Iran, oil, inflation and K-shaped consumption
The conflict with Iran continues, the Strait of Hormuz remains closed and 20% of the world’s energy supply has been constrained for more than 90 days. At the outset of this conflict, May 15 was often stated as the “pain point” when higher energy prices were sure to begin cutting into economic activity. Brent crude oil crested at $118/barrel and now sits at $95/barrel – more than 50% higher than at the outset of 2026.
Inflation data have pushed higher, with core personal consumption expenditures (PCE) now at 3.3% – well above the Fed target of 2.0%. Despite having experienced more than 90 days of this oil shock, our economy and markets have held up quite well. Consumption and overall economic activity are reasonably strong, and 2026 is off to a fine start, from a market perspective, with the S&P now posting an 11.25% gain for year-to-date through May.
Both the energy and equity markets are reflecting an expectation that the Strait will be open relatively soon, assuming that both oil and inflation will be falling throughout the back half of 2026.
Negotiations grind on, with gas prices and interest rates rising
Throughout May, negotiations with Iran stumbled forward with the news flipping from positive to negative almost daily. Along the way, it became clear inflation was being pressured upward by elevated energy costs. Most inflation data pushed higher during May, as the energy inputs finally began to raise broad prices higher. Of course, gasoline prices had already increased sharply, with national average prices jumping above $4.50/gallon early in the month.
Higher energy and inflation data naturally spiked interest rates throughout May. The 10-year treasury note hit a cyclical high of 4.67% mid-month, reflecting rising uncertainty about inflation (and long-term deficit problems).
Toward month-end, the negotiations took a more positive turn, and both oil and interest rates began to fall. The drop in both variables is a very welcome sign – but meaningful progress toward re-opening the Strait must be made soon, or these variables could resume their upward momentum.
War? What war?
Despite the significant geopolitical and economic uncertainties, both the U.S. economy and equity markets continued to advance in May. Household consumption appears to be holding up well, with additional economic thrust being provided by the amazing capital expenditure (CapEx) boom from the AI buildout (ex: hyperscaler construction, server farms). Consumption is likely being bolstered by the wealth effect‡. Household net worth (as a percentage of discretionary income) is at all-time highs due to phenomenal gains in housing and equity prices over the last 10-15 years. This additional wealth likely helps maintain consumption patterns, even during times of conflict.
First quarter gross domestic product (GDP) was revised lower, but only slightly below our long-term trend growth rate of 2.0%. Most forecasters expect the remainder of 2026 to bring normal 2% growth, despite the issues with the Iran conflict. This hammers home the reality that the U.S. is much less energy dependent than we’ve ever been.
Additionally, our recent ascendance to the status of a “net exporter” of oil has made the Iran conflict much easier to navigate. To reiterate, the Strait needs to re-open soon if we hope to preserve the positive economic and market momentum we’ve enjoyed thus far in 2026.
Mid-month, we witnessed one of the best earnings seasons in history. In aggregate, S&P 500 earnings grew nearly 28%. Profit margins expanded to all-time highs (above 13%), and the outlook for both margins and earnings remains optimistic. Margins and earnings continue to be driven mostly by AI-focused industries, but it’s important to note that all but one S&P 500 sector beat their earnings estimates (meaning it’s still a broad-based earnings story). Consequently, the market spiked sharply, with the S&P 500 rising 5.25% for the month (11.25% YTD).
Labor looking better, but other market challenges remain
The labor market has been a consistent worry over the last year, with job creation nearly non-existent. However, in May, we received our third positive report for payroll growth for 2026. Job creation appears to have moved back up to more normal levels, at around 125,000 jobs per month. This is a very welcome trend that, if sustained, would indicate the labor market has recovered from a long period of unacceptably low job creation.
Certain measures of consumer sentiment continue to worsen, with some surveys showing readings at or near all-time lows. This reflects the fatigue settling in on the average household, as they struggle to keep up with costs of living increases that are eating up most of their discretionary income.
As inflation pushes spending higher at a faster rate than wages can grow, savings rates have fallen sharply. The U.S. savings rate is now at 2.7%, one if its lowest readings in history. The wealth effect is helping some households justify lower savings rates, but most equity wealth is held by the top 20% of wage earners. The average household needs relief from inflation.
The K-shaped economy continues unabated. As the market climbs, the wealth accumulation amongst most affluent households (top 20%) continues to create a chasm between them and the rest of the populace. There is evidence that wage growth has also tipped firmly in favor of the most affluent households. This trend is not inherently bad, but it is not the ideal balance of wealth and income growth we hope for in a healthy, balanced economy.
Green shoots in business surveys
Business surveys have recently moved in a positive direction. Some purchasing manager surveys have entered positive territory, indicating positive sentiment in the manufacturing sector. Additionally independent surveys of multiple business sectors from research firm ISI indicate that most business sectors report a positive outlook for activity in the next 6-12 months. This could provide a nice potential tailwind for hiring and wages.
Summary and economic outlook
The U.S. economy continues to hold steady at or near our normal growth rate of 2.0%. The closing of the Strait and the spike in oil prices and inflation have not, thus far, severely hampered either the economy or markets. The stock market is riding a powerful surge of earnings growth, spurred by huge hyperscaler profits and an AI CapEx boom. Assuming the Strait is re-opened soon, the economy and markets should continue to experience reasonable expansion in 2026.
Economic and market optimism is clearly contingent on the Strait re-opening, bringing oil and inflation down in the back half of the year. If these prove to be false hopes, then growth and earnings forecasts will be revised downward. We are cautiously optimistic that political realities will necessitate a resolution to the conflict, and that current market assumptions will become reality. Market returns have already been surprisingly robust for 2026, but we foresee modest additional gains throughout the remainder of the year.
We are here to provide our clients with peace of mind about their financial future. Anchoring to a sound, long-term financial plan will help you weather storms like these. We will remain disciplined, and consistent in our strategies and philosophies. We are confident that together we will manage our way through this (hopefully brief) challenging time.
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