Top of the Morning: CIO Strategy Snapshot - Sustainability of the AI trade

Jason Draho · UBS Global Wealth Management

AI added roughly 0.6 to 1 point to H1 US GDP growth; an AI investment slowdown would hit US growth.

AI has been a very significant driver of US GDP growth. He estimates 60 bps to 1 percentage point of the 2.4% H1 growth could be traced to AI, through investment spending and the wealth effect from higher AI stock prices. If funding concerns curtail AI investment, the US economy would be affected, a 'mini AI slowdown' that would slow growth and show up in rates.

“AI has been a very significant driver of US GDP growth. In the first half of the year... you can estimate anywhere from 60 basis points to a one full percentage point of U. S. Growth that was 2.4% could be traced to AI”at 4:05

Jason Draho · UBS Global Wealth Management

Neocloud and data center debt spreads widened about 80bps; funding strain could curb AI investment.

Credit spreads for neocloud and data center debt issuers rose about 80 bps over the past four or five months, from roughly 120 bps to over 200 bps, with variation between issuers. This reflects doubts about whether these issuers will generate enough revenue to cover their costs. The concern is that higher funding costs could curtail AI investment and hit the broader economy.

“And then you see stress on the credit side where you've seen credit spreads for some of the debt issuers, particularly kind of neo cloud issuers, data centers rising over the course of the past four or five months, 80 basis points.”at 8:26

Jason Draho · UBS Global Wealth Management

Hotter-than-expected CPI shows disinflation is slower than the Fed wants; AI demand adds to core goods.

September CPI rose 33 bps month over month versus about 25 bps expected. Energy, driven by higher oil prices, was the main driver of the headline acceleration. Core goods inflation reaccelerated on firmer vehicle sales and costs, and signs that AI-related demand is acting as a demand-side inflationary force. Core services also strengthened, led by travel categories, with airfares elevated partly because oil is higher. He calls the data 'not terrible' overall, but the pace of disinflation is not where he or the Fed would like.

“it did surprise to the upside. It was at 33 basis points month over month. Expectations around 25 basis points... But again, the pace of disinflation, not necessarily where I think we would like or the Fed would like to see it.”at 1:39

Jason Draho · UBS Global Wealth Management

US economic activity remains healthy, with no sign of a surge above trend despite mixed data.

Core retail sales rose only 10 bps since September, below expectations and below August's strong figure, though seasonality around Labor Day and holidays affects timing. Regional and state manufacturing indices were mixed. Taken together, the data show healthy activity without an above-trend surge. He argues month-to-month data is volatile and revised, so a three-month trend is more useful. Overall he calls the data 'okay, but not spectacular'.

“the pace of economic activity in The US remains healthy, but there's no signs of surge above sort of above trend.”at 3:08

Jason Draho · UBS Global Wealth Management

Fed will hike gradually, about one hike per quarter, letting rates drift lower.

Fed guidance has been clear that it wants a gradual pace, roughly one hike per quarter, with September and December as the expected meetings. The dot plot indicates more hikes are coming, and the CPI data validated his view. The Fed chair's IMF remarks suggested the world has broadly conformed to the September expectations, implying the Fed can keep a measured pace. The committee has hawks and doves, and a gradual pace balances them. A more gradual path gives inflation more time to improve, which could eventually allow the Fed to pause entirely, and this is part of why rates have eased.

“Fed guidance has been pretty clear that they want to take them kind of a gradual pace, let's say one hike per quarter, September, December, we think.”at 4:55

Jason Draho · UBS Global Wealth Management

Market is reassessing memory margins, citing capacity scarcity and Chinese competition.

The sell-off in AI-linked names reflects investors reassessing the durability of supply chain margins, memory capacity scarcity, and competition from China. A Chinese company recently announced a breakthrough it claimed would produce better memory chips. Korean memory stocks were hit hard as a result. The broader concern is whether the growth in AI spending can justify its return on capital.

“investors, the market is kind of reassessing the durability of the supply chain margins, memory capacity, scarcity, competition from China.”at 9:00

Jason Draho · UBS Global Wealth Management

Rising 10-year yields reflect stronger real growth, not inflation expectations; curve not signaling recession.

