What does the rise in energy prices mean for inflation?

If these are sustained, they’ll push inflation noticeably higher in most countries – but not close to the 2022 peak, after Russia’s full-scale invasion of Ukraine.

In the UK, energy prices at current levels will add around 2 percentage points (pp) to CPI inflation by the third quarter of this year, probably taking it to around 4%. Indirect price pressures are also likely to build up over the course of the year, for goods and services where energy commodities are key inputs – most notably, food. But accurately predicting the magnitude and timing of these indirect effects is difficult. And there may be offsetting effects, reducing overall increases in inflation, as higher energy bills suppress consumer spending elsewhere.

In the US, the direct impact should be smaller, at closer to 1pp, taking inflation there to around 3.5%. Most of that comes from the impact of higher oil prices on road fuel. Average gasoline prices have already risen from $3 to almost $4 a gallon so far this month. But the US will still face indirect inflationary pressures in areas like food and air fares.

European natural gas prices are still far below the 2022 spike

How will the Iran conflict affect economic growth?

Higher energy prices will hurt economic growth, and generally by more in countries like the UK that are net energy importers.

But the damage from the increase in prices that has happened so far should be manageable. They’re likely to reduce global GDP growth this year, forecast at around 3% before the conflict, by perhaps 0.1-0.2pp. As explained above, interest rates shouldn’t need to rise as they did in 2022-23. That makes a huge difference. It’s also notable that Europe has reduced its gas consumption since 2022 by 16%. That reduces its vulnerability.

In the 1970s, two major oil shocks contributed to deep recessions. But oil prices rose a great deal more then than they have so far – by more than 200%, compared to about 80% up till now. And the global economy was far more dependent on oil, back then. The energy intensity of US GDP, for example – the energy used for every dollar of economic output – was about three times greater.

That meant higher oil prices did far more damage.

What could happen to energy prices next?

Let’s think through the key risks.

As long as the Strait of Hormuz remains impassable for most tankers, global oil supply may be 10-15% lower than usual. Around 20m barrels of oil per day (20% of  global supply) ordinarily transit the Strait. Reports suggest that 2-3m barrels per day of Iranian oil exports have continued, and a handful of shipments from other countries have been allowed to pass through too. Additionally, analysts estimate that there are 3.5-5.5m barrels per day of spare capacity in pipelines that allow oil producers to bypass the Strait.

Meanwhile, around 20% of global liquefied natural gas (LNG) exports, almost entirely from Qatar, also transits the Strait. There are no alternative routes for this LNG and there’s limited spare unsanctioned capacity elsewhere.

Developments in the Strait will therefore be the primary determinant of what happens to energy prices next. At present, we think oil and gas markets are pricing in disruption to shipping of between one and three months. If traders think disruption could last longer than that, prices could rise further. Much longer disruption could push the benchmark Brent crude price as high as $150 a barrel.

A sustained rise above $150, as some have speculated, seems unlikely. The case for $150 requires some very unfavourable assumptions about how much any given level of supply shortage would affect prices, and/or an even larger hit to supply.

It’s worth remembering that US President Donald Trump has strong incentives to reduce energy prices ahead of the Congressional midterm elections in November, given the high political salience of inflation, even if the cost is an embarrassing climbdown on Iran or the commitment of vast military resources to protecting the Strait.

There are also strong incentives for Europe, China and most Gulf states to force a resolution to the Strait’s closure.

That said, even if the Strait was reopened, prices would remain high for a while. After all, it will take time to restart shuttered oil production. It will also take time to unwind the disruption to refinery supply – some have been damaged by the attacks. But we’d expect prices to fall meaningfully from current levels.

What does this mean for investment strategy?

We’re wary of knee-jerk reactions, based on strong assumptions about how highly unpredictable events will unfold.

That includes the assumption by some people of worst-case scenarios.

We have an evidence-based framework to guide us, which should also help to identify if significant investment opportunities emerge from the volatility.

Looking at different assets:

• Even before the conflict, we favoured shorter-dated bonds, since these are hit less than longer-dated bonds by increases in inflation and inflationary expectations. The current conflict only increases our conviction. Since the start of March, the return for the FTSE index of 10+ year gilts is -5.6%. For 1 to 5-year gilts, the fall is only 1.8%. As well as short-dated bonds in general, we like index-linked bonds. These are bonds whose coupon – the interest payment made by the debtor – is linked to inflation. Short-dated index-linked gilts have delivered positive returns in March.
• We like diversifying assets, including actively managed strategies. So far during the conflict, index-linked gilts have held up better than equities and long-dated gilts.
• Even before the conflict, we saw strong potential in some defence and energy companies – and the case for them is now stronger.
• We favour companies with ‘quality’ characteristics: strong competitive positions and balance sheets. They should be better positioned to cope with economic volatility, and have performed better since the conflict began.