Top of the Morning: CIO Strategy Snapshot - Summer slowdown?
The desk assesses that while recent trading volumes have dwindled, the potential for volatility remains on the horizon as several macro factors come into play. Per the full note source, concerns regarding Fed independence, Q2 earnings season outcomes, and shifts in US trade policy could act as catalysts for market movement. Investors should be prepared for unexpected spikes in activity as these elements evolve. The current environment suggests that institutional traders need to remain vigilant as they navigate subdued trading conditions.
What the desk is arguing
The desk frames this as a time of caution amid relatively low trading activity, pointing out that underlying tensions could shift the market dynamics. Key macroeconomic indicators, particularly the outcomes surrounding the Q2 earnings season and Fed policy perceptions, will be crucial in determining the direction of volatility.
In the commentary, UBS highlights that the market currently reflects a hesitance from traders, with muted volumes reported, yet this does not discount the potential impact of significant news, especially regarding the Fed's stance and trade negotiations. As confidence ebbs, the potential for sharp reactions to new data rises.
Where it sits in our coverage
While we lack specific internal targets for currency pairs in this context, UBS's focus aligns with the overall sentiment of caution as evidenced by cautious positioning we observe across major institutions.
How other firms see it
Currently, firms such as jpmorgan and bofa are aligned in anticipating a cautious approach to market developments, particularly in regard to Fed communications. This could reflect broader investor sentiment, which remains sensitive to macro signals.
Trade developments and press releases from the Federal Reserve will likely influence currency pairs like USD/JPY and EUR/USD, acting as a barometer for market sentiment moving forward.
01Investors should prepare for potential volatility despite recent low trading activity.
02Macro factors such as Fed independence and trade policy will significantly influence market movements.
03Institutional traders need to stay vigilant in a climate of uncertainty, especially around Q2 earnings.
04Low trading volumes may mask underlying tension, requiring careful monitoring of emerging news.
Market implications
Traders should monitor the developments arising from the Q2 earnings reports and Fed communications closely, as these factors could lead to significant market shifts. Any updates regarding US economic policy will be particularly relevant for positioning strategies in the coming weeks.
Risks to this view
A more hawkish signal from the Federal Reserve or unexpectedly strong Q2 earnings could invalidate the current cautious outlook, leading to a reversal in sentiment and possibly increased trading volumes.
ubs
Hi, everyone. Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel.
We've entered what seems to be a quiet period of the summer with relatively low trading volumes and narrow trading ranges. However, there is no shortage of activity from economic data, Q2 earnings, concerns about Fed independence. So joining us on this Monday morning to discuss this all, glad to welcome back Jason Draho, Head of Asset Allocation for the Americas with the UBS Chief Investment Office.
Jason, welcome back to the studio. It's great to have you here to begin another trading week. Welcome back.
Looking forward to our conversation. Good to be in person. It's also nice that it's cold in here after really hot weekend, so I don't mind the lower temperatures in the studio.
Definitely. Very comfortable. We're in a great place.
So, all right, there's a lot to talk about, Jason, despite the lower trading volumes, a lot happening with respect to headlines. So let's begin with recent data on inflation as well as consumer spending and what it says about the state of the U.S. economy and the impact of tariffs thus far. What's your read on what you've been seeing?
Well, if I start with the bottom line, I'd say what we're seeing from the data is in a U.S. economy that continues to be fairly resilient, but we are seeing the effects of tariffs come in. And you can see it from the inflation data. We can see it from other data as well.
So I'll start with the inflation data. This is the June CPI data. And later in the week, we got the PPI data.
But I think the CPI data kind of tells the story relatively well. If you look at the data, their strength in things like household furnishings, recreation commodities, apparel, auto parts, things that are goods that are imported, core goods prices, ex-transportation climbed 0.55% in June. This is the largest increase on a monthly basis in three years.
So notable increase on the goods side. All in because of these tariffs, estimates are about 10 to 12 basis points of tariff impact in the May data. And we're going to see more of this kind of coming through the pipeline because goods that were sold in April and May were imported before Liberation Day.
Now as inventories kind of get drawn down, the goods that are being brought into the country and that are being sold in stores were likely imported within the last three to four months for the most part. So think about the tariff impact is 10 to 12 basis points so far. Cumulatively, we've seen, let's say, about 20 basis points of tariff impact on a year-over-year basis.
Ultimately, estimates vary. But if we thought inflation x tariffs would have been around 2.5% by year end, perhaps in December, we're going to be at the 3.5% range. So one full percentage point.
We've done about 20% of that, just to put this into perspective. So that's kind of the inflation impact. But this is more of the positive story is that core inflation, despite all these tariff impacts, came in at 23 basis points.
