Oil surge fuels inflation fears as stocks test key support ahead of Fed decision and midterms

Stocks took a hit on Friday as investors, traders and algos were forced to focus on a resurgence in oil prices, renewed inflation concerns and an increasingly complicated geopolitical picture - all just days ahead of the Fed’s next interest rate decision and now only ONE WEEK away from the contentious midterm elections.

And once again — OIL was front and center. WTI surged more than 4% to end the day at $103.44, while Brent crude jumped more than 3% to settle near $117 a barrel as escalating violence across the Middle East raised fresh concerns about global oil supplies.

And THAT is a problem — because rising oil prices only add fuel to the inflation fire. Higher energy costs mean higher transportation costs, higher manufacturing costs, higher prices at the gas pump and higher home heating bills — just as we move from fall to winter across the country.

And those higher costs don’t disappear. They either get passed along to consumers in the form of higher prices or they get absorbed by companies in the form of shrinking profit margins and neither is good for the economy, corporate earnings or the consumer.

And speaking of the consumer – Friday also brought us the latest U of Michigan’s consumer sentiment report, which showed confidence falling to 48, a five-month low, while inflation expectations moved higher to 4.7%.

And don’t forget — all of this is happening just as the Fed prepares to make its next move on interest rates. So, the question becomes — What will the FED do now? And the answer to that is nothing. Fed Fund Futures are pricing in No Rate Hike.

At the end of the day – the Dow lost 1.2%, the S&P gave back 0.5%, the Nasdaq lost 0.2%, the Russell lost 0.3%, the Transports gave back 1.2%, the Equal Weight S&P lost 0.8% while the Mag 7 lost 0.5%.

The VIX surged by 8.5% at midday only to settle up 2.2% to end at 19.40 as the day came to a close and the pressure on stocks eased just a bit. The VIX remains above all 3 trendlines but is below the most recent high of 22.20. This morning fear is easing a bit – the VIX is down 1%.

Of the 11 S&P sectors – Consumer Staples got hit the hardest – down 1.9% - making it the worst-performing of all 11 S&P sectors. Now, you might ask—why would defensive names get hit so hard when investors are worried about inflation, geopolitical tensions and the broader market?

Remember staples surged more than 3% on Thursday as investors ran for cover during the technology selloff. So, some of Friday’s action was simply profit-taking. But let’s not kid ourselves…. The bigger issue here is oil. With WTI trading near $104, investors are being reminded of what rising energy costs mean for consumer products companies. Higher transportation costs, higher packaging costs, higher distribution costs cause investors to question whether consumer staples companies like WMT – 1%, COST – 1.5%, KMB – 2%, PG -2.7%, KO -2.7% and PEP -2.2%. can pass those increases along without damaging demand.

And don’t discount the U of Michigan’s consumer sentiment report, Consumers continue to feel ‘more squeezed’ with every month…and now gasoline and energy costs are rising AGAIN – squeezing even harder.

Other sectors losing more than 1% included -Industrials – 1.2%, Healthcare – 1.1%, Financials -1.3%, Consumer Discretionary – 1.7%, Communications – 1.8%.

And here’s something interesting about Friday’s action. Yes, the Nasdaq finished slightly lower, but technology was NOT really the problem. We saw strength in Cybersecurity +3.3%, Software +1.7%, Semiconductors + 0.7%, Disruptive Tech up 0.2%....

So, who was getting sold? It was selective selling in the mega-cap names – think Mag 7 - GOOG – 1.1%, AMZN -1%, META-1%, NVDA -0.6% and TSLA – 0.7%, —along with the weakness in Communication Services.

And THAT is an important distinction, because the headlines would have you believe investors were running away from technology and the AI trade. But Friday’s action tells a different story. The buyers were becoming more selective. They were buying ‘certain parts’ of technology while continuing to reduce exposure to some of the biggest and most crowded names. They’re just being more discriminating about what they’re willing to own—and what they’re willing to pay for it.

And there’s another part of the AI story that deserves attention—the NEOCLOUDS. Now, you ask - what is a neocloud?

Think of companies like CoreWeave (CRWV) & Nebius (NBIS). What do they do? They build and operate the computing infrastructure that helps power the AI revolution. And why are they so important? Because even the hyperscalers - MSFT, AMZN, & GOOG - can’t necessarily build capacity fast enough to satisfy demand. So, they’re turning to neoclouds to provide additional computing power.

And that is creating an enormous opportunity. But here’s where the story gets interesting—and where investors are starting to get nervous. These companies are spending BILLIONS buying GPUs, building out infrastructure, securing electricity and expanding data center capacity. And a meaningful portion of that spending is being financed with borrowed money.

And here is the issue - CoreWeave is the perfect example…. two weeks ago – they completed a $2.6 billion financing facility priced at SOFR plus 5.5 percentage points. That’s not cheap money! And the underlying customer contracts average about three years, while the financing itself has a roughly five-year maturity. That’s the point….3 vs. 5.

The company needs to keep those GPUs working, generating revenue and producing enough cash flow to service its obligations. And when those contracts expire in 3 yrs, they need to renew them or find new customers. Now, as long as AI demand continues to explode, that model can work. But what happens if demand slows? What happens if computing prices fall? What happens when the next generation of Nvidia chips makes today’s chips less valuable? And what happens if borrowing costs remain elevated? And that my friends is what caused the CRWV sell off.

