The spectre of stagflation returns

In Homer’s epic The Odyssey, Odysseus finds himself on a boat trying to negotiate the treacherous Strait of Messina, guarded on one side by the six-headed beast Scylla, while on the other is the mysterious sea creature Charybdis.

After guidance from an island nymph, Odysseus sails closer to Scylla, ultimately passing through the Strait but at the cost of six crew.

We are currently facing what is arguably the greatest supply shock to oil markets in history. With 20% of seaborne energy supply transiting the narrow Strait of Hormuz, along with many other essential commodities, a conflict that is barely six weeks old will profoundly reshape global energy dynamics for years to come.

Significant energy production and refining capacity has already been damaged. Major LNG producer Qatar believes that ~20% of its production capacity will be offline for several years, while a lack of storage has seen production capacity temporarily shut in.

Each day that passes without a resolution creates larger ripple effects for the global economy to absorb. Constrained energy markets will have implications across the economy, including agricultural inputs such as fertilisers and transport costs.

There are three possible scenarios to consider. The first is a quick resolution with resumption of transit and gradual restoration of productive capacity. The second is an intermediate scenario of protracted high energy prices and multi-sectoral disruptions. The final scenario is the most severe and entails actual demand destruction leading to global energy shortages. We will assess these scenarios through the lenses of financial conditions and how monetary authorities may respond.

Financial conditions are tightening

From a markets perspective, the most acute risk to investors in the short term is the tightening of financial conditions. The key drivers have been volatile equities and rising bond yields.

Figure 1: Financial Conditions Index (higher = tightening)

Equities remain exposed to deteriorating investor sentiment and earnings impacts in all scenarios.

Long bond yields have jumped as the war has progressed. Traders have focussed on the potential inflationary implications, reflecting an expectation that the intermediate or severe scenarios are more likely.

If a resolution is found sooner, the inflationary impacts may be contained, allowing investors to “look through” the temporary impact on inflation which will likely be contained to the headline print.

Tightening financial conditions are already starting to reflect on the growth outlook. Weak fiscal positions are contributing to stickier long-term yields, while disappearing term premium suggests rate cuts are quickly being priced out of investor expectations.

In our view, while financial conditions are important for investors, it is sustained growth impacts that investors should be focussed on, and as Figure 2 shows, financial conditions are expected to drag on the growth impulse in the quarters ahead. In an intermediate or severe scenario, these headwinds are likely to intensify.

Figure 2: Implied growth impulse from financial conditions

How do authorities respond?

With each day that passes, the potential impact on inflation, economic activity and global capital flows increases. Short-term concerns will quickly shift to longer-term strategic implications.

In our view, central banks will be forced to weigh a “lesser of two evils” approach. They will need to tailor their responses even more closely to local circumstances, creating divergent policy paths. The calculus today depends heavily on whether there is a single or a dual monetary policy mandate.

If the benign scenario emerges, investment bank Morgan Stanley estimates that headline inflation could jump by 30-50bp for every 10% sustained increase in oil prices. This would be unwelcome but manageable. Prices would only need to stabilise for the effects to start washing through the data relatively quickly.

This scenario would be preferred by central banks with dual mandates such as the US Federal Reserve and the Reserve Bank of Australia (RBA).

Before the outbreak of hostilities in the Middle East, the Fed and the RBA were on very different policy trajectories. While Australia was already expecting policy tightening this year, market expectations pivoted quickly to remove the chance of rate cuts globally.

Countries with a single mandate to control inflation face an insidious policy calculus, particularly if the growth and inflationary shocks are broader and persistent. Higher energy prices could impact growth, such that interest rate increases implemented to address inflation may need to be quickly reversed to address recessionary risks. Herein lies the core dilemma – risk embedding inflation or endure possible recession?

It is almost impossible to make rational forecasts in what can only be described as a “headline-driven” market. But amongst the focus on inflationary and growth risks, there may be realities emanating from the markets which could also influence central bank action.

Take the United States. Almost one-third of its existing sovereign liabilities need to be refinanced over the next 12 months, a process that is heavily reliant on functioning bond markets.

Sustainability of government borrowing is not part of the Federal Reserve’s dual mandate, but if yield curves continue bear flattening and inflation expectations start to translate into nominal yields, the need for lower rates may become the imperative to avoid major dislocations.

Figure 3: Upcoming US debt maturities

Summary

Like Odysseus’ dilemma, the global economy and central banks are left to navigate a dangerous, narrow Strait, caught between the "Scylla" of inflationary supply shocks requiring a monetary response and the "Charybdis" of a growth-consuming tightening cycle.

Even if the Strait of Hormuz reopened tomorrow, significant disruption is already baked in. Higher energy prices will stymie growth by acting as a tax across the economy given energy’s influence throughout the supply chain.

Regardless of the outcome of the current military conflict, the tightening of financial conditions and friction in energy markets will be multi-year themes. Markets will need to grapple with the strategic implications of energy scarcity, higher prices and nation states prioritising energy security.

Central banks have just one blunt instrument with which to respond, placing them in a precarious position. With some estimates calling the current war a catalyst for the largest stagflationary shock in 50 years, monetary authorities will be working overtime to uncover precious signal amongst the constant noise.

One thing is for sure, the coming years will be defined by energy – sources, security and scarcity. Fossil fuels and petrochemicals are inescapably intertwined in the global economy. Investors, policymakers and central banks will need to balance important but competing priorities amid persistent uncertainty.

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