From the desk of the CIO: What we know about the oil shock
Why past energy crises are not a reliable guide in navigating the current oil shock.
The outbreak of a wider war in the Middle East has reawakened fears of inflation as energy prices rocketed. This is a classic example of unpredictable and impactful events that continue to occur. In the short time since the start of the Iran war, equity and bonds have sold off while the US dollar and share prices rose for oil and gas companies. The market moves have not been large (at the time of writing) and have not reversed the gains chalked up in the first two months of the year.
What happens next is not knowable. There are many feasible scenarios, each with quite different economic and market impacts. These range from an imminent ceasefire that leaves the existing Iran regime intact to a “perma-crisis” of prolonged conflict that transforms economies.
Investors now face the question of how to respond. Our approach is to review the readiness of our portfolios for what may come, knowing that there is huge uncertainty. As we do this, we are looking at what markets have already priced in and the likelihood of extreme scenarios.
In a nutshell, energy prices, inflation expectations and bond prices now reflect ongoing higher oil and gas prices and no further cut in interest rates from the Bank of England. So far energy prices have risen substantially (approx. 60% and 180% for oil and European gas), but are still considerably lower than in 2022 when European gas prices peaked at over 6 times current levels and oil prices traded above $100 for about 6 months. It’s a far cry from the horror scenario of the 300%+ spike in oil prices in 1973/74 that pushed up UK inflation rates by 9%.
Thankfully, historic energy crises are not a reliable guide to the more probable future scenarios.
Firstly, the world is a lot less sensitive to moves in oil and gas prices. The Shale revolution has transformed the world’s largest economy, the United States, from an energy importer to an exporter. Plus, renewable energy meets far more of our energy needs, in terms of electricity generation and transport. It’s especially important for China, the world’s second biggest economy. Technological advances mean economies are more energy efficient, with the notable exception of power-hungry Artificial Intelligence.
Secondly, inflation is much better anchored. Global prices are being kept in check by overproduction and exports by China, the disinflationary impact of AI, reduced power of unions globally and renewed vigilance by central banks.
Thirdly, interest rates are at more sustainable levels than prior energy shocks, limiting the need for large rate rises to quash inflationary pressures. UK and US Interest rates are already higher than inflation rates and much higher than 2021 and 1972, in inflation adjusted terms.
So, we do not see a return to 1970s stagflation. There is potential for this crisis to create shocks that are more inflationary than deflationary. For this we hold a range of diversifiers such as defensive industries less impacted by business cycles, inflation-linked bonds and liquid alternative investment strategies.
The crisis, like all prior ones, will also create new opportunities. We are closely tracking how events are impacting businesses and asset prices to identify risks and spot opportunities, working closely with Morningstar’s 400-strong research team.