Core services, ex-housing, rose just 21 basis points month over month. The three-month annualized increase in core services, again, ex-housing, was 1.95%, a little under 2%. So right on target for the Fed's 2% target, service or shelter inflation is coming down.
This has been sort of an ongoing trend for the past couple years. So if it wasn't for tariffs, inflation would be, I think, on a clear glide path towards 2%. Of course, we do have the tariffs and still likely to head higher.
So again, this sort of dichotomy of the outlook that the economy is moving in the right direction, but we have the negative impact for tariffs. That's also somewhat evident in consumer spending, although you can have to look at the overall trends. The retail sales data that we got for June, the core retail sales actually rose 0.5% in June, but that was followed by a downward revision in May.
So again, you can sometimes get these month to month effects. If you take the three month kind of annualized level, it actually declined. And what we see for broader consumer spending, which includes services, it's overall data that's much broader than retail sales.
It has been sort of flatlining to some extent since the start of the year. So you are definitely seeing the consumer be impacted. And all this data is kind of consistent with the Atlanta Fed GDP tracking estimate.
That is volatile. It also reflects distortions because of inventories. We saw that in Q1 and net exports.
So the full half year picture is going to be kind of what's really relevant to look at. But the trend is also interesting. The Atlanta Fed tracking estimate for Q2 was around 4%, a little bit above, a little bit below at the beginning of June.
By the beginning of July, it had fallen to about 3%. And after the latest data, it's down to about 2.35%. So still a solid number.
And again, sort of distorted by a lot of noise, but is reflecting as we get more data moving into the second quarter, that have more impact of tariffs, you are seeing how growth has been impacted. So an overall still relatively resilient story. But again, we are seeing this impact of tariffs.
And that's likely to continue to come through as we move into further into summer and into Q4. Outside of that factor last week, which made headlines caused by President Trump, members of his administration for the Fed to cut rates, that evolved into calls that Fed Chairman Jerome Powell perhaps should be fired. There were reports midweek last week that it was close, coming up to that perhaps.
Now, all of this calls into question Fed independence, which lately has been an ongoing investor concern. And we've seen that at times reflected in the markets. What is your expectation, Jason, for what could happen?
And how could it affect monetary policy? You know, we had this sort of same topic last week, but not about the Fed fire, like the, you know, Powell being fired, at least not so explicitly, where there was actually reports that, you know, President Trump talked about it with Republican, you know, people in Congress. So I think that was a little bit more definitive last week, it seemed like this is literally he's written the letter, which he denied.
But I think that's, you know, there's a good chance that that was actually taking place. So we've moved closer to like, not just pressuring the Fed to cut rates, but actually, could there be an outright change? So I think what we said, and what I said on the pod last week would still kind of largely apply.
But if we just focus more on the firing aspect, I'd point out there was a report in the Wall Street Journal that came out that said that Scott Besant had sort of, you know, talked President Trump into not firing him. And he did it because there are a lot of political legal complications with doing it. There's a question of whether, you know, Trump, the President has the authority to fire the Fed chair.
And there was a Supreme Court ruling earlier in the year that suggested they can't fire them because there's a lot of focus on the renovation of the Fed building in DC, you know, upwards of $2.5 billion using this as a sign of mismanagement. And therefore, that's justification as cause. Again, is that, you know, sketchy grounds illegally, but it certainly, it opens up the question, you know, could Powell then take legal action, you know, create uncertainty of who's the Fed chair, this would be bad for the markets, you know, just because there'd be a period of time of how this will play out.
If you try to do it immediately, there's not a clear alternative, who's the Fed chair, you'd have to make some appointment. And so you'd kind of create some sort of kind of, you know, chaos for what's not clear to me, like, what is the benefit? If you do fire the Fed chair, it just further undermines the Fed independence.
What it means is financial markets in general will price in a high risk premium for all of us assets, meaning all sequel us equities go lower, bond prices go lower, yields go higher, particularly at the back end of the curve, because the fear ultimately is that you have a Fed chair that is complicit to, you know, the President and the President wants the economy stronger won't tolerate inflation later on, because it means a stronger economy now. Therefore, you price and higher inflation expectations in the 10 year to 30 year. So those rates go up, the dollar weakens.
So that's the direction of travel, the question, you know, how much needs to be priced in that's debatable. I'm not a legal expert. I'm not a sort of, you know, I'm certainly a psychology expert to read President Trump's mind.
So I wouldn't sort of put a clear probability on the likelihood of this happening. The further we drag into the, like, you know, the third quarter, the closer we get to the Fed cutting rates. Once the Fed's cutting the justification for like, I want to replace the Fed chair sort of diminishes.
