The S&P 500 Index is trading at an all-time high and approaching the next major milestone: 7,500 points. At the end of March, when the same index was below 6,500 points, there were few optimists who had joined the ranks of the Wall Street bulls. Pretiorates was one of them, and that’s where we remain. Even if politicians continue to give the impression that they’re living on another planet.
The closure of the Strait of Hormuz benefits U.S. energy companies above all. Although parts of their infrastructure in war-torn regions were damaged or destroyed, Q1 results clearly showed that lower production was more than adequately offset by higher market prices. The U.S. energy powerhouse is likely to be largely supplied with oil, as are most African and the big Asian countries, which can benefit from domestic production or Russian supplies. The situation is different in Europe and several Western-oriented Asian countries: the actual oil shock is likely to become apparent there only once inventories eventually fall to lower levels.
The high-tech industry in the U.S. has been barely affected by the war. Investments in new data centers are enormous—several hundred billion dollars, as we discussed in an earlier issue. Anyone who speaks of an AI bubble is essentially implying that the big IT giants don’t know what they’re doing. Our view is rather this: Perhaps many others simply haven’t yet understood what’s coming our way. IT companies know their business better than anyone else. And one thing is obvious: The industry is booming.
Another US sector that will also benefit from this is utilities. In just a few years, data centers will generate an immense demand for electricity. The intriguing question remains: Where is all that power supposed to come from?
Back to the beginning of this article: Wall Street is in record-breaking spirits. And when the champagne corks are popping on Wall Street, profits usually flow in the financial scene as well. It’s clear that the largest US sectors are actually doing brilliantly; it’s just that sentiment is (unfortunately) heavily clouded by geopolitical developments.
That is why the Smart Investors Action continues to indicate that ‘smart investors’ are still accumulating. Even though the red area and yellow dots show initial signs that the market might be taking a temporary breather.
While sentiment on Wall Street has calmed down somewhat recently, the sentiment indicator continues to point to pronounced optimism. Negative surprises can therefore still be absorbed quite well.
Perhaps a word of caution is warranted by the fact that the appetite for more aggressive financial assets such as stocks and high-yield bonds has risen sharply at the same time. A pronounced ‘risk-on’ sentiment is evident in the record-high correlation between these two risk assets. This is not a sell signal, but it shows that Wall Street bulls have the situation under control as long as this correlation does not suddenly begin to correct.
The sharp rise in energy prices, coupled with strong sectors—this smells quite distinctly of rising inflation. In fact, both the Consumer Price Index (CPI) and the Producer Price Index(PPI), released this week, came in significantly higher than expected. However, this development is not really surprising: Given the high oil price and the sharp rise in the ISM Services PMI Report over the past few months—which has repeatedly proven to be a good leading indicator of inflation trends—higher inflation was to be expected.
The Producer Price Index, in particular, came in significantly higher than expected. But we’d like to remind you of a previous edition of our Thoughts: It’s not the case that a significantly higher PPI automatically affects the CPI sooner or later. On the contrary: The two inflation indices correlate very strongly with a three-month time lag.
This chart shows the high correlation between the oil price and inflation. Given the high oil price, one might expect inflation to skyrocket as well. That is certainly possible. But here we’re playing the ‘this time it’s different’ card. The longer the Strait of Hormuz remains closed, the more severe the oil shock is likely to be. Not necessarily in terms of oil prices themselves, since there is generally enough oil available. Oil products, on the other hand, could see a price explosion. Refining costs and processing costs are likely to skyrocket. However, we still assume that the Strait of Hormuz will reopen sooner or later. Then there is likely to be a glut of oil. That is why we are ignoring this chart—for now. We also recall our previous Thoughts: Swap rates have not (yet?) reacted to inflation fears either.
Another consequence of higher inflation would be higher market yields, i.e., higher interest rates. The new Fed Chair, Kevin Warsh, is on the verge of being confirmed by the U.S. Senate and taking office in a few days. The question is whether he will opt to combat inflation—or support the economy with lower interest rates.
The market’s reaction to his first official act is likely to be strong: The 30-year U.S. Treasury yield is on the verge of breaking through the 5 percent barrier—or facing a sharper correction.
A small majority in the market currently expects that an interest rate hike could occur.
Which brings us to U.S. consumers, as they would be the ones to bear the brunt of inflation. But here, too, it’s important to set the record straight on an age-old rumor: Yes, U.S. household debt has continued to rise in recent years. Since 2003, it has climbed from around $7 trillion to over $18 trillion today.
But what is often swept under the rug is this: disposable income has risen even more sharply. The ratio of these two figures stood at over 115 percent during the financial crisis nearly twenty years ago—meaning U.S. household debt exceeded disposable income. Since then, however, the situation has improved significantly. The ratio stands at just above 80 percent today. In other words: The U.S. consumer is no longer quite as weak as his reputation suggests—at least on average. Wolfstreet.com has written a great article on this topic, which we recommend to interested readers.
So we see: It’s not just high energy prices due to the war with Iran that are fueling inflation concerns. Higher interest rates, should they come, are something U.S. consumers can now handle much better than they could during the financial crisis. The markets are therefore likely to be waiting with bated breath for the new Fed chair’s first words. What will he emphasize?
