Top of the Morning: CIO Strategy Snapshot - Q3 earnings, oil prices, inflation data

Jason Draho · UBS Global Wealth Management

AI investment and the wealth effect from AI stocks are major drivers of US growth.

Jason's estimates suggest AI could have accounted for up to 100bp of the 2.4% real GDP growth in the first half of the year. That contribution runs through investment and through the wealth effect from AI-related stock gains, which lifts spending. For this reason, a sustained fall of more than 50bp in the ten-year yield would likely require a significant pullback in the AI investment story, which would also hurt growth.

“that really probably requires some significant pullback in sort of the AI investment story because our estimates would say like, the first half of this year that AI could have accounted for upwards of a 100 basis points of the 2.4% of real GDP growth.”at 6:40

Jason Draho · UBS Global Wealth Management

Third-quarter US real GDP is tracking near 3.5%, with nominal GDP near 7%.

Jason's tracking estimate puts third-quarter real GDP growth at almost 3.5%, with nominal GDP possibly close to 7%. Strong nominal growth should support corporate sales, which then flow through to earnings growth. This strength is also one reason he expects growth to moderate only a little from its current pace.

“And the third quarter growth where we're tracking at almost 3.5 [%] real GDP growth in the third quarter. Nominal GDP could be close to 7%.”at 11:08

Jason Draho · UBS Global Wealth Management

US macro fundamentals stay benign over 12 months, supporting risk assets as growth and inflation moderate.

Jason expects US macro fundamentals to remain benign and supportive for risk assets over the next twelve months. Growth and inflation are both above 2% and should moderate toward that level, which would let rates ease somewhat. This supports his view that bonds, fixed income and equities are all attractive, since the macro backdrop should let assets across the board rally.

“Ultimately, we expect The US macro fundamentals to remain sort of benign and supportive for risk assets over the next twelve months. Growth and inflation are both over 2%.”at 13:40

Jason Draho · UBS Global Wealth Management

Q3 S&P 500 earnings growth should beat the roughly 25% consensus, as estimates have been revised up.

Q2 earnings grew more than 32%, or over 40% excluding one-off private-investment gains. Q3 consensus is around 25%, and Jason's view is slightly higher. Q3 estimates were revised up about 1% over recent months, which usually means companies beat by more than normal. Early reporters have mostly beaten expectations, and guidance has been solid. Tracking nominal GDP near 7% also supports sales. Semiconductors and energy are expected to drive more than half of Q3 earnings growth, with each up over 100% year on year.

“Going into this earnings season, the third quarter estimates have actually been revised higher by 1% over the past few months, that's usually a positive sign.”at 10:41

Jason Draho · UBS Global Wealth Management

Median S&P 500 company earnings growth will slow from 12% in Q2 toward about 7%.

Semiconductors and energy lead aggregate earnings, but the median company grew earnings 12% in Q2. Consensus expects that to slow to about 7%. Jason calls this a solid number by historical standards, but a moderation. Breadth matters because the rally needs more than AI-related names, so a slowdown in the median company is a point to watch.

“in the second quarter, the median company in the [S&P 500] had earnings growth of 12%. This is likely to decelerate. And again, the consensus is around 7% for the median.”at 11:50

Jason Draho · UBS Global Wealth Management

Expects S&P 500 earnings growth of 14% next year, contingent on hyperscaler capex guidance holding up.

Jason expects 14% earnings growth for next year. That depends on broad, healthy earnings and on capex guidance. If the capex guidance disappoints, the trend growth rate of earnings would have to be cut, more than investors expect. He says that would look like capital discipline over the long term but would mean a near-term hit to earnings that markets are not prepared for.

“if those numbers aren't sort of guided higher, that could be a sign for the markets of worrying about the sustainability of earnings more for 2027 and beyond. And we expect 14% earnings growth for next year.”at 12:52

Jason Draho · UBS Global Wealth Management

Investors are short Treasuries, so better inflation or oil news could squeeze the ten-year yield down quickly.

Investors are short interest rate exposure, positioned short Treasuries outright. If inflation and oil news improves, yields could fall, and investors would then cover shorts quickly, pushing yields down very fast. Jason says the ten-year could fall back to 5% within a few days in that case.

“we know investors are kind of short interest rate exposure, short treasuries outright. So if you do get better news on inflation and oil prices, yields could decline... So like the ten year could fall back to 5% in just a matter of a few days.”at 14:42

Jason Draho · UBS Global Wealth Management

Investors chase upside calls rather than hedging, so upside demand could become a directional equity tailwind.

S&P 100 downside skew is below the 1st percentile of the past few years, so investors are not paying to protect against falls. Calls are above the 99th percentile, showing fear of missing out on a year-end rally. Realised one-month volatility is about 10 and the VIX is in the high teens, so volatility is low despite rate churn. Investors appear to be gaining equity exposure through options rather than owning stock outright. If upside looks more attractive, they could add exposure directly, which would support equities.

