Today's number: 1.2 trillion. That's how many dollars the US government racked up in deficit spending in the first half of this fiscal year. On track for more than $2 trillion for the full year. That is a roughly 20% increase from the previous year. Thank God for fiscal conservatism.
Welcome to Prof G Markets. I'm Ed Elson. It is April 14th. Let's check in on yesterday's market vitals. The major indices climbed on hopes of a deal with Iran. Meanwhile, oil prices rose as the US moved to blockade the Strait of Hormuz. We'll talk about that in a second. The yield on 10-year Treasuries fell. And finally, Oracle shares surged nearly 13% after the company revealed new AI tools for the utility sector. That gain led software stocks higher, with broader sentiment turning positive to start the week. Okay, what's happening?
The US Navy has blockaded the Strait of Hormuz. The blockade went into effect yesterday morning after peace talks in Pakistan collapsed this weekend. In a post on Truth Social, Trump threatened to, quote, 'eliminate any Iranian ships that come near the blockade.' Oil jumped nearly 8% on the news, climbing back above $100 per barrel. By the afternoon, Trump said Iran had reached out about negotiations and oil prices pared some gains. This latest trouble at the Strait follows a hot inflation report back in the states, where the price of oil has already pushed gas prices higher. So here to discuss what this blockade means, what these latest developments in Iran mean, we are speaking with Michael Gapen, managing director and chief US economist at Morgan Stanley. Michael, we have a blockade on the blockade, and it's a little hard to understand how everyone feels about it because we do have oil prices obviously rising, but then also we have stock prices rising. I mean, investors seem to be somewhat bullish in a lot of ways coming into the week. What do you make of this blockade? What does it actually mean for investors?
Well, you're right that I think investors — I don't want to use the word complacent because certainly they're not complacent — but I think they're optimistic in the sense that the interpretation of markets is that the day-to-day events here are probably still what they would call in a de-escalation camp, meaning it doesn't appear like things are escalating in a way. So oil is staying around this $100 per barrel level. That's certainly a lot higher than it was going into it, but the view from the market is $100 oil may not be great, but it's something the US economy can withstand and the global economy can withstand as well. So it's — inflation's rising. Yes, that will crimp purchasing power. We can talk about that. But it does not appear that oil is at a level that would destroy demand, right? Because a little bit of oil — I mean, I should say it's been more than a little — but a large increase in oil, it initially shows up in inflation, but if it rises too much, then what it starts to do is weaken activity. And I think the market is telling you we're in that first stage. We're in that first part. It's likely an inflation story. It may dampen demand, but the global economy should remain in an expansion in 2026, and that's why I think stocks have rebounded.
What do you make of the inflation report that we saw as well? For March, it came in at 3.3%, a two-year high. Gasoline up over 20% in a single month. I mean, that inflation report was pretty bad, but of course it is measuring, I mean, the immediate effects of the war in Iran. I mean, as the US economist over at Morgan Stanley, like, what are you supposed to do with that data? Is that meaningful in your long-term projections of how things are going to go?
It's certainly meaningful for where we think headline inflation is going, right? So we typically split out headline and core. Core is X energy and X food because these are commodities determined in global markets, and core kind of gives us a view of where underlying inflation trends may be going. In the data history in the US — I mean, this goes back 30 to 40 years now — where shocks to oil tend to push headline inflation higher in the US, but it often has very limited second-round effects on core. That's important from the economist point of view because you're saying, okay, we get the direct effect from energy. We can't avoid that. It goes right into gasoline prices very quickly in the US. But the good news is history says we don't get second-round effects where other prices rise because gasoline prices are higher or oil prices are higher. So we've raised our forecast for headline inflation. We actually think headline inflation will peak around 3.7% on a year-on-year basis. So there's still probably a little more to come in that regard. But we really haven't changed our outlook on core inflation. We think core inflation can actually move a little lower as we get into the second half of the year. That will be dependent, though, I think primarily on whether the tariff pass-through to goods prices ends. We think it will by the middle of the year. But that's how we're looking at it. It's a boost to headline inflation, but it may not change the underlying dynamics of inflation, and inflation could be lower by the end of the year.
