The seeming reprieve in the Iran war is as uncertain as conditions can get

Outlook

The seeming reprieve in the Iran war is as uncertain as conditions can get. We have worries not only about crude supplies, but also about refinery capability. Europe may have an energy problem this winter. The background factors can easily jump to the head of the line if and when the ceasefire ends.

The Reuters energy reporter has this: “The U.S. energy system is already under heavy strain as record electricity demand, peak summer fuel consumption, growing data-center load and persistent reliance on gas-fired generation push ‌infrastructure closer to its limits.

“While the country remains energy-rich, the key question is no longer whether it has abundant supplies, but whether production is expanding fast enough to stay ahead of demand.”

The important data this week is Q2 GDP, already rear-view mirror but of interest because of the extraordinary capital spending that has had the Atlanta Fed GDPNow as high as 4%+. It was 1.7% at the last release on July 17 and we get a fresh one later today. Durables later this morning are not likely to move any needles.

We also get about one-third of the S&P reporting earnings, including Apple, Amazon, Microsoft, Meta and Qualcomm. Musk has had a comeuppance and the chipmaker story is still unfolding. One worry is that the tech sector is borrowing a seriously unhealthy amount in the bond market.

Then there is the Fed, the BoJ and the BoE.

The BoE is expected to keep rates the same on Thursday, in part on slipping inflation but also as an unspoken nod to a new PM. The BoJ is also expected to stay on hold on Friday, albeit with strong warnings about inflation. We will likely get an improved growth outlook.

Before that, we get the Fed decision on Wednesday, also a hold but likely a hawkish one. We can’t expect forward guidance and the press conference will be well attended, to say the least. The CME FedWatch tool has the probability of a hike at 33.7%, down from 37.4% on Friday but well up from 16.0% a week ago. Note that these numbers jump around quite a lot depending on time of day and the news. 

Forecast

On Friday morning we expected a minor pullback as we get on every Friday but limited because of expectations Trump would continue the war as he had for 13 days.

Then out of the blue late Friday he announced a halt, purportedly because Iran was seeking new talks. We didn’t believe it and sure enough, Iran denies it but who knows? Maybe Trump is telling the truth for once and it’s Iran still lying. Both parties are liars of Herculean size. 

Most markets want to believe the de facto ceasefire will lead to a bigger, better formal ceasefire. One idea is the US conceding Iran can impose tolls on the Strait if they would just open it. This would make Trump look ridiculous because the Strait was open before he started the war, but never mind—Trump wants the oil market to calm down and the equity market to recover.

Re-opening the Strait under any terms will meet those goals. Trump is purely transactional without principles or morals, let alone knowledge of history. This is the most likely of outcomes if only because it’s the most simple.

As we have noted before, re-opening the Strait cuts heavily into risk aversion and lowers the dollar. A resurgence in the G7 currencies would be a renewed dumping of dollars and not a message about relative economic conditions.

About equity markets

The postal service in my little town is really, really bad. The Economist arrives at least a week late. The issue of July 11-17 just came on the 23^rd.

But it had a dandy article on the European stock market, pointing out that it’s not statistically true that economic growth is highly correlated with equity outcomes.

For European equities, this is good news, especially since European companies get  over half their revenues from countries outside the EU. In addition, a big chunk derive higher revenues from rising commodity prices. Foreign interest in European equities tanked when the Strait was closed, but The Economist predicts it’s about to come back. 

Food for thought

We tend to think economic data rules FX. But it’s institutional risk that trumps any and all data. So far the US has managed to get away with government deficits far beyond normal and acceptable for anyone else by having the currency that is the numeraire for trade and the reserve currency. It looks like that will persist, so not covering it here. 

That leaves two versions of institutional risk—the Fed and Trump. We are inclined to believe Fed chief Warsh when he says the top priority is controlling inflation. He may favor changing the inflation target from 2%, a holdover from Mr. Bernanke. He may also prefer some measure other than headline PCE (which is actually the Fed target, not core) and may prefer to define inflation in some new and improved way. But there is no way inflation can be seen as a lot lower and no way a new target can be set that we are now meeting, hence justifying no action.

No action is what the CME betting pool expects this week. That’s using the old methods, and it will change by year-end.

Bottom line, worries about institutional risk arising from Warsh alone, one vote among many, are misplaced.

Just to seal that deal, Warsh has the Supreme Court behind him in fending off any pressure from the White House. He can’t be fired without cause, and plenty of it. We suspect Trump won’t even try.

The risk Warsh poses will come later, when he tries to engineer a way out of QE, which ended up adding a net $6.7 trillion to the Fed’s balance sheet, or almost 21% of GDP. By definition, meddling with the free market allocation of resources results in mis-pricing. In this case, all that money is liquidity for banks to lend, or likely, overlend. Shrinking the Fed balance sheet means depriving banks of the liquidity they have grown accustomed to over the past 18 years since QE began. It will take quite some time to contract the Fed balance sheet and it’s not impossible that a bank or two will fall by the wayside through failing to get the message. We may not hear about shrinking the Fed balance sheet except periodically over the next year or two, but don’t be fooled—it’s coming, and maybe sooner than we think.

Trump is another matter altogether. He poses tremendous institutional risk all by himself.  This takes three forms, the first being indifference to the voting public, now suffering from higher prices from tariffs and the war. It is also suffering from the loss of welfare programs, including Medicare/Medicaid, food stamps, and child care. This will play out in the midterms, assuming the Dems can become more coherent. But add Trumpian cheating and trickery to the usual Dem messiness, the Dems can lose and condemn us to another two years of unbridled chaos.

Second is the geopolitical aspect—tariffs plus attacking Venezuela and Iran, with Cuba and Greenland to come, not to mention Mali and heaven only knows who else. Trump appears unhinged and drunk on what he thinks is his power. The economic consequences are not fully known, but so far we do know that tariffs raise inflation and so does the cost of oil arising from Trump’s inability to make a deal with Iran.

The third is the near total loss of reputation and soft power of the US everywhere in the world. Recent international polls show the US favorability rating as down to about 30% just about everywhere. (Who is favored? Canada and New Zealand, we say because people in those countries have good manners.) Who is favored over Trump? China’s Xi. This is a measure of trust .

The recent Pew survey has only 23% holding a favorable view of Trump. Domestically, it’s about 33% favoring Trump and among diehard MAGA, even less at about 18% regarding the Iran war alone. Nobody knows how long it will take for the US to recover favorability, if it can even be done. This could be a permanent blot.