The 10-year yield is up about 100 bps this year, with over 90% of that from higher real rates. Inflation expectations have been range-bound. Fed funds expectations for December rose about 100 bps, consistent with solid nominal GDP growth near 6%, not slowing growth. The 2s10s curve remains positive, about 35 bps, so there is no recession signal, and it has not steepened, so the market is not saying the Fed is behind the curve. The 10-year peaked near 5.3-5.4% and has drifted lower; he sees about 5.2% as a baseline until macro conditions change. Investors were very short, so buyers may step in, and he recommended extending duration a bit further out the curve.

“Very simply, if you look at the ten year treasury yield, it's up about 100 basis points this year. 90 plus percent of that is due to higher real rates. Inflation expectations have not risen much at all.”at 10:26

Jason Draho · UBS Global Wealth Management

US housing and real estate are very soft, hit by higher interest rates.

Parts of the economy sensitive to interest rates have been affected by higher rates, unlike AI investment, which has been relatively immune. The housing market and real estate are very soft, and he says that is clearly tied to higher rates. Equity markets are only 2% from their highs, but about half of the S&P 100 companies are down more than 20% from their highs earlier in the year, showing that rate-sensitive pockets are struggling.

“other parts of the economy that are impacted by interest rates have been affected. The housing market and real estate, very soft and that's clearly gonna be tied to it.”at 12:12

Jason Draho · UBS Global Wealth Management

Household wealth and balance sheets are strong enough to keep supporting consumer spending.

Household wealth is quite strong and household financial balance sheets are in good shape, which supports consumer spending. This cushions the economy against higher rates, even though the rate-sensitive parts of the economy are struggling. He also points to the AI-driven wealth effect as part of the supportive backdrop.

“Household wealth in general is quite strong and household financial balance sheets are in good shape. That's supporting consumer spending.”at 12:56

Jason Draho · UBS Global Wealth Management

Large deficits and this year's fiscal impulse support growth that is less sensitive to rates.

He lists large deficits alongside AI capex and household wealth as key structural drivers of growth that are not particularly rate-sensitive. The fiscal impulse this year is a support for the economy, which helps explain why rates have risen on growth rather than falling on a slowdown.

“And then you also have just kind of large deficits. We had fiscal impulse this year that supports it.”at 12:56

Jason Draho · UBS Global Wealth Management

AI investment story still intact; not negative on AI, though spending growth may moderate.

The AI investment story still looks very much intact for now, and he is not negative on AI. The debate is about future growth rates: whether CapEx growth decelerates from about 80% toward 40%, rather than a collapse. Who captures AI's gains remains an open question, which drives churn among AI-linked stocks. The market is testing where the vulnerabilities are, and the expected result is some moderation of the pace of growth.

“The AI investment story still looks very much intact for the time being... not again, negative on AI, but it may be like some moderation of this pace of growth.”at 13:56

Jason Draho · UBS Global Wealth Management

Oil has been moving the wrong way, lifting inflation; expected to fall over the next year.

Oil is one of the three key drivers of markets alongside AI and rates. Over the past few weeks oil has been rising and working in the wrong direction, feeding into headline inflation through energy prices and travel costs. Rates and oil are the two factors that have taken a ding. He describes a base case that rates and oil start to decline over the next year, which would align the factors and give markets more support to move materially higher.

“oil certainly been working in the wrong direction. ... If those other two factors, rates and oil start to decline, which is our kind of base case for the next year”at 14:49

Jason Draho · UBS Global Wealth Management

Still constructive on equities with strong earnings growth; material upside needs rates and oil to fall.

He remains constructive on equities and still sees strong earnings growth, while advising investors to diversify and avoid being overly concentrated. Markets are currently chopping in a tight range because AI is strong but rates and oil are headwinds. If rates and oil decline, which is his base case for next year, the markets could move materially higher. Until then, he expects choppy trading, with clarity on the midterms and the Middle East as possible catalysts.

“All that said, still constructive on equities, still see strong earnings growth, continue to sort of message to diversify kind of across the board, not to be kind of overly concentrated”at 15:14

Jason Draho · UBS Global Wealth Management

Commodities and gold diversify portfolios against stagflationary growth scenarios.

In his portfolio positioning, he suggests looking for diversifiers such as commodities or gold, which provide some protection in scenarios of more stagflationary growth. This is a brief positioning suggestion, with limited supporting detail beyond the stagflation hedge logic.

“commodities or or gold, you know, provides some diversification against scenarios of kind of call call... Look. More stagflationary growth, you know, things of that sort.”at 15:41