Introduction

The market is currently hostage to developments in Iran. Escalatory headlines are driving abrupt downside reactions, making directional index calls extremely difficult in the near term. In this environment, any meaningful de-escalation could just as quickly trigger a sharp reversal higher. It’s an unstable setup, and precisely why the “do less” approach we have advocated since mid-January has proven its weight in gold.

We have consistently suggested watching oil for a clearer signal of what is actually unfolding in the Middle East, as headlines are often noisy and frequently misleading. Energy markets tend to cut through that noise.

The reality is straightforward: equity markets will struggle to move higher if oil continues to surge. Rapid increases in crude prices act as a tax on global growth and have historically carried the ability to push the global economy toward recession. We are beginning to see that fear slowly seep into broader market sentiment.

Ironically, that growing fear also makes us incrementally more interested in leaning long from a positioning standpoint. However, any durable long setup will remain tethered to developments in Iran.

As we write this report, WTI crude is trading above $113 per barrel—up ~24% since Friday’s close and ~70% over the past week. That kind of move does not occur without consequences for risk assets.

Unsurprisingly, equity markets are reacting sharply, with major index futures down more than 2% as investors attempt to price in the implications of a sudden energy shock.

This is occurring after the S&P 500 just experienced its worst week since October, adding another layer of fragility to an already tense macro backdrop. With sentiment already weakened and positioning likely shaken out, the market now faces a fresh geopolitical shock at a moment when confidence was already deteriorating.

The bottom line is that the market is not cheap—and hasn’t been for some time, particularly if oil prices begin to meaningfully pressure global profit margins. Rising energy costs function as a tax on businesses and consumers alike. If sustained, they will inevitably force analysts to revise earnings estimates lower, which in turn would make equities appear even more expensive on a forward basis.

That is the conundrum the market now faces.

Higher oil prices will inevitably push inflation higher, as energy is a pervasive input across goods and services throughout the global economy. In the coming week, markets will receive a pair of key inflation reports, including the Federal Reserve’s preferred price gauge, following a disappointing February jobs report that challenged the narrative that the labor market is stabilizing.

These upcoming reports are expected to reinforce the view that inflation remains stubbornly persistent. And given the highly fluid nature of oil prices at the moment, the risk is that future inflation readings begin to re-accelerate if energy costs continue to climb.

A sudden spike in inflation would only complicate the Federal Reserve’s task heading into this month’s FOMC meeting, making it far more difficult for policymakers to alter the current trajectory of the federal funds rate. At present, markets are assigning virtually zero probability to a rate cut in March, while expectations for two additional cuts later this year continue to fade as inflation risks re-emerge.

What the market is now confronting is the rising risk of stagflation—something we have been discussing for months. Cyclical exposures have been leading the market in anticipation of a more stagflationary backdrop, and that possibility is now beginning to look increasingly real.

The current setup is messy, and attempting to confidently predict what comes next is largely a fool’s errand. We have remained cautious and tactical, and at this stage we see little reason to change that posture.

That said, periods of dislocation inevitably create tactical opportunities.

With that in mind, let’s review the charts.