Back to those other bricks

The Strait of Hormuz remains closed, and spot oil prices remain above the $90 per-barrel level we flagged six weeks ago as a key hurdle for markets if sustained into May. Even so, risk assets have begun to look through the Iranian conflict. The rally in stocks may, in part, simply reflect “war news fatigue.” But we think the more important implication is that the market is discounting what will most likely happen next.

At Federated Hermes, we often come back to one of our favorite expressions: “If it can’t happen, it won’t.” Our collective experience has taught us that outcomes that are economically and politically untenable tend not to materialize. We believe this is the very calculus markets are now using. For Iran, a resumption of the war — given existing infrastructure damage, leadership disruption, and depleted missile inventories — risks permanent ruin. For President Trump, an extended conflict carries obvious domestic political costs as the midterm cycle approaches. For the global economy, a closed Strait of Hormuz during the spring inventory-build and ahead of the summer driving season — amid tightening inventories and widening crack spreads (i.e., refining margins) — is simply not tenable. So, rather than work through the various means by which all three highly motivated "players" will, inevitably, resolve the problem, markets are simply moving on.

This scenario remains broadly consistent with our base case, as we held on to our 6% equity overweight position in our allocation model (out of a max 10%). It is time to declare victory and move on. Indeed, Iran has proven to be another “brick” in the wall of worry. The war is material, but not thesis breaking. Now, it is back to those other bricks.

Here are prominent risks we are monitoring — and why, in our view, each is more likely to resolve constructively than to derail the US market expansion. These views underpin our S&P 500 targets of 7,500 for 2026 and 8,200 for 2027.

