Top of the Morning: CIO Strategy Snapshot - The trend is your friend
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Hi, everyone. Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. We are back with the CIO Strategy Snapshot coming to you today from our 1285 podcast studio here in New York. Joining me here at the table, glad to welcome Head of Asset Allocation for the Americas with the UBS Chief Investment Office, Jason Draho, joining us on a Monday morning. Jason, great to be with you today in person. Welcome back.

Thank you, Dan. Good to be here. It's fulfilling one of my work resolutions. We'll do this in person more often. I think I can sustain this one and some other resolutions, hopefully. And I know our listeners will appreciate the enhanced audio quality as well. So that's something else great that we can bring to them here in 2025. Our gift.

for 2025 is better audio. Yes, absolutely. So Jason, I know the markets have had a choppy start to 2025 as investors are dealing with rising rates. This due to better than expected economic data as well as policy uncertainty. So let's begin by diving into some recent economic

data beginning with the December employment report. This came out this past Friday. Data came in better than what was expected. So, Jason, can you speak a bit to the key details from the report? And what does this round of labor data say about the state of the U.S. economy overall? Well, the jobs report was strong kind of across the board. Sometimes we've gotten mixed data points in recent months, but pretty consistently across all the different aspects of the report, it was solid above expectations.

So starting with the actual headline number of...

of, you know, non-farm payrolls. It came in at $256,000. The consensus forecast was $165,000, so a substantial beat there. There was a small downward revision, about $8,000 in the prior two months, but by and large, like that, you know, stayed the same. The private sector kind of payrolls, so not, you know, excluding government, about $225,000. So this wasn't just a case of, you know, jobs in healthcare, jobs in the government. This was the private sector, you know, creating a significant number of jobs.

The unemployment rate ticked down on a rounded basis from 4.2% to 4.1%. Consensus was that it would stay about the same, maybe even tick a little bit higher. So that was a positive development. The jobs number, the 256,000, that comes from the establishment survey that surveys businesses, basically assessing how many new jobs do you have.

The unemployment rate is based off of a household survey where you ask individuals, are you employed or not? For a number of years, like the past couple of years, there's been sort of a divergence. The establishment business survey has shown much stronger numbers than the household survey. Well, this past month in December, the household survey, you know, the jobs increased 478,000. So like a big number after actually being kind of flat or even down prior months. So again, that was a weak point before. That was no longer kind of a weak point. And then the underemployment rate, this is –

You add in people who are unemployed, but also maybe you're not working as much as they would like. It's kind of the U3 measure. That fell to 7.5%, the lowest since last June. It had ticked up to 7.8%. So again, a sign that people are being pulled back a little bit into the labor force.

But if you add on also like the Jolt's data last week, things like the quit rate and the hiring rate, they also moved a little bit lower. So what you see is a strong job market, but it's also the case that the flow of people coming in and out is relatively modest. Companies aren't laying off workers. Hiring by and large, though, the hiring rate is still relatively modest. And the quit rate, people aren't kind of quitting their jobs anymore. But all in a very strong kind of labor market report.

You add that to other data we've gotten thus far this year, such as the ISM manufacturing and the services. You know, data came in a little bit better than expectations.

We don't have official retail sales or consumer spending data for December, but more data on credit card spending, companies reporting on how their holiday sales went, suggests that holiday spending or Christmas holiday shopping was at or better than expected. So we'll start getting data later this week on that. But all told, the economy has good momentum at the start of the year.

The Atlanta Fed GDP tracking estimate for Q4, you know, had dipped down to about 2.4%. It's back up to 2.7%. So that's certainly a solid number. If we think back to like last summer, there were growth concerns. Yes, the economy is slowing down. Those growth concerns are certainly increasing.

have abated, have, you know, the economy is, you know, growing strongly. There's even, you know, some argument that perhaps if there was a bit of a slowdown last summer, the economy is re-accelerating, which kind of leads into other concerns about could inflation also, you know, re-accelerate. And we will get the December CPI data on Wednesday and the PPI data on Tuesday to give us a glimpse of like where is that trend in. Is it also, you know, holding steady coming down or could we see the actually the economy heating up more?

you know, as we enter 2025. So the inflation data will be a big point of interest this week, though a consequence or a byproduct of good economic data, Jason, of course, being rising interest rates, which we have seen a lot in recent weeks. So how do you interpret the rate rise? And what is CIO's outlook for rates from here? Well, let's start with the 10-year treasury, because I think that's the focal point. And think of it of two different horizons.

