Investors are now seriously considering the possibility that conflict in the Middle East could trigger a stagflationary shock, mirroring events from 50 years ago. Disruptions to global energy supplies then sent inflation soaring while simultaneously battering economic growth.

"The risk of a 1970s scenario is rising," stated Kaspar Hense, portfolio manager at RBC BlueBay Asset Management. He warns that prolonged conflict, coupled with significant oil price increases, could jeopardize the safe-haven status of government bonds and, by extension, all assets.

Oil Prices Surge, Growth Dims The epicentre of these stagflation fears is the sharp rise in oil prices. Brent crude has vaulted above $100 a barrel, marking its largest daily jump since the 2020 COVID crisis. This surge, a 70% increase since the start of the year, alongside record-high European wholesale gas prices, spells trouble for inflation. Economists note that a 5% rise in oil prices typically adds 0.1 percentage points to developed market inflation, while the IMF estimates a 10% persistent oil price increase can reduce global economic output by 0.1-0.2%.

Central Banks Face a Dilemma This environment places central banks in a difficult position. Hiking interest rates to combat inflation risks further undermining already fragile economic growth. Chicago Fed President Austan Goolsbee acknowledged the potential for an "uncomfortable" stagflationary environment. Markets are now pricing in at least one European Central Bank rate hike this year, a stark contrast to earlier expectations of cuts. Similarly, the Bank of England faces pressure to consider rate hikes instead of anticipated cuts.

Bond Markets Under Pressure Global bond markets have been battered as investors flee fixed-income assets, concerned that inflation will erode future returns. Short-dated bonds are particularly sensitive. In Britain, two-year gilt yields have seen their worst sell-off since 2022, reflecting sticky inflation and flat-lining growth. German and Australian yields have also risen significantly, while U.S. yields have seen a more modest increase.

US Resilience and Vulnerabilities While the U.S. may be less exposed to commodity shocks due to its self-sufficiency, it is not immune to stagflation. Markets have held up relatively better in the U.S. compared to Europe and Asia, with the S&P 500 experiencing smaller declines. However, the U.S. economy showed signs of vulnerability with unexpected job losses in February, and inflation data is expected to show an uptick. The U.S. dollar remains a key safe haven amidst this global uncertainty.