Although not even close to correction territory, the market has been acting heavier and heavier. Here is part of the reason why:
The huge AI theme may be the market’s spinach, but the three-headed monster of higher oil prices, interest rates, and the U.S. dollar have been the market’s kryptonite. Oil prices have risen sharply this year. This has impacted U.S. inflation which has resulted in higher interest rates. The dollar’s move higher is making our exports more expensive at the time the bull market needs cyclical exporters to join in this year’s rally.
The price of oil has not yet been impacted by the recent attack on Israel by Iran, but that could change if the conflict deepens. This would likely keep the bull market on hold (see main section) and may cause further damage to share prices in the short-term.
As many economists have been saying, the last mile of getting inflation down to 2% from 3% is the longest mile. In order to get the year-over-year CPI reading down to 2% by year-end, the month-over-month CPI readings must consistently come in either flat or up only 0.1%. More readings like the 0.2-0.4% month-over-month we have been seeing recently means we won’t get there.
Last week’s CPI print was hotter than expected, with rent CPI very high and an ongoing problem. But spot rent is coming down and now looks consistent with target inflation of 2%. Excluding rent, core CPI is running consistently below 2% annualized even when accounting for the recent small uptick. So all the inflation news is not bad.
REGIONAL WAR: TWO QUESTIONS FOR INVESTORS
Iran forewarned Israel of a retaliatory strike so it was no surprise last Saturday when it took place. Israel has announced they will respond. Investors remain nervous because there are so many unknowns.
In the short-term, a regional war or even the threat of one pushes markets down. This time is no different. In the mid and longer-term, the damage to markets really depends on U.S. investors asking themselves two questions:
First, will U.S. assets get directly drawn into the conflict? The U.S. successfully helped defend Israel on Saturday, but President Biden has stated the U.S. will not participate when Israel responds to the weekend attack by Iran. But what if Iran directly attacks U.S. assets? Although unlikely, this would deepen the war. U.S. investors are frightened and sent stocks down sharply on Monday.
Second, how will the war (any war) affect the U.S. economy? It is encouraging that oil prices are about flat since the weekend but that could change, especially if Iran disrupts the flow of oil. Higher oil prices leads to higher inflation and higher interest rates. This would only prolong the Fed’s higher for longer posture.
At this point, these two questions for investors remain open. U.S. stocks are likely to be weak until one or both of these questions can be answered. This doesn’t mean the bull market is over, but we are on pause for now. Long-term investors should sit tight but look for opportunities to upgrade their portfolios.