Top of the Morning: CIO Strategy Snapshot - Terminal values

Hi everyone. Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel.

It has been an active few weeks in financial markets as investors grapple with the potential for AI to disrupt business models across industries. They're also trying to assess whether the U.S. economy really is running hot as many investors expected at the start of the year. Joining me today here in studio, glad to welcome back Jason Draho, Head of Asset Allocation for the Americas with the UBS Chief Investment Office.

Jason, been about three weeks since you and I last spoke. I know a lot has happened in between, but to start off, great to be back with you here in studio. Welcome back on this Tuesday morning.

It's good to be back. It's welcome back, Dan. Thank you.

Some off time. Yes. So let's get right into it, Jason.

Let's begin with the biggest market story of the past two weeks, which is the growing concern that AI, artificial intelligence, will disrupt entire industries. Could you first begin, Jason, by talking about the price action that you're seeing and then why is this occurring? Well, it's almost been like a bit of a rolling cascade of different industries being impacted by the concerns about AI disrupting entire business models, especially for incoming companies.

Software has been sort of the poster child for this because what is kind of well-documented is that AI does a really good job of writing software code. It's probably its relative strength. And therefore, there's kind of questions of like, well, what is the future of the software industry if AI can write a bunch of this code and do it at an incredibly low cost?

So as a result, software is sort of an industry or a subsector within the S&P 100. It's down nearly 20% year-to-date, about 25% from its all-time high. And it took a big leg down a couple of weeks ago as companies were kind of reporting earnings.

So you have software, but it's not just software. Other industries have been sort of in the crosshairs, so to speak, of the AI threat. Just last week, it was insurance companies thinking there could be some automation there.

It was down 4% just last Monday as a sector. You have kind of brokers, the wealth management space and alternative asset managers have been hit hard. They're down sort of, these alternative asset managers down roughly 8% year-to-date.

Sorry, brokers and alternative asset managers. Even things like logistics and sort of shippers were down sort of as a component, about 4% last Thursday thinking AI could automate a lot of this stuff. So you're seeing this sort of rolling effect within equities.

It's not just equities though. There's also a fixed income component to this as well, in credit specifically. One aspect of it, which is kind of less important of the two, although not certainly insignificant, is just the amount of investment in CapEx that will have to take place this year and in coming years to sort of build out the data centers to allow for the model testing, for the demand for compute.

The five main hyperscalers through earnings season upgraded their estimates of CapEx investment this year, and it's now roughly $650 billion. This has to be financed with increasing amounts of debt issuance. So concerns about the supply of debt, high quality debt, but still supply of debt.

The bigger concern in the credit space is the fact that a lot of kind of riskier fixed income, like senior loans, private credit, were used as the main financing source for software, for tech companies, still a lot of cases, kind of private companies. And the question is, if software is going to be disrupted, if you're worried about the future business models, obviously you will have to worry about getting repaid as a credit investor. So we've seen spreads widening in those parts of the markets, of the fixed income, the credit markets that have higher exposure.

So more so senior loans versus high yield. Private credit markets, there's not the same kind of transparency, so we don't have a good read exactly. But if you look at some BDCs, these are companies that are sort of publicly issued that have a lot of this debt, and they've also been hit quite hard.

So this is a lot of churn, a lot of activity going on, but it's also below the surface. I think it's just worth pointing out that the S&P 500 is down only 14 basis points year to date, and only 2% from its all time high, despite all these kind of major churns. The VIX volatility index was out 22 as of this Tuesday morning.

That's less than its peak of over 25 last October and November. We don't think of those as being overly disruptive periods. So when you look at all this price action, there's definitely some sort of missed signals.

Obviously, these steep sell off for certain stocks and sectors reflect a real fear that AI disruption is real and it's accelerating. But investors are also sort of punishing this increased AI capital spending, because they're concerned about, is there going to be a real return on investment? So there's a bit of a kind of contradiction that you can't easily sort of have a simultaneous lament about not getting adequate returns investment, yet fearing that all this investment is going to completely eliminate business models.