If we go back to September 16th, that was the FOMC meeting when they cut 50 basis points. Since that time, in about three and a half months, the 10-year treasury yield has gone up from 3.61% to, as of this morning, 4.76%. So you're looking at a 115 basis point increase. That rise following the first Fed rate cut is highly unusual. Maybe it rises a little bit, but certainly not this magnitude.

If you actually just go back a little more than a month to December 6th, the 10-year was at 4.15%. So 60 basis points just in just a little bit over a month. So half of that rise, more than half that rise since September has really been over the past month.

If you then start to decompose, like what is driving this rise higher, the bulk of it, about 75% and literally around like 75, 80 basis points of the rise is due to higher real interest rates, like a higher 10-year real interest rate. The remaining is inflation expectations going higher.

Why are real interest rates rising? Well, because growth is good and we just spent a few minutes discussing the strength of the U.S. economy, especially last summer when there was these growth concerns. Those have been evaded. The U.S. economy is doing strongly. As a result, expectations for Fed rate cuts have also been dialed back. And if we just think of...

where we were, you know, pre-jobs report. We are down now down to just over one cut to the market is pricing, you know, for this year. But if we go even back to December, you know, the market's pricing, the Fed funds rate for this December, about 40 basis higher than it was in early December. So again, you're taking out a fair amount of kind of rate cuts as the market's pricing. Unless you literally see sort of almost like a parallel shift in the, you know, the, the 10 year along with what the market pricing for Fed funds rate is.

There's also another factor that's sort of driving this, and this is the term premium. So the term premium is essentially compensation that investors get for buying, say, a 10-year bond versus a 2-year bond because you have interest rate risk going forward. This has been very low for a long period of time, for a number of years. It's been rising, but it's also kind of rising because the concerns about the very large deficits are

People have to buy a lot of, you know, investors have to buy huge amounts of treasury supply. With the Trump 2.0 administration concerns that deficits will be even larger if they try to cut taxes without reducing spending significantly. So big supply of treasuries. Investors looking forward say, well, how do they deal with this debt problem? Maybe they try to have high inflation. Therefore, I need a higher premium. So there's a little bit of that kind of going on as well.

The challenge of trying to estimate a term premium is that you can't actually measure it. You can only use models to back it up. But these are all the dynamics going on. What it's suggesting by and large is that the rates are going higher because the economy is strong. That could lead to a little bit higher inflation. And then there is this lingering concern about the supply of treasuries. So that's the 10-year. The 2-year hasn't moved as much because ultimately Fed expectations haven't shifted quite as much. I mean, we still expect the Fed to cut. So the question is where do rates go from here?

They certainly could go higher. As they sell off, it could continue. There's systematic strategies where investors could choose to have a bit of a buyer strike or just sell. And depending on the inflation date, if it comes in hot, you could certainly see another move higher in the 10-year yield. And once that goes, it tends to kind of accelerate. So easily we could get to a 5% 10-year, similar to what happened back in October of 2023, so roughly 15 months ago. But it's unlikely to stay there, in part because...

For investors, that becomes a pretty attractive yield to be able to lock in at 5%. If rates go higher but you have much more cushion in terms of your interest payments are 5% a year, the 10-year has to get up about 6% before you lose that return. And of course, if yields decline, well, you get a really nice total return when yields decline plus that kind of carry rate.

So we don't expect them to go much higher, but they certainly can kind of chop around, you know, for the time being. And it's really going to depend on the data going forward. But ultimately, we think between now and year end, rates go lower. But in the very near term, the next couple of weeks, depending on the inflation data, depending on what the Trump administration announces, how the market perceives that in terms of supply, in terms of inflationary aspects, that's going to depend on the data.

you could see yields go higher. So we're a little bit cautious on recommending extending duration at this time. But ultimately, we expect them to go lower. Near-term, they certainly could go higher. So with respect to the market impact, I mentioned at the top, we've witnessed some choppiness as of late. We did have that selling pressure this past Friday in equities. So what does this combination of good economic data and higher rates mean for the markets near-term?

