Top of the Morning: CIO Strategy Snapshot - Sustainability of the AI trade
The desk believes that current market momentum is increasingly driven by the sustainability of the AI trade alongside growing concerns about funding costs. Per the full note from UBS, Jason Draho highlighted the ongoing transition from a corporate earnings focus towards assessing macroeconomic data and AI viability, especially in light of inflation surprises. With Q3 earnings on the horizon, this dynamic may impact risk sentiment. Our institutional traders should be mindful as macro data, particularly inflation figures that exceeded expectations, continues to evolve amid these discussions.
What the desk is arguing
The rise in concerns surrounding the sustainability of the AI trade reflects shifting investor sentiment in the context of corporate earnings. Per the full note from UBS, Jason Draho noted that while inflation data showed some upward surprises, retail sales figures did not meet expectations, suggesting potential headwinds for growth. This has led to questions about whether current valuations around AI investments can hold, given rising costs of funding.
Specific inflation data from September provided a glimpse into this volatility, as the CPI printed 33 basis points month over month, significantly higher than the anticipated 25 basis points. Such trends suggest that while the AI narrative continues to capture investor interest, underlying economic conditions may pose challenges and create a feedback loop affecting risk assets.
Where it sits in our coverage
Our current target for the EUR/USD pair is 1.075, based on the analysis by jpmorgan at a target of 1.10 and bofa, which projects a more conservative 1.04 by March 2026. This places our view at the upper end of the current consensus range.
While jpmorgan anticipates continued strength in the Eurozone, aligning with the desk's optimistic stance on Euro resilience amid ongoing discussions surrounding AI and funding costs, bofa presents a counterargument focused on economic headwinds potentially dampening growth prospects in the near term.
How other firms see it
Overall, firms like jpmorgan and citi align on bullish projections for the Euro amid AI growth narratives, while bofa voices caution over valuation pressures stemming from macroeconomic factors. The conversations around the sustainability of the AI trade have become a focal point across the board, suggesting a more cautious stance may emerge if inflation continues to rise.
Particular attention should be paid to the economic indicators surrounding the Fed's interest rate decisions and the Bank of England's policy adjustments, as these will be pivotal in shaping the macro landscape and ultimately influence the EUR/USD path.
01Investor focus is shifting from corporate earnings to the sustainability of the AI trade and the cost of funding.
02Inflation data showed an unexpected uptick, putting pressure on growth narratives tied to AI investments.
03Current EUR/USD projections reflect a consensus range with differing views from major banks.
04The evolving macroeconomic landscape could create volatility in risk assets, particularly in tech-heavy sectors.
Market implications
Traders should monitor inflation trends closely as volatility in these metrics could drive risk sentiment and impact asset valuations. Any deviation from expected inflation rates may lead to shifts in the EUR/USD trading range, particularly as the market prepares for upcoming earnings releases.
Risks to this view
A reversal of the current bullish sentiment may occur if inflation continues to surprise on the upside, prompting a more aggressive response from central banks, particularly the Federal Reserve. Should the macroeconomic data point to persistent weakness, it could lead to a reevaluation of AI trade sustainability.
ubs
Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. It was the start of the Q3 earnings season last week, but it was concerns about the AI trade and the cost of funding that dominated market discourse.
Earnings season ramps up this week with MedApp and Tesla reporting on Wednesday, which will be closely watched for their spending plans. Meanwhile, the macro data last week took a mild turn for the worst. So joining me here in studio to discuss this all on this Monday morning for the CIO Strategy Snapshot.
Glad to welcome back Head of Asset Allocation for the Americas from UBS, FSI, Jason Draho. Jason, good Monday morning to you. Great to be back in studio.
It's good to be here. Happy Monday. Happy Monday.
So a lot to cover today, Jason. Let's get right into it, perhaps beginning with that macro data, which you did preview during last week's episode. We did receive September inflation and retail sales data prints last week.
What are the takeaways from this latest round of data? Not bad, but the inflation data a little hotter than expected, the retail sales data a little cooler than expected. We also got some activity data like these kind of states or regional level manufacturing indices, those kind of a mixed bag overall.
