Top of the Morning: CIO Strategy Snapshot - Start of the summer
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Hi everyone, Dan Cassidy here. Welcome back to Top of the Morning on the UBS Market Moves podcast channel. We just passed the official start of summer and it's likely to be an eventful one for investors already shaping up to be the case. We did witness over the weekend the U.S. launched airstrikes on Iran's nuclear facilities.

In addition to that, policy developments on tariffs and taxes, the potential impact of tariffs on the economy, and corporate earnings will keep investors preoccupied. So joining us today to discuss this all, glad to welcome back in studio Jason Draho, Head of Asset Allocation,

for the Americas with the UBS Chief Investment Office. Jason, even though it's starting to feel like summer outside, we're not exactly getting that summer slowdown in the markets, right? Well, good morning. Happy Monday. And you're right, it's the start of summer. And of course, it goes into the upper 90s in New York City, where it's kind of all so humid. Thankfully, the office or the studio is nicely cooled to keep the equipment comfortable. Definitely. So yeah, lots of things. It's not going to be quite summer. I think it's something where...

Unlike other years, it feels like there's a whole litany of things that investors have to at least monitor. And with that, Jason, perhaps let's begin with the top story at the moment. And we are continuing to track this very closely, starting with the U.S. military action against Iran that took place over the weekend. What is the chief investment office, Jason, tracking to monitor the situation? And what do you expect from here? Well, certainly at the moment, we know the U.S. launched military strikes targeting Iran's key nuclear facilities.

I think what's still being assessed is, you know, how much damage was done, you know, what, and then also, like, you know, where do we go from here? The two key things that, you know, we're going to be monitoring is, you know, the focus shifts to how Iran...

retaliates and whether energy supplies from the region are disrupting, the two key questions that we have are will the energy exports from the Middle East overall, not just Iran, be interrupted, but also through the Strait of Hormuz, and then also will other major countries intervene? So on the first topic of sort of retaliatory actions by

Iran, certainly it's a clear risk, right? They could attack U.S. bases in the region. They could attack U.S. allies. They could try to damage energy infrastructure to cause oil prices to go higher, which would be negative for certainly for the U.S. economy, at least more directly negative, and certainly for the global economy overall. They could do this also by threatening maritime traffic through the Strait of Hormuz. That's a possibility.

Now, having said that, it's also kind of relatively clear that Iran's military capabilities have been significantly damaged by the air campaign, not just by U.S. actions, but also by Israel over the course of the past now about 10 days. Iran's military and Navy likely won't be able to resist a combined to the U.S. and Iran forces for that long. So they could retaliate, but there's limits to what they can do.

In terms of other countries getting involved, Russia is one or even China, but both have a relatively muted response. Russia would certainly stand to benefit if the price of oil went higher. As a major oil producer, it would help fund their own government and maybe give them a

economically a stronger hand as they continue to perpetuate the war in Ukraine. However, ultimately, we don't think this is kind of in Russia's interest to want to get involved. They have their own sort of issues with Ukraine. They would stretch it further. They don't want to perhaps give the U.S. reasons to then and President Trump to up the stakes by imposing stricter sanctions or other actions supporting Ukraine. So all that suggests those two issues are

Disruptions to oil, other countries are going to involve certainly risks, but we think those would not be part of our base case. The main conduit ultimately for many action in the Middle East comes down to oil and the supply and the further price of oil. That's how it impacts the global economy. That's how it's going to impact broader financial markets.

And it's interesting that this morning the price of oil went up $4 sort of overnight. And then actually now as we speak, it's basically flat. Now it did rally quite a bit leading up to this in anticipation. Right. Or at least the moment Israel launched attacks, then the thought was, well, there's a risk premium that we need to build into the market, including the possibility of extra U.S. airstrikes.

In order for oil prices to go really kind of sustainably higher, a couple things probably have to happen. One is that there needs to be actual physical damage to the region's energy infrastructure. That would ultimately kind of push oil, you know, say towards $100 a barrel. Like there has to be physically some sort of constrained supply.

