking of inflation expectations, you know, for example, in Japan, that is also sort of engaging in some expansionary fiscal policy. You can see that kind of picking up. So that is sort of what the market's doing overall.

In terms of how should investors position for this, ultimately, I think this is consistent with our outlook for 2026, in which we see a good upside for equities, first predicated on the economy growth being resilient, growth likely accelerating, you know, inflation is coming down and you have a Fed that will be cutting rates. That is a conducive macro environment to equities going higher. We still think AI, the thesis has good runway.

There's definitely been some questions and challenges in the marketplace about aspects of the spending and infrastructure layer. But we see opportunities kind of across the board and particularly in some more application layers, you know, that would also provide almost a broadening out to other sectors, whether it's financials, health care, sort of implicitly kind of benefiting from that. In terms of fixed income, you know, the risk that rates could rise is one of the reasons why we continue to like more the intermediate part of the curve, the five to seven year, not extending duration, you know, too significantly.

And ultimately, if you're running it hot, you know, credit can do fine in that case. But if you're, you know, having high nominal GDP growth, it's better to take, in our view, kind of the exposure, the risk through equities, you know, that kind of adjust for that versus bonds, which more of a nominal asset class will be negatively impacted by higher inflation overall in terms of real after tax returns. So those are some of the ideas we like, including commodities, which we think will, you know, will benefit from this overall environment kind of globally.

We'll appreciate the positioning guidance. As always, Jason, it will be an interesting couple of days ahead accounting for the economic data releases. Of course, the FOMC meeting, I'm sure we'll cover these outcomes during our next conversation next week.

In the meantime, Jason, wish you a great week ahead and look forward to picking back up with our conversation again soon. Thank you for tuning in. Be sure to visit UBS.com slash studios to view the entire UBS studios suite of podcast channels, along with our video offerings, such as UBS trending.

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