It's sort of one or the other. I think it just speaks to the reality that a lot of confusion, a lot of uncertainty, no one really knows the exact path or the endpoint for all these kind of AI developments. There's a bit of a sell first, ask questions later.

Well, very eye opening, a lot to figure out, and certainly a lot of potential impacts, implications across industries. So something will continue to, of course, cover. I want to turn to the economic calendar a bit, Jason.

We have received a number of major economic data points recently, as last week, including the January jobs report, inflation, December retail sale. So a lot there to unpack. Based on that, Jason, how would you characterize the U.S. economy?

Does it look like it's running hot? Think about where the view was at the start of the year, which was the expectation, a pretty consensus view, was that the U.S. economy growth would accelerate in the first half of this year. You're getting tailwinds from some fiscal stimulus, easier monetary policy, CapEx spending.

These numbers keep going up. You also have a president in the Trump administration that would want the economy to be strong going into the midterms. So looking for ways to deal with things like affordability, already kind of talking about perhaps having some exemptions on tariffs, and that was sort of news last week.

So all that was a reason to be sort of constructive about cyclical growth acceleration. That's what we saw the markets are pricing in, really, for January before we got to February. We take this step back now and see, as we start to get this data for January, for December, is it sort of consistent with that?

And bottom line, is it that is so far? You didn't mention, but the ISM, like in a manufacturing index, was that, you know, kind of jumped up a little bit above expectations. You're seeing kind of on a global basis sort of the cycle.

So it looks like it's sort of accelerating. So all that sort of data would suggest the thesis is still in play. We start to kind of break down some of the specific data points.

Last week, we got the January payrolls report. Headline number definitely better than expected. The unemployment rate ticked down a little bit.

There's been obviously a lot of noise in the data, you know, for a variety of reasons. Some of it is government shutdown late last year. Some of it is the fact that because of the shutdown, we just weren't getting data.

So it would probably take a couple more months to get a really kind of clear read of like what's the underlying trend. But after sort of softening last summer into the fall, it appears that the labor market is sort of stabilizing, you know, not necessarily getting worse. I think probably the most positive news is that the unemployment rate has actually ticked down a little bit, even though the participation rate has increased.

So it looks like it's not getting worse. It's holding steady for the time being. And as, you know, real incomes rise, as we get this sort of benefit, you know, healthy consumer spending should flow into at least an uptick in labor market demand.

But I think the risks are certainly skewed to the downside. I just spent five minutes talking about how the market is trying to figure out AI and the impact for business models. I think for a lot of companies, therefore, you know, they may be kind of cautious in terms of hiring.

So job losses from AI may not really materialize, but it could be a concern about actually, you know, adding to labor force growth at this point in time. On the consumer, consumer spending, the December retail sales data were, you know, a little bit disappointing. But the more high frequency consumer or credit card data suggests, you know, that there's going to be a bit of a pickup.

Also, it's early, but we're tracking tax refunds. So a big part of the fiscal story is that the tax cuts were retroactive to last year. So as people file for tax refunds, the expectations are going to be bigger this year than they otherwise would be.

And the estimates, you know, vary between say $60 billion to $100 billion. It depends a little bit on how you account for it. There's about two weeks of data or less of like how that refunds are tracking.

It looks like just towards the end of last week, it's starting to kind of break above last year's level. But this is a key thing, like, you know, that's supposed to happen. If it does happen, again, this is, you know, like additional money for consumers to spend.

Pivoting to inflation, you know, the overall picture still seems, you know, relatively solid. You know, the shelter piece is, you know, of inflation, which is about a third is coming down. We're seeing certainly the impact of tariffs still playing through, but that should pass through, you know, by the middle of the year.

