Markets Navigate Flat Job Growth, Middle East Conflict, Rising Energy Prices
- The S&P 500 turned slightly negative for the year last week, but many other major indexes have solid gains.
- Inflation risk has risen as energy prices have soared, but we still expect price spikes to be relatively short lived.
- The economy lost 92,000 jobs in February, and job gains have been near flat over the last 10 months.
- The unemployment rate remains low at 4.4%, and new claims for unemployment remain quite low.
- As long as energy prices remain high, the Fed will likely be more focused on inflation than further protecting the job market.
The S&P 500 fell 2% last week, leaving it down 1.3% for the year. While we would rather see the index positive, that’s not a meaningful decline. We’ve highlighted before that February into March has typically seen seasonal challenges historically. In fact, over the past 20 years, the index bottom has taken place in mid-March on average. Of course, we know that the conflict in the Middle East is the driver of this decline rather than just the calendar, but the calendar can still play a role—after settling into the new year post-holiday season, February and March can be a time when stuff happens.
But the S&P 500 isn’t the only story. Despite the small S&P 500 decline, six of 11 sectors are up for the year and eight are outperforming the S&P 500. The major benchmark for both international developed market stocks (the MSCI EAFE Index) and emerging market stocks (the MSCI EM Index) have year-to-date gains. Small cap stocks (the Russell 2000 Index) as well as mid-caps (the Russell Mid-Cap Index) are both higher this year. Core bonds (the Bloomberg Aggregate Bond Index) are also higher. And let’s not forget that both gold and broad commodities are having good years. In fact, outside the S&P 500 and related weakness in the technology sector and US growth stocks, global markets are having a pretty good year so far.
The conflict in the Middle East has led to some genuine concern, but even just thinking back to last year can provide some perspective. The S&P 500 had its pre-Liberation Day high close on February 19 last year; the closing low was on April 9. In between, we saw some record volatility. So far, the sell-off this year has been more orderly, but still feels familiar.
Many did not believe the low was in on April 9 last year, but on a total return basis, the S&P 500 went on to post nine straight months of gains starting in May, a streak that only ended last month with a less-than-1% loss. Last year doesn’t tell us anything about what will happen this year, but it can still be useful to remember how last year (and other similar declines) felt.
It does look like the volatility will continue into the new week, although that’s not unexpected. When futures markets opened Sunday night, WTI Crude (the US benchmark) jumped to over $105/barrel. (WTI was at $57.26/barrel at the end of 2025.) Events over the weekend had increased existing concerns about expanded or extended supply disruptions. These include:
- Weekend strikes on Iranian oil infrastructure.
- Continued effective closure of the Strait of Hormuz.
- The selection of Mojtaba Khamenei, son of Ali Khamenei, as Iran’s supreme leader, a choice President Trump called unacceptable.
While the threat of a more extended conflict has increased, we still think the length of the conflict will be measured in weeks rather than months. Part of that will come as a result of political pressure measured against the potential for achieving additional military objectives (and cost). This is a midterm election year, and while we are still far from Election Day, the president and his party do have some vulnerability around inflation. Inflation risk is far from 2022, but quite a lot of inflation and price fatigue has built up, which likely creates added sensitivity to price movements, especially prices at the pump.
There will likely come a decision point where the cost and commitment to achieve the next set of military and foreign policy objectives jumps rather than just climbs incrementally, a move that would see a sharp rise in practical and political risks. The conflict has already seen some meaningful success achieving its goals, and, as all politicians do, once hostilities end, the president and his surrogates will spin a win, which even now wouldn’t be just talk. Some objectives will continue to be pursued by other means, but there is likely a pragmatic limit to how long the conflict will last.
Payrolls and Inflation Diverging, Creating a Problem for the Fed
The February payroll report was an ugly one, and bit of a mess. The economy lost 92,000 jobs in February, versus a forecaster consensus gain of 55,000. We saw significant revisions for the last two months as well:
- December payrolls were revised down by 65,000, from +48,000 to -17,000.
- January payrolls were revised down by 4,000, from +130,000 to +126,000.
The revisions obviously tell you that we should take monthly numbers, and even the previous month’s data, with heaps of salt. The three-month average is more useful here, and that’s clocking in at just under 6,000. That’s not good and not enough to keep up with population growth. As you can see in the chart below, we’ve now alternated between job creation and job losses each month for the last 10 months. The payroll data is a mess right now, and likely not giving us a very good picture of what’s happening one way or the other.
