Operation Epic Worry

Can America Cut the Head Off an Amoeba?

Soundbite: From an American perspective, one welcome outcome from this weekend’s attack would be that China is exposed once again as being absent when an ally requires support. China had just exhibited a striking level of disengagement when President Nicolas Maduro was extracted. Importantly, this marks the second attack on a strategic Chinese partnership where oil was exchanged outside of the Petrodollar sphere.

The problem posed by Iran is that, to subordinate China’s influence in the region, the U.S. must manifest regime change, and that is far from certain. There appears to be a network of bureaucrats already operating in Iran that represents their de facto government. If this anonymous group can hold on to power until the tractor pull of U.S. midterms, that could change the calculus for our administration. There is a strong possibility that Iran turns into a geopolitical marsh that will not go away and holds energy prices hostage.

This is yet another open question for markets to shoulder. Before this weekend, investors had to wrestle with opaque issues spanning the uncertain path of AI-disintermediation, the lack of visibility over Section 122 tariff expiration after July, and whether Kevin Warsh’s monetarist streak could impede monetary policy. Risk markets may continue to lurch from one headline to another within a crawling band before something ruptures.

Markets punish investors who abandon sound risk management and rely on hope.

Expecting a rapid transition toward massive cultural change in Iran borders on the romantic, when a pragmatic view is required. If gasoline prices jump 60% to the same $5 a gallon level after Russia’s Ukrainian invasion, an inflationary backlash is likely unless a Middle East solution is in sight.

Market attention is focused on activity within Iran, but the key to any resolution may lie outside the country’s borders. If countries in the region that have been the target of Iranian retaliatory strikes call for regime change, then there is a chance revolutionary momentum could begin to build among Iranian citizens. However, inertia is a powerful force, and expecting a rapid installation of democracy is about as hopeful as expecting that killing El Mencho would have led to a tranquil outcome.

Perhaps this is yet another transient storm U.S. corporate earnings will manage to dance through as retail investors buy the dip. However, the next Point investigates the potential that a more nefarious path could lie ahead.

A Crude Indicator

Soundbite: Forget about gold, watch crude when looking to gauge the true fallout. We expect the crude market to give the clearest signal on the expected degree and duration of the Iranian conflict. If energy participants forecast a prolonged incursion, we would expect sell-side oil analysts to extrapolate the same $120 price target for crude that occurred after the 2022 Ukrainian invasion. Given our economy’s reliance on the data center buildout, any additional energy constraints carry heavy consequences for investors.

If high oil forecasts prove correct, that would be a major problem. Historically, whenever crude oil doubles in price over the span of one year, recessions follow. Regular readers will know we believe that the primary driver behind the 2008 recession was crude doubling between May 2007 and May 2008. What turned it into the Global Financial Crisis was the disintegration of our economic foundation thanks to housing, but the recession trigger was explosive energy costs hitting businesses and households.

One hope is that we mirror the quick outcome of the Iraq war’s “Shock and Awe” episode of 2003. In that case, markets troughed at 850 in the S&P 500 Index at the time of the invasion and then rallied 40% over the ensuing twelve months. However, at the time, markets were tracing out an extremely oversold base with depressed valuations, the reverse of our current situation.

The Federal Reserve traditionally looks through oil shocks because they are believed to be either caused by idiosyncratic demand or supply disturbances that cannot be controlled by increasing interest rates. However, consumption contracts due to belt-tightening when oil has doubled, and corporate margins also suffer.

What do the following dates have in common?

• July 1987
• Sep 1990
• Nov 1999
• May 2008
• October 2021
• April/May 2026?

The first five cases were periods to become defensive because economic activity and stock prices were about to turn down sharply. In each instance, crude had risen dramatically over the prior year. If crude hits $110 a barrel in April or May 2026, it would represent a 100% price increase from the April and May 2025 lows of $55 in West Texas Intermediate (WTI) crude oil futures prices.

Will we hit those prices? We cannot know with certainty, but in the absence of a rapidly de-escalating Iranian conflict, crude prices could experience a rapid escalation that could result in $110 oil prices. Under such a scenario, it would pay to take decisive defensive action.

The problem is driven by supply constraints. OPEC+ has pledged to increase production to compensate for the 20% of global petroleum traffic that may no longer pass through the Straits of Hormuz. That promise may prove difficult to deliver in a timely manner. Regardless, investors must contend with the more immediate dilemma that insurance companies worried about war risk have already begun cancelling coverage on oil tankers. There are reports of premiums rising 50 percent for tankers that are not American or Israeli (those ships are effectively uninsurable). This creates a complete regional bottleneck, and even non-energy shipments through the Red Sea have been affected. Supply disruptions will pressure prices and fuel speculative buying.

We have warned, perhaps ad nauseum this year, that we may be entering a sustained period of rolling geopolitical crises. There is much at stake, and now energy prices have been thrust to the forefront as a major driver of stock prices. Forewarned is forearmed.

China: Another Wave of Exports?

Soundbite: It is time to face facts: there are too many structural imbalances being ignored that must first be resolved before repairing our trade deficit with China.

