Stagflation Nightmare Returns? Global Markets Face Their Severest Test in 50 Years Amid Middle East Conflict Impact!

As the situation in the Middle East continues to escalate, soaring oil prices are sounding the global economic “stagflation” alarm. From stock markets and bond markets to gold, investors have little place to hide.

Investors are currently seriously assessing a possibility: that conflict in the Middle East could trigger a stagflation shock. This is like a replay of the script from 50 years ago, when disruptions to global energy supplies caused inflation to soar and severely damaged economic growth.

Kaspar Hense, portfolio manager at RBC BlueBay Asset Management, said: “The risk of replaying the crisis of the 1970s is rising. If another prolonged conflict breaks out, causing oil prices to rise further, the safe-haven status of government bonds will be at risk, and all assets will face danger.”

The Key: Oil

Concerns about stagflation mainly stem from rising oil prices. The biggest question facing global markets right now is: how long will these high oil prices last?

Brent crude surged above $100 per barrel on Monday, marking the largest single-day gain since the COVID-19 pandemic crisis in 2020. Since the beginning of this year, Brent crude has already risen by 70%, and wholesale natural gas prices in Europe have also hit their highest levels in over three years.

This is undoubtedly bad news for central banks trying to control inflation.

Citi Macro notes: “A practical rule of thumb is that, every 5% increase in oil prices tends to raise inflation in developed markets by about 0.1 percentage points.”

Meanwhile, high oil prices also dampen economic growth.

The International Monetary Fund estimates that for every 10% increase in oil prices, global economic output declines by 0.1% to 0.2%.

Looking back, soaring oil prices have been one of the “behind-the-scenes drivers” of recessions in the US in 1973, 1980, 1990, and 2008.

Central Banks in a Dilemma

This puts central banks around the world in a difficult position: if they don’t raise interest rates, inflation remains unrestrained; if they do, economic growth could be further hampered.

Chicago Fed President Goolsbee warned last Friday in an interview with The Wall Street Journal that a “very uncomfortable stagflation environment” may be approaching.

Markets currently expect the European Central Bank to raise interest rates at least once this year; before the conflict erupted, there was a 40% chance of rate cuts.

At the same time, investors also believe the Bank of England may raise rates this year, whereas previously markets had expected at least two rate cuts.

Rainer Guntermann, a rate strategist at Deutsche Bank, admitted: “It now seems that only a decline in oil prices can dispel fears of rate hikes, even as dovish officials at the ECB emphasize downside risks to economic growth.”

Expectations for Central Banks Shift

Inflation-Linked Bonds

The concerns above have already dealt a heavy blow to the global bond markets. Because inflation erodes future returns, investors are rushing to sell fixed-income assets.

Among them, short-term bonds are the most sensitive. Given the high inflation and stagnant growth in the UK, the past week saw the two-year UK government bond yield soar nearly 50 basis points, experiencing the worst sell-off since the 2022 budget crisis.

Meanwhile, the two-year bond yields in Germany and Australia also rose over 30 basis points. In comparison, the US two-year Treasury yield increased a more modest 13 basis points.

This has led investors to turn their attention to inflation-linked bonds, which have principal and interest that rise with inflation.

Driven by this, since the end of February, the UK’s five-year breakeven inflation rate (the difference between inflation-linked and nominal bond yields) has risen 28 basis points. On Monday, it reached nearly 3.5%, a new high since April last year.

At the same time, over the past week, the US five-year inflation-linked Treasury yield increased by 4.2 basis points, while nominal Treasury yields rose by 15 basis points.

Focus on the US

Some may wonder whether this market and economic turmoil will prompt President Trump to change policy direction. But it’s important to remember that the stagflation impact from the conflict is likely to be less damaging to the US than to Europe or Asia.

Michael Every, senior global strategist at Rabobank, pointed out in a report: “Whether directly or indirectly due to the blockage of the Strait of Hormuz and the resulting supply disruptions of many commodities, the US and the Americas can largely achieve self-sufficiency.”

Besides oil, he also specifically mentioned fertilizers and helium, which is crucial for semiconductor manufacturing.

Unsurprisingly, the US market has performed relatively better. Last week, the S&P 500 fell 2%, while European stocks plunged 5.5%, and the MSCI Asia ex-Japan index tumbled 6.3%.

Last week, US bonds also outperformed German bonds.

However, the US is not immune to stagflation; in fact, even before energy prices soared, the US economy showed signs of fragility. In February, the US unexpectedly lost some jobs, and data due out this week is expected to show signs of rising inflation.

Geopolitical Shocks Rapidly Disrupt Market Momentum

Where Are the Safe Havens?

Investors dislike stagflation because it not only devastates stocks and (non-inflation-linked) bonds but can also impact gold, which does not generate interest income.

Last week, gold fell 2%, and continued to decline on Monday. However, analysts say that part of this is due to investors selling gold to cover losses elsewhere.

Since the conflict erupted, the only truly resilient safe haven has been the US dollar. Compared to almost all other developed market currencies, the dollar has appreciated.

Kit Juckes, head of FX strategy at Société Générale, said: “The US is a major oil producer and can fully withstand the impact of oil shocks, although this may trigger some political chain reactions. But Europe simply doesn’t have that resilience, especially the UK.”

Comparison of Oil and Gold Prices