Headwinds Mounting, U.S. Economic Resiliency Being Tested
Highlights
Equities rally on hopes of Iran War winding down: Markets bounced last week, but the fragility of the geopolitical landscape means sudden headline shocks remain a primary risk to asset prices.
Corrections during midterm election years are par for the course: While a potential shift in Washington is unnerving markets, a >10% drawdown in a midterm year is historically normal and often precedes robust recoveries.
Wait and react rather than anticipate: With the risk/reward heavily skewed and the Fed boxed in by inflation, the current environment demands a balanced portfolio that preserves capital while keeping "skin in the game."
Full Commentary
Equity markets bounced last week with the S&P 500 ramping +3.4%, the Nasdaq Composite ripping +4.4%, and the Dow gaining nearly +3.0%. Why? My guess is that it was more about technical conditions triggering an oversold rally on the hopes of a way through the Iran war rather than anything fundamentally improving. Look, over the past 24 hours, I’ve reviewed viable analysis from a research provider that has boots on the ground over in the Strait of Hormuz, suggesting that trading partners are figuring out terms with the IRGC to secure safe transit. This is a constructive development in that it indicates transit through the Strait is higher than publicly being reported, but their work suggests that the IRGC understands how important controlling the Strait is for Iran’s long-term viability. That being said, the only way for the U.S. to gain control (if that is an objective) is to do so by force, which won’t be easy, nor come without a significant confrontation with the full force of the IRGC.
Such a setup keeps asset prices in a fragile position of chopping around with the latest headline as the two sides jostle for position. President Trump’s most recent comments indicate he wants the war to end in the next two to three weeks, and I’m sure Iran feels the same way, but there is a gap the size of the Grand Canyon on the terms each side would settle for to wind down the war. On a high level, it's not difficult to lay out why it's such a high bar for each side to come to terms: the U.S. and President Trump (putting aside how the U.S. got into this position and instead focusing on the position the U.S. is in) cannot pull up stakes and walk away (no matter how many times President Trump threatens he is considering such an option) without controlling the Strait. Such an outcome would be a geopolitical disaster for the West as it would allow Iran to enforce selective sanctions on whoever it wants and whenever it wants, and essentially hold the flow of shipping through the strait at risk going forward while keeping global energy security at perpetual risk.
Then there is the law of unintended consequences: abandoning the Strait could also jeopardize America’s ability to project power, put at risk the U.S.'s longstanding security guarantee in the Gulf Region, and further impair relations with Europe. This is yet another clear-cut illustration of the world transitioning from a unipolar order to a multipolar order. However, make no mistake, how this war ends matters to the pace and magnitude of this transition.
As for Iran, control of the Strait has now become the most critical issue, more so than nuclear ambitions, because surviving this war means control of Hormuz and Kharg Island, as they are its only deterrence and source of revenue to backstop whatever economy it has left.
Keep in mind, Iran has a geographical advantage in that there is nearly 1,000 miles of coastline that it can use to launch attacks, as it has consistently proven this past month, even cargo vessels under a multinational force of protection will be tough to fully protect against a surprise attack (as the Houthis in Yemen displayed on the Red Sea back in 2024).
Moving on from geopolitics to markets, let me start by saying that a market dominated by headline news is a dangerous market in which to make highly convicted commitments. Yes, you want to stick to your process and a well-thought-through long-term strategy, but a President that is consistent in being inconsistent is not helping one bit. In one breath, he is willing to walk away from Hormuz even if the hostilities don’t end, and in another, he says that he will “blast Iran into oblivion” if the regime’s stranglehold continues. The range of outcomes and fat-tail risks is far too wide to dig in right now, or to put on any large positions in anything outside of either cash or short-term bonds. Sure, there are opportunities availing themselves with some worthwhile ones to dip a toe in and start building long-term positions, but be prepared that if things go pear-shaped on the war front, so too will they in equity markets. Financial and Tech are two areas that have been beaten up the most ytd, with all of the MAG7 stocks down since the start of the year (-5% for Nvidia to -23% for Microsoft) and underperforming the average stock in the S&P 500 (which is up 1%). About half of the planned data center construction this year has now been shelved due to shortages of key materials, including transformers, batteries, and switchgear. And for the first time since 2019, Tech sector valuations are now identical to the overall market. I like some of the MAG7 group at current levels and think the group has undergone a proper cleansing in sentiment, positioning, and lowered expectations. This repricing in the MAG7 has occurred with forward 12-month earnings growth rising more than 60% over the past twelve months.
Valuations in U.S. tech have compressed because, if AI delivers on what many proclaim it can, the business models of many companies in the future are set to become much more uncertain. AI is forcing a brutal repricing of business model durability, margins, and moats, with investors no longer willing to pay peak multiples for earnings that may be disrupted. At the same time, capital is being put aside for the next wave of mega-IPOs – SpaceX, OpenAI, Anthropic – are all vying to go public at +$1 trillion market caps. That is a lot of equity supply hitting the market and competing for funds currently allocated elsewhere. These names also precisely represent the new AI tech world. This isn’t just a de-rating; it’s a reset of what investors are willing to pay for “legacy” tech in an AI-first world.
I’m hearing and reading many analysts referencing the fact that earnings estimates remain firm. I see the same numbers, but I’m skeptical that they stay there once we get into the Q1 reporting season, which kicks off in under two weeks.
Consider that the war started at the end of February. That leaves one month before Q1 closed. Is a company really going to come out and derail Q1 numbers when the quarter is almost over, and the impacts to most businesses from the war won’t land until the second half of the year? My guess is these rosy estimates for full-year 2026 will come in, but not by reducing Q1 numbers, as I expect estimates for the back half of the year to come under the knife. Amazon is the latest high-profile company to announce how it's navigating the war impacts by adding a fuel surcharge to its e-commerce deliveries, but not all companies have the pricing power of a dominant tech company like Amazon.
