This week in the markets: Oil fluctuates as tensions ebb and flow in the Gulf; markets hold firm despite the Mag 7’s underperformance; all eyes are on interest rates, with decisions due on both sides of the Atlantic; and earnings expectations nudge higher

The summer lull has arrived. But there’s still enough going on to keep the attention of those investors still at their desks.

Gulf tensions ease

The oil price continues to be where the ebb and flow of Middle East tensions is most obviously reflected. The price of a barrel of Brent crude fell 7% as the week got underway after a quiet weekend in which both the US and Iran refrained from attacking each other.

President Trump is reported to be giving ongoing negotiations some room, changing his mind about the rumoured massive attack that rattled markets last week. With around three months to go until mid-term elections, the domestic political agenda is likely to have an increasingly important influence on America’s international gameplan.

With petrol prices above $4 a gallon, up from less than $3 before the Gulf war began in the spring, the President’s approval ratings are plumbing new lows. Just 36% of US voters approve of the job he is doing. Keeping control of both Houses of Congress will become a key consideration over the next 100 days or so.

Oil is now below $90 a barrel although economists are quick to warn that further drops from the recent high of over $100 should not be counted on, given that the Strait of Hormuz remains largely shut still. The recent ceasefire was too short and fragile to really make much progress in refilling oil inventories around the world.

And with rising tensions between Yemen’s Houthi militants and Saudi Arabia, the Red Sea route out of the Middle East looks compromised too.

Rate hikes in focus

That’s the backdrop to a flurry of interest rate decisions this week, with the US, UK and Japan all making decisions about the cost of borrowing. Across the board, no change but a more hawkish tone looks like the most probable scenario this week.

In the US, it will be new Fed chair Kevin Warsh’s second meeting in the chair. Pressures are mounting on him to deliver the first rate-hike of his tenure, although this week’s drop in the oil price reduced the odds on a quarter point rise from 36% to 30%.

Even if there is no move this week, markets have fully discounted a first rate-hike in September and one or maybe two more by the middle of next year.

A strong US economy and labour market, with jobless claims hitting their lowest level since 1969 last week, add to the case for raising rates. Although inflation dipped lower last week to 3.5%, that was seen as a one-off caused by lower petrol prices during the short-lived ceasefire. It is anyway safely ahead of the Fed’s 2% target.

On this side of the pond, there is little prospect of the Bank of England raising rates just a week after a new Prime Minister entered Downing Street. But with oil prices bouncing higher again, the Bank is expected to treat last week’s inflation number of 2.6% with caution. Recent rises in gilt yields show that investors are worried that more inflation may be just round the corner.

The other big rate decision this week is from the Bank of Japan. Here the story is slightly different from those in the US and UK. After years of stagnation, rising global energy prices have actually fed into a positive reflation story, allowing the BoJ to start getting interest rates back to normal, albeit a Japanese normal of positive but low interest rates. Markets expect 1.25% by the year end.

Earnings remain supportive

Aside from interest rates, the main focus this week will be a continuation of the second quarter earnings season, which investors are watching closely for signs that profits can provide ongoing support to the four-year bull market.

Expectations at the start of earnings season a couple of weeks ago were strong and they have nudged higher as the early announcements have come through. After a couple of years of better than expected results, another quarter of 20%+ earnings growth has been pencilled in.

That’s good news for investors because as a matter of simple arithmetic it reduces the valuation of the stock market. Shares are not cheap in the US, but they are far from the excessive levels that typically end a bull market.

Broadening bull market

Another factor bringing the average valuation down is the relative underperformance of the market’s most highly valued stocks, the Magnificant Seven technology shares.

These have gone sideways since the end of last year as investors have worried about whether or not the so-called hyperscalers will ever return an acceptable return on the hundreds of billions of dollars they are currently investing in AI infrastructure.

Just in the past three months, the equal weighted S&P 500 index has outperformed the capitalisation weighted headline index as investors rotate out of the Mag Seven into shares which have lagged the tech leaders for many years.

The good news is that the underperformance of the previous market leaders has been achieved without too much damage to the broader market. Since its high at the start of June, the S&P 500 index is down just over 2% compared with a 9% fall in the Mag Seven. The equal weighted index is up by 2% and non-AI related stocks are up by 5%.