And there was an uptick in the January kind of the non-core services inflation. It's a little bit tricky to read that because there is sort of tends to be an annual increase. So that number always tends to be somewhat high in January.

But I think the idea of sort of disinflation trends being in play is believable. And then going back to AI, if you're worried about AI being disruptive, part of it is that, you know, you can produce things at lower cost and more efficiency. So that should be disinflationary.

And there's certainly anecdotes of companies saying, well, if my inputs are going lower because, you know, the people I'm buying from can use AI to reduce cost, you need to pass that on to me. So again, I think it's ultimately going to be disinflationary. Add this all up, you know, the macro view stays intact.

For the Fed, though, you know, we had been calling for a rate cut in March. We pushed that back to cuts in June and September. Labor market data doesn't necessarily warrant immediate action.

Inflation is still above trend. Economies, if anything, are likely to accelerate. The Fed can certainly step back and wait.

And now, with only two more meetings where Fed Chair Jay Powell is in the seat before, presumably, let's say Kevin Walsh, the nominee for President Trump gets approved, is in the role by June. We don't think the Fed will do anything until that point. But the, you know, the data would warrant for the Fed to cut you twice more from there.

This is a good time, Jason, to tie in your recent blog. Title is Terminal Values, available, by the way, now up on UBS.com forward slash CIO. Though, Jason, within your blog, you note that macro factors have taken a backseat to AI as the main market driver over the past few weeks.

However, you also state that the two are inseparable over the long term. So what do you mean by that, Jason? What are the implications?

Well, we think about it on a company by company basis. If AI can be disruptive, we start to aggregate that that actually has an impact for the overall economy. So I'd say like widespread adoption of disruptive AI tools does have to have an impact.

AI is a general purpose technology. It's not just a certain thing that in certain industry. And we've seen these kind of developments in the past that can have broad based implications of the economy.

And the way therefore that I think about AI is essentially is a positive aggregate supply shock that should lead to higher productivity. I mean, that's the idea is that we get these tools that allow us to do more in the same amount of time or do the same amount in less amount of time because AI allows us to be much more efficient. So I think that's not really in dispute that AI is going to be a productivity enhancing tool.

The real debate is just over the magnitude, how big it is, how soon it will be, obviously how much it will disrupt the business models, how much it's going to impact the labor market. If we think about the productivity piece specifically, their estimates are kind of pretty wide ranging. Some would suggest that it's going to be relatively modest, all is equal, take it up by 50 basis points.

Others are more optimistic, say it can increase productivity growth relative to a trend level upwards of 300 basis points. There's some extreme views that growth could be 10% a year. I think that's fanciful.

But within the range of plausibility, a decent increase, this ultimately kind of matters because a higher level of productivity growth leads to a higher trend level of growth. So just for simple terms, the trend level of growth, people assume it's around 2-ish percent, slightly less, based off of around one half percent productivity growth and about a half a percent of labor supply growth. Well, labor supply is going to shrink just because of demographics and tighter immigration.

But if productivity growth increases 150 basis points versus that baseline, gets up to 3%, well now your trend growth is over 3%. This matters because that means the economy can grow at that level without being inflationary. So that's positive, you're growing more significantly.

It also means that the cumulative or compounding effect of just higher growth overall makes a material difference if we think about like how big is the economy going to be, say in 2035 and roughly 10 years from now. If you're growing at 3% plus versus under 2%, that 1-1.5% a year compounds to mean the economy could be 5-6 trillion bigger by 2035 than otherwise. It's a lot of value kind of creation.

So that's again sort of a positive. So these are significant things. The impact on labor markets, that really kind of remains a question of is this going to be a labor-enhancing tool or a labor-displacing tool?

Are we going to be sort of using it for means that are kind of effective in terms of efficiency and cost efficiency? I think for sure, beyond that in terms of like replacing us doing a podcast, that – Hopefully not. Hopefully not.