Another factor is there could be an internal power struggle in Iran that would lead to sort of supply disruptions, similar to what happened back in the Iranian revolution in 1979 or Libya during the Arab Spring of 2011. So again, new possibilities, but that's what will really kind of have to happen. Thus far, it's just the market's response. If oil keeps flowing and there's no real sort of damage to supplies, then oil kind of stays where it is. It's pricing in.

a reasonable escalation from here, but not outright supply damages. So that's why I think you're seeing overall the markets take it somewhat in stride. And Jason, despite unknowns with respect to how this might all develop from here, as you mentioned, market pricing, as we're recording on Monday morning around 9.15 Eastern, I

fairly muted. In fact, U.S. equity futures have turned now slightly positive leading up to the market open in about 15 minutes. How do you interpret this reaction? Well, so oil rose and now it's flat. The S&P futures lower, but then now they're basically flat as we're recording.

Treasury yields are down a little bit, but not significantly, like a few basis points across the curve. So a little bit of flight to safety, but not entirely because if you look at traditional safe-haven currencies like the Japanese yen or the Swiss franc, the yen is actually a little bit lower. The Swiss franc also against the dollar a little bit lower. The dollar overall is up a little bit sort of.

indicative at least for the moment of a sort of the safe haven status. But if you looked at this price action, didn't know what happened over the course of the weekend, you'd think, all right, it's a Monday morning, early summer, people have gone away for vacation, we're not seeing a lot of activity. And that's kind of interesting.

But it was sort of consistent with, you know, you could say the muted response by Iran so far, and whether there will be a significant response or not, that time will tell. But that's what the markets are perhaps saying is that a measured response or something that would be telegraphed by Iran in some way is signaling that, you know, we don't want this escalated. Perhaps we don't want to negotiate. So it's at least consistent with that. That could prove to be, of course, the wrong assumption.

The muted market response, I think, is also consistent with the view that, you know, Iran doesn't want oil supplies to be disruptive because it actually needs the money, you know, given other problems domestically they have going on with, you know, it's been a difficult economic environment for Iran for a number of years. So they may not want to have that goal escalate. So you could have skirmishes and fighting and missiles launched back and forth. But in terms of the global economy, this may not, you know, ultimately kind of matter that much. And we've seen this, you know, in the past, which is,

The market response being muted is consistent with the market's response being muted to past escalations and tensions in the Middle East. Even if we go back to October 7th, almost two years ago, markets sold off and then within weeks we're already kind of rallying to all kinds of highs even though there was a risk of escalation back then. And so ultimately, it sort of comes back to

You know, putting a probability on what happens in the Middle East at this point in time, what happens with Iran's response is very difficult. What we can try and do is calibrate, well, if they do respond, what are the consequences for the U.S. and global economy? And unless there is a real disruption of oil, and there's not a strong incentive for that to happen, then the impact is relatively modest. So it is...

The market response is logical. It's still sort of surprising when you think of what happened over the course of the weekend. You think this could be, you know, triggering another broader regional war. So the market's just going to shrug it off. It's...

It is noteworthy at this point in time, but not sort of unexpected given the facts we have on the ground. So, Jason, this segues into the market set up at the start of the summer with so many factors for investors to closely monitor. I'm curious, is there a ranking order, so to speak? Is there anything in particular that you feel investors should watch out for most closely? Well, we continue to obviously monitor the situation in the Middle East and how that plays out, along with other geopolitical consequences.

This is going to have knock-on effects for what's going on in Ukraine and how that evolves over time. Same thing with geopolitical matters with China and issues there.

Putting that aside, I wouldn't say there's a rank order of things, but just maybe, you know, at the top of my mind, which perhaps is implicitly a sign of my order of importance, is thinking about sort of the economy overall, because ultimately it sort of comes down to what is the fundamental picture, and then anything that happens that you can sort of contextualize it in the context of does this make the economic outlook look better or worse for whatever reason. So in terms of the economy, I think where, you know, the markets where investors are really focused is

What are the consequences of tariffs that have already been put in place continue to be put in, you know, increased and stay in place? The expectation is that, at least from a sequencing perspective, that the real kind of consequence for inflation probably won't become apparent until the July data that comes out roughly in mid-August with sort of the peak level of month-over-month increases in inflation at some point in the fourth quarter before it starts to kind of moderate. Year-over-year effects can continue to rise well into next year.

After that, you look for a slowdown in economic activity. Growth was slow, consumption was slow, the labor market was slow. That would come after the inflation increase. And then the logic behind that is you need a negative kind of real income shock because inflation goes higher due to the tariffs.

