US Strategy Weekly: Cygnus Atratus

It is not clear if the current war between Israel and Iran qualifies as a black swan (cygnus atratus) event or not, but to the extent that the US could be drawn into this Middle East conflict, it is clearly a sudden, relatively unpredictable, and powerful issue that was not on the minds of investors even a few days ago. As we write, President Donald Trump is calling for Iran’s unconditional surrender, warned that US patience was wearing thin and that Iran must abandon its nuclear ambitions. Meanwhile, the US is moving fighter jets to the Middle East. And, as this war enters its sixth day, a Reuters headline states that explosions are hitting a Tehran suburb, sending flames and smoke into the sky.

Perhaps more surprising is that financial markets remain relatively undisturbed, at least to date. WTI crude oil has jumped to $75.41 from an early May low of $58; however, it is still below the $80.33 level seen in June 2024 and is down on a year-over-year basis. This is important for future CPI reports, because year-over-year increases in the price of oil could feed into energy prices and ignite inflation. In terms of equities, the S&P 500 index is up a mere 1.7% year-to-date but is also a mere 2.5% below its all-time high of 6144.15. The 10-year Treasury bond yield is similarly complacent and trading at the midpoint of the 4.0% to 4.7% range it has maintained all year. In short, markets appear unconcerned about a war in the Middle East.

We are less complacent. Still, we know that wars trigger substantial government spending and historically have been a boost to economies. This is particularly true for the defense industry; and in the current environment, where drones, spyware, hackers, trackers, and robots dominate, we expect the conflict will also generate income for a variety of technology companies.

But while Iran dominates the headlines, there are other significant events taking place this week. The G7 meeting is taking place in Canada, although President Trump left early due to the escalation of the Israel-Iran battle. The Federal Reserve also meets this week; but we do not expect any policy changes. The Senate is tweaking the Big Beautiful Bill in hopes of passing something before the July 4^th recess and the US Senate just passed a bill to create a regulatory framework for a dollar-pegged cryptocurrency token known as stablecoin. This stablecoin bill has been buried by geopolitical headlines, yet it could prove to be a turning point for the digital asset industry.

The technical condition of the equity market remains distinctly bullish and is relatively unchanged from last week. The 25-day up/down volume oscillator is at 0.67, down from a week ago and neutral. This intermediate-term oscillator was overbought for 9 of eleven days in May and reached a high of 5.10 on May 16. The 5.10 reading was the highest overbought reading since August 18, 2022, which was shortly after the market rebounded from its June 16, 2022 low. This is very positive action since it confirms that significant demand (volume) is driving stocks higher. More importantly, it is a characteristic of a bull market cycle. See page 11. The 10-day average of daily new highs is 196 and new lows are averaging 53. This combination of daily new highs above 100 and new lows below 100 is positive. The NYSE cumulative advance/decline line has been making a string of new highs, the latest on June 12, 2025. In sum, technical indicators are favorable. See page 12. Last week’s AAII survey showed bullishness rose 4.0% to 32.7% and bearishness fell 7.8% to 33.6%. These percentages are neutral but the April 2, 2025 reading of 61.9% bearishness was a new high for this cycle and very favorable. The 8-week bull/bear is currently at minus 14.5% and remains positive for the 16th consecutive week. See page 13.

First quarter earnings season is over, and second quarter results will not begin until mid-July, but we have noticed that earnings forecasts for 2026 and 2027 have been creeping higher in recent weeks. This is a good omen; however, equity valuation remains stretched with the 12-month forward S&P 500 earnings PE at 20.2 times. This is well above the long-term average of 17.9 times. See page 9.

A Bloomberg chart on page 3 is interesting given that this is Fed week. It shows that interest rates in the US and Hong Kong are well above interest rates in other developed countries. With the effective fed funds rate at 4.33% and inflation at 2.4%, this 197 basis point differential puts the real fed funds rate well above its long-term average of 1.3% (or 130 basis points). May’s PCE deflator will be released on June 27, but the current differential is 2.2%, well above the long-term average of 1.7%. In short, there is clearly room for the Fed to cut rates in June, but we doubt they will. In truth, the rising price of crude oil is a potential inflation risk. See page 3.

The May CPI report showed inflation was stable with the headline index up slightly to 2.35% YOY versus 2.33% YOY in April. Core CPI was unchanged at 2.8% YOY. In general, both indices have been trending lower since the 9.1% YOY peak seen in June 2022. Note that energy prices were 3.5% lower YOY which helped to keep inflation in check. As we noted, WTI crude remains down on a year-over-year basis, but oil will continue to be a risk factor as long as the Israel-Iran conflict continues. See page 4. And in terms of the main components of the CPI, it was food and recreation that moved slightly higher in May. Conversely, clothing and footwear, two areas one would assume would be negatively impacted by tariffs, fell 0.91% YOY and 1.59% YOY, respectively, in May. See page 5.

The June University of Michigan consumer sentiment indices recovered to February and March levels with the main index up 8.3 points to 60.5, the present index rising 4.8 to 63.7, and the expectations index jumping 10.5 to 58.4. However, all three indices remain below levels seen in December. However, we have downgraded the significance of most sentiment indices recently due to the bias seen with respect to political affiliation. As seen on page 6, the consumer expectations index for Republicans was 95.9 in June versus 22.7 for Democrats. This disparity degrades the integrity of sentiment readings.

All components of the NAHB Single Family Housing Environment survey moved lower in June, with the traffic of potential buyers falling to 21 for the first time since November 2023. The housing market has been weak for months, but the current instability in the Middle East will add greater uncertainty to the housing market. In addition, the Federal Reserve reported that household net worth fell in the first quarter from $170.9 trillion to $169.3 trillion, due primarily to a decline in household assets, including small losses in equities, mutual funds, and real estate. Liabilities also declined in the quarter. Disposable personal income to liabilities rose to 107.2%, the highest and best since June 2020. Nonetheless, declines in net worth are rarely good for the residential housing market. See page 7.

Retail sales for May were disappointing and fell to $715.4 billion on a seasonally adjusted basis, down from $722.0 billion in April. Still, this was up from $692.6 billion a year earlier. Total retail & food services sales rose 3.3% YOY, down from the 5%+ levels seen in recent months, but still respectable. Retail sales excluding autos rose 3.5% YOY and excluding autos and gasoline, sales rose a healthier 4.6% YOY. The weakness in retail sales is seen after adjusting for inflation. Real retail sales rose a mere 0.9% YOY in May, down from the 2.6% pace seen in recent months. See page 8.

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