Walk me through that thesis then, because my understanding is — I mean, yes, we see the obviously immediate impacts of oil prices on gasoline, but we also know that what's happening if the Strait of Hormuz is blockaded further, then I mean, fertilizer prices will go up. You need fertilizer to grow food, which would mean food prices would go up. In addition, you know, you need gasoline to transport things around the country, to move stuff from countries to other countries. I mean, my understanding is that pretty much the whole economy is dependent on oil in one way or another. So how would it not pass through to core inflation, to things like food, groceries, consumer goods, etc.?
Well, two things. One is higher oil prices tend to weaken activity, right? So gasoline prices go up. You and I pay more for prices at the pump. We can't spend it elsewhere. So demand in the economy actually slows, and it's that softening in demand and that softening in activity which means other prices don't tend to go up. Now, this is just what history suggests as the guide. It may not be the case this time around. Inflation in the US has been above its 2% target for about five years. And you make good points about, let's say, the downstreaming of oil into other distillates and products, and like, for example, food costs do involve a lot of transportation. So it's conceivable maybe we do get some second-round effects this time. So history says we won't, but we can't be too blasé about it, and we may get it. The other point I'd like to follow up on that — it's a good point you make — is right now we're still largely talking about this as the effect of higher oil prices. What you're getting at with the closure, the potential long-term closure of the Strait, is, well, at some point this may turn into a quantity story, right? So right now I might be able to get as much oil as I need at a higher price. What happens if it's not available at any price? Then you could start to see things through the lens of supply chain disruptions like we had during COVID. Where that's going to show up first is in Asia, because I think, as you know, about 85% of the oil that comes out of the Strait of Hormuz, its destination is Asia. So if some economies are going to experience outright shortages first, it will be there. And then you're talking about, I can't get the oil or, as you say, the fertilizer or the distillate that I need. Therefore activity has to stop. So those are the risks. We could get second-round effects on inflation because we've been above target for so long, or this conflict could go on long enough where it actually changes from price effects to quantity effects. Then you're right, we could see a much more persistent inflation story.
Right. It is really interesting, just and kind of depressing almost, that when you look through history, basically what you're describing is that when oil prices rise, the reason that everything else doesn't rise is because people are so strapped for cash that you literally can't test them that much further. Either way, the situation is you're testing the American consumer literally to their limit. And if you hit that limit, then there is a world in which, you know, companies will basically say, okay, well, we can't raise our prices further because they're just not going to pay for this. It does get into sort of murky territory, I think, when we think about things like food, where it's like, well, you got to pay for food. But I mean, it's just striking that we are getting to that point just from an investment perspective. I mean, the way this story has changed is getting almost comical. Like, we start with, you know, we're only going to be in Iran for four or five weeks. Then we say, actually, we're going to increase that and we're going to create a deadline. And then we get to the deadline and we say, we're going to escalate this. And then we say, actually, no, we're not escalating it. Now we have a deal. And then we say, actually, wait, no, the deal didn't really work because now more bombs are being dropped. And so now they're going to blockade the thing. So we don't have a deal. Now we're going to blockade in response. In a funny way, nothing is really happening here. And yet every time something happens, the market is reacting and saying, 'Okay, something's changed. Now we have a blockade. Now we don't have a blockade. Now oil is going to pass through fine.' And to me, I'm sort of like, shouldn't we just not even be reacting at all? Or is that even — I mean, what is the correct response to what was said?