All this data needs to be taken with some kind of grain of salt because we see a lot of volatility month to month, subsequent revisions. So it's more important to kind of look at a, let's call it a three-month kind of trend to take out some of the month-to-month noise. But just on the data, like with CPI data that we got on Wednesday, it did surprise to the upside.
It was at 33 basis points month over month, expectations around 25 basis points. Headline number was high, but it's still being impacted by oil prices and energy was the primary driver of that headline acceleration. But again, things that are not overly concerning, but it was notable that core goods inflation re-accelerated driven by firmer vehicle sales or vehicle costs.
And ongoing signs that AI-related demand is kind of being sort of a demand-side inflationary story. Core services inflation also strengthened and driven by things like travel-related categories, perhaps reflecting the fact that oil prices are higher, therefore fewer classes are hired for anyone who's wanting to travel, especially as if you might be planning for the holiday season. You're probably noticing like the ticket prices to travel are a little bit elevated, let's put it that way.
So not terrible, but again, the pace of disinflation not necessarily where I think we would like or the Fed would like to see it. On the retail sales data, the core retail sales number that kind of strips out some of the volatility from oil prices, energy prices, food prices, that increased only 10 basis points in September. So that was below expectations.
It was also below the August number, which is quite strong. So again, there's some seasonality, depends on where Labor Day is or other holidays. That can impact some of the timing.
I think if you take it in totality, the overall data would suggest that the pace of economic activity in the US remains healthy, but there's no signs of a surge above sort of above trend. So overall, okay data, but not spectacular, but in the overall trend, you're still relatively healthy US economic activity. It was interesting, despite the inflation data, we did see that treasury yields fell last week by a good amount.
So what explains that move, Jason, knowing that we've been tracking treasury yields on the rise in recent weeks? Well, I mean, just to put it in context, across the treasury curve, the two-year treasury yield fell about four basis points, but if you go out further, the 10-year, the 30-year, they fell closer to 15 basis points, which as you point out, a little bit surprising to see rates go lower when inflation numbers are higher, at least that's not the typical pattern you would expect. So what kind of caused that decline?
And there's three main factors I would point to. One is that I think there's a little bit of concern that arose last week regarding kind of the AI trade, and we'll get into that a little bit more detail. And really kind of boils down to the fact that AI has been a very significant driver of US GDP growth in the first half of the year.
You could estimate anywhere from 60 basis points to one full percentage point of US growth. That was 2.4%. It could be traced to AI, whether it's the investment or sort of the wealth effect as a result of the AI kind of stock prices going higher.
What we saw was some concerns about the funding, that you've seen valuations or spreads for certain type of issuers kind of going up quite a bit. Could that curtail investment, and if that's the case, the US economy would be overall impacted. So that mini, mini, mini AI kind of slow down from a set of rates that kind of slow US growth, that's kind of what we reflected in rates.
That's one factor. A second factor is that on Fed guidance has been pretty clear that they want to take them kind of a gradual pace, let's say one hike per quarter, September, December we think. And then as a result, the inflation data, but even before the inflation data, our view is that the communication from senior Fed officials indicates that they want to take a methodical pace.
The dot plot indicates there's more hikes coming, and we were prepared to already go to two more hikes December, and then ultimately we did it with March after the CPI data that sort of kind of validated that particular view. Fed chair Kevin Warsh was at an IMF meetings in Bangkok, did a kind of fireside chat on the sidelines, and then commented that the world has broadly conformed to our expectations at the time of the September meeting. Between the lines, sort of implying that it's not been extreme, so they can sort of continue to take a more measured pace.
There are different views on the committee, some are more hawkish than others. I think by taking this more gradual pace, it probably balances to some extent those who want to move aggressively and those who thought like we don't necessarily want to move at all. So kind of signaling this and being consistent with that pace was one factor.
So all this would suggest the Fed's more gradual pace allowed rates to go lower. The more gradual it is, the more chance there is for inflation to get better, allowing them to pause entirely versus if they said we're going to go every single meeting. So that's the second factor.
