UBS CIO: “We think volatility is likely to remain high in the near term”

We think volatility is likely to remain high in the near term, and that the Fed is likely to cut interest rates more quickly.

But we believe recession fears are overdone, and that investors should focus on deploying cash in quality fixed income, tilting equity allocations toward “quality” stocks, and diversifying portfolios across asset classes, including with gold and the Swiss franc.

As noted in UBS CIO Daily - Market scenarios from here (UBS Global Wealth Management), while US economic data has been softer than expected for several months, Friday, 2 August’s employment data appears to have triggered a mood change in the market.

The report contained significant downside surprises, with nonfarm payrolls increasing by only 114,000 and the unemployment rate rising to 4.3%, up from 4.1% in the prior month and from a low of 3.4% as recently as May 2023.

Notably, the speed of the rise in unemployment gained particular attention, as it triggered the Sahm rule, by which since 1960 a recession has begun every time the three-month average unemployment rate rose over 50bps from its low in the prior 12 months.

Our base case

In our view, despite the weaker payroll data, recession risks remain low. Our base case is for a soft landing for the US economy, with growth bottoming slightly below the 2% trend, and further moderation in inflation.

We believe investor concerns about a recession are overdone for several reasons:

• It can be a mistake to read too much into a single data release. It is

possible that the weakness of the July jobs report was accentuated by

Hurricane Beryl. The number of people who reported being unable to

work owing to the weather was 436,000, compared to an average of

33,000 for July since 2000.

• The Sahm rule, which suggests that the rate of increase in

unemployment is a harbinger of recession, looks questionable under

current circumstances, in our view. With total nonfarm employment

increasing by 2.5mn over the past year, we believe the higher

unemployment rate is mainly due to a larger labor supply, rather than

job shedding. Initial jobless claims—an indicator of labor demand—are

still low by historical levels.

• While earnings commentary suggested some slowdown in advertising,

auto, industrials, and software, profit margins remain solid, suggesting

that companies have little reason to commence job cuts. S&P 500

companies are on pace to grow earnings per share 11% in 2024.

• Consumers and consumer spending are still in decent shape. June retail

sales and personal consumption expenditure data suggest spending

is normalizing from an elevated level, not deteriorating. Moreover,

households are in good financial shape overall, with positive real income

growth and average debt servicing costs that remain low relative to

historical averages.

• Services sentiment is positive. The Institute for Supply Management

(ISM) reported that its nonmanufacturing purchasing managers’ index

(PMI) rebounded in July to 51.4, with a jump in new orders and an

increase in employment for the first time in six months.

• The Federal Reserve has plenty of scope to support the economy and

markets. Recent data has improved confidence that inflation is headed

sustainably back toward the 2% target, freeing the Fed to focus more

attention on supporting growth and employment. At last week’s

policy meeting, Powell repeated that the Fed would be “watching very

carefully” for signs of a sharp downturn in the labor market. We now

believe the Fed will likely start the easing cycle with a 50-basis point cut

Daily Europe at the September meeting, with a further 50 basis points of easing in

the remainder of 2024, and more to follow in 2025.

• The promise of AI remains intact. Investors appear to have swung from

rewarding companies for fast-rising capital spending, to becoming

impatient with the pace of monetization. Yet the second quarter

earnings season has continued to suggest top tech companies are

confident that spending on AI infrastructure will deliver a high

return. We have also been encouraged by anecdotal evidence that AI

monetization is picking up.

• A further escalation of the Middle East conflict can still be avoided.

Risks in the region have increased in recent weeks, and an attack on

Israel from Iran and Hezbollah now looks imminent, according to US

Secretary of State Antony Blinken. However, recent history suggests

Israel will opt for a measured response, as it did following an Iranian

drone and missile launch in April.

• The US election campaign could be a further source of volatility. Vice

President Kamala Harris has continued to build momentum in her

race for the White House. An average of national polls on Friday

indicated that Harris has support of 45% of Americans versus 43.5%

for Trump, according to 538, the opinion analysis website—within the

1.5-percentage-point band of uncertainty. This suggests that Harris

has closed the lead that former President Trump had built up over

President Biden, who dropped out of the race last month. A blue wave,

in which the Democratic Party claims control of both the White House

and Congress, is not our base case. But such an outcome might lead to

an increase in capital gains and corporate taxes, which could lead some

investors to harvest capital gains before such a move.

• With the latest drop in the USDJPY to 142, we estimate the market will

have unwound the bulk of its net-short yen positions. This is not the full

story when it comes to yen strength, but it could at least limit the risk of

a currency-linked pain trade that fed into Monday's global risk sell-off.

What would happen to markets in such a scenario?

