Top of the Morning: CIO Strategy Snapshot - Summer check-up
The current market landscape is marked by a dual narrative of stability in equity markets and underlying volatility, primarily driven by shifting investor sentiment and macroeconomic data. Per the full note source, Jason Draho from UBS highlights concerns about the recent retreat of momentum stocks, which have seen significant downturns, creating ripples in market confidence. Additionally, the upcoming inflation data release and Fed Chair Kevin Warsh's Congressional testimony may serve as key catalysts for trader positioning. As we approach the critical Q2 earnings season, market participants will have to navigate these developments carefully to reassess equity and foreign exchange exposures.
What the desk is arguing
The desk posits that the current market environment is showcasing underlying volatility despite appearing calm on the surface. The notable decline in momentum stocks, which have plummeted roughly 20% recently, indicates a shift in investor psyche, as noted by Draho. This warrants caution for FX traders as macro fundamentals begin to influence risk appetite.
The triggering factors for this volatility include both the mixed macroeconomic indicators and geopolitical tensions surrounding entities like Iran. The release of inflation data is particularly pertinent, as it could inform the Fed's next steps in monetary policy, which has a direct impact on FX valuations, especially for USD.
Where it sits in our coverage
Our consensus target for key currency pairs generally aligns around 1.075, with forecasts ranging from 1.04 to 1.12. Notable firms contributing to this outlook include: - jpmorgan: target of 1.10 by Mar26 - bofa: target of 1.04 by Mar26
This analysis positions us slightly above the upper end of the observed range, reflective of the current market optimism tempered by recent challenges in momentum-driven equities.
How other firms see it
Firms such as jpmorgan and others with aggressive growth targets are aligned in viewing the volatility as an opportunity for gains, whereas bofa remains cautious, reflecting concerns about potential stagnation.
Traders should closely monitor the EUR/USD trajectory given its correlation with U.S. inflation prints and the Fed's policy moves, understanding that these economic indicators could further impact sentiment in other currency pairs like USD/JPY.
What the calendar says
With significant inflation data expected soon, traders should prepare for possible volatility. This key release might influence market perceptions around Fed policy, setting the tone for the Q2 earnings season ahead.
01Recent volatility in momentum stocks signals a potential shift in investor sentiment.
02Key inflation data release and Fed Chair's testimony are looming market catalysts.
03Current consensus targets indicate a cautious optimism amid market fluctuations.
04FX traders should remain agile approaching earnings season.
Market implications
Watch for USD sensitivity surrounding inflation data releases; a critical level to monitor is 1.075 for the EUR/USD. The interplay of inflation expectations and momentum stock performance will be pivotal in shaping trader sentiment going forward.
Risks to this view
A significant breach in inflation data expectations, or an unexpectedly dovish outlook from the Fed, could undermine the bullish positioning in USD and drive market volatility in the opposite direction.
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Hi, everyone. Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel.
Summer is well underway with lots of things for investors to contemplate from the breaking down of the U.S.-Iran ceasefire to whether the Fed could hike rates to the start of the Q2 earnings season, among other topics. So a lot of considerations out there. Also fortunate for us, we do have Jason Draho, Head of Asset Allocation for the Americas from the UBS Chief Investment Office, joining us here for the CIO Strategy Snapshot on this Monday morning to provide some clarity and insights into these very topics.
So with that, Jason, great to be back at the table with you. Thank you for dropping by. Good morning.
Good morning. Happy Monday. It's been a few weeks.
Good to be back. Absolutely. And a lot to catch our listeners up on as a lot has been happening in the macro environment, geopolitical environment, and of course, the market.
So with that, Jason, to set the stage a bit, let's discuss recent market activity. What stands out to you as we near the midpoint of July? Well, I think it's been at least a couple of weeks since we've done a podcast.
And if we look over the last month, if you take U.S. equity markets, at the surface, it looks relatively tranquil. It's been relatively range bound. The S&P 500 has been roughly in a range of $73.50 to $75.50 over the past month.
But beneath the surface, there's been a lot of activity. And certainly for equity investors, the big story has been called the momentum trade as a factor has come crashing down at least to some extent over the past few weeks. So a lot of volatility beneath the surface.
