Potential New Inflationary Risks Emerge

This week saw a range of events that could lead to inflationary pressures down the line. The escalation of geopolitical tensions, a strong jobs report, and the European Union’s move on tariffs all suggest future inflation risks, even if these effects aren’t immediate. The inflationary regime we have been in since 2021 is one that we have not experienced since the 1970s. It is important to understand how this affects us in our daily lives and in markets.

Middle East escalation and oil prices

• The conflict between Israel and Iran escalated as Israel launched a ground invasion into Lebanon to dismantle Hezbollah. In response, Iran fired hundreds of ballistic missiles at Israel, most of which were intercepted
• The market reacted by pricing in these geopolitical risks, and oil prices spiked significantly. As we've discussed before, the price of oil can filter through to nearly all goods and services, as transportation and production costs depend heavily on oil
• Brent Crude reached $78/barrel, a level not seen since earlier this year
• If oil prices remain elevated, this could lead to broader inflationary effects in the months to come, affecting everything from shipping costs to consumer goods

Stronger-than-expected jobs report

• On Friday, the U.S. Labor Department reported that 250,000 jobs were added last month, well above expectations, and the unemployment rate fell to 4.1%
• A strong labor market suggests inflationary pressures because a tight labor market can drive wage growth. As businesses face higher staffing costs, they may pass these on to consumers through higher prices
• A notable example of wage inflation is the recent contract agreement with the International Longshoremen Union, which saw a 62% wage increase over five years, or roughly 8% annually

European Union tariffs on Chinese EVs

• The European Union announced new tariffs on electric vehicles from China. This could lead to higher costs for vehicles and related goods in the EU, which would be inflationary for European consumers
• The use of tariffs as a tool for managing trade imbalances was widely used by the Trump administration and continued under Biden. Depending on the outcome of the November election, this trend may persist, adding further inflationary pressure in the global economy

Market Reaction

• Despite the Federal Reserve beginning to lower interest rates two weeks ago, the 10-year U.S. Treasury yield has climbed significantly, reflecting the market's concern over long-term inflationary risks
• The Fed has limited control over long-term interest rates, which are largely market-driven unless they directly intervene in the bond market
• The rise in long-term yields signals that the market is pricing in potential inflation from recent developments, even as the immediate threat remains muted

What to watch

• None of these developments are expected to cause an immediate spike in inflation, but they represent longer-term risks that could shape the economic landscape over the next several quarters
• Inflation is not always detrimental to stocks but poses challenges for fixed income, which has underperformed since inflation became elevated. This continues to underscore the importance of considering alternative allocations for bond-heavy portfolios
• While the Federal Reserve and other central banks remain focused on managing inflation risks, the complex interplay of global events makes predicting outcomes difficult. We are in an environment with no modern precedent, making it even harder for market participants to forecast accurately
• For now, we continue to monitor these developments closely, as longer-term inflationary pressures could build, even if they are not immediate

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