Is it a net positive or negative? And at what combination does it perhaps flip? Well, I'd say for equities overall, ultimately this isn't still going to be a net positive when we think of the full year.

You know, good growth data is not a bad thing. And if you have, it means a little bit higher inflation, all is equal. Then you have higher normal GDP. That should translate into, you know, higher revenues, higher earnings for companies. You know, in some way that they should be able to pass, you know, these kind of the strong growth and higher prices, higher inflation, higher input costs onto consumers. So ultimately, a good thing.

But if we just sort of isolate the impact of higher interest rates, you know, all equal evaluations just you should have a lower valuation. So it sort of nets off to some extent. So higher earnings on the one hand, higher rates on the other. On net, we're saying that it's a positive.

But in terms of higher rates, it's not just a level that matters. It's also the speed at which you get there. So anytime you have a big movement rate, and we discussed just in the past month or so, you had the 10-year go up 60 basis points. That's a lot for the equity markets to digest. So seeing some pullback, it's not surprising. This is consistent with historical patterns. There's a lot of focus on the 5% level for the 10-year. That's a pit-like level if you breach that. Equities have real trouble there.

I think ultimately equities are kind of a real asset class. They can kind of adjust for inflation. Therefore, you should look at the real interest rate. And if we go back the past year and a half, anytime the 10-year real rate has gotten above 2%, you start to see equities wobble a bit. If they get up around 2.1, 2.2, you actually see some pullback. It depends on why. If it's because the Fed has to hike more because inflation is hot, that's worse. Versus if it's high because growth is good, it's been able to kind of manage it.

Right now, the 10-year real rate is 2.3%. So it gives some perspective, like it's not surprising on that level that you'd see the equity markets pull back a few percentage points from their all-time high. But another way to look at the equity market performance last week is that the things that were hit the hardest, or you could say were the bond proxies, more defensive sectors versus cyclicals, these tend to be, again, going to be more adversely affected by higher rates just from a valuation perspective. They don't have the growth story. The fact that cyclicals did reasonably well

and materials and energy are actually one of the two best performance sectors, suggest investors and equities are not worried so much about growth. They're just trying to kind of reprice in kind of these higher rates, the implications of higher rates. So, so far, it's, again, being able to digest it, sort of adjusting to it. And then big picture, it should be net positive. But just from a market perspective overall, given as it's trying to adapt to these maybe shifting economic views that people had,

And then we also have the uncertainty of the policies coming from the Trump administration was to start to be announced, you know, just over a week after the inauguration, you know, next Monday. Given where the valuations are and assets like equities, even credit, they're certainly not cheap. There's uncertainty about the inflation impact of Trump 2.0 policies. There's really kind of little margin for error to be above expectations. So you actually don't want things from the market's perspective to be, you know, too hot, whether it's growth or inflation. Yeah.

So I think we can see higher inflation as the data comes in, as the policy announcements take place, or at least expectations for what the policy could be. So a reasonable template for kind of volatility. It's a little bit like what happened in 2018 and 2019 when you'd see, you know, a little bit bigger sell-offs. You know, volatility was higher than it was in 2017. It was incredibly low. Last year, volatility was relatively low. I think we could see, you know, volatility kind of jump up again. But ultimately, over 2018, 2019, volatility,

The total return for the S&P was over 20%. So a CAGR of roughly 10%, which is kind of what we're forecasting for the S&P. But the path together certainly was not easy. If you kind of recall, 2018 in particular was a difficult end to the year.

How we in the near term kind of evolve is going to probably depend a lot on the CPI data. If it comes in hot, you could see rates going higher. You could see equity suffer more. If it ends up being a little bit on the soft side, it could sort of stop this kind of sell-off that we're seeing in financial classes, stop the dollar rise, which has been pretty relentless for the past couple of weeks.

