The Iran Flare-Up and Oil Flows
The overnight market reaction to renewed U.S.-Iran tensions was perfectly predictable. Markets are settling into a stable equilibrium. The path toward detente was never going to be linear, and the world has to get used to regular kinetic action between the two sides as part of the new landscape.
Neither Trump nor Iran wants a return to the hostilities of a few weeks ago. That environment was unsustainable for both: too costly for Trump politically and domestically, too costly for Iran economically and with its trading partners. That situation will not be revisited.
Regional actors are moving. The Saudis, Qataris, and Emiratis are building pipelines, and OPEC+ is increasing production. Flows still pass through Hormuz. As long as they do, the general market direction should remain to the upside.
The Fed as the Biggest Risk
The single greatest risk to the market is a Fed mistake, specifically a renewed hiking cycle. One or two hikes do not matter; that outcome is already baked in and discounted, and investors will not react to it. A full rate-hiking cycle is different, and it could undercut the current rally. That is the greatest short-term risk. With the Fed minutes, the goal is to read the Fed's reaction function and understand what is in policymakers' heads. Kevin Warsh and colleagues left themselves ambiguity by not committing to forward guidance, which keeps them from looking stale as oil ticks higher.
Yields and Rate-Sensitive Stocks
The move higher in yields tracks what is happening overseas and is pressuring rate-sensitive parts of the market, including Home Depot and the Russell 2000 small caps. The Russell 2000 has performed well despite everything. Rising yields are exactly what a Fed mistake would look like, so this warrants close watching. A sustained move higher would pressure the equity rally.
At 4.5% on the 10-year, there is no problem for either the U.S. economy or equities. Moves toward 5% or higher would be worrying, and some view the 4.6% area as the danger zone. For now, equities can live in harmony with roughly 4.5%.
A Higher Earnings Bar
The other major catalyst is earnings season, starting next week. The bar was reset higher by the spectacular quarter just completed, and companies did not guide forward because of the Iran situation. The focus falls on guidance and results coming out of the second quarter, since the bar now sits high.
Samsung illustrated the danger. It posted a strong earnings report this week, a preliminary one, yet the market punished the stock because the good news was already priced in.
The S&P 500 year-end target is 7,800. That is higher than today but not materially so, meaning most of the easy gains this year have already been had. Even so, earnings and guidance should come in strong enough to guide the market to a higher close by year-end. Progress will not be linear, and earnings, rather than multiple expansion, are expected to drive it.
Where the Upside Still Sits
Markets need to be distinguished. U.S., Korea, and Taiwan have run hard and priced in a lot; other markets have not, so their bar is much lower. Alibaba jumped 10.5% today on a Q1 report showing its e-commerce business profits returned to growth, and it rallied strongly precisely because China has not discounted the good news the way Korea has. For investors hunting tactical opportunities with further upside, China and some other emerging markets are interesting places to look. A large rotation is underway.