The U.S. economy is contending with higher input costs across many sectors (fertilizer, oil, gasoline, base metals…), a stronger U.S. dollar, and higher interest rates. Mortgage rates have hit a seven-month high while gasoline prices are at a four-year high, and the Fed is in no position to come to the rescue. The same goes for fiscal policy. Unlike the COVID-19 shock, there is no policy flexibility this time around to combat the series of shocks the economy is confronting. So those investors betting on the cavalry coming to the rescue as they did in COVID and the GFC before that, might want to think about the sequence of events that need to occur before that happens. Given the backdrop of a stable labor market and sticky inflationary pressures, policymakers won’t have the cover to provide support until something breaks. They lack the ability to be anticipatory and, as a result, are forced to be reactionary, which means pain must come before the prescription is provided.
It was constructive to see the yield on the 10-year Treasury get rejected at the 4.4% level last week. At the same time, interest rate volatility has started to retreat (see chart below). These are two necessary and constructive developments to quell recent market anxiety, but investors need to watch the 4.4% level on the 10-year because a sustained break above there opens up the door to 4.5 – 4.8%, with the upper end of that range being a level that really riled up markets back in the Fall of 2023.
I share many of the concerns investors have about allocating capital to the longer end of the Treasury curve, given the enduring inflation dynamics, shift in Global World Order, and the unsustainable path of fiscal deficits and debts. None of these are helped by this latest incursion into the Middle East. The U.S. went into this war with intractable deficits of over 5% of GDP, a debt ratio in excess of 100%, and annual interest costs now consuming 20% of federal revenue, a figure that is only going to rise. And just to confirm once again that when sitting in the seat (as opposed to campaigning for the seat) there is no concern for fiscal irresponsibility, President Trump released a budget proposal on Friday with total spending approaching $2.2 trillion, including $1.5 trillion in new military spending. The original ask for this year was $1 trillion for the Pentagon budget expansion. Meanwhile, Social Security will be insolvent in 2032 if left unchecked. There is no magic number at which U.S. debt becomes unsustainable, and there have been cries of a crisis unfolding now for many years. I won’t go there, but an elongated period ahead of a higher fiscal premium will exert a higher floor on mid-term and longer-dated bond yields, even if we do rally on cyclical terms in the case of a recession. No wonder gold has performed the way it has for the past four years.
Another headwind for both the economy and equity markets is the likely change in political power coming this November. Betting odds now place over a 50% chance on a Democratic sweep this November. It’s long been expected that the House was going to flip, but seeing the Senate potentially go Blue is something markets weren’t expecting as recently as six weeks ago. Should it happen, it would more than likely mark the end of the era of broad-based tax cuts and pro-business policy measures. The research department at Jefferies put out some detailed work on this, and here is their conclusion, which I agree with. It’s just a matter of having the patience and discipline to make it work if history were to play out in a similar manner:
"We had a look at the past 25 midterm election years to get a sense of how they have typically played out. We found that it’s actually weirder for the SPX to not correct during a midterm year, with >10% draws in 75% of the years with midterms going back through the ‘30s. In addition, whether due to policy changes or the removal of uncertainty, performance after such drops tends to be quite good, with average performance from trough to midterms of 16.5% and performance 12mo beyond the midterms adding another 13% on average. So while the current tape has plenty to feel awful about, it’s still pretty consistent with the historical pattern."
Let me wind this up with some closing thoughts. Markets remain at the whim of the events playing out in the Middle East. The latest being a Tuesday 8:00pm EST deadline set by President Trump for a deal to be agreed to, or power plants and bridges in Iran will be demolished. Nobody wants this outcome. Not the President, not the IRGC, nor do the majority of citizens around the world. Such an outcome benefits no one, and pretty much guarantees a global recession given the retaliatory acts from what remains of the IRGC. All that said, I don’t think this is a base-case investors should be positioning portfolios for.
However, we do have a President who has moved the goal post on several occasions and risks his credibility being hit even more than it already has if Iran calls his bluff. So, even if there is a less than 10% probability of mutually assured destruction, you can’t just ignore it. I estimate that a global economic recession takes equity markets down another 25% from current levels vs. a push back up to all-time highs (+6%) if the war ends and everything goes back to normal functioning immediately. The downside of such an outcome massively outweighs the upside if a deal is reached. But make no mistake, even in the best-case outcomes, there is built-up scar tissue from this war that will take the global economy time to work through. Keep in mind the U.S. equity market was contending with other obstacles (elevated valuations, AI disruption, decelerating labor market, hemorrhaging private credit market…) that haven’t gone away.
All I’m trying to get at is that the current investment backdrop still favors a balanced approach. You need some skin in the game to participate in the rally if a deal is reached – U.S. and International equities, commodities, gold, and likely Bitcoin. You also need some allocated to the preservation bucket should things devolve from here, in which case they likely do so at an accelerated pace, given the margin for error lessens with each passing day that transit through the Strait remains restricted – cash and short-term bonds (that’s it).
The risk/reward given the current setup remains heavily skewed towards too little reward and too much risk. If the S&P 500 were down around the 6,100 level with the current backdrop, I’d feel differently. In such an instance, I’d argue the risk/reward was skewed towards investors increasing risk because the reward warranted it. Here at 6,600 on the S&P 500, it’s the classic Carter Worth poker analogy – “it’s a pair of twos,” implying it’s the lowest quality hand that still qualifies as a play. Stated simply, stay invested, and be prepared to react as the setup evolves.
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