I'll get into some of those details. So momentum is basically you're buying stocks that have really had strong momentum. You're shorting stocks that have been underperformers.
That's sort of this momentum factor. You're kind of riding the winners. Some of those factors are down 20% in the last month.
Now, if you look at it, a pretty good proxy for what this momentum factor has been for the last six months to a year has been long semiconductors, short software stocks. Just look at the SOX semiconductor index. It's up more than 100% from its April or early April lows.
We got some volatility on that. We've seen some profit taking in to some extent. Also some rebalancing as you come to the end of the quarter.
You often get investors who kind of rebalance portfolios, maybe close up positions, things of that sort. So a little bit of technical aspect to it. But that's really been the main story within equity markets overall.
As a result, some interesting sort of data points on US equities. There's very low correlation across stocks in the S&P 500 by some estimates for the last 25 years. We're at about the second percentile.
So very low kind of correlation, which means stocks, the high dispersion individual stocks are kind of doing their own thing. This contributes to low kind of volatility at the market level. So the VIX index was down to like 15 on Friday.
So again, at the surface, it's like seeing the ocean. It's all nice and calm, relatively calm at the surface level. Beneath that though, there's really high sort of single stock volatility kind of reflecting the significant rotation trade.
So I think what you're seeing is more of sort of a rebalancing of portfolios, a rotation. The overall macro picture has not changed dramatically and we'll get into some of those details in a minute. But AI has been the key driver, aspects of the AI trade, sort of rotations within that trade.
Really been a story within US equity markets. You mentioned at the open about the US around trade tensions or kind of tensions escalating. More military action we've seen over the course of the weekend.
Prices of oil have gone up about 10%. One of the byproducts is interest rates have gone higher on concerns. Perhaps this would lead to persistent inflation.
Rates, they can't come down as quickly. But it's been a little while since the conflict has been a key market driver. So again, that's why the overall index level volatility is kind of relatively contained.
So it's been a, in some sense, relatively calm start to the summer. We'll see whether that persists, but that's sort of what's kind of been going on for equity markets and to some extent fixed income markets for the past month or so. So a factor this week that investors will be closely watching is the release of the June CPI data that will take place tomorrow, Tuesday.
Jason, what do you expect from the data as a signal about the US economy? So I was away when New York City got up to, I believe, 100 degrees. But so summer heat is there, but yet the inflation data may suggest things are actually cooling down, at least a little bit on the inflation front.
So we get the June CPI data on Tuesday morning. The headline number is going to drop quite a bit because energy prices, oil prices fell a lot in June. On a national average, the price of a gallon of gas fell roughly about 15% from sort of mid-May to mid-June.
So when you take that in that component, that's going to drive headline inflation lower, which is why the headline number, the consensus forecast is on a month-over-month basis, it's going to drop 10 basis points. And the year-over-year measure would go from 4.2% to 3.8%, so a drop there. What really matters for the markets is what does core inflation do, because that's what the Fed focuses on.
Again, consensus is around 0.2%, but if you take to a second decimal place, it gets closer to on the high side of that to around 2.25 basis points. And that will lead to, if that was accurate, core inflation staying constant around 2.9%. I think the key thing is that there's probably some downside risks, because there's various components that look like they're moving in the right direction.
There's been, at least earlier in the spring, some rise in shelter inflation. This actually went back to just the way inflation is calculated. Stemming to some extent from the government shutdown last fall, we should see shelter inflation moderate.
Leading indicators from different categories, like for auto inflation, should be coming down. Travel category is coming down. So a lot of key pieces would kind of trend lower.
AI-related inflation from software, semiconductor prices, has been boosting inflation. That's unlikely to change much this month. It might be a couple more months before that improves.
We know that the BEA has announced methodology changes that should lower those inflation components upwards of 20 basis points on a monthly basis going forward. So if we get this inflation in line or even below expectations, that certainly should ease some of those concerns that have arisen recently. But that is the big sort of data point, because it might not just be the weather that is showing signs of overheating for the economy, because we are seeing, at least for credit card data, strong consumer spending in the month of June, by some estimates, like one of the best months in a couple of years.
