The obvious big story over the weekend was the U.S. strike on Iran’s nuclear facilities. While the White House hailed the strike as a complete success, full assessment of the damage awaits more facts. While Iran could do nothing in response and capitulate to U.S. demands to curtail any thought of building a bomb, few expect no response at all. At the moment, the ball is in Iran’s court. Its response will determine the next moves by Israel, the U.S. and others.
Instinctively, one would expect the shock and awe of Saturday night to elicit a meaningful result today in financial markets. But, based on early morning futures, there seems to be almost no response at all. Why? Two reasons. First, as of now, there is little economic damage. Oil prices are little changed suggesting no immediate inflationary reaction. Iran itself is not a major worldwide economic factor. It does ship over 1.5 million barrels of oil daily, but others in OPEC+ have enough spare capacity to offset any curtailment of Iranian production.
The one big possible negative event that could result from an Iranian response to Saturday’s attack would be any attempt to close the Strait of Hormuz, a narrow 20-mile passage through which over 20% of oil flows daily via tankers. But such an action from Iran would be seen as a major escalation sure to bring further response from the U.S. and oil producing nations in the Gulf. With that said, such an event would cause an immediate spike in oil prices and a negative reaction in markets overall. However, this remains a big if, one markets clearly aren’t even beginning to price in.
With all this said, and after watching all the talking heads over the weekend, both inside and outside of government, one can reach the following conclusions:
1. Until Iran responds, it is hard to reach any definitive conclusions.
2. While the risks of an economically catastrophic event are higher than they were a week ago, markets have concluded that those risks are still quite small.
3. History tells us that in conflict, most responses are measured to avoid provoking further escalation.
4. Just as Israel’s goal of wiping out Hamas and its terrorist acolytes in Gaza is elusive, preventing Iran from moving forward to develop nuclear capability over time could be just as elusive. However, clearly the attacks on its nuclear facilities and the assassination of key scientists will be a major near-term deterrent. What we don’t know yet is whether Iran has been able to move and store enough enriched uranium and centrifuges to keep its focus to develop a weapon possible.
5. With that said, Iran is playing with a very weak hand. Furthermore, key partners like Russia and China are preoccupied elsewhere. Thus, markets expect a face-saving response that could lead to a ceasefire with Israel followed by talks to constrain its nuclear ambitions. If that is the path taken, there would be a mild positive response in financial markets. However, just as the markets today are calm in the aftermath of Saturday’s bombings, any reduction in black swan risks will soon give way to focus on earnings, economic growth and interest rates.
Which brings us back to our economic world. The Fed continues to keep interest rates steady while acknowledging some economic weakness and improved inflation data. But choosing to wait and see what develops still appears to be the consensus. The next FOMC meeting is July 29-30. Trump’s postponed tariff deadline in July 9. No one expects the postponed Liberation Day tariffs to be imposed then. But, at the same time, no one knows what Trump might do instead. To date, there has been one announced (the United Kingdom) framework of an agreement. These deals are complicated and very country specific. The White House would like a framework for all (or at least most) done quickly but an agreement requires two sides to sign and, so far, none have. Trying to guess Trump’s next move is fruitless. However, if he takes any action, it will have economic implications. We have also seen big threats quickly reversed or toned down. That could easily happen again. While economists can make a cogent case that rates could be cut by a percentage point over a relatively short period of time, doing so in front of possible adverse tariff news or an outlier response from Iran seems problematic. No harm to wait until late July.
With that said, there are a few concerning signs within the economy. Housing is a mess. High interest rates and significant down payment requirements are clear deterrents. Auto sales are likely to be bumpy at least for a few months following accelerated buying in late winter seeking to beat the announced tariffs. Retail sales in May were down almost a full percentage point. I wouldn’t expect weakness at that rate to continue more than a month or two assuming no further tariff shocks.
While Trump has indicated he will not fire Fed Chair Jerome Powell prior to the end of his term next spring, he will try to influence the Fed. His likely proxy within the Fed is Governor Christopher Waller, a Trump appointee. That’s not to imply that Waller is a talking head for Trump, but he does share similar views and probably would like to be appointed as the next Fed Chairman. But he is only one vote of many on the FOMC. Nonetheless, he could instigate discussions that might otherwise not happen. So far, that hasn’t changed the Fed’s trajectory. Futures markets still favor 25-basis point cuts in September and December.
So far, I have left out the possible impact of the reconciliation bill now making its way through Congress, one that in its present form is likely to double the nation’s debt load over the next decade. In an effort to prevent longer term yields from rising, Treasury has redistributed is fundings to favor short-term issuance. A meaningful increase in the supply of 10-year Treasury bonds coincident with rising deficits would almost certainly depress bond prices and increase yields. If you think housing markets are weak today, imagine how they would be if mortgage rates rose above 8%!
One would think that if the economy is starting to weaken and the Fed will resume cutting rates within a short period of time, that longer term bond yields would start to decline, possibly recreating an inverted yield curve. But that isn’t happening. What also isn’t happening is dollar strength. While a weaker dollar should help increase export demand while bringing a surge of foreign visitors to the U.S. enticed by greater buying power, that isn’t happening. Moreover, while corporations currying favorable White House support are announcing plans to spend tens of billions of dollars in the U.S. over the next decade, few are taking any immediate steps to change behavior. The weak dollar also makes foreign capital investments more expensive while also wiping out the benefits of buying higher yielding sovereign U.S. debt. Indeed, yields all over the world, notably in Germany and Japan, have been rising. Deficit spending fever isn’t limited to the U.S.
Let me close and try to put deficit spending into some sort of perspective. In round numbers, our GDP is about $30 trillion. Our deficit is roughly $2 trillion or almost 7% of GDP. One could cut that impact in half backing out increased interest costs and elevated levels of transfer payments, everything from SNAP to Social Security. But my point is that a significant amount of our growth today comes from spending beyond our means. Few want to stop that. Social Security recipients like that their payments rise with inflation. Recipients of Medicare and Medicaid rely on government funding. Members of Congress want to spend as much as they can in their home districts. When one proposes to put a lid on the cookie jar, the sugar addicts cry foul. And Congress gives in and spends more.
That works until it doesn’t.
Yet what is most likely is that before we get to mid-summer Congress will pass the big bill and everyone will hope that the day of reckoning is beyond the horizon. Meanwhile, the IPO calendar is building, crypto speculation is rising, and investor confidence continues to build. Second quarter earnings are likely to be solid. Future commentary by management teams could be tempered by any post-July 9 tariff announcements. Meanwhile, AI is for real and a true stimulant for capital spending.
The bottom line is that while the events of this past weekend were both shocking and worrisome, until Iran reacts, the best advice is to do nothing differently than you were doing last week. Guessing and investing don’t go well together. Let the dust settle, which should happen over the next days or even weeks, and then make whatever educated reaction is necessary.
Today, Frances McDormand is 68. Justice Clarence Thomas turns 77.
James M. Meyer, CFA 610-260-2220