Investors are increasingly pricing in the possibility that the current unrest in the Middle East could produce a stagflationary shock reminiscent of the 1970s, when interruptions to global energy supplies sent inflation sharply higher while growth sagged. The core of that anxiety is a renewed and rapid ascent in energy prices, which market participants say could force an uncomfortable trade-off for policymakers and unsettle a broad range of assets.
"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."
The oil trigger
At the centre of stagflation concerns is the dramatic move in oil. Brent crude climbed above $100 a barrel on Monday and recorded its largest single-day increase since the 2020 COVID crisis. Year-to-date, the benchmark is up 70% and European wholesale gas stands at its highest level in more than three years. These developments directly feed inflationary pressure while also posing a brake on growth.
Analysts note a simple rule-of-thumb for the inflation impact: a 5% rise in oil prices typically adds roughly 0.1 percentage points to developed market inflation, according to Capital Economics. Beyond inflation, the International Monetary Fund’s estimates indicate that every persistent 10% increase in oil prices is followed by a 0.1-0.2 percent decline in global economic output. Historical precedent underscores the risk: oil price surges factored into U.S. recessions in 1973, 1980, 1990 and 2008.
Central bank dilemma
High energy costs are placing central banks in a difficult position. Raising interest rates to contain inflation can itself hinder economic growth, potentially creating the very stagflation investors fear. The prospect of such a trade-off was emphasized by Chicago Federal Reserve President Austan Goolsbee, who warned of a "stagflationary environment that’s as uncomfortable as any."
Market pricing has shifted noticeably since the energy shock. Expectations that had been leaning toward easier policy have reversed: markets now anticipate at least one European Central Bank rate hike this year, a marked change from the roughly 40% chance of a cut that was priced in before the conflict. Similarly, the Bank of England is now seen by markets as having a credible chance of a rate increase this year, after previously pricing in at least two cuts.
Commerzbank rates strategist Rainer Guntermann described the dynamic succinctly: "It seems only retreating oil prices could reverse rate hike fears, even with dovish minds at the ECB also stressing downside growth risks."
Bond markets under pressure
The prospect of a persistent inflation shock has hit fixed-income markets hard, as inflation erodes the real returns from nominal bonds. Short-dated government bonds have been particularly sensitive to the change in expectations. In the United Kingdom, two-year gilt yields rose by nearly 50 basis points in the last week, marking their most severe sell-off since the 2022 budget crisis amid sticky inflation and stagnating growth. Two-year yields in Germany and Australia climbed by more than 30 basis points over the same period, while U.S. two-year yields rose by a more modest 13 basis points.
Investors have increasingly turned to inflation-linked debt to protect real returns. In Britain, five-year breakeven inflation rates - the gap between inflation-linked and nominal yields - have increased by 28 basis points since the end of February and reached almost 3.5%, their highest level since last April. In the United States, five-year inflation-linked Treasury yields rose by 4.2 basis points in the last week, compared with a 15 basis point increase in nominal yields.
U.S. resilience - but not immunity
Despite the global nature of the shock, analysts point out that the United States is relatively better placed to withstand certain commodity disruptions. Rabobank senior global strategist Michael Every highlighted that the U.S., together with the Americas, is self-sufficient in many of the commodities affected by disruptions that could stem from the Strait of Hormuz. He also flagged the potential impact on inputs beyond oil, such as fertiliser and helium, the latter important for semiconductor manufacturing.
Reflecting this relative resilience, U.S. equity and bond markets have performed better than many peers since the conflict intensified. The S&P 500 fell 2% last week, compared with a 5.5% decline in Europe and a 6.3% drop for MSCI’s Asia Pacific ex-Japan index. U.S. bonds also outperformed German government debt over the same timeframe.
That said, the U.S. is not immune to stagflationary pressures. Economic indicators showed weakness before the energy spike: the economy unexpectedly shed jobs in February, and data due this week was expected to show a small rise in U.S. inflation, suggesting vulnerability even in a relatively more self-sufficient region.
Where investors are seeking shelter
Stagflation poses a unique problem because it undermines traditional safe havens. Stocks and nominal bonds both suffer when inflation rises while growth slows, and even gold can be challenged since it does not yield income. The precious metal declined about 2% last week and fell further on Monday, a movement market participants attributed in part to selling used to cover losses elsewhere.
The U.S. dollar has stood out as a haven of sorts, appreciating against nearly every other developed-market currency since the conflict began. Kit Juckes, head of FX strategy at Societe Generale, observed: "The U.S. is a major oil producer and can withstand an oil shock - though there will be political fallout. The same simply isn’t true of Europe, and the UK in particular."
Implications for markets and policy
Market moves since the outbreak of hostilities have repriced expectations across asset classes. Energy and commodities have driven much of the recent volatility, squeezing margins for consumers and businesses and complicating the inflation-growth trade-off for central banks. Fixed-income investors have rotated into instruments that offer inflation linkage, while equities have shown differing regional sensitivity depending on energy exposure and domestic economic resilience.
Observers note that the path forward depends heavily on the duration and intensity of the conflict and the corresponding persistence of elevated energy prices. Only a retreat in oil prices, analysts say, would ease immediate rate-hike fears, though central banks with dovish leanings continue to highlight downside growth risks.
Conclusion
With oil and gas prices elevated and policymakers facing a fraught policy choice, investors are forced to consider a scenario where inflation and weak growth coexist. That prospect is reshaping positions across bonds, equities, commodities and currencies, and is prompting renewed attention to inflation-protected instruments and the uneven regional impact of energy shocks.