War has dented the outlook for U.S. economic growth, but investors who think that’s a sign to short the market should think again.
Even with hopes that the Iran war will soon wind down, oil prices are very unlikely to revert to pre-conflict levels, meaning it will remain a drag on economic growth. Counterintuitively, that could ultimately be good for stocks if it can tame inflation, according to 22V Research.
At this point, investors are hoping for the best and trying to ignore all the ongoing uncertainties about the war even as the S&P 500 wrapped up its worst quarter since 2022 on Tuesday. Although any conclusive peace agreement remains elusive, the thought is that the U.S. is at least edging closer to de-escalation with Iran, which should at least make worst-case scenarios about the price of oil more remote.
Just because it may not go to $150 or more a barrel however doesn’t erase the fact that the status of the Strait of Hormuz remains uncertain, keeping prices elevated. Current gas prices would result in an income transfer from the household sector to the energy sector, writes 22V Research President Dennis DeBusschere, a “manageable drag” given that personal income is up 4.5% on a nominal basis, compared to inflation’s nearly 3% clip.
In addition, he believes the Federal Reserve’s Financial Conditions Impulse on Growth (FCI-G)—a monthly measure of financial conditions that encompasses data points like interest rates, asset prices and the dollar—shows that conditions have tightened enough to reduce demand growth by about 50 basis points over a one-year horizon. Taken together, the energy shock and tighter conditions should equate to a roughly 100 basis point economic downshift.
The silver lining is that the “slowing in demand growth described above IS NEEDED to lower inflation longer term,” DeBusschere writes. “Investors are pricing in a Fed that DOES not respond to the expected slowing in demand with more cuts. Investors realize the Fed will let demand growth slow. Unless the unemployment rate moves up significantly.”
That explains why longer-term inflation expectations and 10-year Treasury yields have moved lower recently.
It also explains why stocks are unbothered by slowing growth. Investors are still betting that recession odds are still low, and a “non-recessionary slowdown in demand growth, that lowers inflation, should increase the odds that the economic cycle lasts longer,” he posits.
That means it’s difficult to short the market, even with the headwind of the war. Likewise, stock multiples have come down, even as many management teams have expressed confidence about earnings power and 12-month forward earnings expectations have increased since the start of the year.
That puts bears in a tough spot, even if their concerns are legitimate. Call it a Catch-22 for investors.
Write to Teresa Rivas at teresa.rivas@barrons.com