• Equities: While markets are likely to remain volatile in the near term,

we expect concerns about growth to ultimately prove unfounded. And

investors should remember that Fed rate cuts in prior episodes that did

not result in recession have typically been followed by strong equity

market returns, with the S&P 500 rising by 17% on average after the

first Fed rate cut. More than 75% of the S&P 500 market cap has now

reported 2Q earnings. We have seen some softening in earnings data,

but not so much as to change our profit growth outlook. Corporate

profits are likely to grow by 11-12% in 2Q on a year-over-year basis,

at the higher end of with our initial estimate. While the breadth of

earnings beats is in line with historical averages, the magnitude of the

beats are a bit below normal. Our base case year-end and June 2025

S&P 500 price targets remain 5,900 and 6,200, respectively. We expect

11% S&P 500 earnings growth in 2024 (USD 250) and 8% growth in

2025 (USD 270).

• Bonds: Fixed income markets are also likely to remain volatile, and a

further rally in high-quality bonds (and declines in US 10-year yields)

is possible in the near term should recession concerns persist, and the

unwinding of carry trade positions continues. That said, if future data

demonstrates the US remains on course for a soft landing, as we expect

in our base case, then we would expect yields to settle in the 3.5-4.0%

range by the end of the year. From a portfolio perspective, we continue

to believe investors should deploy excess cash into high-quality fixed

income, which can help cushion overall portfolios against heightened

fears of recession.

What could trigger a downside scenario?

Of course, we do also need to consider the possibility that things could

turn out worse than in our base case. This could happen by a variety of

mechanisms:

• Future data demonstrates that jobs are being shed, adding to evidence

that Fed policy has been too tight for too long. As more Americans

become fearful about losing their job, they could cut back spending to

build up precautionary savings.

• AI investment slows. AI investment has been driving both the fortunes

of chipmakers, notably Nvidia, and the cloud operations of the likes

of Microsoft, Amazon, and Alphabet. If top tech companies start

announcing that they are scaling back capital spending plans, we

would be concerned about earnings sustainability. We would also be

discouraged by a slowing in the growth of cloud revenues. Finally,

disappointments on expected advances in chip technology could also

trigger downside for tech stocks.

• A miscalculation by either Israel or Iran leads to a significant escalation

in the Middle East, leading to higher global risk premia, as investors fear

potential disruptions to oil supplies.

In such a scenario, we would expect global growth to fall sharply owing

to weakness in consumer spending and labor markets, as well as a fall

in AI-related investments. In response, we would expect central banks

to cut rates swiftly, bringing monetary policy back into accommodative

territory. The Fed would likely reduce rates well below the neutral policy

rate, which we currently estimate to be around 3%.

What would happen to equity and bond markets in such a scenario?

• Equities: We see the S&P 500 falling to around 4,200 in our hard

landing scenario driven by cuts to profit growth expectations and a

reduction in valuation multiples.

• Bonds: A hard landing would prompt an aggressive Fed cutting cycle, in

our view. In this scenario we would expect the 10-year US Treasury yield

to finish 2024 at 2.5%. In addition to gains for high-quality bonds, we

would expect appreciation in other relatively safe-haven assets such as

gold, the Swiss franc, and the Japanese yen.

Recommendations

Throughout 2024 we have reiterated the theme of “quality,” in both bonds and equities. With recession fears rising, quality remains a key theme. In fixed income, we would expect quality bonds to deliver positive total returns in our base case, and they could rally even further if recessionary fears continue to mount.

With cash interest rates likely to fall more quickly than we had previously expected, it remains important in our view for investors to deploy excess cash into medium-duration quality fixed income. In equities, quality is an investment style that has historically outperformed as whole, but with the highest relative returns during recessions. Since 1992, quality stocks have delivered 9% annualized outperformance over global indices during recessions. (MSCI ACWI quality index versus MSCI ACWI).

Companies with strong balance sheets and a track record of earnings growth, as well as those that are exposed to structural growth drivers, should be relatively well positioned if cyclical fears mount. Elsewhere, we continue to like gold and the Swiss franc. The cost of direct hedging on equity markets has risen in recent days. As such, diversification with quality bonds, gold, and the Swiss franc is an important way for investors to insulate portfolios against further equity market volatility.

Switzerland looks closer to the end of its policy easing cycle than most other central banks, and we would expect gold to benefit from central bank reserve diversification, investors seeking relative ”safe havens’” and anticipation of faster interest rate cuts. While the yen is often a safe haven play, we remain cautious on taking yen loans or buying the dip in USDJPY until global risk sentiment stabilizes.

Mark Haefele, Chief Investment Officer, UBS Global Wealth Management