And remember, this is not just about the neoclouds. It’s about that circular financing. Nvidia sells them the chips. The hyperscalers rent their capacity. Lenders finance the infrastructure. And in some cases, the same companies supplying the technology are also investing in the businesses buying it.

NVDA CEO Jensen Huang defended the neocloud industry, saying ‘demand for its services was essentially off the charts. And I have no reason to dismiss that demand’.

Yesterday – Elon Musk said that the ‘neocloud industry is headed for widespread failures and consolidation because its debt-financed business model may not be sustainable’. Oh boy…. And now we have fight between two of the biggest, smartest minds in the industry…. This morning CRWV is quoted down 3.3% while NBIS is quoted down 2.7%. – So, for now, it appears as if the market is siding with Musk…. Just fyi CRWV is down 24% ytd while NBIS is up 90%.

Remember - strong demand and a good investment are NOT necessarily the same thing. You can have an incredible business opportunity and still end up with a disappointing investment if you pay too much, borrow too much or fail to generate adequate returns on the capital you’ve committed. And THAT is why the neoclouds have become such an important part of the AI debate.

The question remains: WHO is going to make the money, WHO is taking the financial risk and WHO ultimately gets stuck holding the bag if expectations get ahead of reality. And THAT is why investors are suddenly paying so much attention to debt, cash flow, financing costs and returns on invested capital.

Let’s move onto the bond market…. the TLT and TLH both lost 0.5% sending bond yields a bit higher…the 10-yr ended the day at 4.99%, while the 30-yr ended the day at 5.33%. This morning they are unchanged.

Now all this comes as we are about to get not one, but 5 different central bank decisions this week. The FED – expected to hold, the Bank of Canada – possible 25 bps hike, Reserve Bank of New Zealand – possible hike of 25 bps, the ECB and BoJ are expected to hold – like the FED. The BoE won’t report until November 5^th – and if nothing changes – they are expected to hold as well.

And remember, last week we heard from three Fed officials -Williams, Collins and Barkin – who all reinforced the idea that the Fed can afford to remain patient this week, even as inflation remains stubbornly elevated. Both Williams and Collins suggested another hike may be appropriate before year-end, which puts December squarely in focus. And THAT is the distinction - holding rates THIS week doesn’t mean the Fed is finished raising them.

And on Friday – gold broke below $4,000 to trade as low as $3,975 before settling at $4,007 – losing more than 4% for the week. And here’s what’s interesting. With geopolitical tensions rising you would expect investors to rush into gold as a ‘safe haven play’. But that’s NOT what happened.

Why? Because oil spiked higher and higher oil prices mean higher inflation expectations, which means the Fed may have to keep rates elevated or even raise them again. And with Treasuries yielding nearly 5%, investors can get paid to own government bonds rather than hold a non-interest-paying asset like gold. Add in some forced selling as some investors raised cash following the technology sell off and you begin to understand the pressure.

This morning gold is finding some support, trading up $11 at $4,018 as oil retreats - WTI is down 2.1% and inflation concerns ease just a bit.

Earnings today include WHR, NUE, RMBS, BRO, WELL – representing Consumer Discretionary (appliances), Steel production, Semi’s/Info Tech, Insurance and Healthcare Reits.

No significant eco data today.

European markets are higher – up between 0.5% - 1%.

US futures are up. Dow + 253 pts, the S&P’s +23 pts, the Nasdaq is +76 pts, while the Russel is +9.

The S&P closed at 7,623, down 40 points—but NOT before testing an intraday low of 7,612, bringing us within just 8 points of kissing that longer-term trendline sitting near 7,604. And recall, on Friday morning I told you that I would NOT be surprised if we tested that trendline before the day was over.

Well, guess what? WE DID! And more importantly, WE HELD!

Now, that is a positive, at least for the moment. It tells us that buyers were willing to step in as we approached an important technical level. But don’t mistake one successful test of support for an all-clear signal. The angst is NOT over—not by any stretch of the imagination.

We still have three more weeks of earnings season ahead of us, the Fed is on deck this week, and then NEXT week we have the midterm elections. And THAT introduces another layer of uncertainty. A Democratic sweep could force investors to reassess the outlook for taxes, regulation, government spending and the administration’s ability to advance its agenda. Some strategists are warning that the market could experience more pressure.

But here’s the other side of that argument. If stocks continue to sell off INTO the election, we could actually see a relief rally once the results are known—regardless of which party wins. (Think Sell the Rumor/Buy the News).

WHY? Because markets are forward-looking. They don’t wait for an event to happen before reacting to it. They anticipate, they discount and they adjust. So, if investors spend the next week selling stocks because they’re nervous about the election outcome, some of that uncertainty may ALREADY be priced in by the time we get to November 3rd.

In other words, the damage may have already been done. And once the uncertainty is removed, buyers may decide it’s time to step back in. Remember, the market doesn’t necessarily need GOOD news to rally. Sometimes it just needs the absence of BAD news—or the removal of uncertainty. But for now, keep your eye on that trendline near 7,604. Friday’s successful test was encouraging, but a decisive break below it would raise the risk of another leg lower.