Financial markets are experiencing significant turbulence as Wall Street prepares for the possibility of extended Middle Eastern hostilities that could reignite inflation concerns and jeopardize economic expansion while weakening arguments for Federal Reserve rate reductions.
Tuesday marked another volatile trading session following weekend military actions by U.S. and Israeli forces against Iran. Concerns about potential disruptions to the Strait of Hormuz, a vital shipping lane handling approximately 20% of global oil transport, have heightened worries about energy-fueled price increases.
“While not much has changed fundamentally since yesterday, investors are growing anxious about the duration of the war and its impact on energy prices,” explained Joseph Tanious, chief investment strategist at Northern Trust Asset Management in San Diego. “The reality is setting in that a prolonged conflict could dampen global growth and re‑ignite inflation pressures.”
Oil prices continued their upward climb for the second straight day, pushing major stock indices lower. The S&P 500 dropped 0.9%, reaching its weakest point in more than three months despite recovering from steeper earlier declines. All eleven sectors within the index posted losses, signaling widespread selling pressure.
International government bonds also weakened, though they recovered somewhat as traders assessed the likely duration of the conflict.
Wall Street’s volatility indicator, the Cboe Volatility index, climbed to its highest reading in over three months.
“The reaction has become more intense…there’s no sign of a quick resolution,” noted Que Nguyen, chief investment officer of equity strategies at Research Affiliates in Newport Beach, California. “People are waking up to the fact that this is a lot more complicated than they assumed.”
Market participants are particularly focused on how sustained oil price increases might pressure inflation. Brent crude recently traded near $81 per barrel, significantly higher than the roughly $60 level seen at year’s beginning.
The five-year U.S. breakeven inflation rate, which reflects market-based inflation expectations, climbed to 2.503% late Monday, marking the highest level since February 11.
According to Goldman Sachs economists, every sustained 10% rise in oil prices adds 28 basis points to the consumer price index, a key inflation measurement.
Market expectations for Federal Reserve rate cuts appear to be diminishing. Fed Fund futures Tuesday showed a 56% probability the central bank will maintain current rates at its June meeting, compared to greater than 50% odds for a cut that markets had priced in late last month, based on CME FedWatch data.
“The biggest issue that (investors) are trying to weigh gets back to the intertwining of inflation and interest rates,” said Chuck Carlson, chief executive officer at Horizon Investment Services.
While other geopolitical tensions involving the United States, including situations with Venezuela and Greenland, haven’t substantially damaged stocks, some investors view current weakness as a potential buying opportunity.
“We are taking cash we raised from tech to aggressively get more positioned for a global acceleration of economic growth,” said Eddie Ghabour, CEO of Key Advisors Wealth Management, whose firm has been purchasing emerging markets ETFs this week.
Even with this week’s declines, the S&P 500 remains just slightly more than 2% below its record closing high.
Andrew Slimmon, senior portfolio manager at Morgan Stanley Investment Management, suggested the market’s resilience “suggests to me that investors might be underestimating the geopolitical risk.”
Market participants will closely monitor developments in coming days.
“We’re really still at the mercy of the headlines,” said Kevin Gordon, head of macro research and strategy at Charles Schwab. “The potential for whiplash in parts of the market is very high.”