And the third is rates move very rapidly, in part repricing better growth expectations this year, a little bit lower or slower disinflation. But for rates to keep going higher, you need to kind of keep revising those growth expectations higher. And what we've seen over the past few weeks is rates have sort of stabilized, they haven't gone higher.
The 10-year sort of peaked around 5.3%, 5.4% intraday, has drifted a little bit lower. So maybe it's in a range where it's going to trade around 5.2% as a baseline until again, the macro conditions change fundamentally. And investors were very short, meaning people were kind of reluctant to step in and buy.
Now that it looks like rates have perhaps stabilized, you might get some sort of buyers kind of stepping in. I think there's some positioning elements to what also drove rates last week. Drilling deeper into one of those factors, Jason, you mentioned some of the financing concerns for AI.
There appears to be a rising worry about the sustainability of the AI trade. So what is actually happening with the trade and is there a real reason at this point to be concerned? Let's just look at some of the price data for last week.
The S&P was down 2% overall, but the NASDAQ was down 5.5%. And for context, the small cap index, the Russell 2000 was down 3%. Some of the details more specific to AI were even more kind of dramatic.
Baskets of AI stocks are kind of widely circulated and falling on Wall Street. For a basket of AI tech beneficiaries, some of those were down like 15% last week. The SOX Semiconductor Index has now declined for eight consecutive sessions.
Not until Friday, I think that was the eighth consecutive day. That's its worst streak since or longest downstreak since 2008 and it turned down 11.5% last week. So some big kind of moves overall.
At the same time, you're seeing mega cap names kind of far up from it in recent weeks. So again, the market is shifting towards higher quality, bigger companies, maybe a little more bigger moats. As concerns really kind of emanate from the fact that can this AI investment, this return on capital actually going to be justified?
And then you see stress on the credit side where you're seeing credit spreads for some of the debt issuers, particularly kind of neocloud issuers, data centers rising over the course of the past four or five months, 80 basis points. So from maybe an average around 120 basis points to over 200 basis points and some variation within. So again, that kind of speaks to some of the concerns about, well, will they actually generate enough revenue to cover these costs?
So that's kind of what's going on. And ultimately, you can see the big picture. What seems to be happening is investors, the market is kind of reassessing the durability of the supply chain margins, memory capacity, scarcity, competition from China because a week ago, we were discussing how there was a company in China that announced some breakthrough technology.
So again, you saw memory stocks, Korean memory stocks in particular kind of being hit hard overall. I think the big picture, really, it's kind of the argument is that the markets and investors are getting concerned about the overall growth rates. Could the growth rates still stay very elevated in AI, but moderate a little bit and the markets are priced off of a lot of good news in terms of the overall cutback story.
There's certainly some consciousness of that there will be a slowing of capex and earnings growth, but it really is the market sort of, you can say, testing different theses, probing and assessing where is their vulnerabilities as you kind of go through this kind of overall period of kind of assessing like where is this, how robust is the growth, how resilient is the growth for AI spend overall. Going back to interest rates for a few moments, Jason, the question that seems to come up in every investor conversation is why hasn't the rise in rates caused more pain in both equity and credit markets? What's your take as to why that is?
Well, I think you have to ask why have rates gone higher and kind of alluded to that higher rates have risen because growth has been better than expected. Very simply, if you look at the 10-year treasury yield, it's up about 100 basis points this year. Ninety plus percent of that is due to higher real rates.
Inflation expectations have not risen much at all, like they've been very range bound. Inflation expectations for where the Fed funds rate would be in December of this year have gone up about 100 basis points, again, consistent with the idea that instead of growth slowing, inflation falling, you've seen reflation to some extent or solid kind of 6% nominal GDP growth. So again, you should not have rates that are that low overall.
So that's kind of the key driver. It's also another aspect that's interesting about the rates market that is not signaling kind of growth weaknesses that the yield curve is still positively sloped. So if you're worried, if the market investors were worried that the economy could slow, what you'd see is the 10-year yield falling below and the curve could actually invert such that the 2-year yield is higher than the 10-year.
