• The S&P 500’s rally may be on its last legs, though investors should stay in US stocks.
  • A leading mind at UBS Global Wealth Management shared the top risks to watch for.
  • Here are five ways to hedge against the threats in markets in the second half of the year.

Investors who’ve ridden this market rally to all-time highs should be cautious, though it’s not yet time to abandon ship, according to a top strategist at UBS Global Wealth Management (GWM).

David Lefkowitz, who’s the head of UBS GWM’s Americas-focused equities team, was optimistic about US stocks in early May following the only shaky stretch in markets this year. He reasoned that while higher interest rates were a concern, solid earnings growth would keep stocks afloat.

Since then, the S&P 500 has rallied 11.1% off its early May lows and extended its year-to-date surge to 16.9%. In response, Lefkowitz and his colleagues have raised their year-end target for the index to 5,500 and 5,700 in a bull scenario, up from 5,200 and 5,500, respectively.

However, like many of their peers, strategists at UBS's wealth management arm don't see significant upside for equities. Several major investment firms have raised their S&P 500 targets in recent months but think that most, if not all, of stocks' gains this year are already in the books.

Even in a best-case scenario, Lefkowitz and his colleagues see only marginal upside for the S&P 500, which, at around 5,600, is hovering halfway between the firm's base and bull targets.

Since UBS GWM is neutral on US stocks, Lefkowitz recommends that investors keep their expectations in check and look for alternatives. Still, he believes exiting markets is a mistake.

"Remain invested; have a full allocation because it is a favorable environment that we think will persist," Lefkowitz said in a recent interview. "But we also want to recognize that, yeah, gains have been pretty good so far this year. We'll have to see how it goes."

A soft landing looks likely, but key risks remain

The dreamy scenario for the US economy that many doubted appears to be playing out. Economic growth is firmly positive but not red-hot, the labor market looks healthy and balanced, and inflation is slowly but steadily receding toward the Federal Reserve's 2% target.

"You could call it 'Goldilocks,'" Lefkowitz said of this so-called soft landing outcome.

If the status quo continues, the Fed may be able to cut interest rates as soon as September. UBS GWM is counting on a cut then and another later in the year.

But that's not to say the economy is out of the woods. Lefkowitz outlined several key risks to this seemingly ideal setup for markets and the economy, including the possibility that economic data and corporate earnings are weaker than expected.

"I think there are some legitimate questions about how sustainable the growth will be," Lefkowitz said. "Again, that's not our base case. We think it is sustainable. But can you slip from 'Goldilocks' into something more nefarious if the growth doesn't come through?"

Earnings are arguably the biggest driver of stock returns in the long term, and Lefkowitz will be watching the forthcoming second-quarter results like a hawk. Early reporting companies have underwhelmed so far, Lefkowitz noted, which is the opposite of what happened heading into Q1.

Softness reflected in economic indicators may trickle down to companies' revenue, but Lefkowitz remains confident that earnings are heading in the right direction.

"Obviously, we're seeing a little bit of a slowdown in terms of the economic data," Lefkowitz said. "I would say though, in terms of the earnings, the profit growth — which is really, ultimately, what the market cares about — that has been broadening out and has been pretty solid over the last couple of quarters."

What hasn't been broadening out are the market's returns. The 10 largest companies in the S&P 500 make up 38% of the index's market capitalization, which is up 6 percentage points from the start of the year, Lefkowitz noted.

This narrow market breadth pressures the biggest stocks to deliver strong Q2 results. If large-cap leaders like Nvidia can't meet analysts' expectations again, an ugly sell-off will likely ensue, though Lefkowitz said that's not his base case.

"If there's any hiccup in terms of the AI adoption and investment and deployment, that would really be pretty disruptive," Lefkowitz said. "So could you imagine that the day that Nvidia actually misses? I mean, that is not going to be a pretty day."

The other outcome that could spoil a soft landing is excessively strong economic growth that keeps inflation hot and prevents the Fed from cutting rates this year.

"There is now a clear expectation that the Fed will — as a result of the cooling labor market and the cooling inflation — they will deliver on some interest rate cuts," Lefkowitz said. "So I think that's got to be part of the story. And if the Fed doesn't, that could be a little bit of a bumpier ride."

Regardless of what happens to the economy, Lefkowitz believes the results of the US elections could be pivotal. Politics shouldn't sway portfolios too much, but investors should consider what a win by Donald Trump, Joe Biden, or someone else entirely would mean for markets.

"You do tend to see some uncertainty creep into the marketplace ahead of the election until there is more certainty about the outcome — usually happens right after the election," Lefkowitz said. "And then everybody moves on and just adopts or adapts to the new political constellation or political situation in Washington."

5 investments that can protect your portfolio

Market participants who are anxious about how far US stocks have run or the litany of risks that Lefkowitz outlined can hedge by making a handful of moves.

UBS GWM remains bullish on stocks in the technology and industrials sectors due to the wave of spending in areas like artificial intelligence and infrastructure. However, the firm no longer recommends investing in healthcare or small caps, both of which have underwhelmed this year.

Quality stocks remain a reliable bet in uncertain, slower-growth environments like this one, Lefkowitz said. The group tends to perform well in late-cycle settings where the jobless rate is low, though the strategist said such backdrops can persist for years.

Outside of equities, investors can diversify with medium-term bonds and gold, Lefkowitz said, seconding a call made in an early July note from UBS GWM investment chief Solita Marcelli.

Though not flashy, bonds boast attractive yields and should continue to rally if the Fed cuts rates this fall, according to UBS GWM. The firm is especially bullish on investment-grade bonds that mature in five to 10 years.

"We think investors should position for a lower interest rate environment and buy quality bonds, which have attractive yields and the potential for capital appreciation amid the potential for a deeper easing cycle," Marcelli wrote in the note.

Meanwhile, gold will sell for $2,600 an ounce by the end of 2024 and $2,700 in a year, up from $2,365 today. The yellow metal has kept pace with the S&P 500's rally this year as investors insulate themselves from geopolitical volatility, election risk, and lavish government spending.

Another potential tailwind for gold is that Trump, who's now the frontrunner for the White House, may assert more control over the US central bank if elected to a second term. Such changes could drive even more portfolio managers toward the ultimate safe-haven asset.

"In the Trump outcome, there is some question about Fed independence," Lefkowitz said. "That certainly is another reason to think about adding gold as a hedge in case some of those fears become a bit more prevalent in the marketplace."