Top of the Morning: CIO Strategy Snapshot - What risks?
The desk observes a paradox where global political risks are on the rise, yet investor sentiment remains unperturbed, a sentiment echoed in the UBS commentary. In the latest payroll report, nonfarm payroll growth aligned closely with expectations at 227,000 jobs added, suggesting a labor market that continues to stabilize despite a slight uptick in unemployment to 4.25%. This mixed labor market data, highlighted by UBS, underlines the Fed's current position and reinforces the cautious optimism seen in U.S. equities and bonds. Without high-impact calendar events in the next month, traders should monitor upcoming data closely for shifts in sentiment.
What the desk is arguing
The desk posits that the resilience of U.S. markets, despite increasing global political tensions, echos a broader narrative of investor confidence amid mixed economic signals. Per the full note from UBS, the nonfarm payroll report showed 227,000 jobs added in November, with a slight increase in the unemployment rate reflecting shifts in labor force participation.
Additionally, average hourly earnings rose by 0.4% month-over-month, showing persistent wage pressures, which could further influence the Federal Reserve's policy stance. This backdrop frames a narrative of an economy that, while cooling, remains buoyed by strong labor fundamentals.
Where it sits in our coverage
Our current consensus target for the USD is 1.075, within a range of 1.04 to 1.12. Notable firm targets include: - jpmorgan: 1.10 (Mar26) - bofa: 1.04 (Mar26)
The desk's view aligns closely with jpmorgan, placing us slightly above the median target but diverging from bofa, which takes a more cautious stance.
How other firms see it
Firms such as jpmorgan and others exhibit a bullish outlook on the USD, citing resilient economic data as support. In contrast, bofa holds a more bearish view, attributing potential declines to global uncertainties.
Indicators to watch include U.S. labor market trends and upcoming employment data, as these will be critical in shaping expectations around future Federal Reserve policy decisions.
02The November payroll report aligned closely with expectations, showing nonfarm payroll growth of 227,000.
03A slight increase in unemployment signals shifts in labor market dynamics that could influence Fed policy.
04Average hourly earnings growth persists, reflecting ongoing wage pressures in the U.S. economy.
Market implications
Traders should pay close attention to labor market indicators as they could lead to a shift in Federal Reserve policy. Resistance levels for the USD are at 1.10, while support is found at 1.04, which may guide positioning in the near term.
Risks to this view
A sudden deterioration in the political climate or unexpected shifts in labor market data could reverse the current bullish sentiment on the USD. Increased geopolitical tensions or signs of recession could also pressure equities downward.
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Hi, everyone. Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel.
It was another positive week for U.S. equities and bonds, too, as the year-end rally continues. This is happening despite political risks around the world, from Europe to South Korea and back to the U.S. with respect to fiscal policy uncertainty. Now joining us today to discuss this all as part of the CIO Strategy Snapshot.
Glad to welcome back Head of Asset Allocation for the Americas with the UBS Chief Investment Office, Jason Draho. Jason, nice to be back with you here on the podcast. Thank you for dropping by on this Monday morning to begin another trading week.
Welcome back. Good morning, Dan. Happy Monday and happy holidays.
I know it's a little bit early, but it's just around the corner. So, Jason, let's begin with the November payrolls report, which we received this past Friday. What's your assessment of the state of the labor market as it stands today?
Well, the data was mixed, but largely in line with expectations. So the nonfarm payroll growth for November was $227,000. The consensus expectation was $220,000.
So almost bang in line with the expectations. The prior two months, September and October, they were collectively revised $56,000 higher. Less good news was the unemployment rate increased slightly from 4.15% to 4.25%, so about a tenth of a percent.
Some of that is due to shifting labor force participation. And also it's based on a household survey, a different survey versus the payroll growth. There's a little bit more weakness in the household survey.
In addition, average hourly earnings rose 0.4% month over month. Year over year, it's still around 4%. It's a little hotter than expected, but kind of generally still in line with the overall trend.
If I were to bottom line it, I'd say the takeaway is that the labor market remains on solid footing. It is continuing to cool, and that's really been the story all year. But at the moment, we're seeing hiring is moderating, firing is also very low.
It's a little bit of a holding pattern, waiting for more clarity on the state of the economy, more clarity on what the Fed does. But overall, in line with expectations and kind of a new consistency that we've seen for many months now about a good labor market, while that is also cooling. So, Jason, based on the labor data, what the state of the U.S. labor market looks like, what does that mean for the chances of a Fed rate cut next week?
Well, it certainly increases the chances. If you look at market pricing for the probability of a 25 basis point rate cut at the meeting next week, it's now an 85% chance of a cut. Two weeks ago, it was only a 55% chance.
So it's a pretty sizable increase from a coin toss to now someone that is quite likely. The only data point between now and then that can really alter the Fed's actions or decision is the November CPI data that we get on the 11th. The consensus forecast for both headline and core CPI is kind of basically unchanged on a year-over-year basis at 2.7% and 3.3%.
