Markets are underestimating the persistence of inflation

Markets are underestimating the persistence of inflation This is an excerpt from our Investment Outlook, in which specialists from across our investment platform share insights on the economic and market forces that we expect to influence portfolios.

Despite heightened geopolitical uncertainty, the market remains priced for a relatively swift and lasting resolution of the US-Iran conflict and normalisation of energy supply and prices as well as growth and inflation. If that prediction turns out to be right, the market is likely to re-engage quickly with the strong policy-driven growth outlook that was beginning to play out at the start of the year. However, we think the risk is skewed to a more sustained rise in energy prices and inflation. Even if the Strait of Hormuz reopens in the coming weeks, the disruption to energy markets will take time to normalise. Our commodity team now expects oil prices to average above US$100 per barrel this year. Moreover, policymakers are accommodating the energy shock. Both monetary and fiscal policy were stimulative before the conflict. They have now been loosened further. A sustained rise in energy prices will intensify regional divergence and accelerate the erosion of monetary and fiscal policy credibility at a time when investors appear increasingly willing to penalise the worst offenders. In the extreme, countries that lose control of inflation and public deficits could experience significant risk-asset underperformance reminiscent of what we observed in the 1970s. While we are still some way from the magnitude of the oil shock seen in the ’70s, the risk of such dynamics would rise if the Iran war proves more prolonged than currently expected and priced in. In our 2026 outlook, we highlighted that the conditions were in place for nominal growth to accelerate through 2026, given loose policy settings. We also argued the market was underestimating a pick-up in inflation this year from already sticky levels and that recession and stagflation were tail risks. The first few months of the year, before the start of the US-Iran conflict, appeared to corroborate our outlook as nominal growth data and lead indicators started to pick up. In parallel, inflation was beginning to accelerate in some G7 economies, though the market continued to price a benign inflation outlook in the belief that AI would anchor prices in the short and medium term.

The US-Iran conflict has abruptly moved stagflation from a tail risk to a live risk that could undermine the growth momentum we observed at the start of the year. The scale of its impact on the outlook for 2026 and beyond will depend on two key factors: how high, and for how long, energy prices rise, with the fallout ratcheting up over time; and how policymakers respond, given that significant additional fiscal support or tolerance of higher inflation could have the unintended consequence of amplifying the shock.

At the time of writing, markets still seem mostly priced for a relatively quick and lasting resolution to the conflict and the ensuing normalisation of energy flows and prices as well as growth and inflation. If that prediction turns out to be broadly right, the market is likely to re-engage quickly with the strong, policy-driven growth outlook. The spike in energy prices and the broader uncertainty resulting from the conflict would likely reduce the global growth rate in the second and third quarters of this year, but only temporarily. We think many central banks would try to look through the shock and leave policy unchanged. In this scenario, a still-supportive policy backdrop should help to drive a reacceleration in growth over the remainder of 2026. This outcome would be largely positive for risk assets. Markets would likely revisit questions that were top of mind before the start of the conflict, notably: whether the disinflationary impact of AI will be sufficient to offset structurally accelerating inflation; and the extent of diversification away from US dollar assets as tariffs and institutional volatility impact the flow of capital into the US.

However, we think the risk is increasingly skewed to a more sustained rise in energy prices and inflation. First, drawing on the work of our commodity team, we believe there is a growing risk of oil prices remaining high. Even if the Strait of Hormuz is reopened in the coming weeks, our commodity team expects oil prices to average in excess of US$100 per barrel this year. Second, policymakers are accommodating the energy shock. Monetary policy was loose and fiscal policy was stimulative before the conflict, and both have been loosened further since. The rise in inflation expectations has pushed average real rates across developed markets into negative territory. Financial conditions are looser than they were at the end of February, and fiscal policy at the margin has been loosened further. A significant source of regional/country divergence The hit to growth from a sustained energy shock is not evenly distributed. Asia and Europe are the most affected. By contrast, in the US, as a marginal net energy exporter, trade gains have helped to offset the squeeze on household incomes and corporate margins from higher fuel costs. And for some large commodity exporters, this shock is even a net positive for growth, given the associated trade gains. Further weakening of already stretched policy credibility Since the outbreak of the COVID pandemic, policymakers across the developed world have maintained persistently loose policies. While this stance helped the global economy weather the pandemic, Russia’s invasion of Ukraine and now the US-Iran war, it has eroded the monetary and fiscal credibility earned over the preceding two decades. Governments have run consistently large fiscal deficits since the pandemic, despite a nominal growth boom. In response, the market has priced in more risk premia for governments, and the worst offenders have seen some of the largest increases in risk premia. Central banks, meanwhile, have persistently kept monetary policy loose. As a result, medium-term inflation expectations are now running above the 2% target in most developed markets and by some significant margin in Japan, the UK and the US. Until these loose policy trends come to an end, the resulting upward pressure on term and inflation premia underpins our view that government bond yields are structurally on an upward trajectory and that curves can keep steepening structurally too.

So far, the reaction to the conflict from developed market central banks risks further de-anchoring inflation expectations. Initial hawkish language has given way to a wait-and-see approach. While this approach would avoid unnecessary policy tightening if wages do not accelerate, it is an effective commitment to be behind the curve if wages do rise and would make it even harder to combat potential second-round effects on wages. On the fiscal side, the conflict has caused further deterioration in countries’ debt trajectories through higher rates but also the growing potential for further meaningful stimulus as the crisis extends. So far, there has been limited fiscal offset to the energy shock compared with 2022, but some countries are starting to implement energy price caps or cuts (Japan, Sweden and Germany, at the time of writing).

The erosion of policymakers’ inflation and fiscal credibility since the pandemic is a slow-moving theme but one that we think is increasingly being priced by bond and currency markets. Countries experiencing the biggest overshoot in medium-term inflation expectations relative to their target now have the steepest 10-and 30-years yield curves. There is also a very strong inverse correlation between the steepness of yield curves and government debt sustainability: the less sustainable the public finance dynamics, the steeper the curve. And the country running the most inappropriate monetary policy with some of the most challenging government debt metrics — Japan — has seen particularly large moves in both the back end of its curve and its currency.

The takeaway for investors is that government and central bank policy credibility is becoming an increasingly important source of risk, but also a source of return potential, particularly in countries with the most challenging dynamics. Japan, the UK, France and the US are key to watch in this regard. In the extreme, the 1970s exemplified how losing control of inflation and fiscal credibility can lead to much broader relative asset underperformance. Countries like the UK prioritised nominal growth over stable inflation during the first oil shock in 1974. That may have engineered exceptionally strong nominal growth. However, with most of that growth stemming from accelerating inflation, the UK still experienced the worst risk-asset performance, the highest bond yields and the weakest currency. Stronger nominal growth is generally better for risk assets at moderate levels of inflation but that changes when inflation accelerates sharply. In the ’70s, countries such as Germany that kept policy tighter endured more economic pain but ultimately experienced stronger asset performance. While we are some way from the magnitude of the oil shock we saw 50 years ago, the risk of those dynamics reoccurring would rise if this evolving conflict proves significantly more protracted than the market currently expects.

Geopolitical Strategist Thomas Mucha and Commodities Portfolio Manager Elise Backman analyse how the Strait of Hormuz chokepoint is affecting oil, energy and other commodities. The views expressed are those of the authors at the time of writing. Other teams may hold different views and make different investment decisions. The value of your investment may become worth more or less than at the time of original investment. While any third-party data used is considered reliable, its accuracy is not guaranteed. For professional, institutional, or accredited investors only.

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