Top of the Morning: CIO Strategy Snapshot - UBS House View (Feb)

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

We're now in the depths of winter and much of the country remains in a deep freeze after a hot start to the year. Financial markets and the news flow have also cooled off a bit, but activity could easily heat up again at any time. So this means it is a good time to reassess the investment outlook in light of market developments, economic data and, of course, policy news.

Joining us for that conversation today, glad to welcome back from the UBS Chief Investment Office, Head of Asset Allocation for the Americas, Jason Draho. Jason, welcome back on this Monday morning. Great to be with you to begin another trading week.

Hope you survived the storm okay, as it was quite a big event. But of course, a lot to cover on the episode today. So great to be back with you.

Good morning, Dan. Happy Monday. Doing a remote day because we're all a little bit snowed in.

Hopefully everyone is doing well and safe. But I survived and on to another week. That's it.

So, Jason, let's begin with the markets overall performance. Still good, but what's notable to you about what's being priced across the markets right now? A couple of weeks ago, I wrote a note titled, like, starting with a bang because the markets just came out of the gate so kind of full on.

I'd say things have cooled a little bit, but I think it needs to be put in perspective with the markets. For example, the S&P 500 is up 1% year-to-date. It's getting close to the end of January.

That's not a bad performance, but it went down slightly in the last two weeks. Even last Tuesday, it sold off a lot after the threats of tariffs related to Greenland. It recovered at least by the end of the week.

But there's a few observations I would make about the markets overall, which I think kind of puts the context as we think about where do we go from here. The first is that there's been sort of definite broadening of performance across equity markets specifically. I mentioned the 1% for the S&P 500, but if you look at the equal weight S&P 500 index, it's up 3.7%.

The Russell 2000 small cap index is up 7.9%. Developed market equity is 3.9%. Emerging market equity is 7%.

We did have a stretch where 14 days in a row, the Russell 2000 index had beat the S&P up until Friday. That's the longest such streak since 1996. So, definitely a clear rotation of the markets and flows are following it.

So, it seems a broadening of performance. That's the first takeaway. The second is that this is kind of consistent with the run hot narrative that investors started to embrace last fall.

The idea that economic growth would kind of accelerate this year would be strong because of policymaker support. And if you have that environment, you should get some kind of broadening of performance relative to the mag 7 that have been sort of dominating the market performance for the past couple of years. And the data we've seen thus far, especially Q small caps are the best example of that performing well on maybe the hopes and expectations that growth will pick up.

That's certainly our view. But now, we will need kind of the growth data to sort of reinforce that view for this run hot narrative to really kind of have legs well into the Q1, but even going into Q2 sets a second observation. The third is on rates.

If we look at yields across the treasury curve, they're up most at the front of the curve, whereas the 10-year, the 30-year actually have not changed very much year to date. The front of the curve, rates have gone higher there because of expectations for rate cuts this year have gone lower so that the market price is up. That impacts the two-year more than it does the 10-year.

But in some ways, the long end of the curve is really where the risks to the markets lie. If there's new concerns about the fiscal situation, if inflation needs to run hot, if there are just sort of overall, you get sustainability questions, all that could sort of create volatility and higher back-end yields. We saw an example of that last week where the 30-year JGB, the 30-year Japanese government bond yield was 40 basis points in two days to start last week.

It's retraced mostly at about 75% of that. But if JGB is to go higher, and that's probably something for policy changes or potential policy changes there where they can run into cutting back on certain taxes, ultimately, instead of trying to run their economy hot, it does spill over into the US and other global bond markets. We saw that last Tuesday.

Today, that was risk off for markets as well because of the Greenland news yield that the eight-year or the 10-year or the 30-year were up 8 to 10 basis points, largely because of Japan more so than anything else. That remains sort of a story this year that pricing cuts, but the back of the curve kind of remains a bit of a risk for the markets overall. And that feeds into the fourth observation, which is that I think that's kind of a store of value seems to be in high demand, and specifically, the precious metals.

Gold is up 17% year-to-date. Silver, 50%. Just last week, gold was up 8%, and silver was up around 15%.

And they're almost going like vertical at this point in time. So definitely investors thinking what may proceed to be a safe haven and certainly some momentum chasing going on there as well. So it's still very much a eventful market, a lot of interesting dynamics taking place in terms of broadening out growth sensitivity, some long and rate risk, and then investors looking for places to store stores of value.

Okay. So quite a few considerations there. Jason, what is driving this market performance, and what role is policy playing?

