Missiles, Drones, Inflation & Earnings
What happened last week?
The S&P 500, Dow and Nasdaq shed -1.56%, -2.37%, and -0.45%, respectively. All 11 S&P 500 sectors were in the red, as investors digested a rise in geopolitical tensions in the Middle East and higher bond yields.
Pullbacks in financial markets are common. Staying invested is what has historically been required for portfolios to outpace inflation over the longer run.
This week, 44 S&P 500 companies, including six Dow stocks, will release their first quarter earnings results on top of the 6% than have already reported.
3 Things to Know
State to State Conflict in the Middle East
For global markets, the largest impact of the conflict was always likely to be felt in the price of oil.
We would still expect financial markets to immediately price in a higher possibility of enlargement of the conflict through higher risk premiums. Given the rapid timeframe for production and consumption of oil and related products, the oil price tends to move very sharply relative to actual supply impacts.
As was the case following Russia’s invasion of Ukraine in 2022 and Hamas’s attack of Israel in late 2023, oil markets feared a larger supply disruption initially.
These fears then faded as greater clarity around supply followed. While we cannot know the future course of the Iran/Israel conflict, we believe there is a high probability that this pattern will unfold again.
In our Wealth Outlook for 2024, we note that geopolitical risk to oil supplies suggests a greater need for investment in energy security – redundant energy supplies – even as energy demand is being satisfied by a new mix of energy sources.
Russia and Iran depend on petroleum exports for revenue and unlike the 1970s, the US has risen to be the world’s largest petroleum producer. Therefore, a repeat of the energy-rationing inflationary-recession of 1974 is unlikely.
US Inflation Print May Stoke Rate Fears
Last year, the consensus formed around a rapid decline in inflation. In the final quarter of 2023, inflation annualized at just 1.9%. Had this been sustained, the Fed would have had no reason to maintain its “considerably restrictive” policies.
We still expect the headline CPI to rise just 2.5% in the year through December 2024. We have not lost confidence that global demand and supply growth are gradually moving into balance. And we still believe that equity markets will benefit from higher-than-expected US corporate profits likely to be reported over the coming month.
Nonetheless, financial markets are prone to excesses of optimism and pessimism.
Our own preferred measure of core CPI inflation has bounced from a 2.0% to a 2.4% pace over the last five months. Therefore, we expected the Fed to maintain a restrictive stance until the deceleration of inflation resumes. In our own view, this could come sooner than markets now expect, but not likely in the next two months. During this time, markets are more vulnerable to rate fears.
Broadening EPS Gains
We believe 2024 will offer a broadening set of positive returns relative to 2023 as more sectors post EPS gains. Our asset allocation reflects a broadening strategy to take advantage of wider gains.
For example, we overweight the S&P 500 equal weight index to reduce concentration risk and seek to take advantage of “catch up” opportunities including healthcare.
While we expect solid performance for both equities and bonds in 2024, “headline” index performance was never likely to be as strong as 2023, which followed sharp losses in 2022.
Returns for the S&P 500 over the past six months would have annualized near 50%. In short, equity markets were appreciating too fast to be sustained.
We believe investing in economic development – generating capital appreciation and income – is still the paramount opportunity for wealth preservation and growth. The precise number of rate cuts in the remaining eight months of 2024 is trivial by comparison.
See our weekly CIO Strategy Bulletin for more details