The conflict with Iran continues, the Strait of Hormuz remains closed and 20% of the world’s energy supply has been constrained for more than 90 days. At the outset of this conflict, May 15 was often stated as the “pain point” when higher energy prices would begin cutting into economic activity.
Inflation data have pushed higher, with core personal consumption expenditures (PCE) now at 3.3% – well above the Fed target of 2.0%. Despite having experienced months of this oil shock, our economy has held up quite well. Consumption and overall economic activity are reasonably strong, and 2026 is off to a fine start, from a market perspective, with the S&P now posting an 11.25% gain for year-to-date through May.
Both the energy and equity markets are reflecting an expectation that the Strait will be open relatively soon, assuming that both oil and inflation will be falling throughout the back half of 2026.
Gas prices and interest rates rising
Throughout May, negotiations with Iran stumbled forward, and it became clear inflation was being pressured upward by elevated energy costs. Most inflation data pushed higher during May, as the energy inputs finally began to raise broad prices higher. Of course, gasoline prices had already increased sharply, with national average prices jumping above $4.50/gallon in early May.
Higher energy and inflation data naturally spiked interest rates throughout May. The 10-year treasury note hit a cyclical high of 4.67% mid-month, reflecting rising uncertainty about inflation (and long-term deficit problems).
Toward month-end, Iran-U.S. negotiations took a positive turn, and both oil and interest rates began to fall. The drop in both variables is a welcome sign – but meaningful progress toward re-opening the Strait must be made soon or these variables could resume their upward momentum.
U.S. economy continues to advance
Despite the significant geopolitical and economic uncertainties, both the U.S. economy and equity markets continued to advance in May. Household consumption appears to be holding up well, with additional economic thrust being provided by the remarkable capital expenditure (CapEx) boom from the AI buildout.
Consumption is likely being bolstered by the wealth effect. Household net worth (as a percentage of discretionary income) is at all-time highs due to phenomenal gains in housing and equity prices over the last 10-15 years. This additional wealth likely helps maintain consumption patterns, even during times of conflict, showing that the K-shaped economy continues unabated.
First quarter gross domestic product (GDP) was revised lower, but only slightly below our long-term trend growth rate of 2.0%. Most forecasters expect the remainder of 2026 to bring normal 2% growth, despite the issues with the Iran conflict. This hammers home the reality that the U.S. is much less energy dependent than we’ve ever been.
Mid-month, we witnessed one of the best earnings seasons in history. In aggregate, S&P 500 earnings grew nearly 28%. Profit margins expanded to all-time highs above 13%, and the outlook for both margins and earnings remains optimistic. Consequently, the market spiked sharply, with the S&P 500 rising 5.25% for the month (11.25% YTD).
Labor improving, but other market challenges remain
The labor market has been a consistent worry over the last year, with job creation nearly non-existent. However, in May, we received our third positive report for payroll growth for 2026. Job creation appears to have moved back up to more normal levels, at around 125,000 jobs per month. If sustained, this trend would indicate the labor market has recovered from a long period of unacceptably low job creation.
Certain measures of consumer sentiment continue to worsen, with some surveys showing readings at or near all-time lows. This reflects the fatigue settling in on the average household, as they struggle to keep up with costs of living increases that are eating up most of their discretionary income. As inflation increases spending at a faster rate than wages can grow, savings rates have fallen sharply. The U.S. savings rate is now at 2.7%, one if its lowest readings in history.
May economic summary and our outlook
The U.S. economy continues to hold steady at or near our normal growth rate of 2.0%. The closing of the Strait and the spike in oil prices and inflation have not, thus far, severely hampered either the economy or markets. The stock market is riding a powerful surge of earnings growth, spurred by huge hyperscaler profits and an AI CapEx boom.
Economic and market optimism is clearly contingent on the Strait re-opening, bringing oil and inflation down in the back half of the year. If these prove to be false hopes, then growth and earnings forecasts will be revised downward. We are cautiously optimistic that political realities will necessitate a resolution to the conflict, and that current market assumptions will become reality. Market returns have already been surprisingly robust for 2026, but we foresee modest additional gains throughout the remainder of the year.
Eric Kelley is chief investment officer at UMB Bank.
