Rising oil, rates and yields brew up stagflation cocktail for markets

By Stefano Rebaudo, Harry Robertson and Shashwat Chauhan

LONDON, Sept 18 (Reuters) - The surge in energy and global borrowing costs as a result of the war in the Middle East is pushing economies and markets further towards a potentially damaging period of high inflation and slow growth.

For now, stocks remain near record highs and economic growth, thanks to the avalanche of spending on the AI boom, has been resilient. The rise in the value of oil and gas, and the increase in global government bond yields to financial crisis-era highs, has been orderly.

But a growing number of metrics are showing that fragility may be creeping in.

"Up until now, it's just been a commodities and rates story. It's not been an equity and credit story. We're starting to worry that we might be getting to a point where it starts having equity and credit effects," Chris Jeffery, head of macro strategy at LGIM, said of the rise in borrowing costs, rates and energy.

PUMP IT UP

Oil futures are back above $100 a barrel, 50% above where they were prior to the war, as intensifying attacks across the Middle East threaten more supply routes. The derivatives market shows traders aren't expecting any near-term drop in the price.

Investors are betting most heavily on Brent crude at $100 by the end of December, closely followed by options to sell it at $60, highlighting the extreme uncertainty right now.

It isn't just crude. Diesel is nearing record highs, jet fuel is double what it was in February before the Iran war broke out, while European natural gas is at its highest since 2022, as regional utilities vie with competitors in Asia for cargoes.

Online prediction market Polymarket shows users are attaching just an 18% chance of the Strait of Hormuz reopening by December.

INFLATION EXPECTATIONS

After subsiding over the summer, inflation is picking up again. In the US, headline inflation held at 3.4% in August, with a 3.9% jump in gasoline prices.

Europe tells the same story. Euro zone annual inflation accelerated to 3.3% in August from 2.9% in July, well above the ECB's 2% target, driven largely by energy. The UK is no better, with inflation accelerating to a five-month high of 3.1% in August.

The European Central Bank earlier this month upped its inflation expectations to an average of 2.5% next year, while underlying inflation is ​seen at 2.6% in 2027, from 2.5% previously.

The swaps market shows inflation in the euro zone is expected to be around 3.5% next year and still only at 2.4% in five years' time.

US one-year inflation expectations are close to 2.5%, with little change for the next five years..

ENERGY INCREASINGLY DRIVING RATE BETS

The war has totally changed the outlook for global interest rates. Previously, markets and economists expected the world’s largest central banks to either leave rates on hold, or cut them.

Traders now expect almost a full point in rate rises from the European Central Bank in the next year, and at least two more hikes for the Federal Reserve after Wednesday’s 25-bp increase.

They see energy as the most influential factor in the rate outlook.

The Bank of England on Thursday left rates unchanged, but said it expects UK inflation to top 4% — double its target — by early 2027, from a previously forecast peak of 3.2% by late 2026.

The Bank of Japan raised rates to a 31-year high on Friday and signalled its readiness to keep pushing up borrowing costs.

GROWTH HEADWINDS BUILD

So far this year, countries’ economies have powered through the headwinds.

PMI scores - closely watched measures of the private sector - pointed to solid expansion in the US and Europe in July and August. Data this week showed UK growth beat expectations in July, as did US retail sales in August.

This resilience has underpinned stock markets. Second-quarter earnings for S&P 500 companies are expected to have grown 53% year-on-year, according to LSEG ​I/B/E/S data.

Yet energy prices look set to stay high and the global bond selloff has pushed up yields on government debt, which set the tone for borrowing rates everywhere. The average US 30-year mortgage is at its highest since June 2025 above 6.7%.

The question for investors is whether growth can survive higher energy and borrowing costs, just as doubt about the sustainability of the billions of dollars pouring into AI is starting to creep into investors' minds.

CASH-STRAPPED

Consumers are increasingly in the line of fire. The cost of fuel at the pump has soared, household energy bills are likely to do the same this winter, especially in Europe, where storage levels are at their lowest in 15 years for this time of year.

Mortgage and borrowing rates are up and wage growth is not keeping pace.

Investors are anticipating a slowdown. US consumer discretionary stocks are the worst performers on Wall Street so far this year, with a drop of nearly 6%, compared with the S&P's 10% gain.

In Europe, the contrast is even starker. Consumer discretionary stocks are down 17% this year, the second-worst performers after luxury, versus a 7.5% gain in the STOXX 600.

With interest rates going up, squeezed consumers will be more likely to save, than spend, further depriving their domestic economies of oxygen.

(Additional reporting by Yoruk Bahceli in and Amanda Cooper in London; Editing by Hugh Lawson and Jan Harvey)