And then, of course, we get the policy news next week, how the market's going to react to all that, especially on immigration and on the tariffs front. So big picture, still fundamentally positive. But something that we talked about last week is markets likely to be kind of range-bound, volatile, swinging based on policy. A lot of wait and see. A lot of wait and see. But ultimately, dips, I think, will be bought. So anything where the market pulls back –

high single digits, so the S&P in a 55 to 5,600 range, you'll probably see investors come in because they'll say, well, now the valuation is a little more attractive. I still think the growth outlook is going to be favorable. This is a good kind of reentry point. So I think there'll be some resistance for a bigger sell-off, but momentum could easily take us to those levels. If the data and the policy announcements in the next

Two weeks end up being market unfriendly, at least as a first blush. So against this backdrop, Jason, as investors are recalibrating expectations when it comes to rates, waiting for some of this policy clarity to come through within a week, two weeks, what should investors be doing in their portfolios at this moment? Well, our core messages haven't changed. So there are more to go in equities. We still definitely believe that for all the reasons I just mentioned.

you lay it out. And so if, if you're looking to put capital to work as the markets pull back, these become good entry points, you know, especially as you're having conversations with clients, you know, kind of early in the year, uh, within sort of the sectors, we still like the tech sector, you know, the AI theme has a lot of runway. If anything, it's going to probably be also another volatile year within that space. Uh,

And momentum seems to be building, at least as a narrative, that this will be a year of going from AI infrastructure to data centers. That will continue, but a lot of focus on AI adoption, these AI agents, and sort of kind of broadening out the AI theme a little bit. So a lot of opportunities there. That's another area that can look attractive.

within fixed income. You know, I mentioned that, you know, rates in the near term could go higher. Something we've been recommending for a couple of months is kind of looking at about the five-year point or the five-year duration. We did that post-election, in hindsight, a little bit early. But, you know, thinking about where would you want to add some exposure, still find that attractive at these levels. So,

They're not going to be as sensitive if rates go higher. It's harder for the five-year to go much higher unless you really start to reprice in what the Fed does, meaning not just pricing out cuts, but even the possibility of hikes, whereas the back end of the curve can certainly move around more. So it's a little bit of the risk-worth. It's more compelling. I think that's still the intermediate part of it.

At some point, I just also want to mention our kind of Fed expectations have not changed in result of the jobs data, the strong data that I alluded to earlier. We're still looking at two cuts this year, June and September. Market pricing is basically not one until December.

But for the Fed to cut, it actually needs weaker economic data, lower job growth, lower inflation for them to cut. Otherwise, it's hard for them to justify cutting rates if inflation is still above 2% and we're still producing 170,000 jobs per month on average, which has been the case for the last six months overall. So just a point of clarity in terms of where rates could go and why we'd stick with the five-year duration perspective. Yeah.

Credit spreads haven't actually widened that much. They've been stayed pretty tight, again, sort of based on good economic fundamentals. Don't feel like this is a compelling risk reward tradeoff for a lot of credit, but rather have the upside for equities. So stay up in quality overall, excuse me, in fixed income. And the last thing is gold as a kind of a hedge to this whole macro kind of environment.

It's chopped around, been somewhat sideways recently. But if growth stays strong, inflation stays strong, and that looks like it's going to be, independent of the policies, that looks like it's going to be the regime going forward. Gold, we think, has more sort of fundamental upside as well. It certainly is more of a portfolio hedge.

Jason, thank you for the guidance when it comes to positioning and for helping us make sense of this recent market movement. I know next week we will likely speak on Tuesday as markets will be closed for Martin Luther King Jr. Day. And at that point on Tuesday, we will have a new administration. So perhaps some more clarity when it comes to policy. We will have witnessed the inflation print. So plenty to talk about next week. Looking forward to it.

There will definitely be things to talk about next Tuesday morning. Just in terms of the administration itself could have a flurry of executive orders for us to and for the markets overall to try and digest. Well, Jason, thank you for dropping by on this Monday morning to kick off another week. And do you look forward to picking back up with our conversation in the week ahead?

Looking forward to it. Have a great week. You as well. Thank you, Jason. Again, today we have been joined by Jason Draho, the head of asset allocation for the Americas with the UBS Chief Investment Office. Before we close out, I would like to highlight for you Jason's recent blog. Title is The Trend is Your Friend, which is now available up on ubs.com forward slash CIO. For clients of UBS, be sure to 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. Thank you for joining us.

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