Researchers at the Peterson Institute for International Economics (PIIE) predict China’s current account surplus will double in the next two years. They expect the increase in China’s trade surplus will take share from producers in Europe, Japan, and Korea. Global current account imbalances have already widened over the past two years. China’s ongoing property unwind and loose U.S. fiscal policy have deepened the trade surplus in China and the deficit in the United States. The International Monetary Fund believes China’s surplus will narrow over the next two years, but according to the PIIE analysts, the only path to a reduction in the gaping U.S. trade deficit is a severe recession. If the Peterson Institute forecast is accurate, the world must brace for growing tensions between China and an increasingly frustrated U.S. administration.

Incremental negotiations to target specific exports and prevent China from rerouting goods through other countries such as Vietnam would amount to nothing more than a superficial fix. China has  shown neither the willingness nor the ability to commit to increasing domestic consumption, as doing so would require raising wages, thereby making exports less competitive. Chinese consumers’ high savings rates are a function of falling property prices, which depress consumer confidence and spending. Until Beijing can engineer an adjustment of this internal imbalance, the government will continue to rely on additional debt financing of inefficient investment in export sectors to meet their 5% growth target. That means one thing—we are stuck with large Chinese trade surpluses that will only get larger. That binds the U.S. to a corresponding trade deficit and prevents any meaningful shift toward rebuilding a manufacturing base.

Let us rip the band-aid off: the world must prepare itself for a new phase of Chinese trade dominance.

China’s exporters enjoy a competitive advantage that is not going away soon; furthermore, it is supported by an imbalance as Chinese companies expand into developing economies while foreign direct investment into China is lacking. Ironically, Washington’s hope that China will invest in U.S. industries such as semiconductors and autos is misplaced, as that would only deepen the fiscal imbalance. China’s trade advantage is bound to increase as Beijing continues to push investment into new export industries, accelerating the move into medium- and high-tech goods. With the government’s reluctance to appreciate the currency or further expand their giant fiscal deficit, the export sector remains the only viable growth driver. Therefore, China’s external surplus will inevitably rise unless and until the U.S. enters a recession.

We have discussed the minefield developing from future defaults as commercial banks continue lending to private credit sponsors that are masking weakening credit profiles through Payment-In-Kind and other financial engineering practices. This increases the risk of a global contraction because even a small U.S. slowdown could trigger a chain of domestic defaults. According to PIIE, a deep recession could cut our deficit in half through lower import demand and eliminate the trade surpluses in the rest of the world, leaving China’s surplus seemingly untouched. If the world finds itself in such a situation, dramatic trade barriers could emerge globally to protect domestic industry, endangering globalization to an even greater degree.

The severe deflationary potential of this scenario creates an even greater dependence for AI to accelerate productivity gains and preserve growth.

What to Look for This Week

(All times E.S.T.)

1.  Friday, March 6 at 8:30 a.m. February Nonfarm Payrolls. The first thing to observe is the size of the January revision from the initial estimate of 172,000 Private Payrolls, and then study the February data. Average Hourly Earnings have fallen from 4.2% in March to 3.7%, and we will look for any change, along with the Participation Rate, which has rebounded recently. ADP Employment Change for January was only +22,000, back to the October lows, so that will be a focus on Wednesday, March 4 at 8:15 a.m., as will the 4-week moving average of Initial Claims on Thursday, March 5 at 8:30 a.m. Claims have averaged 220,000 for the past three weeks, up strongly from early January. Also out Thursday is February’s Challenger Report at 7:30 a.m. January Challenger Layoffs were the highest since October and the largest January total since 2009.
2. Wednesday, March 4 at 10:00 a.m. U.S. ISM Non-Manufacturing Prices for February. The headline number for December and January hit one-year highs, but we are focused on the Prices subcomponent because it is a leading indicator for CPI. Prices hit a three-month high in January, resuming its two-year upward trend. We will be combining this reading with the Q4 Productivity data out at 8:30 a.m. on Thursday, March 4, sitting at a 4.9% multi-year high.

Any move higher will be good news for inflation (Unit Labor Costs have been negative the last two quarters) and could promote the administration’s push for rate cuts.

3. Wednesday, March 4 at 7:00 a.m. Mortgage Bankers Association MBA Purchase Index and Mortgage Rate for February 27. The move in mortgages below 6% (lowest since September 2022) made the news last week, yet the Purchase Index continued its sharp fall last week to the lowest levels since last April. As we wrote last week “Mortgage rates fell from over 7.00% in January 2025 to 6.10% last week and is currently at 6.01%, so if there is no pickup in the Purchase Index, it is concerning.”

FOMC Voters Speaking: Tuesday, March 3 at 9:55 a.m. New York Fed President and permanent voter John Williams speaks, followed by Neel Kashkari at 11:55 a.m. Vice Chair for Supervision Michelle Bowman speaks Thursday, March 5 at 1:15 p.m. After the payroll data Friday, March 6, Cleveland Fed President Beth Hammack speaks at 2:30 p.m. Wednesday, March 4 at 2:00 p.m. the Beige Book is released for the March 17-18 FOMC meeting. Bank of Japan Governor Ueda speaks Monday, March 2 at 11:00 p.m.

Earnings: Marquee event for the week is Broadcom (AVGO) after market on Wednesday, March 4. We will look for any negative tone by selling into strength, similar to NVDA last week. Tuesday, March 3 Target (TGT) and Best Buy (BBY) report before market on the consumer. Thursday, March 5 after market we hear from another retailer, Costco (COST), and we are focused on any signs of customers who are trading down based on squeezed budgets. Thursday before market, Alibaba (BABA) reports.

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By Peter Corey

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