Geopolitics stands as the single biggest risk to markets right now. The US and Iran are exchanging strikes, and this morning the memorandum of understanding is no longer understood and the ceasefire has broken down. That matters because the bullish base case for continued market growth, receding inflation, a potential rate cut, and the ongoing AI revolution all rest on the same conditions: the Strait of Hormuz stays open, the Iran conflict moves behind us, and oil prices come down.
The broken ceasefire reopens hard questions. Does the strait close again? Do oil prices climb back up? Do inflationary pressures mount? And does the Fed then have to lean toward a rate hike instead of doing nothing for the rest of the year? Expect more short-term bouts of volatility of this kind. Once the conflict is ultimately resolved, growth opportunities lie ahead.
Oil is rising today but has come off the session highs and still trades below $80 a barrel, a reassuring level given where prices could have gone. The move is a direct response to comments from President Trump, and prices could creep toward $80 by the end of the week unless the hostilities recede.
A Goldilocks economy, for now
The economy still fits the Goldilocks description, and today's news does not yet break that conviction; it calls for wait and see. Unemployment sits at 4.2%. The labor market runs neither too hot nor too cold and stays relatively stable. The Atlanta Fed's GDPNow forecast for Q2 is about 1.2%, which is not knocking the cover off the ball but holds up. If inflation keeps receding, even moderately, that combination sustains the Goldilocks state, and the Fed does nothing for the foreseeable future, the exception being oil climbing back near $100 a barrel.
Reading the Fed
The new Fed chair, Kevin Warsh, is hard to pin as hawk or dove. Is he a hawk in dove's clothing, or a dove in hawk's clothing? Unresolved. What is clearer: he is a reformer who wants to transform how the Fed operates and communicates, and both shifts are positives for markets and for portfolio managers.
Anyone who left the last Fed meeting convinced the Fed had turned hawkish should think again. Of the 18 voting members, nine favored a 25 basis point rate hike, eight favored no change, and one favored a 25 basis point rate cut. That is far from unanimity. The meeting minutes due out later today are worth watching closely: was the debate entirely about oil, or do members see other, stickier areas of inflation that might justify a 25 basis point hike? Either way, a 25 basis point hike at the end of the month would do nothing to oil prices. The only thing that brings oil down is the strait staying open.
"AIR" versus the Mag 7
On the AI theme, the "AIR" basket of AI revolution stocks has performed well. Seven of those names were up roughly 75% year-to-date through the first two quarters. Over the same stretch, the Mag 7 was down 1.7% year-to-date.
The appeal is a smoother, more diversified ride along the AI revolution across the full stack: software (Alphabet/Google), semiconductors (Nvidia), semiconductor manufacturers (Taiwan Semiconductor), memory makers (Micron), data centers (Digital Realty), and cooling solutions (Vertiv). Power belongs on the list too. American Electric Power, a utility, was up over 20% through the first two quarters, a surprising amount of growth for a utility, driven by its role as a backdoor play on AI demand.
The market rotation underway is healthy for the sustainability of this bull market, provided it does not come at the expense of the technology sector or the Mag 7. The Mag 7 accounts for 33% of the S&P 500 and 41% of the Nasdaq 100. Breadth is welcome, but not if it drains those names; the move is to diversify and lean into those areas while still needing the top of the leaderboard to do the heavy lifting. The market feels like Atlas, and one hopes Atlas does not shrug.
Small-cap biotech and the M&A wave
A set of names on the radar all share a ticker starting with A: Alnylam (ALNY), Alkermes, and Arcturus. All show strong year-to-date performance, and two post very strong year-over-year gains.
How can they keep outperforming? They lean into the healthcare rotation coming from the small-cap biotech side. Over the next couple of years, more than 200 drugs are scheduled to come off patent, and 69 of them are blockbusters with annual sales above $1 billion each. Large-cap pharma will have to turn acquisitive to replace that revenue gap. A name like Alnylam, a smaller-cap biotech using T-cell therapies to fight blood cancers and solid tumors, could be a very attractive acquisition candidate for large-cap pharmaceutical companies. That makes the M&A theme compelling, and small-cap biotech should continue to outperform.
