As we get into the new week, it seems like it will only be a matter of time before oil starts knocking on the door of $100 again. And this time around, markets may want to pay closer attention.
We already got a taste of things during the previous episode back in March to May. But now, we’re well over six months from the US-Iran conflict and renewed tensions between the two sides. And the bigger worry is that there doesn’t seem to be any appetite for de-escalation this time around.
Ship traffic along the Strait of Hormuz is basically at a standstill, despite what Trump may claim and what backdoor channels may apply. And the longer this persists, the higher the chances are there will be a further dislocation in the oil market in terms of supply-demand dynamics.
That being said, whether or not oil actually hits $100 is almost besides the point I would say. The more important question is what happens if it stays there for much longer, especially with the war continuing to rage on.
$100 oil threatens to put inflation back on the agenda
This is almost a given and is very much already showing up on inflation numbers again over the summer.
A renewed energy shock is coming through as higher oil prices feed into more expensive petrol, diesel, aviation fuel and transportation costs. The main worry is then this will spill over to other parts of the economy.
As central banks were able to breathe a sigh of relief after the March to May oil price surge, this is threatening to put them back into the frying pan. A prolonged energy shock risks reversing some, if not all, of the progress made in the last few years in trying to sustainably bring inflation back down.
The immediate impact will show up in things like headline consumer price inflation (CPI) numbers. However, policymakers will be much more concerned about what happens next.
The real danger is the second-round effect
Central banks have been actively trying to skirt around having to make policy decisions based on short-term or temporary shocks. During this whole geopolitical crisis, they are not acting any differently. And rightfully so.
After all, raising interest rates doesn’t help to create another barrel of oil to address the supply issue.
But when push comes to shove, they have to deliver on their mandate to try and at least do their part. And this is where the problem extends further.
A trucking company paying more for diesel may increase their delivery charges. Airlines facing higher jet-fuel costs may raise air fares. Manufacturers may pass higher transport and electricity bills to customers.
In turn, workers can only demand higher wages to compensate for rising living costs.
Suddenly, what began as an oil/energy shock starts appearing in services inflation, wages and inflation expectations. And this is exactly when central banks will begin getting nervous and policymakers start gripping the edge of their seats.
Central banks are facing a policy dilemma
As $100 oil returns, this is where things will start to heat up for markets and for central banks.
If oil pushes inflation higher while economic growth remains robust, the answer for central banks is relatively simple. That is to keep monetary policy tight and/or raise rates further.
The problem comes though is when $100 oil begins hitting at growth conditions more seriously. Take it as a scenario where households have less disposable income when petrol and electricity become more expensive. Businesses see margins squeezed. Consumption slows.
That is when we might start to see higher inflation pressures but weaker economic growth at the same time. Sound familiar? Yup, that is the whole stagflation narrative once again.
Policymakers have to do their job to deliver on their mandate. But in doing so, they may risk sending the economy over the edge if the status quo persists for another six months to a year. How much pain will then be too much?
The equation for broader markets will begin to change
For the better part of the last six months, one can argue that broader markets – especially equities – have taken the whole US-Iran conflict in stride.
Investors have been able to look past the immediate $100 oil headline before and they may very well be able to do so again this time around.
But as mentioned, the question isn’t so much so a case of if oil will hit $100 again next. It is what happens if we do see oil print at $100 and stay there for a prolonged period of time.
We’re already seeing the bond market exhibit signs of stress and financial conditions will only tighten further the more this keeps up. High inflation and higher rates while weighing on the economy tends to be a poor setup for equities to thrive.
So, it isn’t so much so that oil hitting $100 will hurt broader markets. It is that if oil stays up there for long enough to cause investors to rethink the whole landscape driving risk assets.
And with every passing day of the US-Iran conflict keeping as it is, the danger of that becomes more real.
This article was written by Justin Low at investinglive.com.