Peace interrupted, markets held firm
How did markets react to renewed hostilities?
Three weeks ago, the markets were pricing in peace in the Persian Gulf. Oil fell to a three-month low, the war premium drained out and the Dow Jones (the Dow) Industrial Average hit a record high. This week, the bill came due. After Iranian attacks on ships in the Strait of Hormuz and fresh strikes on both sides, U.S. President Donald Trump declared the ceasefire over. Brent crude jumped 5.4% to $78 and bond yields spiked worldwide as investors repriced inflation.
We warned in June that the peace deal was a draft, not a signature, and that the floor under oil was soft. Both proved true.
The stock market reaction was the interesting part. The Dow fell a percent or so, but the S&P 500 slipped just 0.3% and the Nasdaq actually gained. Where the bond market saw an inflation event, the stock market treated it as noise it had already learned to live with. The question now is which market is correct.
Are U.S. rates set to rise?
The same day, minutes from the U.S. Federal Reserve (the Fed) Board's June meeting landed, and they leaned hawkish. Some policymakers argued for rate hikes if inflation remains elevated, while concerns about the labour market have eased. Most notably, the minutes flagged price pressure spreading beyond energy and into goods like electronics.
The uncomfortable part is the growth picture. The Atlanta Fed's gross domestic product (GDP) tracker has fallen from above 5% earlier this year to about 1.3%. A Fed that is considering rate hikes as growth slows, with oil rising again, is a harder mix than anything markets faced in the first half of the year. The oil spike hands the hawks their justification just as inflation appeared set to fade.
Where is capital flowing?
The year's best trade continued to correct. Semiconductors are now down 16% from their late June peak after gaining more than 80% in the first half. Even record profits from Samsung could not shore up the sector. Meanwhile, SpaceX fell 6% the day it joined the Nasdaq-100 and sits around 25% below its peak. Two weeks ago, we called that stock a test of risk appetite. The test came back negative.
But look under the surface: on the worst tech day of the week, most S&P 500 stocks rose. Money is rotating into financials and industrials, and small caps just posted their best first half since 1991. That is healthier than it feels, as long as earnings validate this broadening of the market.
What's next?
Next week is loaded. U.S. Consumer Price Index (CPI) data will be released on Tuesday, Fed Chair Kevin Warsh testifies the same day and JPMorgan will open bank earnings season. You read that right, it's already Q2 earnings season. Then on Wednesday, the Bank of Canada will make its rate decision, and also release its full Monetary Policy Report — with the oil spike reviving the energy inflation case just as it appeared to have passed.
Listen to the latest podcast from the IG Investment Strategy Team for further insights.