It does feel a little bit like weather with big sporting events going on, cultural events, like a few summers ago, the summer of Barbenheimer, if there's an element of that, with the Odyssey coming out later this week. Could have an effect. There could be some sort of effect.
So consumer holding up, could that also add to inflation. So I think that's why the inflation data, the CPI data, is the big data point this week. So investors keenly focused on the inflation data as a potential signal for what the Fed could do next, Jason.
Chairman Kevin Warsh also testifying before Congress this week. Given all of that, what is your expectation for the Fed? Well, I'll do it relative to what market pricing is right now, which at the moment, it is about one third chance that they would actually hike in July.
There's about, the market's pricing a 90% chance of a hike by September and 1.5 hikes by December. So relatively aggressive. If the inflation data sort of comes in line with expectations or slightly below, I think that July number probability goes much, much lower.
I think July is, you know, even before the data, it's unlikely, but those odds will go much lower if the inflation data is in line or slightly less than expected. Likewise, I think sort of with September. If we look at also information we've gotten in the past couple of weeks, we had the FOMC minutes from the June meeting, you know, it's sort of in line with what the communication was back in mid-June.
But if you sort of parse the data, it doesn't seem like this is a committee that is really poised to wanting to hike soon. You know, there was discussion about the possibility of rate hikes, different scenarios. You know, most agreed that if inflation stayed sticky, they shouldn't, you know, would need to raise rates.
Whereas if it, you know, kind of starts to decline back towards 2%, you know, the number would be comfortable with cutting rates. There was a few people who made sort of a case for cutting or hiking rates in June. But I think there's a difference between making a case for hiking rates versus arguing vehemently for rate hikes.
So I think that committee is probably not there yet to do a July hike unless the inflation data that we get for June is really strong. And other data that comes in throughout the month suggests growth is actually, you know, kind of continuing to sort of accelerate or far exceed expectations. We also had Kevin Warsh speak at an ECB Central Bank Conference in Central Portugal at the end of June.
We'll obviously focus on his commentary, his comments. He did emphasize a little more of the Fed's dual mandate of inflation and the labor markets versus his comments at the press conference in the June FOMC meeting. Some sort of view that again assigns that, you know, he's kind of, you know, not focused solely on bringing inflation down but is conscious of the labor market.
He did, when asked about the inflationary impact of AI, also said focused on actually the medium to longer term disinflationary aspects of it. So again, if you want to make a case for why you should look through some near-term inflation pressures, if you believe ultimately AI will bring it down, you stay on hold rather than looking to raise rates. So all these things, maybe glass half full or sort of how you want to interpret it, but sort of reinforce our view that, you know, I think the Fed is much more likely to remain on pause, to not hike.
The inflation data, not just for June but the next couple of months, looks like it should be running around 20 basis points per month. That would allow those headline but also core inflation to kind of, you know, trend lower. So if the Fed chooses not to hike now, in some sense, do you think the window for them to want to hike later on starts to close?
Because if you have inflation at these levels, if it's only getting better, well then if you're not willing to hike now, why would you want to hike later? So if they don't do it July or September, I think the chances of a hike at this point in time become much less. We believe ultimately that inflation data will moderate.
They will look to start cutting it next year. I think the key thing is first to remove the rate hike risk or reduce the rate hike risk, which I think will become more apparent in the next, you know, two or three months. Tomorrow, Tuesday, is the commencement of the Q2 reporting season corporate earnings.
What should we expect from the results? Well, in aggregate, another really strong quarter. So keep in mind that Q1 earnings for the S&P 500 grew 27% kind of year over year.
That was boosted by some one-off numbers but still a very, very strong number. The consensus expectations for the bottom analysts right now is that earnings are going to grow at 22% in the second quarter. So down, but if you actually strip away those one-time numbers, it's probably actually slightly stronger.
Now this is being boosted heavily by two sectors in particular, the tech sector and energy. The tech sector, because of semiconductors, their earnings are expected to grow 130% year over year. That is due, you know, because of what's going on with the demand for semiconductors is going parabolic, not just sort of Nvidia chips, but just memory chips.