Well, I've already kind of alluded to this running hot narrative of a kind of cyclical growth acceleration. That's definitely reflected in not only broadening out of equity market performance or the demand for gold, but you're seeing industrial metals, for example, also doing quite well in an environment where if you have good kind of growth globally, they should benefit. So that's one factor.

The other factor on policy of when you get clear policy signs of trying to run the economy hot, Japan is the most explicit because they have called a snap election, and the expectation is to consolidate power from the current ruling government where they can sort of move forward with some of their fiscal expansion plans, which includes, for example, tax cut on or sales tax cut on food. In the US, I think it's likely we're going to see a policy announcement from the Trump administration, essentially, maybe as soon as this week and going forward on things that would try to spur growth, deal with affordability, put more money in the pockets of consumers, which ultimately should benefit spending overall in the economy. And just on that point, the escalation and sort of de-escalation of tariffs on Greenland sort of consistent with that, kind of stable rattling, but ultimately not falling through.

In another, I think on February 20th, that's the earliest we're going to get potential news on the Supreme Court ruling on the IEPA tariffs. If they were to rule against them, the question would be like, how much does the Trump administration want to try to reinstate them or use other means to apply tariffs, knowing that affordability concerns are a primary political consideration going to midterms, yet they try to be more selective. So all these things suggest a bias towards a running hot narrative.

So that's why I think that kind of reinforces that view. But also a lot of the policy news, whether it was Greenland last week with the tariff threats or other policy announcements taking place, including the possibility of a government shutdown at the end of this week because they won't have passed the various appropriations bills, you know, will create more noise, I think, for the outlook rather than fundamentally altered overall. So, Jason, if we spend a few moments now on the Fed, it's timely because the Fed's FOMC meeting is on Wednesday, and another cut is unlikely at this meeting.

So what will you be watching for? And what is your Fed rate cut outlook from here, Jason? Well, back in the December FOMC during the press conference, Jay Powell kind of used language to suggest that, you know, the committee was going to take a pause.

You know, for example, like, you know, the policy rates in the range of neutral, that's a signal that we think, you know, maybe we need to kind of reassess where policy exactly is, where the economy is. And we just do not have enough data, you know, since then that would warrant definitely another cut given the signs of, you know, a little bit of stabilization improvement, especially in the labor market, you know, the signs of the economy doing, you know, relatively well. So, you know, unlikely to get, very, very unlikely to get any, you know, content that would be very, very surprising in the market.

There's also limited new information. The Fed doesn't update its economic forecast. There's no change in the dot plot.

During the press conference, you know, Chair Powell was likely to reiterate kind of similar message that he had back in December. He will get peppered, I'm sure, with a lot of questions regarding the Department of Justice litigation, you know, the Supreme Court sort of, you know, looking at the case between now it's called Dean Trump versus Cook. Lisa Cook is the governor of the Fed, and the question is, can she remove the knot?

A lot of questions on those topics. I think Powell will try to parry all of them, and I could be essentially saying, you know, not commenting right now. So, a relatively uneventful FOMC meeting.

Our expectation right now is that it's still, the Fed will cut in March, but I think it's getting close to a toss-up. I think one more cut if not in March than by the spring is still likely. Beyond that, it really depends on how the economic conditions, you know, play out.

And if growth is accelerated, as we expect, and inflation is still above 2%, from an economic perspective, it's harder to justify the Fed cutting beyond that. I think part of what the market is pricing in is that a new Fed chair will be more dovish, but I think the news to really kind of watch for in the coming days or coming weeks is almost like, you know, when does President Trump decide to nominate his next Fed chair? The betting markets, the prediction markets, probability of who that would be have continually shifted.

I think the two leading candidates right now, based on prediction markets of Rick Reeder and Kevin Warsh, are not particularly sort of dovish. You know, there's not a reason to think they would then try and make a case to strongly cut rates overall. And now in terms of other, you know, kind of questions about Fed independence, the Supreme Court had a hearing or a testimony regarding the Cook case last week, and the tone of questions from most of the justices, including those who are on the conservative side, raised real questions about the validity of the case and sort of reinforced the view that perhaps they're leaning towards favoring Fed independence.

So, you know, the markets respond accordingly. So all of this suggests that, you know, a lot of the view that we would have for this year in terms of what is the Fed going to do, all the personnel will certainly matter, but ultimately economic conditions are probably the biggest driver. And we think it warrants probably one more cup and not much more than that.