It's still about 35 basis points down from its peak earlier, but not negative at all. So consistent with the idea that things are good, but it's not the point where the Fed is now having to hike to actually potentially create a recession. At the same time, the curve hasn't steepened out where the 10-year has gone much higher because if that was the case, then the market would be essentially signaling we think the Fed is behind the curve, that they will have to hike a lot more because inflation is going to get too hot and the 10-year is already reflecting that.
So the overall story is in some sense from the rates market, even though rates have gone up a whole lot, is this is just reflecting the economy is doing better than we expected and the Fed's policy is calibrated reasonably appropriately given these overall conditions. And then if you actually look at though, it is a bit perhaps misleading to say higher rates have been completely shrugged off by the economy. Certainly the AI investor story has been relatively immune to higher rates because there's such a structural story kind of going on there.
But other parts of the economy that are impacted by interest rates have been affected. The housing market, real estate, very soft and that's clearly going to be tied to it. Private credit has been certainly impacted by that overall.
With the equity markets, S&P is only 2% from its all-time high, but you have 50%-ish of S&P of 100 companies that have traded down more than 20% from their highs earlier in the year. So there's certainly been challenges kind of below the surface. And then you think about some of the key structural drivers for growth, AI CapEx, spending and AI overall, maybe a full percentage point in growth this year, not going to be particularly rate sensitive.
Household wealth in general is quite strong and household financial balance sheets are in good shape. That's supporting consumer spending. And then you also have just kind of large deficits.
We had fiscal impulse this year that supports it. So all told, rates is a reflection of the strength of the economy as opposed to the economy performing well despite higher rates. Considering these factors, Jason, from a positioning standpoint, what is CIO recommending that investors be doing right now?
So we go back to my opening comments regarding the data last week. Not quite as good as investors expected. But overall, activity is solid.
Inflation trends still look like they're going to go lower over the course of the next year. The economy can handle some of those higher rates. So the macro story, the fundamentals are still kind of relatively strong at a macro level.
We talked a lot about AI and what is the market concerned with. Yes, there's concerns about future growth rates, but it's more like are you decelerating from 80% growth rate at CapEx to 40%. This is just to kind of put some numbers around it.
The AI investment story still looks very much intact for the time being. Who will kind of capture the gains and the benefits from AI, that still is kind of an open question. I think that's where you're seeing some of the churn overall.
So not, again, negative on AI, but it may be some moderation of this pace of growth. If we kind of look at the year overall, and certainly the last six months, if we were to think about what are the factors driving financial markets across the board, I could just talk down to three things. One is AI, certainly.
Second is rates. Third is oil. And so in the past few weeks, past couple of months, rates and oil have not necessarily been cooperative.
They've been rising. Rates due to growth, but certainly not moving in a direction that's kind of going to be boosting growth and just creating some headwinds for parts of the economy, whereas AI is by and large kind of going to continue to sort of power ahead. So if you think of like three legs of a stool, one is really sturdy right now, two of rates have had taken a bit of a ding and oil certainly been working in the wrong direction.
If those other two factors, rates and oil, start to decline, which is our kind of base case for the next year, that means all things could then be more aligned. You could have a sturdier support for the markets to actually move material higher as opposed to kind of just grinding in a relatively tight range. But until that sort of happens, we could kind of continue to kind of chop around for the time being until we get to perhaps the midterm elections, get clarity to the extent we can on what's happening in the Middle East.
All that said, still constructive on equity, still see strong earnings growth, continue to sort of message to diversify kind of across the board, not to be kind of overly concentrated within fixed income. Given these higher rates, we were sort of cautioned on extending duration, but a few weeks ago, we did say that kind of go a little bit further on the curve, and given how the rates have performed, that's sort of consistent kind of with that view overall, and looking for things that would kind of help other diversify your portfolio. So commodities or gold, it provides a diversification against scenarios of what's called like more stakeflationary growth, things of that sort.
Well, Jason, very helpful clarity this morning as to the factors driving market momentum at the moment. It will be interesting to see what earnings deliver this week. I know we have another Fed meeting next week, which I'm sure we'll preview on next Monday's conversation.
Thank you for dropping by for the touch base today, Jason, and I look forward to continuing our conversation next Monday. You're welcome. You too.