Last quarter we referenced the US-Iran memorandum of understanding that was agreed to near the beginning of July. This agreement proved to be short-lived, as it fell apart within a few weeks time. In its place, it seems as though the state of hostilities has largely been in a holding pattern, with some flare ups of activity, but no real dialogue between the parties, at least from the public’s viewpoint. It also seems as though the US, in particular, is trying to get past the midterm elections to possibly ramp up hostilities or come to a broader agreement at that time. Whatever route this takes will have large implications for the overall economy, energy prices, interest rates, and geopolitical stability and will be something to watch closely in the coming quarter.
One area of concern relates to the effect the war is having on energy prices, and by extension, inflation levels. One thought is that the longer the war continues, the more of an effect it has on energy prices and inflation readings. It was initially held out as only taking a few weeks or couple of months, with everyone worried about the potential for the longer term. We’re now 6+ months into the war, and there is no clear end in sight.
This has correspondingly kept inflation readings higher, and this has garnered attention from the Federal Reserve. While we stated in this piece last quarter that we didn’t see the Fed raising rates until year end, that has proven to be incorrect. The Fed has taken a harder line view of inflation, and decided to go ahead and begin raising rates at their last meeting, raising the Fed funds rate by 25 bps. Markets largely anticipated this, and we saw market yields sharply increase in the weeks ahead of this announcement. These rate movements have caused some more conservative investors holding bonds to experience the downside of rate increases in their bond portfolios. However, one difference we see between this rate rise cycle and the previous one in 2022 is the starting point. While rates were near zero in the 2022 cycle, they started at 3.75% this cycle, which means that they will hopefully not have to move rates nearly as much this go around.
On top of the geopolitical tension, we still have significant disruption and uncertainty related to trade and tariffs. While the Supreme Court struck down many of the Trump administrations tariffs in Q1 of this year, the administration has added back a number of these through other authorities. That, along with a more hostile attitude towards what seems like all of our trading partners, leaves a large amount of uncertainty for international trade. Even agreements previously negotiated by the first Trump administration, such as the USMCA, are under scrutiny and are not being renewed without significant negotiation. Many trade partners are finding ways to diversify their trade and find ways to not be as reliant on the US. There appears to be no end in sight for this source of uncertainty, at least through the end of 2028.
Given the effects of the Iran war on energy prices and the broader economy, as well as the trade and tariff uncertainty, it is amazing to see the resilience of financial markets and the US economy. Economic growth has continued, consumers have continued to spend, job growth continues and the unemployment rate remains low. The stock market has rebounded as well, and much of this is supported by earnings growth.
With that, it is important to note the contribution of the so-called AI infrastructure, semiconductors, and data centers buildout that is currently happening in the economy. The scale of this investment is enormous, and between that, and some potential reshoring on the manufacturing side of things, we are seeing a lot of activity that has helped support the broader economy during this time. In fact, the scale of this is so large that the financing of the buildout is competing with investor appetite in the US Treasury market, which has seen yields increase significantly over the last quarter.
Much focus is also currently on the US midterm elections. It seems almost certain that there will be at least some change in government, based on current polling. Divided government brings a number of challenges, but as the phrase goes, “markets love gridlock”.
Federal Reserve Policy. For those who thought Chairman Warsh might be in place to do President Trump’s bidding, it didn’t take long for him to make his mark and defy those expectations. The Fed announced they were increasing interest rates starting in September, with more likely to follow. The Fed has expressed that the inflation picture warrants more attention, and that they are intent on bringing inflation down to target. They may skip raising rates in the upcoming meeting, but watch for more to come later this year and into next as they focus on bringing inflation down.
Economic Growth – GDP. Economic growth has continued, with Q2 growth coming in at 2.2%. Much of this was driven by consumer spending, exports and business investment (particularly that for nonresidential structures such as data centers, equipment, and intellectual property/AI).
Labor Markets. Job growth has largely continued, but at a slower pace and the numbers seem to be coming in a little choppier. With lower immigration, productivity boosts from AI, and a job market more in equilibrium, expectations are for growth to be slower going forward. The unemployment rate still remains historically low at 4.2% as of September’s data.
Inflation. While we got a brief reprieve around the time of the US-Iran MOU, that was short-lived as that agreement quickly fell apart and energy prices went back up. Overall CPI sits at 3.4% year-over-year, and the core PCE reading sits at 3.0% year-over-year, both well above the Fed’s 2.0% target. These numbers are expected to remain elevated while the war continues.
Consumer Sentiment & Spending. Consumers spending has continued to present a bright spot in the economy, even though some of this additional spending is inflation related. Retail sales have been in the 5% and 6% ranges year-over-year. This has continued even though consumer sentiment is very low, likely due to inflation’s impact on real wage growth (which has been flat to slightly negative of late).
Housing & Real Estate. Housing market continues to struggle with elevated interest rates dampening activity. The hoped for reduction in rates has now changed into a rising rate environment.
Business Investment & Manufacturing. Business investment has been a strong spot in the economy, particularly related to AI investment, as referenced a couple of times in this piece. We may see peak investment in the next couple of years, after which companies are hoping to be able to recoup the funds they’ve invested during the buildout phase. There is much speculation as to how many firms will land on their feet.
Regulatory Environment. The Trump administration officially released its rollback of Corporate Average Fuel Economy (CAFE) rules in the automobile industry. While the penalty was previously reduced to zero, this new action officially rolls back the increases put in place during the Biden administration. Climate policy will continue to be a source of back and forth with different administrations as the two sides are far apart on this issue.
Global Economy. The US-Iran war continues to dominate the global environment. It is anyone’s guess as to the true state of play. Both sides seem to be in a holding pattern to see who can outlast the other. Iran is under tremendous financial pressure as they cannot bring much of their oil to market with the current blockade in place. The US is under pressure from constituents unhappy about the war and the resulting high energy prices, particularly at the pump. In addition, Ukraine has ramped up its attacks on Russian energy, particularly diesel, which is adding more pressure to the US side. We expect more action to come shortly after the elections.