Well, I would argue — I think you laid it out very well. I would argue that markets are reacting a little less to the headlines now than they were two to three to four weeks ago. So, as you said in your introduction, oil was up around 8 to 10% today in response to the implementation of the blockade, but US equity markets did okay today. So I do think the market is discounting a little bit the headline noise, looking through some of the day-to-day volatility in a way that it did not do a few weeks ago. So I agree with you that it can be very disconcerting to hear headlines one way one day and the other way the next day. But I think the market is actually starting to filter that out better, and volatility has come down. I think a second factor behind that is markets had to de-risk for the first two to three to four weeks of this, right? Most investors were positioned for rates to fall, at least at the front end of yield curves, throughout most of the world — not all the world, but much of the world. And what this oil price shock did, of course, was push yields higher. So markets needed to rebalance and de-risk and get out of positions and kind of get flat or neutral, as we would call it. That process leads to a lot of initial volatility. But now that positions have been squared, to use the terminology of the industry, and risk is a little more neutral now, markets can afford to look through some of this headline noise.
We've seen how investors are reacting. You know, as an economist, it's almost — it's a slightly different job because you're not necessarily trying to make a bet on what's going to happen. You're just trying to understand what are the possible potential scenarios, what are the possible futures. I guess, as an economist, I mean, when you put your economist hat on, how seriously have you taken these developments in terms of their potential to, I guess, adjust the trajectory of the US economy? Like, when you see the headlines and you see, okay, now he's blockaded the blockade, do you look at that and then say, okay, well, this is going to change the economy in this way, or this isn't going to change things? I mean, how is an economist supposed to digest what's happening here?
So the way that we've approached it is to kind of think of the world through three lenses, three possible paths here. One is kind of the everything goes back to normal and we return to February 27th. We think that's very unlikely. We think there has been a structural regime shift in the balance of power in the Middle East and the way oil flows in and out of the Strait. So we're not here thinking, hey, if we just get over this or that, things are going to go back to where they were six to eight weeks ago. So that leaves us kind of two possible outcomes. Obviously there's more than two, but I'm just in terms of trying to think about how things may go. And one is what I'll call the oil is high but not too high. And then the second one is oil moves so high as to create a recessionary kind of outcome. So there's a nonlinearity here where above a certain price, oil becomes really problematic for the US expansion and the global expansion. Below that level, it's kind of what I was saying before. It's about a spike in headline inflation. It suppresses demand a little bit in the US, but the US economy continues to go and the expansion continues. But after all, we had about $120 per barrel oil at the beginning of the Russia-Ukraine conflict. That was a slightly different US economy at that point in time. A lot of fiscal stimulus in the economy, a lot of jobs being added. But you know, this price level of oil is not unusual. So we have passed it through the lens of essentially saying, well, the average consumer, about 2.5% of their spending goes to gasoline. Lower- and middle-income households, it's more like four to five percent. It's about double the average. And so what it's really doing is that shock, that hit to real disposable income and real purchasing power, is basically offsetting the fiscal stimulus that we assumed from the One Big Beautiful Bill Act. So in some of our prior conversations, you know, before the Iran conflict started, we were talking about how optimistic the outlook was for the US this year. We've trimmed the sails on that from growth rates that could be above 2.5%, closer to 3% maybe, and thinking, well, this is just going to offset that fiscal stimulus. Maybe it's another year of growth around 2%. But you're getting inflation moving higher. Maybe we get the Fed cuts that we were expecting. Maybe we don't. Maybe the Fed stays on the sideline. So right now we're saying it's a headwind, but we need to be watchful, as we were saying, that maybe it becomes a quantity story. Maybe it does re-escalate. Maybe oil moves to $125 to $150 a barrel. And then I think equity markets would look much weaker. Sentiment would be worse. And in addition to weaker spending, maybe what you get then is negative wealth effects. And the private sector that says, well, let's delay that capital spending plan, let's delay those hiring plans, and then the economy can slow down much more abruptly.
All right, Michael Gapen, managing director and chief US economist at Morgan Stanley. Michael, always appreciate your time. Thank you.
We'll be right back. And if you're enjoying the show so far, be sure to like and subscribe to the Prof G Pod YouTube channel at the link below.
This is advertiser content brought to you by Virgin Atlantic. Ed, a couple weeks back, I got you a birthday gift. Not to pat myself on the back, but it was a pretty good one.
It was indeed. You surprised me with Virgin Atlantic Upper Class tickets to London.
