Market behavior in Q1 was dominated by the war with Iran, with global oil prices soaring and equities collapsing after the February 28 attacks by the US and Israel. But after weeks of war, the extraordinary resilience of the US economy began to reassert itself. Creeping doubts about profitability of AI had dampened performance before the war. But these and other concerns seemed to be cast aside at the end of Q1 as “buy the dip” fervor took over. It continued into April.
A sharp rally on the last day of March limited S&P losses for Q1 to 4.4% for the S&P and just under 7% for the tech-heavy NASDAQ. In April so far, despite a continued standoff in the Middle East that is blocking almost all oil exports from the Persian Gulf, US markets hit new record highs mainly due to AI-related stocks. Overseas, markets are also feeling upbeat with global equities up over 9% month-to-date, European and Japanese equities up more than 7% apiece, and emerging market stocks roaring back after their sharp decline in March, posting returns close to 15% so far in April.
Looking ahead, RockCreek expects volatility and uncertainty around geopolitics to continue. At the same time, the strong fundamentals of the US economy amid investor enthusiasm for AI will likely prevail, absent further big shocks.
RockCreek sees four themes going into Q2:
War damage: Both Iran and the US want a lasting end to hostilities. But trust is lacking and escalation is possible. The longer energy supplies are locked up behind the Strait of Hormuz, the more scarring there will be to the global economy.
So far, US consumers have grumbled but continued to spend. If that spending weakens, so will earnings. In other parts of the world, shortages of fuel and fertilizer – and other key commodities from oil and gas – are already showing up. Food prices are expected to go up once the impact of current fertilizer shortage is felt with a lag. Jet fuel shortage in Europe is already resulting in flight cancellations while some countries are rationing fuel and gasoline. This may hasten use of SAF (sustainable aviation fuel).
Overall, these forces will hurt global demand and push up inflation. The US is in a stronger position than most. It is now the largest producer of oil and gas in the world. Its dominance in technology innovation is rivaled only by China. And, in the flipside of America’s persistent trade deficits, economic growth does not depend principally on demand in other countries but rather on consumers and investors at home.
Interest rates and inflation: Rising oil and gas prices abruptly shifted the outlook for central bank actions this year. With the concern that higher fuel and energy prices will feed through to other prices, rate hikes are now expected in the UK and Europe. In the US, markets have revised down the number of policy rate cuts priced in for this year from three to possibly one.
Short-term rate expectations are complicated by the transition looming at the Federal Reserve. The Justice Department on April 24 dropped its probe into current Chair, Jerome Powell, over building costs. This clears the way for a Senate vote to confirm Trump’s pick for Chair, Kevin Warsh, to happen before Powell’s term ends on May15. Powell may decide to stay on as a Board governor after that; his term as governor runs through 2028.
Warsh was careful at his Senate hearings this week to avoid tipping his hand on rates. But he is widely expected to lean towards easier money, in line with President Trump’s expectations. The Fed’s traditional preferred inflation measure seems stuck at around 3%, above the 2% target for the fifth year. Warsh joined those who now wonder if that is overstating inflation risks.
Fiscal and financial pressures: While the Federal Reserve sets short-term interest rates, markets set the longer-term rates that feed through to the real economy through mortgage and other loan rates. There is a debate about the impact on rates of expected productivity increases from AI. The impact of fiscal pressures is clear: they tend to raise rates. Private sector lenders, whether domestic or foreign, want a higher return to satisfy increased debt issuance, other things equal. But so far, mounting US debt and the prospect of continued large budget deficits, despite economic strength, has had little if any measurable effect on demand for Treasuries. Some observers believe government debt is the achilles heel of the US economy. But don’t expect the fiscal position to cripple growth any time soon. A more pressing concern is the potential spillover from problems with private credit. Investors are learning that lending in private markets, even through institutions (Business Development Companies, BDCs) that may be publicly traded, locks up money. The key will be whether systemically important banks successfully limit their exposure to BDCs.
AI and associated demand for energy and “compute” infrastructure: Remarkably, the AI boom has been enough so far to outweigh concerns arising from the three preceding issues. In Q1, some of the shine came off tech companies, including the megacaps. And not all tech companies are created equal. SAS companies whose longer-term prospects with AI came under review. But the revival of “risk on” sentiment as investors discounted a broader conflict in Iran has propelled tech stocks forward again. Apart from tech, analysts see some associated sectors – notably energy – as undervalued – energy is one that will thrive on increased demand from AI.
