Commodity shocks and financial markets

 

The first quarter is a commodity shock quarter. We had the gold and silver bubble and it bursting at the end of Jnauary. That seems like ancient history versus all the uncertainty from the war in Iran. The broad market is off more than 5%, yet the energy sector is up over 35%. More importantly, the price of oil is up over 50%, and gasoline futures are growing by 60%. There is a clear link between oil price shocks and financial markets. It is a one-two punch to equity and bond markets, and we have strong evidence of its effect across decades, dating back to the shocks of the early 1970s. Most of these large shocks are self-induced through violence. 

Beyond the magnitude of the shock, the key issue is the time required to return to normality. Short-term shocks can have a strong impact on short-term returns but then reverse quickly. The longer the shock lasts, the more likely it is to have a real effect on growth and inflation. The effect on growth is simple. An increase in energy prices is a tax on consumers and production. However, the US economy is less oil-price-sensitive than it was in the 1970’s, so it is hard to use this period as a control or base case. For inflation, the impact is closely tied to the actions of the central bank. An oil price shock is a relative price change, not an increase in the general price level; however, if the Fed lowers interest rates to support the economy, this price change can trigger an inflation surge.

All eyes are on whether this conflict will be prolonged, and with each day it continues, this short-term shock will be revised into a larger, economy-wide recession-inducing crisis. For many in the emerging markets, energy shortages are real and already disrupting growth.