Resilient So Far

Resilient So Far

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The U.S. equity market has enjoyed a fairly quiet and orderly run so far in 2026. After initially declining by 7.7% at the beginning of the Iran conflict in late February through late March, equities rallied sharply by 20.2% through early June, and have since then been moving mostly sideways, up 0.9%. For the year so far, the S&P 500 is up 12.7% and one could argue that this is reflective of the overall health of the U.S. economy. Unemployment is currently low at 4.1% and the Atlanta Fed’s GDPNow forecast for growth in the current third quarter is at 4.4%(!). These are very impressive numbers and they help to understand why equities have remained resilient despite higher fuel prices, a stubborn level of inflation, and rising interest rates. As we approach the fourth quarter, we’ll take a look at some key details.

Higher Fuel Prices Put Pressure on the U.S. Economy

Those higher fuel prices have been particularly costly for anyone or any business that uses diesel. At $6.06 a gallon, it recently hit its highest point since 2022 shortly after Russia invaded Ukraine. Before the start of the Iran conflict, it cost $3.76 a gallon, so that’s a 61% increase in price. This higher fuel price really hits the U.S. economy. Most every large piece of farm equipment is fueled by diesel, as well our freight trains, and the trucks that haul all of our products to market. The American consumer ends up paying for these higher fuel prices via higher food prices and just about everything else. Fuel accounts for roughly 15% to 30% of the total cost of food, according to the Independent Grocers Alliance (a group of 7,500 global supermarkets). Gasoline prices have increased by 44% since the start of the Iran conflict. One reason for the discrepancy in the price increase of gasoline relative to diesel is that there’s less flexibility in the demand for diesel.

Global Supply Constraints Disrupt Fuel Markets

Iran’s strikes on Middle East refineries and Ukraine’s strikes on Russian refineries and the closure of the Strait of Hormuz has constrained and slowed the flows of crude to be transformed into fuel and the flows of refined products. Somewhere between 7 and 8 million barrels a day of global refining capacity is offline according to Enverus Intelligence, an energy industry platform. This in turn has meant that U.S. fuel production is running at full capacity and needs more capacity, and this is helping to push up prices domestically (chart below shows the year-to-date change in the price of crude oil is mostly impacted by supply constraints despite a modest decrease in demand).

Inflation Keeps Interest Rates in Focus

It’s fairly safe to say that higher fuel prices have contributed to the stubborn level of inflation. And the overall level of inflation has caused the Fed and the bond market to indicate that higher rates are perhaps necessary in order to reduce those pressures. One of the Fed’s closely watched inflation metrics, the U.S. Core PCE Index, was most recently reported at 3.3%, and Fed officials would like to see this number as close as possible to 2%. Easier said than done, at least at this point in time.

And yet, we’ve seen equities rally this year by 12.7% despite stubborn inflation and interest rates moving higher. The 2yr and 10yr Treasury rates are up by 1.15% and 0.80% year-to-date, respectively, (the 2yr note is currently at 4.62% and the 10yr note is at 4.97%). Fed Fund futures reflect an 88% likelihood of a 25-bps increase at the Sept 16th meeting.

Strong Earnings Growth Supports U.S. Equities

The main driver of the move higher in equities seems to be strong underlying earnings growth, particularly for the largest companies in the index. The forward price-to-earnings multiple for the market has actually contracted. It started the year at about 25.6x and is now at about 21.4x. Year-to-date earnings growth for the S&P 500 is currently expected by the average analyst to come in at 28%. And within the market, the formerly famous Mag 7 have rerated to a much more reasonable valuation. After averaging about 31x over the past five years, the group is now trading at 25x compared to the S&P 500’s 21.4x. Within the Mag 7, three of those companies are trading at multiples below the market: Meta Platforms at 18.8x, Alphabet at 17.6x, and Amazon at 17.6x. So, by this measure, there are value investing opportunities within the market and we could see these mega cap tech companies resume their market leadership if growth in the broader market slows.

What Higher Inflation and Bond Yields Could Mean for Stocks

The point of this being that equities have increased by over 12% YTD despite the persistent level of inflation and interest rates moving higher – this has been an impressive equity rally to date. But if inflation doesn’t start to recede at least modestly and if rates continue to move higher, we could see equities lose some ground as bond yields become increasingly more attractive to investors.