S&P 500 outlook: Rising oil prices threaten to derail the equity rally

Things have become noticeably more complicated after the latest escalation between the US and Iran reignited concerns over global energy supplies. While the initial market reaction was relatively contained in US equities and foreign exchange, the sharp rise in crude oil cannot be ignored – and hasn’t been ignored by European investors. Brent’s return towards the $80-a-barrel mark has the potential to reshape the macro narrative if prices remain elevated, putting the S&P 500 outlook on a potentially bearish course.

 

Recently, the assumption was that inflation was steadily moving lower and central banks would eventually have room to ease policy, even if they delivered an insurance hike or two. The renewed move higher in energy prices threaten that assumption. A sustained move higher in oil would feed directly into inflation expectations, making it harder for the Fed to justify staying on a holding pattern rather a hiking one.

 

That is likely to keep the dollar well supported, particularly against the currencies of net energy importers, while also making it increasingly difficult for equity markets to sustain the valuation expansion that has underpinned much of this year’s rally.

 

Europe reacts first, but Wall Street may not stay immune

 

European equities were quick to reflect the deterioration in sentiment, with the DAX and IBEX leading yesterday’s declines. US indices, by comparison, showed greater resilience, although Wall Street is unlikely to remain insulated if energy markets continue to tighten.

 

Markets have become accustomed to geopolitical flare-ups fading almost as quickly as they emerge. Whether this episode follows the same script will depend largely on developments in the Middle East in the coming days. The uncertainty should be enough to hold investors back from significantly bidding up stock prices.

 

Still, Trump attempted to calm markets by suggesting Tehran remained open to negotiations, helping to temper some of the immediate fears of a broader conflict. Even so, the risk premium embedded in crude oil has increased, and traders will remain alert to any threat to shipping through the Strait of Hormuz. Any disruption there would almost certainly force another reassessment of inflation expectations and risk appetite alike.

 

Fed expectations hinge on inflation once again

 

The minutes from June’s FOMC meeting offered little to challenge the market’s existing expectations. Policymakers remain cautious, and yesterday’s release passed with barely a ripple across financial markets. The focus now shifts firmly to next week’s US CPI report, which arrives at a particularly sensitive moment. Should higher fuel prices begin feeding into headline inflation, expectations for policy tightening could be pushed forward. Kevin Warsh’s appearance before Congress will also attract close attention, particularly for any comments on how policymakers are weighing persistent inflation risks against slowing economic momentum.

 

For now, the balance of risks appears tilted towards a more hawkish interpretation of geopolitical developments than markets were pricing only a week ago.

 

S&P 500 outlook: Bulls must reclaim 7,500 or else…

 

Technically, the S&P 500 outlook remains constructive, but the margin for error has narrowed. Key resistance remains around the 7,500 region following the initial sell-off triggered by geopolitical headlines. That level once again proved its importance, with index futures struggling to climb above it. The key question is whether buyers can build on the recovery we have seen since yesterday afternoon. A sustained move above this resistance zone would shift attention back towards the recent highs at 7,600-7,620, with the 200% Fibonacci extension near 7,716 remaining the next upside objective.

 

 

Failure to climb back above 7,500, however, would be a bearish sign. The next level of support comes in around 7,396 then at 7,334, before bringing 7,224 into focus. That level marks the beginning or the rally that started in June and, in my view, remains the line separating a healthy consolidation from the beginning of a broader retracement.

 

Should that support eventually give way, attention would quickly turn towards the psychological 7,000 area, also a former resistance zone.

 

-- Written by Fawad Razaqzada, Market Analyst

Follow Fawad on Twitter @Trader_F_R