And between 25 and 30 basis points kind of on a month-over-month basis. So again, in line with very gradual disinflation, it's certainly possible there could be an upside surprise. And if inflation runs much harder than that, if it's a big upside surprise, that certainly can alter the Fed's plan.
But one thing that's kind of noticeable, in addition to inflation that are moderated over the past year or two, is that inflation surprises relative to these consensus expectations have also moderated. Meaning you're not seeing inflation coming in at 0.5 when the forecast was 0.3 on a month-over-month basis. It might miss by a few basis points.
As a result, the market impact should be relatively muted because if the market sort of gets what's expected, what's expected should be kind of in respect to the market pricing. Therefore, the overall market response to inflation data should be somewhat muted. And you can actually look at the options markets to see what is it essentially implying for a price move in the S&P 500 up or down after the data is released on that day.
And what it is right now is about a 50 basis point move, plus or minus, for the S&P 500 on the 11th, when the data comes out on Wednesday. That's the smallest such implied move in about three years. So what it means is that long inflation is sort of roughly in the ballpark of expectations and the past year suggests it will be.
And the market's going to kind of shrug it off. It ends up being somewhat uneventful and therefore the Fed's kind of path to cutting 25 basis points is all clear. Last week, before the jobs data came out, there were multiple Fed officials, including Chair Powell, who were speaking.
They could have pushed back more clearly on what the market was expecting to sort of set the market up for the likelihood of no cuts that they were kind of reiterating that were data dependent. Well, the labor market data certainly gives them reason to continue the cuts. And my assumption is the market's assumption is that the inflation data will as well.
So assuming the Fed delivers the 25 basis point cut, the market reaction on the 18th should be relatively muted, unless there's real big surprises with what the Fed does in terms of its 2025 economic projections, the changes in its growth or inflation outlook. Or more significantly, if the dot plot for rate cuts next year, which is right now it's four, if that changes significantly, it's a good chance to get pared back to about three instead of a median number. But if it falls to two, for example, that could certainly spook the markets because it's going to be more hawkish than the markets are currently expecting.
So it's more likely what the Fed says about next year that could move the markets when they meet rather than actually not cutting 25 basis points, which looks sort of not a done deal, but we're quite likely at this point in time. Now, if we turn to the political risks I had mentioned up at the start, they span from France to Germany, South Korea and even here in the U.S. to a lesser degree. Yet, as you point out in your latest blog, title is What Risks, the markets seem to be shrugging them off.
Now, is this due to complacency or perhaps something else? Well, let's just kind of think about what's happened in the markets in the past few weeks. Two weeks ago, President-elect Trump tweeted out that he could apply 25 percent tariffs on all imports from Canada and Mexico.
The next day, the S&P 500 rose 57 basis points. So it kind of shrugged that off. In the past month, we've seen the German coalition government collapse.
And now there's a snap election on February 23rd. The French government collapsed last week after a no confidence vote. It's unclear how this will exactly play out.
Yet the Eurostox 50 index is up 3 percent since the end of October and 5 percent just in the past couple of weeks. And even Korean equities are down only 1 percent last week, despite the various political turmoil that's going on there. So why is the market kind of shrugging this off?
Well, one, they could just be, you know, kind of making a mistake. They're not going to price in improper risk premiums. But there are also some fundamental justifications for the way the market is behaving.
One is that such events that we have alluded to have not really clearly altered the trajectory for these economies in 2025 or even beyond. The threat of tariffs are not actual tariffs and post-election policy changes in 2025 will take time to have an impact. And they need not be negative for growth or inflation.
And that applies to the U.S., but also to what could happen in Germany post-election, whatever sort of comes out of what's happening in France. So right now, a lot of political noise, not necessarily changing of the economic outlook. And the second sort of fundamental factor where the markets could be somewhat different to this, at least appear complacent, is that the U.S. assets dominate global financial markets and the U.S. economy is the best position to withstand these policy risks, even if there's higher tariffs, the U.S. in some ways less impacted by them than other markets could be.
One thing that seems to be pretty clear within the U.S., but even hearing from colleagues around the world, talking to investors in Europe, London and Asia, is that investors everywhere seem to agree with the idea of sort of U.S. exceptionalism in terms of better economic outlook, more predictability and stability, better market outlook, at least conviction in that market outlook. So there could be a bit of a, quote unquote, sort of flight to safety bid for U.S. equities and bonds that could be supporting this kind of grind higher. So if the U.S. is holding up because it's somewhat immune, even if there's other risks around the world for the overall market backdrop, it actually could be somewhat insensitive to what's playing out.
That doesn't mean that this is the right approach, but this is how the markets and you can sort of justify some of what the markets are behaving and doing at this point in time, given a lot of political uncertainty around the globe. So, Jason, reading further through your blog, you also argue that the market is no longer pricing in for reflation in the U.S. What do you mean by that?
Well, so reflation is another way of describing the Trump trade. So the idea is that when you have President Trump getting elected, but also a red sweep that the replay or potential replay of 2016 is that you will get policies that lead to both higher growth and also higher inflation. I know the day after the election, November 6th, that's what you saw.