“And likewise for equities, the data I mentioned earlier of investors really positioned more in the options market for upside rather than downside suggests that they don't necessarily have a lot of long positions on. They're using the option markets to get exposure.”at 15:01

Jason Draho · UBS Global Wealth Management

Ten-year yields should fall over six months if rate-hike pricing unwinds and oil prices decline.

The ten-year yield is up about 107bp since January, mostly from better growth expectations rather than inflation. Fed funds expectations rose from just over 3% to about 4.1% by December 2026, roughly matching the move in the ten-year. Most of the rise reflects higher real rates. Cutting more than half the rise (over 50bp) would need a clear deterioration in growth, likely a pullback in the AI investment story, which is unlikely near term given economic momentum. Still, yields should decline over six months if the market prices out some 2027 rate hikes and oil falls on US-Iran de-escalation. Jason expects this to show up before year end, though it may take a few months. Until oil is clearer, yields are more likely to chop in a range.

“We still think that yields will decline over the next six months, provided two factors sort of materialize. One is that we'd expect the market to price out some of the rate hikes it has for next year. And then oil prices will actually sort of decline”at 7:16

Jason Draho · UBS Global Wealth Management

Expects a December Fed hike, with a third possible, but three more hikes in total is not the base case.

The market prices just over one full Fed hike by December, another by March, and about 1.3 hikes by summer 2027. Jason expects a hike in December and says a third is possible. He calls three more hikes in total quite extreme and not his base case. As hike expectations get priced out, yields should fall, since the rise in the ten-year has tracked the rise in expected Fed funds.

“We expect certainly a hike in December, a third hike is possible, but three more hikes in total seems quite extreme not our base case.”at 7:53

Jason Draho · UBS Global Wealth Management

Midterms could clear risk by bringing divided government and clarifying the Iran outlook.

Democrats are expected to win the House, which means at least some divided government. Domestic policy changes may not be dramatically different as a result. The more important effect is geopolitical. The midterms could clear up the Iran escalation question, and the response afterward could determine whether oil and rates fall. The election is therefore a potential risk-clearing event for markets, though the outcome is hard to predict because it depends on politics and geopolitics rather than economics.

“it does suggest is that the midterm elections could be a bit of a risk clearing event.”at 9:10

Jason Draho · UBS Global Wealth Management

Inflation should move in the right direction over coming months, helping yields fall before year end.

Inflation is still elevated, but Jason expects the data to move in the right direction. Combined with growth moderating from its current pace, which has been the main driver of higher rates, he expects yields to fall by year end. Better inflation news is one of the two conditions he gives for lower yields, alongside a decline in oil prices.

“we think yields are gonna go lower. They're gonna go lower because the inflation data will move in the right direction. Growth should moderate a little bit from its current pace.”at 9:30

Jason Draho · UBS Global Wealth Management

Oil prices will ultimately fall, but escalation risk with Iran keeps oil and rates a key risk.

Oil is the bigger wild card for markets. Reports of possible US military strikes on Iran raise escalation risk. Jason suggests Iran may want escalation before the midterms to maximise political pain for Trump and Republicans, and could de-escalate afterwards. He still expects oil to come down, but if it stays high, rates could stay high or go higher, and until the oil outlook is clearer, yields are likely to chop in a range.

“Oil prices ultimately we do think will come down, but those are the kind of the probably in some sense, the key risks is that rates stay high, even go higher. Likewise for oil prices.”at 14:02

Jason Draho · UBS Global Wealth Management

Expects US-Iran de-escalation to become the market's base case, after the midterms if not sooner.

Escalation between the US and Iran is uncertain. Iran could push for escalation before the midterms to maximise pressure on Trump and Republicans, while Trump may avoid strikes before the midterms. The midterm outcome could clarify the geopolitical path, and a reversal toward de-escalation is possible afterward. If there is no escalation, investors will start to price in de-escalation, which Jason says is his central expectation. That would ease oil prices and, in turn, rates.

“If it's not escalation, then I think investors will start to bank on some de escalation. And that's ultimately what we do think.”at 14:37

Jason Draho · UBS Global Wealth Management

US equity gains have been too narrow; diversifying beyond megacaps should lead performance over the medium term.

The index is near its record, but beneath the surface about 85% of S&P 500 companies are more than 10% below their highs, about 60% are more than 20% down, and about a quarter are down more than 40%. Mega-cap quality names have held the index up while many other stocks sold off. Small caps have lagged. Jason's message is to position for upside but also diversify. In the medium term, he expects that broader approach to deliver the best performance after a challenging couple of months.

“We've seen small caps kind of lag. A message we've had for a while is kind of position for upside, but also kind of diversify in this macro environment.”at 15:44