I think the key question to me would be, is monetary policy, would it be that much different overall? So in not even 10 days, nine days from the time we're recording, the Federal will be meeting in making a decision on July 31. It's unlikely that we'll cut rates given the you know, where the data is.
But there's certainly some people like Fed Governor Chris Waller advocating for it. September seems much more likely they'll have two more months of data to kind of, you know, see where things are trending. And given what I outlined earlier with the economic data, that the size of the economy slowing that you probably will see the Fed cutting, that's our expectation is that the Federal cut starting in September.
And ultimately, by Q1 of next year, have a total of 100 basis points of cuts. That gets you to a level that is around neutral, and certainly, you know, would be supportive of the economy, and would provide grounds to say, like, we are cutting rates. If you replaced, you know, Powell now, would the pace be much more rapid, unlikely, you do have a committee, you do have a lot of dissents.
And whoever's appointed, at least the various people that are being touted as the most likely candidates, those who could actually get through the Senate, they're still relatively mainstream candidates, you know, there's some of the more dovish, some more hawkish, but we're not talking about someone who's was suggesting that we should be cutting rates to 100%. Knowing that Chairman Powell's term is up May 2026. As we get closer to the back end of this year, is there a scenario where President Trump could make known potential replacement candidates and the market looks towards them for guidance as to how they would lead the Fed how they would lead monetary policy?
Could that cause confusion amongst investors? Well, the in terms of sequencing, there is a Fed governor who is set to step down in January. So a replacement for that Governor Kluger could be announced in the fall.
And the assumption is that person, you know, Trump could use that seat to appoint the person who then would be the chair in waiting. And rather than wait until November, December could sort of make the announcement, frankly, as soon as August or September, like relatively soon. I think there is a, you know, you know, if you want to have some influence, there's advantage to do it sooner.
But if you, of course, do it sooner, it just so seeds for confusion, because that person won't even be on the Fed until January, they can say what they want. But, you know, I think the Fed didn't impound particular, it seems like they're pretty clear. If you think you're a lame duck at that point, like, well, then I really have nothing to lose of doing what I think is right.
I think the committee would almost rally around the Fed share in that case. So it'd create noise, but I think it will, again, wouldn't change what the Fed is doing. But I think if you want, if you want to sort of create clarity, this is the path going forward.
It certainly would not be surprising to see, you know, Trump announced essentially the replacement through an indirect means initially, as soon as, you know, you know, let's say, you know, August, you know, September timeframe, but probably not much later than that. And it seems now the president has backed off from wanting to fire Jerome Powell. Well, I think he wants to, I think he's probably not going to, right?
I think that there's a, there's a key kind of distinction there. I think he would recognize that the benefits at this point in time are probably not worth the negative cost to him. All right, well, something we'll continue to monitor.
I do want to move over to the Q2 reporting season. As we are getting into the thick of it, we had the financials report last week, some of the big banks moving into some tech names this week, but any notable takeaways that suggest how the rest of the season could go based on what we've seen thus far, and what earnings say about the health of the economy at the moment? Well, we've had about 15% of the S&P 500 total market cap report.
So still relatively modest, it's like one sixth, one seventh way through, but it's a solid earnings season thus far. About 80% of companies are beating their EPS estimates, which is a little bit higher than the average, which is usually in the mid to low 70s. The median EPS is beating by about three and a half percent.
So again, a little bit higher than the average, about 3%. Guidance has been kind of a relative strength. Typically when companies sort of kind of guide, you know, those companies report will give guidance, say for the next quarter for Q3, usually it's sort of revising lower to kind of some sense lower expectations.
So then you can have a lower bar to meet. And the usual trend decline is about 1%. But so far, the median EPS revision is actually slightly positive about 20 basis points, not huge, but just relative to the normal, like a full percentage point higher.
So that is another positive. You mentioned that, you know, the banks have been the predominant reporters of financials overall. You know, they've reported solid earnings, you know, you know, beating EPS, but it wasn't really enough to lift, you know, at least the bank stocks.
They had a strong rally going into the earnings season, the S&P, you know, banks index was up 9% in June. So there's a little bit of, you know, travel than arrive, you know, you know, it's kind of traveled into the earnings season, expecting good numbers, and then we got the good numbers. So that's kind of the market sort of, you know, you're already kind of priced for that.
I think from a broader macro perspective, the thing that's most relevant is that the banks noted sort of improving credit conditions and no clear signs of weakness in the consumer. So again, concerns about is the consumer stressed? You're not a lot of data from the banks, at least to suggest that there's a real kind of uptick.
