How investors can navigate an oil price shock

Investors are struggling to understand what the rapid escalation of events in the Middle East means. Is this a spell of heightened but temporary volatility, or the start of a more sustained oil price shock? 

Since the 1970s, there have been five major oil supply shocks, as the table below shows. In each case, oil prices rose sharply over the following three months, putting upward pressure on global inflation. 

These kinds of supply-side shocks leave policymakers in a bind. Central banks usually respond to high inflation with higher interest rates, but this depresses household demand and business investment – all while failing to address the root cause (rising oil prices). The alternative is to tolerate an inflation surge, and hope that it eventually fades. History suggests that neither path is painless.

As the table reminds us, the oil shocks in the 1970s were particularly brutal. These coincided with US rate hikes, and were followed by a recession within a year. More recent episodes came against a milder economic backdrop, but were still distinctly uncomfortable for investors. Few of us would want to return to the conditions of 2022, when inflation surged, interest rates soared, and stocks and bonds suffered simultaneous negative returns. 

When it comes to oil shocks, this pattern isn’t unusual. Société Générale research shows that, over the past five decades, US 10-year Treasuries and global equities are each typically about 1.5 per cent lower six months after an oil price shock.

Why this time is different

Today, the key variable is the Strait of Hormuz – a 20-mile-wide shipping channel between Oman and Iran. Its location and narrowness means it is a crucial chokepoint for deliveries from Opec countries to customers in Asia. A third of all seaborne oil exports pass through it (as well as a fifth of all natural gas exports). If flows are materially disrupted, analysts think that prices could quickly climb above $100 a barrel, from $72 at the end of February. Markets would adjust to some degree: Opec will increase supply, as could US producers – although the additional output could take six months to materialise.

Analysts note that the economic backdrop is more resilient than it was during earlier oil shocks, which should reduce the risk of a deep contraction. But this carries another danger: it will be easier for an inflationary spiral to bed in. In the US, tariffs are already adding to price pressures, as are loose financial conditions and generous fiscal policy. Atakan Bakiskan, Berenberg’s US economist, said that with the economy showing signs of overheating, “it is hard to be in the disinflation camp”. 

He believes that even signaling rate hikes could provoke a political backlash – but if the Federal Reserve hesitates, inflation expectations could soar. He warns that if price growth reaccelerates towards 4 per cent, it would be very hard for the Fed to cut interest rates this year at all. On these shores, given the Monetary Policy Committee’s sensitivity to energy prices, market expectations for a spring rate cut from the Bank of England suddenly look far less certain. 

How UK investors should position themselves 

The gold price has risen on news of the attacks, and historically performs well after oil shocks. Société Générale estimates that it gains 10 per cent in the week after a shock, and 31 per cent over the following six months. Equities tend to fare less well, with average declines of 3.5 per cent in European markets and 1.6 per cent globally after six months. These are broad averages, however: analysts think that defence and energy stocks (particularly those based outside the region) could stand to benefit this time. 

In the past five oil shocks, US equities and the dollar proved resilient. Historically, rattled investors seek safety in US government bonds, pushing yields lower – but that pattern hasn’t emerged this time. Yields on 10-year Treasuries rose at the start of the week as prices fell. This could be a recalibration as traders price in fewer interest rate cuts, but there is another interpretation for investors to be aware of. John Hardy, global head of market strategy at Saxo Bank, thinks that “it is more of a signal that the world doesn’t see US Treasuries as a credible safe haven any longer”.