The surge in energy prices and global borrowing costs triggered by the ongoing conflict in the Middle East is increasing the risk of a damaging combination of persistent inflation and slower economic growth, according to a report by Reuters.
Global markets have so far remained relatively resilient, with stocks trading near record highs and economic activity holding up, helped in part by heavy investment in artificial intelligence. However, rising oil and gas prices, alongside a sharp increase in government bond yields, are beginning to expose vulnerabilities across financial markets.
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Global government borrowing costs recently climbed to their highest levels since the 2008 financial crisis, with the average 10-year yield across G7 economies reaching its highest level since mid-2008. U.S. 10-year Treasury yields also moved above 5% earlier this week.
Oil prices remain above $100
The energy shock remains at the centre of the inflation threat. Brent crude has climbed above $100 a barrel as attacks and disruptions across the Middle East have raised concerns about supply and shipping routes.
Brent settled at $105.83 a barrel on September 16, according to the report by Reuters, even after Saudi Arabia offered additional crude cargoes through Oman to ease supply concerns. Shipping through the Strait of Hormuz has remained severely restricted, adding to uncertainty over future supplies.
The impact is spreading beyond crude. Diesel prices have surged, while jet fuel and European natural gas prices have also risen sharply. Reuters reported that European gas prices were around 150% higher than a year earlier, while the continent's gas storage levels remained well below their five-year seasonal average.
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The renewed energy shock is also complicating the fight against inflation.
Inflation has accelerated in several major economies, with energy costs becoming an increasingly important driver. The European Central Bank has already responded to renewed inflationary pressures by raising interest rates and warned that the return of inflation to its 2% target could be delayed further.
In the UK, the Bank of England kept interest rates unchanged at 3.75% but indicated that inflation could exceed 4% next year as higher energy prices feed through the economy.
The United States is facing a similar dilemma. The Federal Reserve raised its benchmark interest rate by 25 basis points this week to a range of 3.75%-4%, its first increase since July 2023, while policymakers signalled that additional tightening could be required if inflation remains elevated.
Borrowing costs add to the pressure
Higher energy prices are being accompanied by rising borrowing costs, creating a difficult environment for households and businesses.
The increase in government bond yields has pushed up financing costs across the economy, including mortgages and corporate borrowing. Reuters reported that U.S. mortgage rates have approached 7%, putting additional pressure on the housing market.
For governments, higher yields also make it more expensive to service already elevated debt levels. For companies, higher financing costs can discourage investment and raise the hurdle for new projects.
Despite these pressures, economic growth has so far shown considerable resilience.
Activity indicators in the United States and Europe have pointed to continued expansion, while recent data on U.S. retail sales and UK economic activity have also provided evidence that demand has not collapsed.
Corporate earnings have offered another source of support for equity markets, while the surge in spending on artificial intelligence has helped sustain investment and growth.
The key question for investors is whether this resilience can continue if energy prices remain elevated and borrowing costs stay high for an extended period.
Households are increasingly exposed to the energy and interest-rate shock.
Higher fuel prices directly raise transportation costs, while increased household energy bills could put further pressure on disposable incomes, particularly in Europe. Rising mortgage rates and other borrowing costs are adding to the squeeze.
Consumer discretionary shares have significantly underperformed broader markets this year, reflecting concerns that households may reduce spending as essential costs rise.
A sustained increase in energy prices could therefore create a broader economic feedback loop: higher inflation could keep central banks focused on tighter monetary policy, while higher interest rates could weaken household consumption and business investment.
Markets face a tougher test
The combination of expensive energy, elevated bond yields and tighter monetary policy is creating a more challenging backdrop for global markets.
So far, the adjustment in commodities and interest rates has been relatively orderly. But Reuters reported that investors are increasingly watching for signs that the shock could spill over into equities and credit markets.
The central risk is that an energy-driven inflation shock persists long enough to force central banks to keep rates higher, even as economic growth begins to weaken. That would leave policymakers facing the difficult combination of slowing demand and stubborn inflation, which are the defining characteristics of stagflation.
For markets, the resilience of the global economy and the continued AI investment boom remain important cushions. But if high energy prices and borrowing costs persist, the ability of households, companies and governments to absorb the shock will increasingly come under scrutiny.