You saw interest rates go higher by quite a bit, close to 20 basis points across the curve. Inflation expectations went up significantly, the dollar rallied. Equities were up a lot, but led by more cyclical parts of the market, like whether it's financials, small cap stocks.
If you look at market pricing from November, the close of November 6th onward, though, the markets aren't pricing for reflation anymore or the Trump trade. They're pricing for what I would say is more along the lines of disinflationary growth. You know, if you look at the rates market, the 10 year yield is down 27 basis points since the 6th and more than half that 15 basis points is led by falling inflation expectations.
The S&P 500 is up 2.7% since that day, but it's been led by the MAG Magnificent 7, they're up 6%. Large cap growth stocks, probably skewed towards the MAG 7, are outperforming large cap value stocks by 5% and the Russell 2000 small cap index is up less than 1%. So the equity rotation that you would expect in reflation, that's not occurring.
And just in the past week or so, we've also seen AI related stocks, baskets of different AI kind of exposure have also kind of come rolling back quite a bit. And then the last two weeks were much of this, you know, disinflationary growth trade has taken place. You've also seen the U.S. dollar down 1.4%.
So it's a little bit surprising this is happening. It's also occurred at a time when by and large U.S. economic data has been surprising to the upside. And the Atlanta Fed's tracking estimate for fourth quarter GDP has gone up from 3.3% or it's now at 3.3% up from 2.4% at the start of this period about a month ago.
So better growth seems to be less concerned about inflation. Markets doing well, but it's not sort of for the reasons that necessarily you would have thought in a red sweep outcome. It suggests perhaps less worry about inflation risk from policies.
And it could also be other factors. It could just again be real optimism about the overall state of the U.S. economy. But it's interesting that it's a little bit maybe of also complacency on inflation risk and what the markets are price are not necessarily the theme that was evident, clearly evident on the day after the election.
So, Jason, as we begin to close out, what does this all mean for the market outlook as we begin to close out 2024 with only a few weeks remaining? Well, we know risks are either not materializing or investors not paying much attention to them. The path of least resistance is for the market rally to continue.
If we get an inflight and line inflation data this week and the Fed kind of 25 basis point next week, you know, that doesn't guarantee this rally continuing because those should be largely priced in. But generally absent negative news flow or any real news flow and a lot of volatility upward momentum in the market tends to be self-reinforcing, is supported by investors kind of chasing the rally. What it does mean is that if this keeps going, we can sort of overshoot the fundamentals at some point in Q1 and it sets up the markets for a correction in Q1.
If the data or policy fall short of expectations and the margin for error become smaller, the more stretched you become, the more any sort of negative news and the more sensitive the market becomes to any sort of disappointment on that front. And this could be what the Trump administration's policy sequencing priorities could be more negative for growth inflation than investors assume. So from day one, they could be announcing significant tariff increases in a way that the markets perhaps are assuming a more cautious or gradual sort of introduction of these tariffs.
That's one possibility. But even if the fiscal policy is relatively benign, inflation on its own could surprise to the upside. Growth may not moderate market expectations for rate cuts.
You know, instead of pricing in like two and a half to three for next year, it could actually end up being whittled down to as low as one that could cause rates to go higher. This scenario right now, the market's not kind of in a pricing form. That ultimately still is kind of more early in the year, sort of potential correction and pullback after really strong performance in 2024 and ending the year and looks like a high note.
But overall, if we take a 12 month perspective, we think there are more to go to equities, but it won't be a smooth path. It'll be bumpy before we get to what we think will be the price target of 6600 on the S&P 12 months from now. As I noted, tech stocks and AI have actually done well in the past couple of weeks.
You're seeing sort of a sign of that sort of theme resuming after being kind of drifting sideways for a few months. So that's something that we kind of continue to like. And then on fixed income, you know, the recommendation we have is to still kind of focus on the intermediate or the belly part of the curve.
You're looking at five year duration, five to seven years of maturity overall. But the idea that if growth is elevated, if inflation doesn't come down, there's certainly a real risk that rates could go higher. And if they back up, the more interest rate risk you're taking, the longer duration, the more you're exposed to that.
So rather than taking a lot of interest rate risk, we expect you or recommend you to position for a lower rate, but by only taking a modest amount of incremental alteration around the intermediate part of the curve, up in quality. If equities could correct in Q1, so could, you know, riskier credit as well. That's probably a better reentry point, but that's the outlook right now.
Well, Jason, as always, a very productive and insightful conversation. Thank you for spending some time this morning with our listeners and their clients to keep them current on CIO's market views, as well as guidance when it comes to asset allocation, and do look forward to picking back up with our conversation in the week ahead. You're welcome.
Have a great week. Thank you, Jason. You as well.
Again, today we've been joined by Jason Draho, head of asset allocation for the Americas with the UBS chief investment office. Again, I would like to point you, our listeners, our clients to Jason's latest blog, a title is what risks, which is now available up on UBS.com forward slash CIO for clients of UBS, simply reach out to your UBS financial advisor. If you would like to receive a copy of Jason's latest blog directly from UBS studios, I'm Dan Cassidy.
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