Theme of the Day: FT - Are we facing the greatest energy shock in history?

Energy shocks come in different shapes and sizes, according to analysis by the Financial Times. A surprising aspect of the present one is how long it took the markets to register the scale of what was afoot in a war where Iran has the capacity to sabotage global energy production due to its control of the Strait of Hormuz. According to Fatih Birol, head of the International Energy Agency, we are confronting the greatest energy security threat in history. More oil has been lost than in the twin shocks of the 1970s, while the volume of gas cut off is twice the level that Europe lost after Russia's invasion of Ukraine in 2022. Yet events in the Middle East are changing minute by minute. In the fog of war, history provides useful guidance on what might happen to the global economy and the prospect for investors. Supply shocks invariably pose a supreme stress test for central bankers because of the increased risk of inflation and economic stagnation or the ugly combination of the two known as stagflation. The crisis following the Yom Kippur war in 1973, when Arab members of the Opec cartel cut production and imposed a fourfold rise in oil prices had devastating consequences for the world economy. Four years later the oil price doubled again. The then Fed chair Arthur Burns declared that the soaring oil price was non-monetary and did not call for a monetary response. He and other central bankers believed that they should look through supply shocks because the short-run inflation problem would be taken care of by the elasticities of supply and substitution whereby increased prices incentivise energy saving, more investment in new oilfields and a search for oil substitutes. The risk then is that expectations about price stability become de-anchored, in central bank speak, and a wage and price spiral ensues. That nullifies the logic of looking through a one-time energy shock. So, across most of the world in the 1970s, inflation ran out of control. Only the central banks of Germany and Switzerland took the measure of the threat. By 1974, the inflation rate was in double digits and the economy was stagnating. Not until Jimmy Carter's appointment of Paul Volcker to the Fed in 1979 did the Fed properly address the price stability part of its dual mandate, which also covered full employment. The cost of bringing inflation back under control was a savage global recession. Things are very different today. The developed world economy is much less energy intensive than in the 1970s and thus less hostage to sanction by the oil-producing countries. Labour bargaining power was radically reduced in the 1980s by Ronald Reagan and Margaret Thatcher. More of the advanced countries' central banks are, in varying degrees, independent. Another point of difference compared with the 1970s is that public debt has surged to levels never previously seen in peacetime. In a stubbornly low-growth economy, governments are also prone to so-called deficit bias arising from the burgeoning pension and healthcare costs of ageing populations and pressure to increase defence spending. If, as seems likely, we are heading for stagflation, this is invariably bad for both bonds and equities. Gold is the great geopolitical hedge, but it recently reached sky-high levels after its 65% rise in 2025. Its steep decline in the past three weeks nonetheless shows it does not always stand when other asset classes are falling. As for bitcoin, it has no intrinsic value and has dropped more than 40% in the past six months. The latest UBS Global Investment Returns Yearbook draws on a global market database going back to 1900 to look for asset classes that offer a hedge against inflation. That takes them to commodities. It highlights the merits of a balanced portfolio of collateralised commodity futures. These have provided great long-run returns but, be warned, their inflation-hedging properties mean they underperform in extended periods of disinflation. Cash-generative equities may not be an inflation hedge in terms of correlation but they beat inflation over the long run because of the equity risk premium — the additional reward investors require for forsaking supposedly safer sovereign bonds.