Markets are underestimating the persistence of inflation

• 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.

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