Oil Spills on the Rate-Cut Thesis

U.S. equities endured a volatile trading week as geopolitical tensions, weak economic data and inflation fears weighed on sentiment. The S&P 500 slipped 2.0%, while the tech-heavy Nasdaq lost 1.2%. Meanwhile, the Dow Jones Industrial Average underperformed, sliding 3.1%. Small-cap stocks bore the brunt of the selloff with the Russell 2000 falling 4.1%, reflecting the space’s sensitivity to interest rate pressures and economic shocks. WTI crude oil bucked the downtrend with prices surging 36% for the largest weekly gain since 1985 as the U.S./Israel-Iran conflict effectively shut down the Strait of Hormuz.

Headlines last week have centered around the energy market’s impact on the broader economy as expectations for the Federal Reserve to cut rates have been pushed out. Recent commentary from Fed officials show uncertainty and caution as a “wait and see” approach to the conflict in the Middle East will likely be taken. The Cleveland Fed President stated it’s “too early to know” the full impact of an oil shock and is in favor that policy should remain on hold. Typically, February’s negative employment report that came in well below expectations would boost odds for a rate cut; however, the unknowns of the inflationary impact from last week’s oil price shock have overshadowed the data. Members of the Fed seem to think rate cuts in this environment could be like pouring gasoline on an inflationary fire despite visible cracks in the labor market.

Central banks are navigating a geopolitical backdrop in which their traditional policy toolkit offers limited near‑term relief. Traditional monetary policy is intended to counter demand shocks where inflation and growth tend to move in the same direction. Meanwhile, supply shocks can put pressure on inflation, while demand for a commodity stays the same or increases. In simpler terms, the Fed could cut rates to zero, but monetary easing does little to address physical supply constraints, such as a closed Strait of Hormuz, which has been the primary driver of higher oil prices. Attention next week will be in focus on whether shipping traffic can normalize through the passageway, which is responsible for roughly 20% of global oil supply.

Ten of the 11 S&P 500 sectors finished the week in negative territory, led lower by materials and consumer staples. Energy was the lone outperformer, benefiting from a sharp move higher in oil and natural gas prices. Elsewhere, Treasury yields climbed on renewed inflation fears, while the U.S. dollar appreciated amid a broader flight-to-safety trade. When these three asset classes (oil, Treasuries and the dollar), often referred to as the market’s “three-headed-monster,” move higher in tandem, they tend to act as a meaningful headwind for stocks. For this monster to be put back to rest, oil prices will likely need to see stabilization in the region, potentially tied to a de-escalation in conflict or an agreement to reopen the Strait of Hormuz. Resolving the energy‑driven supply shock would be an important step toward reopening the conversation around potential rate cuts. Furthermore, this would help lower inflation expectations and the demand for the dollar, shifting toward a more supportive environment for equities.

Coming into the year, the macroenvironment was favorable for equities as higher valuations were supported by a path forward to a lower Fed funds rate, strong global earnings growth and fiscal stimulus supporting the consumer. The conflict in the Middle East has thrown a lot of this out the window as markets starts to price in uncertainty surrounding the length of the conflict and the impacts on inflation and global earning growth. The stock market’s kryptonite tends to be uncertainty, and the first thing it comes for is repricing the valuation on stocks, which is currently at a premium. Given the unknowns listed above, traders will start to question if U.S. stocks should be trading at one of the most expensive levels relative to history. This can be illustrated by the movement of Wall Street’s fear gauge, measured by the CBOE Volatility Index, which surged 48% last week.

Ultimately, the trend for stocks seems to be toward the downside as investors grapple with a timeline for the U.S./Israel-Iran war. The good news for stocks is history suggests geopolitical risk shocks tend to be short-lived and have limited impact on domestic earnings. In fact, higher oil prices tend to be earnings-neutral as they benefit energy companies but are disruptive to margins for industries that rely on oil, such as travel and consumer stocks. Notably, despite the surge in volatility, equities have declined only about 2% since the onset of military operations. Since no one can predict if this will escalate or de-escalate from here, my advice as uncertainty increases is make sure you are not taking excessive risk, follow your financial plan, and time in the market beats timing the market.

Looking ahead to this week, investors will have a jam-packed week of economic data and earnings reports aside from ongoing geopolitical updates. Headlining the economic calendar will be the inflation report with the Core Consumer Price Index forecasted to show a 0.2% increase for the month of February. Another inflation update will be given on Thursday with a delayed personal consumption expenditures report for the month of January. Other notable releases include personal income and spending as well as real estate updates on housing starts and existing home sales. Off-cycle earnings season will continue with software companies such as Adobe and Oracle. Meanwhile, other companies worth watching include Casey’s, Dicks’s Sporting Goods, Kohl’s and Ulta.

Economic Calendar March 9 – March 13

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