That hit to real income means people consume less. That slows the economy. That means job growth kind of slows. So there's a sequencing of that. So that's kind of what I would be monitoring there, how that data actually plays out. Because thus far, it's not really evident yet in the data, the inflation data of a real impact. On domestic policy, certainly the situation with tariffs and how that plays out. We are now just under two weeks away, or maybe exactly two weeks away from inflation.

The 90-day reprieve on the reciprocal tariffs that was announced back on April 9th, that would expire by July 8th. And so what happens then? It's only one sort of deal, kind of in quotes, framework between the U.S. and the U.K. So not a lot of time to get progress there. A lot of hope at the G7 that we'd hear more on that front. We'd hear more, and of course that became sort of a...

Once President Trump left, then that became sort of a secondary or at least kind of definitely a back burner issue at the moment. There's the question about the one big beautiful bill that works its way through Congress. It should be coming out of Senate committee this week.

There is certainly momentum that it could be passed potentially by July 4th, or at least it looks like it's all still on track to be able to be passed at some point in July. But that is something that's kind of worth watching. And then as we get into July, mid-July, that's when second quarter earnings season starts. So again, looking sort of for further guidance of like how are tariffs impacting companies. In Q1, they hadn't really been put in place yet. Now by Q2, it has been sort of disruptive. Do we see impact on...

revenue, margins, sales, and projections from companies going forward. So a lot coming down the pike that could move markets. Sticking with markets for a few more moments, just given the market's response to the U.S.-Iran news over this past weekend, I'm curious, Jason, what do you think would actually move the markets more significantly, or do they keep grinding higher from here? Well, if we look at the price action this Monday morning,

despite the rationality for why it's not surprising that the markets have been sort of shrugging their shoulders. But it is consistent with, you know, if this can't sort of stop the markets, you know, from moving higher, causing a significant pullback, you know, what would? If we also look at the price action just last week, which is kind of a holiday-shortened week with Thursday being a holiday, so definitely lighter trading activity on Wednesday and Thursday, Friday, so take it with kind of a grain of salt. But for the week, the S&P 500 was down 0.15%.

But the Russell 2000 small cap index was up 0.4%. And for the month of June, the small cap index is up 2% roughly, and the S&P is up 1%. And this is despite rising geopolitical risks, higher oil prices that are up 20% during the course of the month. These things should be weighing on cyclical assets, and yet small caps have been doing better.

So it is suggesting even if the S&P hasn't sort of broken out to all-time new highs, there's this broadening of risk and sort of people wanting to take almost more risk, you know, kind of small caps or emblematic of that, consistent with the market sort of grinding a little bit higher. You know, will this continue or not? You know, this is, on a very technical basis, it's hard to make these predictions, but it does provide the moment, the path of least resistances for the markets to keep grinding higher until some kind of material risk event happens. So really the kind of, to me, the question then is,

what would cause the markets to have kind of a real hiccup. So if we go to kind of the growth data that I mentioned, it's widely expected that because of tariffs, that inflation will go higher and growth will slow. So if we see data moving in that direction, and it's not really surprising, this is sort of what we anticipate. It's like the pilot coming on the plane saying, we're going to hit some turbulence coming up. So when the bombs hit, you're not completely caught off guard.

The question is whether turbulence is mild or actually causes a real problem or not. And so I think, you know, a mild turbulence is okay. But if we think of inflation and the sequence that I mentioned, if investors sort of become somewhat complacent because the inflation data has been relatively contained thus far, you can

surprising to the downside for the May data that if they get complacent and all of a sudden we get the July or August data and it's 0.5 or 0.6 month or a month largely due to tariffs, suddenly this might be like kind of jolt investors. We're actually seeing this. We're now in the eye of the storm. Likewise for growth, the sequencing I laid out would suggest you're not going to see growth really roll over until towards the end of summer or the fourth quarter.

But if we get a situation during the summer where consumer spending drops quickly or we get a payrolls number that is, say, sub-50,000, you know, well below where it's been sort of holding steady in the 125,000 kind of range, that will spook investors. We saw that last summer where it was a July labor market report that came out early August that was around 11,000. Sub-50,000 kind of revised higher, but it definitely spooked markets and investors about how our growth is kind of rolling over. Okay.

