Back to the 1970s? Investors brace for a return of stagflation

Investors Brace for Stagflation Risk Amid Surging Oil Prices and Inflation

By Alun John, Yoruk Bahceli and Sophie Kiderlin

Stagflation Concerns Rise as Oil Prices Surge

LONDON, March 9 (Reuters) - Investors are now seriously considering the possibility that war in the Middle East could create a stagflationary shock, just as it did 50 years ago, when disruption to global energy supplies sent inflation surging, and battered growth 

“The risk of a 1970s scenario is rising,” said Kaspar Hense, portfolio manager at RBC BlueBay Asset Management.

“If there is another extended war, with oil prices going up significantly further, then the safe-haven status of government bonds are at risk, and with that, all assets.”

Here's how stagflation is a risk and could play out in markets in five charts. 

Oil Prices at the Epicentre of Stagflation Fears

OIL THE KEY 

The epicentre of stagflation fears is the surge in oil prices, and the biggest question for world markets now is how long will those prices remain elevated. 

Brent crude vaulted above $100 a barrel on Monday and was on track for its biggest daily jump since the 2020 COVID crisis. 

It is up 70% since the start of the year, while European wholesale gas prices are at their highest level in over three years. 

That's bad news for inflation. 

"A useful rule of thumb is that a 5% rise in oil prices adds around 0.1 percentage points to developed market inflation," Capital Economics said.

And high oil prices also could dampen economic growth. 

The International Monetary Fund estimates for every persistent 10% rise in oil prices, a 0.1–0.2 percent fall in global economic output follows.

Oil price surges contributed to U.S. recessions in 1973, 1980, 1990 and 2008. 

Central Bank Dilemma: Inflation vs. Growth

CENTRAL BANK DILEMMA 

This puts central banks in a bind, as rate hikes to restrain inflation could further undermine economic growth. 

Chicago Fed President Austan Goolsbee told the Wall Street Journal on Friday a "stagflationary environment that's as uncomfortable as any" could be looming.

Markets now see at least one European Central Bank hike this year, compared to a 40% chance of a cut before the war.  

They also see a chance of a rate hike this year from the Bank of England, having earlier priced at least two cuts. 

“It seems only retreating oil prices could reverse rate hike fears, even with dovish minds at the ECB also stressing downside growth risks,” said Commerzbank rates strategist Rainer Guntermann.  

The Impact on Global Bond Markets

THE MISSING LINKERS

That has battered global bond markets as investors ditch fixed-income assets, where inflation erodes future returns. 

Short-dated bonds are the most sensitive. In Britain, two-year gilt yields have shot up by nearly 50 basis points in the last week, their worst sell-off since the budget crisis of 2022, in light of the UK's sticky inflation and flat-lining growth. 

German and Australian two-year yields have risen more than 30 bps in that time, while U.S. two-year yields are up a comparatively modest 13 bps.

That's got investors looking at inflation-linked debt, where both the principal and the interest are linked to the rate of inflation. 

This has pushed British five-year breakeven inflation rates - the difference between inflation-linked and nominal yields - up 28 basis points since the end of February. On Monday, they hit almost 3.5%, their highest since last April. 

Meanwhile, five-year inflation-linked Treasury yields have risen by 4.2 bps in the last week, compared with a 15-bp rise in nominal yields.   

U.S. Market Resilience and Vulnerabilities

EYES ON THE US 

Those wondering whether the market and economic hit will cause U.S. President Donald Trump to change course have to remember the stagflationary hit from the war will likely hurt the U.S. less than Europe or Asia.

"The U.S., with the Americas, is self-sufficient in many (of the) commodities being choked off directly or indirectly via (Strait of) Hormuz," said Rabobank senior global strategist Michael Every in a note. 

As well as oil he flags fertiliser and helium, important for semiconductor manufacturing. 

Not surprisingly, U.S. markets have held up better in relative terms. The S&P 500 dropped 2% last week compared to a 5.5% fall in Europe and 6.3% drop for MSCI's Asia Pacific ex-Japan index.

U.S. bonds also outperformed German last week. 

However, the U.S. is by no means immune to stagflation and was looking a bit vulnerable even before the energy price spike. The economy unexpectedly shed jobs in February, and data this week is expected to show a tick higher in U.S. inflation.     

Safe Havens and Investment Strategies

WHERE TO HIDE? 

Investors don't like stagflation because it hurts stocks, bonds - that aren't inflation linked - and even potentially gold, given it does not have a yield.

The precious metal dropped 2% last week, and was down again on Monday, though analysts said this was in part selling to make up for losses elsewhere. 

The only safe haven that has really held up since the war begun has been the dollar, which has gained on nearly every other developed market currency. 

"The U.S. is a major oil producer and can withstand an oil shock - though there will be political fallout," said Kit Juckes, head of FX strategy at Societe Generale. 

"The same simply isn’t true of Europe, and the UK in particular."   

(Reporting by Alun John, Amanda Cooper, Dhara Ranasinghe, Yoruk Bacheli Sophie Kidderlin and Samuel Indyk; Editing by Susan Fenton)