Respect Risk Even If the Market Doesn’t

Talks in Islamabad went nowhere last weekend. No real surprise there…

The sticking point remains Iran’s ambitions for its nuclear program. The U.S. won’t allow a nuclear Iran, so the situation is at an impasse.

Now the Middle East conflict moves to its next phase…

This week, the U.S. Navy is set to blockade the Strait of Hormuz. It aims to choke off Iran’s access to Gulf ports to further cripple its economy.

That will add another layer of pressure to Iran’s ruling regime. But the situation has consequences for the global markets and the economy.

So today, let’s dig into the key issues…

Iran Holds the Cards

While the U.S. blockade of the Strait will tighten the screws on Iran, the key risk is that it will become a long, drawn-out process. That would have major ramifications for the economy.

At the heart of the conflict is oil. Anything that hampers its flow will see already elevated prices stay higher for longer, creating more inflation.

Last week, we saw the first real effects of higher oil prices on inflation data. The Consumer Price Index (CPI) came in at 3.3% year-over-year for March – its highest reading in almost two years and well above February’s 2.4% reading.

Yet the real standout was the month-over-month data for March, which came in at 0.9%. That was triple February’s 0.3% print and its highest reading since June 2022.

The biggest contributor to that jump was gasoline, which was up 21.2%. And that plays right into Iran’s hands…

The longer Iran can disrupt oil flows, the higher the oil price will remain. That means more pain for the global economy.

Higher gas prices have already sapped consumer confidence. Last Friday’s University of Michigan Consumer Sentiment survey was its lowest reading on record.

But despite all of these concerning factors, the stock market doesn’t seem to reflect the current reality…

The Stock Market Disconnect

Against this backdrop, stocks enjoyed a strong run last week. Friday’s close on the S&P 500 (SPX) was just 2.6% off its all-time high.

Yet consider the macro story: Inflation is rising sharply, geopolitical risks are significant, and consumer confidence is tanking. Plus, the high oil price increases the chance of recession.

However, on Friday, the S&P’s volatility gauge closed around the same level as it was before hostilities broke out. That means that markets aren’t placing any premium on war risk.

But that’s a big mistake…

There’s a disconnect between the stock market and what’s unfolding in Iran. When markets are clearly mispricing risk like this, you need to remain leery. You’re not being rewarded adequately for the risk you’re taking on.

And when that disconnect between price and economic reality unravels, it doesn’t happen slowly. It often comes with a sharp and brutal move.

So stay cautious and restrained with your trades. Given that we’re only a quarter of the way through the year, there’s plenty more to play out.

Regards,

Larry Benedict
Editor, Trading With Larry Benedict