But I think we can say for sure that it's going to probably be the former, will be more efficient. That's disinflationary again. Then just going back to the Fed, this is already I think will be a point of debate for the Fed this year.

Jay Powell in December at the FOMC commented how the committee, the FOMC did see productivity being higher. AI seemed to be a little bit of a contributor to that. As a result, I think they upgraded their overall economic forecast.

Kevin Warsh, the Fed chair nominee, has already been out there saying higher productivity due to AI should be disinflationary. That's a reason to cut. The flip side is that if you have higher trend level growth at 3% or higher, the neutral rate for the Fed funds rate should actually be higher as well.

Therefore, that's less of a reason to cut. So I think a big debate that will take place at the Fed later this year, especially if Warsh is making this argument. It's like, well, how much – how do we think about productivity?

Does it mean higher growth overall? Is it disinflationary? Do we cut?

But clearly, all these things, all of this AI has a big impact for the overall level of growth, obviously for the labor market, for what the Fed's going to do. So it's not just a micro company-by-company story. It is a macro story.

One that's, I think, positive, but exactly how this plays out and who are the winners from it at an aggregate level remains to be seen. So we have a few moments remaining, Jason. Let's just end here on asset allocation recommendations.

In light of all that's happened in recent weeks in the markets, what are CIO's current investment views? Well, just picking up on the point about the market uncertainty and a lot of choppiness underneath the surface, I think market narratives around AI are going to change kind of frequently. And a clear direction for them is unlikely to materialize soon.

After all, it's kind of hard to falsify the conjecture that in the next five years, AI will seriously disrupt incumbent business models. We don't know. So I think the markets are going to maybe trade in a range a little bit for the time being.

But overall, the macro story still remains constructive. And therefore, that's constructive for equities overall. So we still think equities globally look attractive.

And we didn't get into other markets. But again, the fundamental story elsewhere is relatively constructive. So that remains in play.

We did downgrade a week ago, a view of tech from attractive to neutral. This is sort of reflecting the fact that this AI will be sort of disruptive. It could be disruptive for software, which is about a third of the industry.

And again, until there's clarity of how this will play out, it's hard for them to get a real sort of bid for this to rally. Like, what's the catalyst? That's one thing.

Apple is a big part of the hardware part of tech. And they've had a good replacement cycle. But the question for Apple is sort of what comes next.

And then there are semiconductors, which are very important for the infrastructure application layer or the infrastructure layer of AI. The markets are starting to kind of move beyond that to think about, well, what are the applications? What are the winners from this?

And so again, it could do fine. But when we say market neutral, it really is not a negative view on the tech sector, but it should perform in line. We don't expect it to keep up performing.

And I think the year-to-date performance is consistent with that. On the fixed income side, as I mentioned, the parts of fixed income are under a little bit of stress because of the AI. Other parts, though, remain relatively attractive, like securitized credit that's not tied as much to these kind of fundamentals.

Still think rates are going to be somewhat range bound. And we've seen them fluctuate between 4% and 4.4%. That's likely to continue for the time being.

And then it's almost forgotten on all this discussion, but gold a few weeks ago was the big story, very volatile. It is back over 5,000. We still think the fundamental story in terms of diversification and a structural sort of hedge against long-term inflation, debt sustainability, sort of a debasement trade kind of argument suggests that gold still has attractive upside and is a good diversifier.

Well, Jason, it was great catching up. Great to have you back here in studio. Productive conversation to begin this holiday shortened week.

And of course, do look forward to picking back up with our conversation next Monday morning. You're welcome. Have a great week.

You as well. Thank you, Jason. And once again, do want to highlight Jason's recent blog, which we have been tying into our conversation today.

That title terminal values is available for you now up on UBS.com forward slash CIO for clients of UBS. Please, of course, reach out to your UBS financial advisor. If you would like to receive a copy of Jason's blog directly from UBS studios, I'm Dan Cassidy.

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