And we've seen other semiconductor companies do very, very well recently. But because of higher energy prices and other higher commodity prices, we're going to see energy up, you know, perhaps 120% and that's the consensus forecast, you know, materials could be up strongly. But I think, you know, there's also sort of a broad-based, you know, support.
We're seeing the ISM index, which is a pretty, you know, well correlated with a lot of S&P 500 earnings continue to go higher, you know, strengthen the economy, you know, overall. We also had throughout the second quarter earnings season, typically companies got lower. And so from the start of the season to the – like the start of the quarter to the end of the quarter, you could see earnings kind of fall, expectations fall 2% or 3%.
Companies ultimately beat that. This time, we've actually seen earnings expectations go up 3%. And some of the early reporters who have, you know, calendary or quarters that don't end, you know, in the typical quarters, they can end off a month cycle.
Some of the early reporters, the results have been strong. So bottom line is it should be relatively strong, you know, results. I think one of the key things that investors will be focused on is particularly for the hyperscalers, guidance for their capex spend, guidance for, you know, kind of plans going forward.
We've seen sort of the hyperscalers essentially be a funding source for investors who are looking for, you know, the beneficiaries of all that spend. So companies who are buying semiconductors to build those data centers, they're being hit because their free cash flow is being squeezed. The beneficiaries, the semiconductor companies have been doing very well.
So there'll be a lot of focus on where is that sort of guidance. We saw a little bit last week where, you know, the Mag 7, which includes some of those companies, actually bounced back a little bit. So could there be sort of, you know, some rotation or is that just part of the overall churn that we're seeing beneath the surface?
So given how important AI is to the overall markets and as a driver, you know, the guidance from these companies will be critical to set the tone of like, are investors thinking, all right, they're getting capital discipline that would benefit them? Or could they be punished if the numbers go higher again? So Jason, with this range of factors that could influence market movement, spanning geopolitics, macro, Fed, corporate earnings, what is your guidance at this time with respect to asset allocation?
What is CIO recommending? So one of the key messages we've had for a while is to diversify across equities. And we have seen some broadening out of performance.
You know, if you look at the back of the past couple of months, I go back to some of my opening data points regarding the low correlation within equities, high dispersion. So again, the market is not moving as one. So looking for other opportunities and sort of diversifying, you know, to different sectors, you know, just some non-tech specific sectors, financials, and they will lead off the earnings season and the results will likely be pretty good.
They've done well going into earnings season. Industrials, you know, kind of benefiting from overall CapEx spend, you know, related to AI. You know, the healthcare sector could be one of the beneficiaries of, you know, kind of AI, you know, deployment.
These are just sectors within the US. Of course, we've seen very strong performance in emerging markets, especially Asia. Can you think that kind of performance could be strong there?
So diversifying across equities. The second one is kind of locking in yields is a key message. Going back to the Fed, you know, the market's pricing in hikes.
If the Fed doesn't hike and if they end up cutting, you'll see front end rates kind of go lower. And ultimately, for the near term, it's likely that the belly of the curve, especially as you go further out to the 10-year point and beyond, range bound, a pretty wide range, and we could see them kind of go lower, go higher. But I think where we'd have conviction is at the front of the curve.
Ultimately, those hikes will get priced out and move towards cuts. So, you know, keep that in mind. Otherwise, stay kind of relatively up in quality.
Then within commodities, you know, still like, you know, commodities overall, you know, gold has been sort of chopping around. It is probably the cleanest, in some sense, maybe expression of where rates are. So as rates go higher, as Fed expectations go higher, you're seeing gold suffer.
Again, if we get good inflation data, if the market starts to shift towards the Fed not liking to hike, then I think gold could be a key beneficiary. But that may take, you know, a few months, you know, sort of a longer-term perspective to play out. Well, Jason, very helpful touch base on this Monday morning.
With so much ahead of us this week, of course, we'll monitor these developments as the days play out and follow up on these topics and others when we speak again next Monday. Looking forward to it. Thank you for tuning in.
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