OK, so that covers the Fed. We will see what happens on Wednesday. Let's turn now to the Q4 reporting season.

It is underway. We have a busy week ahead of us. So, Jason, what are the notable observations from what we've seen thus far?

Well, you had close to 15 percent of the S&P 100 market cap report. We're seeing 70 percent of companies beating on sales estimates, 80 on earnings estimates. Those are about historical averages.

And the median earnings beat is about 4.6 percent. That's about a percentage point higher than the historical average of 3.6 percent. And guidance has been fine going forward.

We're not necessarily guiding lower. So, as long as it's not going lower, that's generally a positive. Now, the market reaction to these results has been pretty muted.

In fact, on average, even those companies beating, you're seeing the stock price flat, even down the next day. So, you could say this kind of good news has been largely priced in. With the companies that have reported thus far skewed heavily towards financials, this week is a real ramp up for earnings season.

It's about 35 percent of the S&P market cap is going to report this week, including four of these seven Mag-7 companies. So, a lot of focus on what they're doing, a lot of focus on the EICM in terms of the CapEx story, will they continue to ramp up CapEx, what kind of monetization they're having. As a precursor to that, last week, Tom Webb Semiconnector, which is the most important semiconductor manufacturer in the world, reported and they beat and revised up their revenue guidance.

That could be a potential sort of sign that you'll get a good earnings season from the Mag-7, which is notable because for a while now, your tech stocks, some of these Mag-7 companies have essentially lagged the overall market as they're spending this rotation of broadening out of performance, perhaps as a sign of some investor exhaustion, but seeing good results, good guidance could then get investors sort of re-engaged in terms of the outlook going forward. We think there's probably too much pessimism baked into the market. So, I think there's definitely scope for upside for these 10 companies, not just to beat, but sort of reinvigorate sort of the tech as a team, as a driver in AI in particular.

So, with that, Jason, let's end with asset allocation and the house view, which was updated just last week. What are the main investment takeaways, Jason, from the latest house view? So, two kind of broad ideas.

One is more tactical and that we expect this broadening out of equity market performance to continue, supported by both kind of the US and sort of a global economic backdrop that's likely to improve as we move forward this year. And then also as the AI innovation cycle continues to evolve, sort of broadening out from a handful of companies that have been the dominant winners to a number of other companies at different layers of the AI cycle to be beneficiaries. So, that theme will continue.

We've liked equities globally and equities, whether it is in the Eurozone, Japan, APAC overall, China and China Tech. So, it's not just been the US story, it's not just been the US tech story, but we see kind of opportunities across the board. In the US, we did upgrade consumer discretionary as part of that theme.

As consumer discretionary should benefit from the cyclical acceleration, as well as some policy measures by the administration to try to help affordability, help consumers. And the best way they can do it is get more money in the pockets of consumers. That's money they are likely to spend.

So, further broadening out of the equity rally and with more upside there. Strategically, I think that the lesson so far this year is diversification across different regions and asset classes. As the political environment shifts, as the global geopolitical environment shifts, there's more uncertainties out there, more divergences in terms of market policy performance.

That actually augurs well for the benefits of diversification because all markets aren't going to move anything lockstep. And given all these uncertainties, that's also kind of why we like things like the precious metals like gold, even though they've done incredibly well. In the very near term, it's hard to suggest how much higher can go versus because it's up 17% year to date.

But the direction of travel, we think, is more demand for safe assets. Diversification being done by central banks and major asset allocators and sort of the structural tale with that switch to gold and other precious metals going forward. And then finally, on rates, I mentioned rate risk is still a concern, which is why we're a little bit cautious on extending duration, still stick to more of that eight, five to seven-year part of the curve, still lean a little more towards securitized credit, but just not taking a lot of risks overall in the fixed income space right now.

Jason, productive way to begin the week. As always, thank you for dropping by to provide our listeners, our clients with some timely thoughts, spanning the Fed to Q4 earnings and ending there on CIO's latest asset allocation recommendations and investment outlook. So I'm off to shovel more snow, but Jason, appreciate your time today and look forward to picking back up with our conversation again soon.

You're welcome, Dan. Appease yourself. It's a marathon, not a sprint when it comes to shoveling snow.

Definitely. That's great advice. Thank you, Jason.

Again, today we have been joined by Jason Trejo, Head of Asset Allocation for the Americas with the UBS Chief Investment Office from UBS Studios. I'm Dan Cassidy. Thank you for joining us.

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