1. Private credit. With war headlines fading, investors may return their focus to the well-flagged stresses visible in private credit for some time: an inherently illiquid asset class that has been distributed to retail investors with expectations of liquidity; a poorly defined and almost unknown share of underwriting tied to forward cash flow in segments of software that may face margin and pricing pressure from AI-driven disruption; and less-understood linkages back to the banking system via bank financing provided to private debt vehicles themselves. The two indicators we are watching most closely are: high-yield credit default swaps (CDS), which investors are increasingly using as a hedge against private-credit risk, and the growth in bank reserves associated with this ecosystem. So far, so good. After spiking in recent weeks, CDS spreads have fully retraced from recent highs, suggesting near-term stress has eased. Through earnings season to date, the consistent refrain from the money-center banks is that private credit exposure is manageable and well-protected. No blowout in credit reserves has happened. While retail liquidity has been an issue, institutional investors are opportunistically stepping up to replace exiting retail limited partnerships as loan spreads become more attractive. As the earnings spotlight now turns to the regional banks, the tone thus far remains the same. We do not see a systemic issue with private credit and expect market worries to fade in the coming weeks as management commentary supports this view. Our optimism here is one reason our allocation model remains overweight Value stocks and by implication, regional and money center banks.
2. The AI disruption challenge in software. Software names saw a temporary reprieve from the disruption narrative during the Iran conflict, as other parts of the market faced more dire implications from a prolonged conflict. Now, we expect these concerns to re-enter the narrative — particularly after the recent rebound in many of the names in this space. AI deployment in the enterprise and its impact on the software sector are still in the early days. But fear, uncertainty and doubt about AI’s impact have exerted significant pressure on software names. The upcoming earnings season is unlikely to dispel those concerns. The first quarter tends to be seasonally weak for companies spending on software, and we doubt that results and guidance will move software estimates materially higher, meaning that investor sentiment is likely to remain unchanged. Longer-term, we expect that investors will continue to worry that revenue models based largely on seat licenses face existential risk. While savvy, long-term investors will eventually be able to sift through the rubble for compelling value opportunities, we think that is still some way off. For now, we are remaining cautious on this space, with the exception of cybersecurity related companies where the growth path seems more transparent. 
3. The Middle East conflict. Our base case remains de-escalation on a timeline that avoids material damage to US and global growth. The tail risk — renewed escalation and/or a prolonged closure of the Strait — cannot be dismissed, so our risk dashboard includes a set of market-based indicators to watch. We focus first on the forward curve in crude oil, which embeds informed expectations for stabilization in the back half of the year. After peaking in the high $70 per barrel several weeks ago, the December contract has settled near $75. While that is modestly above the $65 assumption in our constructive US growth outlook, it is not at a level that would typically impair economic growth. Another series we are watching carefully is gasoline prices. These peaked at $4.16 (national average) two weeks ago — considerably beneath the $5.00 level that historically creates a negative impact on demand. As long as energy prices stabilize at these levels, we are less concerned. Given the upcoming summer driving season and the May inventory building season, we would like to see progress here. That should happen if the Strait opens, as we and the markets expect.
4. AI investment payoff for the hyperscalers. Another key worry for investors has been that the massive $650 billion dollar investment in AI infrastructure by the previously high free cash-flow generating hyperscalers may not produce an adequate forward return. This concern will be difficult to resolve in the coming quarters as the payoff of this mega-investment is likely to be measured in years, not weeks. This uncertainty is a key reason we have reduced our terminal multiple assumptions for parts of mega-cap tech and, by extension, for the index. Over the next several weeks, we will listen closely to earnings calls and capital allocation commentary for signals on utilization, pricing power and the time horizon for free-cash-flow re-acceleration. While management commentary is unlikely to resolve all of the longer-term concerns, it should help in the short-term. We are cautiously overweight these stocks in our balanced models but not aggressively so. 
5. US macro data: aggregate demand and inflation. The fifth section of our risk matrix is always there, the macroeconomic data. Coming out of this mini-cycle, there are several key data series we are watching. First, retail sales. They are the best indicator of what, if any, impact the Iran conflict has had on US consumer demand. So far, the news has been pretty good, including February’s sales numbers, which were ahead of consensus expectation. Next week’s March data is also expected to be solid. Another key retail sales data point is auto sales, a sign of longer-term consumer confidence. Again, so far, so good here. The figure in March was good, up 3.7% month-over-month (m/m), despite the recent spike in gas prices. And, perhaps surprisingly, travel and credit card data remain very strong. Second, the capital expenditures series (especially capital goods non-defense, ex aircraft, which also has so far been well behaved, rose a strong 1.0% m/m in February. Third is the steady labor market. US nonfarm payrolls leapt by 178,000 jobs in March, a 15-month high; the unemployment rate (U-3) was 4.3% in March, an eight-month low; and average hourly earnings slipped to a 3.5% annual pace in March, a five-year low. Not too hot, not too cold — more of a Goldilocks variety. And finally, inflation, and especially the Federal Reserve’s favorite measure, Core PCE. Our expectation entering the year was it would decrease because the all-important housing component (owner equivalent rents), which accounts for about 18% of the total, continued to decline. We expect that the disinflationary impact of housing is likely to be far larger to Core PCE than any potential bleed through of oil/gasoline. Right now, we anticipate a short-term bounce, but no more than that. If so, the three additional quarter-point Fed rate cuts we had been expecting (taking the fed funds target range to 2.75-3%) should remain on the table, though perhaps delayed a few months beyond December of this year, as we had originally expected.
6. Earnings and, especially, guidance. The final brick, as it always is, remains earnings and earnings guidance. Ultimately, stocks are priced on earnings and the growth, from $140.23 in 2020 to the $274.54 reported on a trailing 12-month basis by the S&P for 2025, has been a key driver of the bull run. A collective beat against the consensus earnings forecast seems pretty likely, as analyst numbers have not shown any moderation over the last few weeks. The key will be commentary and, importantly for  investors, full-year 2026 and 2027 forecasts. At present, consensus sits at $323 and $374 against our internal projections of $325 and $370, respectively. The banks have gotten us off to a good start here (average beats of 9%), and we anticipate, on average, more good news to come.

Stepping back, the wall of worry that every bull market feeds on, remains intact. There are enough unresolved issues to keep positioning and valuations from becoming complacent. That is also why the market has not (yet) risen to our 2027 S&P target of 8,200. We should expect periodic setbacks; if any of the points above look like they might become a genuine growth or liquidity shock, a pullback is likely. Consistent with our framework, we would view that as an opportunity to add risk selectively, not as a reason to abandon our base case.

Read more about our views and positioning at Capital Markets.