So as much as you can prepare for it, it's off like the Mike Tyson expression that everyone has a plan until they get hit in the face. So I think it's going to take more than just some modest slowdown in the economy or higher inflation to really kind of cause the markets to pull back. And that's definitely a risk that happens. If we turn to other policy matters, like everyone now, I think investors who are in the market have become –

complacent perhaps on tariffs as a risk because, and for justifiable reasons, because we've seen multiple times now just in the past few months where higher tariffs are announced and then a short bit of time later they're delayed, they're lowered, they're reversed. So anything that is, you know, ideal is not done, it's okay, fine, we'll extend the deadline. Whether they go higher, that's fine, but then two weeks later there'll be some more. So at some point you just sort of kind of ignore it. It also seems like it's in the administration is sort of zeroing in on a range where

They would like to keep a 10% universal tariff in place, maybe some sectoral tariffs. So the effect of tariff rate may not be that much different than where it is now. The allocation could differ, but it would be surprising or it would take a lot for the markets to suddenly move a lot on tariff news at this point in time, which again, not saying it won't, but I think the bar is high to be negatively surprised. For the budget deal, the one big beautiful bill,

Like this is something that if it doesn't pass, I think the markets would view at least near term, they will extend existing tax cuts. But the market rally we've seen in the past couple of months has not really been predicated as on this OBBB being a key catalyst thinking we'll get more fiscal stimulus. Anything not having that bill passed in the current form that doesn't increase the deficit, that actually might be welcomed by investors in terms of bringing kind of rates down. So again, that's probably not a major kind of market moving event.

So really it's almost things that are harder to predict or not fully on the top of investors' radar screens. It can reflect some investor positioning.

If you recall last summer, there was a situation where the yen carry trade was very prevalent. And then the Japanese, the Bank of Japan kind of surprised the markets by saying we'll raise rates more quickly than anticipated. That caused a significant unwind and just that deleveraging caused massive churn in global financial markets. At the same time, there was a massive churn within U.S. equities.

You know, when investors pivoting away from just being long sort of tech stocks and then for at least a brief period of time going into small caps, this massive rotation. So July had a huge churn. A lot of that was also driven more by technicals more than it was huge fundamental changes. So I guess things like that could also play out. And there are certainly some

Consensus trades, whether it is short dollar, long gold, long bank seven again is sort of a consensus trade at this point in time. So things like that could amplify moves where something that seems relatively minor could actually trigger things at the expert cascade to be a bigger pullback. It's just harder to sort of identify when a catalyst like that can materialize.

So with those considerations, Jason, in mind, you shared with us CIO's market outlook. What should investors be doing right now with respect to portfolio positioning? Well, you know, I kind of laid out a case where the markets could grind higher. And so the more they do and the more that they become indifferent to some of these risks, the more vulnerable they are to some sort of data point materializing because then position will get further stretched and you get higher.

unwinds like we saw last year in the summer and in April this year in terms of the tariff news. So there is certainly some vulnerability and things ultimately the economic data is likely to get worse before it does at some point kind of get better later on. So I think you need to kind of be prepared for that. But

But I think this is what it does tell you, that there's some sort of market resiliency, that any sort of pullbacks of 5% or more will probably be quickly bought. So our message of phased-in equities, be prepared to deploy that capital if you want to invest in it because the pullbacks could be relatively shallow for the time being and of short duration, so you have to be ready in that regards. Within it, U.S. equities look relatively well-positioned to do that and enlarge that part because it's

an area where there's still a fairly strong consensus is on the Mag7 and sort of the tech sector. That remains one of our more attractive sectors. And it has certainly been kind of outperforming. The AI theme that got dinged earlier this year after the DeepSeek news, that's been a key driver, and there's definitely positive momentum around that. And that's something we can continue to kind of like at this point in time. You know, thinking about on the fixed income side,

A lot of uncertainty, you know, yields kind of chopping around. So again, just not taking a lot of interest rate risk because yields could go higher. Also not taking a lot of credit risk because you don't need to take a lot of risk to get decent income right now. And then gold, you know, continues to perform as this kind of portfolio kind of diversified at this point in time. So those are a few of the key things. You know, in some way, I've said this on recent calls, but they were valid before. And as we see the price action the last week, I think they're consistent with that kind of thesis holding in place.

Well, Jason, thank you for reinforcing CIO's current guidance when it comes to portfolio positioning. A lot of factors to be mindful of, a lot to keep us busy in the weeks and next couple of months ahead. So do look forward to picking back up with our conversation on next Monday. In the meantime, stay cool and thank you for dropping by on this Monday morning. Thank you. Have a great week. You as well. Thank you, Jason.

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