Interestingly, the job market slowdown is not really about AI-related layoffs. The health care sector was the main engine of job growth last year, but the industry lost 19,000 jobs last month after averaging 73,000 jobs per month over the prior three months (November-January). This is partly because of a strike that included 31,000 physicians. But job creation has been weak even in blue-collar industries: Together, construction, manufacturing, transportation, mining and logging, and utilities lost 35,000 jobs in February. Job creation in these sectors has been running well below trend over the past year (about 500,000 jobs below where you’d expect based on the 2023-24 trend).
The unemployment rate did tick up from 4.3% to 4.4%, but that is still low relative to history. One month doesn’t make a trend, and there’d be some real worry if it continues to rise, but it wouldn’t be all that bad if the unemployment rate stabilizes around here. For perspective, the unemployment rate was 4.1% a year ago. The labor market has clearly cooled since then, especially after Liberation Day, but things may have stabilized for now.
More positive is the prime-age (25-54) employment population ratio. It did fall from 80.8% to 80.7%, but that’s still close to this cycle’s high of 80.9% and higher than at any point between May 2001 and June 2024. It tells you that more people in their prime-age working years have a job now than at any time during the 2000s and 2010s economic expansions (as a percentage of the prime-age population).
Another positive is that initial claims for unemployment benefits, which offer a real-time view of the labor market, remain really low. As of last week, initial claims were running below where claims were a year ago, or even in the same week in 2018-19.
The big picture here is pretty much the same as it has been over the last two years. We’re in a low-hiring, low-firing economy. Companies have really clamped down on hiring recently, especially after Liberation Day last April, amid increased economic uncertainty. But that also leaves the economy vulnerable to a shock, especially if it leads to a pick-up in layoffs.
The War with Iran Is Creating an Inflation Shock
Even before the conflict with Iran, inflation was looking elevated—nothing remotely like 2022, but not moving in the right direction. Our estimate is the January core Personal Consumption Expenditures (PCE) Price Index is going to be hot based on already released data, likely sending the year-over-year pace to 3.2%, the fastest pace since November 2023. That’s before any impact from what’s happening in the Middle East.
Gas prices have now surged to their highest level in almost two years, with nationwide average gas prices rising over $3.30/gallon. It was close to $2.80/gallon a couple of months ago, which means gas prices have surged close to 20%. Diesel prices have surged even more, hitting $4.12/gallon, the highest since November 2023. Diesel prices were close to $3.50/gallon a couple of months ago. The bad news is that prices are probably heading higher for now.
Higher diesel prices are going to increase transportation costs, which will put upward pressure on food prices as well. Fertilizer costs are also surging as the war disrupts supply and shipping. Natural gas, which is a key ingredient for fertilizer production, has seen prices surge with Qatar (the world’s second largest producer) shutting down production.
The Fed Has a Problem, and So Do Households
This is the picture we’d be looking at even if the Middle East hostilities didn’t happen:
- Elevated inflation (3%+) as 2026 gets underway.
- Potential AI-related bottlenecks, including items like memory chips that are required for goods like computers, electronics, and even cars.
By itself, the above two points would imply the Fed would have a hard time justifying cuts this year. Yes, labor market risks persist, as February payrolls highlight. But the labor market has stabilized in recent months (though that doesn’t mean it’s in great shape). Keep in mind that the Fed already cut rates by 0.75 percentage points in Q4 to protect the labor market.
Now you have an energy shock as well. Even if you treat that as “transitory,” the case for cutting rates this year isn’t clear-cut. Right now, markets (using fed funds futures) are pricing in 100% probability of one more 0.25 percentage point cut in 2026, and a 71% probability of a second one. The probability of a second cut was 100% last Friday before the war started (February 28), and markets were even pricing in 44% probability of a third cut.
Perhaps a better way to look at this is the probability of no more interest rate cuts in 2026. That’s risen from below 5% last week to over 17% right now. That’s a big shift, but perhaps it’s not big enough given the data. We would say the probability of no more cuts in 2026 should at least be 50% even if you discount events in the Middle East and assume things get to normal quickly. If they don’t—and, arguably, it’s hard to predict what happens on that front—the probability of no cuts should be closer to 100%. Even if the labor market falls off a cliff, which is not our base case now, it’s likely the Fed focuses on fighting inflation if prices really surge. Recall that the Fed was ready to send the economy into a recession (and even predicted it) when inflation surged to a 40+-year high in 2022.
Of course, higher inflation and higher interest rates are a problem for households as well, especially when the labor market is looking a bit shaky and it isn’t easy to find a job if you lose your current one. That’s a recipe for lower consumer sentiment. For now, that is unlikely to translate to lower consumer spending (since it hasn’t over the last several years). Workers are still seeing fairly solid wage growth, and over the past year, households have been saving less, though that’s partly because household wealth has increased amid a strong stock market and rising home prices. But that could change if inflation picks up and layoffs pick up. We’re definitely keeping an eye on it all.
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