Hut, Hut, Hike

U.S. equities finished lower for a second straight week as investors grappled with escalating geopolitical risks and a Federal Reserve (Fed) that suddenly looks more likely to hike than cut. The S&P 500 slipped 0.8% while the Nasdaq fell 0.6%, snapping a four-session losing streak with a strong Friday rebound that trimmed what would have been much steeper weekly losses. The Dow lagged its large-cap peers, shedding 1.6% on the week.

The big story remains the oil and bond market. The 10-year Treasury yield pushed to nearly 5.0% last week, its highest level since 2023, as traders priced in rising odds of a Fed rate hike at this week’s meeting. Behind the shift in policy is sticky inflation stemming from a supply shock rather than an overheating economy. The ongoing U.S.-Iran conflict has pushed oil prices above $100 a barrel, with gasoline prices up nearly 27% year-over-year. Crude and Brent oil spiked further last week after Saudi Arabia shut down its East-West pipeline following a drone attack. This has been the kingdom’s main workaround for exporting oil while bypassing the Strait of Hormuz. The pipeline has capacity to move 5 million to 7 million barrels a day, which is roughly 5% of global supply. The pipeline closure removes one of the last remaining release valves for Gulf oil exports.

Meanwhile, the national average for gas at the pump has topped $4/gallon, while diesel is getting hit even harder, with the national average above $6/gallon for the first time ever. Not only are consumers’ back pockets being pressured by higher prices at the pump, but the main input cost to get goods from point A to point B has doubled since the start of the year and will undoubtedly be passed on through higher prices. This supply-side shock makes it a tougher problem for the Fed to solve with rate policy alone. Raising rates does nothing to unclog the Strait of Hormuz or repair the East-West Pipeline, but it is one of the few tools Fed Chairman Kevin Warsh has to keep inflation expectations anchored.

Last week’s data did the Fed no favors. The August Consumer Price Index showed headline inflation at 3.4% year-over-year, with a hotter-than-expected 0.3% monthly core reading, and a hot producer price report on Thursday added to the case for tightening. Encouragingly, core inflation on a 12-month basis actually eased to 2.4%, the lowest since March 2021, a reminder that the trend beneath the monthly noise is not uniformly bad. Still, markets are now pricing in better than 80% odds of a 25-basis-point hike this Wednesday, which would be the Fed’s first increase since 2023. Consumer sentiment is feeling the strain, too, with the University of Michigan’s index declining to 47.8 and one-year inflation expectations climbing to 4.6%, both signs that households are increasingly uneasy about the price backdrop.

History offers a useful guide on what types of scenarios could happen next. Looking back, there have been seven prior instances since 1988 when the Fed kicked off a hiking cycle. The S&P 500 has typically wobbled in the short term, averaging a decline of roughly 2% over the following three months. The good news is that the pain tends to be temporary with the indexing averaging single-digit gains over the 12 months following that first hike. The only exception here is 2022, which saw a broader drawdown and a slowing in growth.

None of this guarantees how this cycle plays out, especially given its unusual, war-driven origins, but it’s a reasonable framework for how markets may digest a hike this week. Earnings growth has been exceptionally strong this year, which gives stocks a much better chance of absorbing higher rates without a repeat of 2022. Sector leadership in those early months has been inconsistent from cycle to cycle, though energy and technology have, on average, held up best, while health care has tended to lag. Rate-sensitive corners of the market, homebuilders in particular, are usually among the hardest hit as long-term yields climb, while financials have historically been relative beneficiaries of a higher-rate backdrop.

Sector and stock-level performance was volatile last week, with eight of 11 S&P 500 sectors clocking negative returns. Technology and communication services led, with artificial intelligence (AI) infrastructure-adjacent names among the week’s best performers as investors continued to reward the “picks and shovels” of the AI buildout. Energy was more of a mixed bag despite the run in oil prices, while health care and select consumer and technology names were hit hard. Stock leadership from last week to this week looks to be flipping as several AI frontier lab leaders call for a framework to ensure safety measures when rolling out more advanced AI models.  

Looking ahead to this week, all eyes will be on the central banks and economic data as earnings season has wound down. Next week, there will be a slew of monetary policy meetings, with Brazil’s central bank, the Bank of England and the Bank of Japan all meeting alongside the Federal Reserve. Globally, the common theme has been tightening policy, as the European Central Bank did last week with a 25-basis-point hike. On the economic calendar, retail sales and industrial production data for August are due Tuesday and will offer a final look at consumer and manufacturing health heading into the meeting. The Federal Open Market Committee decision, updated economic projections and Fed Chair Warsh’s press conference all land Wednesday afternoon and should set the tone for markets into year-end. The earnings calendar is light, with the homebuilder Lennar being the one notable report on the calendar, offering a read on housing activity in a higher-for-longer rate environment.

Economic Calendar September 14 – September 18

Links to previously published commentaries can be found at benjaminfedwards.com/Latest Investment Insights/Market Commentary/Market

5922857 – Exp. 09/30/2029