Markets remain skittish as rising oil prices may undermine inflation retreats

Inflation and interest rates still wrestle over the fate of the economy. Meanwhile, equities have had a pretty good run so far this year as investors celebrated continuous inflation retreats and rising soft-landing probabilities. However, recently, equity markets had to give up a small part of this year’s impressive gains revealing underlying uneasiness over the trajectory of inflation and the economy.

True - inflation has consistently retreated in many geographies since the beginning of this year (i.e. in the US headline inflation fell from 6.4 to 3.3 in July y-o-y), economies have proven fairly resilient thanks to a buoyant consumer and unemployment has remained low – many reasons for investor confidence and applause to the central banks.

However, over the past few weeks, major equity markets took a bit of a dive as commodity prices rose revealing signs of wavering trust in the process. Oil prices jumped this summer as OPEC+ extended its production capacity cuts sending Brent crude 16% higher since its low in June.

Rising oil prices might not be great news for everyone but this nervousness does seem a bit excessive. So, what are the reasons?

Rising commodity prices could extend the current rate hiking cycle

First and foremost, rising commodity prices are not just an inconvenience for those at the pump but may mean adding fuel to the inflation fire which could ultimately derail central banks' plan to wrap up their rate hiking cycle slowly but surely. The prospect of fresh and forceful interest rate increases are deeply worrying to markets that have been anticipating a central bank pivot in the foreseeable future, in fact as early as Q2 next year.

A recession remains a possibility until mid-2024

Furthermore, we are currently in the middle of major recession windows as we outlined in our Global Market Outlook for August . Depending on which indicator you look at, a recession could hit at some point between now and spring/summer 2024. This is because the effects of previous rate hikes are still building up and only slowly trickle through to the system. Another uncomfortable truth is that we already are in the midst of a manufacturing recession whereas services power on thanks to unabated consumer demand that has been pumped up by fiscal policy with extra cash as well as with extra savings accumulated during the pandemic. This is also reflected in recent core inflation numbers that reveal a consistently stubborn services CPI that peaked at 4.2% in February and only declined to 3.5% in July so far.

Long ends of yield curves reflect increased inflation pressures

Last but not least, bond markets have been in stark disagreement with equity markets over the past months as elevated volatility kept reflecting continuously high inflation pressures and uncertain interest rate trajectories – aspects equity markets chose to gloss over by stellar tech title performance in anticipation of a soft landing and a swift unwinding of rate hikes next year. More recently, bond markets even saw a bear steeping of curves across many geographies as increased longer-term inflation expectations pushed up the longer ends of curves while short ends remained sticky at elevated levels. For example, the inflation premium made the yield on the 10-year US Treasury rise from 3.75 to 4.27% within a matter of just a few weeks between July and mid-August.

This economic cycle has been confounding for many of us as the particularities of pandemic-related monetary and fiscal policy decisions keep uncovering surprises and new realities. Until we know more by summer next year, participating in equity performance is necessary to reap some benefits and cushion against future shocks but not without downside-protection strategies as markets remain highly sensitive to any signs of inflation flare-ups. Bonds can offer attractive yields but don’t expect much capital gains until inflation pressures dissipate.