It doesn't mean that consumer spending is moderating, but does, you know, does suggest that the overall the consumer is still relatively resilient. If we look at EPS growth on a year over year basis, coming into the earnings season, the expectation was about 4%, a little over so far early on, but it's tracking about 5% year over year growth. So that's kind of where we are, you know, we'll get more indicators this week, as we broaden out to other sectors, about 15% of the market cap is set to report this week.
But the next week, the week of July 28, through August 1, that's the big week for any season. With we get nearly almost like 40% of the market cap reporting a lot of the big mega cap tech names reporting. So relatively quiet this week, still next week, bigger earnings week.
In addition, we also have the Fed meeting, we get jobs data. So next week, so it's going to be a big week at the end of July going into the beginning of August. So setting the tone for what is the fundamentals look like for the economy and for the equity markets going forward.
So a decent start for earnings with obviously much more to go and much more to interpret. So we'll continue to keep our listeners informed on the results as they come in over the next couple of weeks. Maybe Jason, let's end with the markets, which I noted at the start, it does seem a bit quiet at the moment as we are in the middle of summer.
How do you interpret recent market performance? And what does it say about the outlook from here? You know, the expression of the dog days of summer usually apply to August, but it sort of feels like even though it's only July 21, kind of in that mindset right now.
And it was indicative of like just the market volume last week, there was a data point that I saw for last Thursday, that the consolidated tape volume was a mere 3% of the 20 day average. So that is a really low volume that we saw last Thursday. It's indicative of kind of relatively narrow ranges, the S&Ps, you know, chopping in between 6250 and 6300.
The 10 year treasury yield hovering within about 510 basis points. This is reflected in market volatility indicators like the VIX index for equities, staying roughly in the 16 to 17 range, you know, chopping around slightly above it and below. But this is in this is the past few weeks, despite, you know, the, you know, the tariff threats have been renewed for August 1, despite questions about Fed independence, the markets are like kind of shrugging their shoulders.
The MOVE index less kind of widely followed, but the MOVE index is for kind of similar measures of implied volatility for the treasury market. That's also at its lowest level or very close to its lowest levels in the past three or four years. A simple metric thing it's interesting to look at is if you sum up the VIX index, the 16 and a half, let's say and the MOVE index, you know, which is a different scale, but around 80.
If you sum that up, it's also near one of the lowest levels we've seen for the past few years. So again, market implied volatility, you know, relatively low. You could say this is some signs of potential complacency, that investors are a little bit, you know, comfortable about the macro environment, you know, they're kind of maybe complacent on their threat of tariffs and negative impacts that are coming through on the, or perhaps kind of looking through it.
But that's kind of, you know, the setup where we are right now. If we, I take the point on banks, you know, up 9% in June, kind of shrugging their shoulders to the earnings results, which were solid overall. I think that's sort of indicative of that markets at price and a lot of good news, the good news, you know, all this relatively good news is coming through the earnings data, the economic data still holding up okay, even though clearly some signs of tariffs.
So to me that the risk reward, at least in the near term suggest, you know, conditions have to stay relatively benign. But if they don't, if we start to see some impact, bigger impact of tariffs, which I think that there's a very good chance that happens, we see them, you know, scope for the markets to potentially kind of pull back. Investor positioning has, you know, it's still not extreme, but it's more and more kind of getting folded, fold up like sort of systematic strategies that tend to follow momentum, they tend to lever up when volatility is low, those have been an exposure.
So compared to two to three months ago, when investors had de-risked and positioning was could be a tailwind, I guess less of a tail wind and potentially could become a bit of a headwind. That's the near term like that's kind of the rest of the summer. So there's a risk that will, you know, higher you want to beat some point in August, there is some some volatility.
But the bigger picture, we think, you know, six to 12 months out, we remain relatively constructive on the US economy that the tariff kind of impact will work its way through, we'll get sort of almost a bit of a modest acceleration of growth next year. Earnings will kind of follow that path. That's why we remain constructive on equities on a 12 month basis, and use any sort of pullbacks is probably as opportunities to, you know, to add exposure, and there will be volatility.
So instead of, you know, necessarily hedging a lot using sort of volatility as you know, as kind of to play to add some of that exposure. Your financials reporting good numbers, I think there's there's more upside, there's further deregulation kicks in, which is why we like them and there's an attractive sector. Same thing with tech, the AI theme just continues to run very strong.
And we'll see the numbers next week, a lot of good news could be priced in, but the theme and the momentum still seems to be very strong in that direction. And then rates kind of chop it around. But I noticed that credit spreads have tightened quite a bit again.
So if you're going to take risk, we feel like it's probably parts of equity markets more so than riskier credit. Stepping quality within fixed income. Well, Jason, thank you for helping our listeners, our clients manage expectations with respect to the outlook helpful to have some guidance with respect to how to position how to do it.
Thank you, Jason. Have a great week. You too.
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