Asia Wrap: Implications of rising Oil prices

Options markets are now pricing a 45% probability of Brent staying above $90/bbl by Jan-2024, with the right-tail risk for oil being re-priced higher. Still, many in the oil markets think OPEC+ is unlikely to pursue prices over $100/bbl, but they see near-term bullish risks to their forecasts from recent developments.

The recent surge in oil prices, which have reached a 10-month high of $95 per barrel (bbl), is causing ripples across the global economy and financial markets. One of the contributing factors to this surge is the extended unilateral output cuts implemented by major oil-producing nations like Saudi Arabia and Russia. These cuts have effectively tightened the global oil supply, pushing prices higher.

This rise in oil prices carries significant implications for inflation. Oil plays a crucial role in various industries, and as energy costs increase, it tends to lead to higher prices for goods and services. Consequently, there's a growing concern about the potential inflationary pressures this could exert on the global economy, potentially leading to an unfavourable shift in the global growth/inflation balance.

Financial markets have been reacting to these developments. Short-term breakeven inflation rates have shown an uptick, reflecting increased inflation expectations. Interestingly, the correlation between the S&P 500 and Brent crude oil has weakened, signalling that higher oil prices may have mixed effects on equity markets, with some areas benefiting while others face challenges.

The performance of energy-related assets during this oil price rally has been multifaceted. Initially, US and EU energy equities and credit spreads underperformed compared to their historical relationship with oil prices. However, there has been a noteworthy reversal in the second phase of this rally, with energy equities experiencing a resurgence. Additionally, short-term breakeven inflation rates have displayed strength.

In light of these developments, investors are carefully considering strategies to hedge against the risks associated with higher oil prices and potential market volatility. Treasury Inflation-Protected Securities (TIPS), both shorter and longer-dated, are emerging as preferred instruments for hedging against both near-term and long-term stagnation risks.

Furthermore, some investment teams maintain an overweight position on energy assets, indicating a continued positive sentiment toward the energy sector. In conclusion, the dynamics of the oil market are proving to have far-reaching effects on the global economy, inflation expectations, and financial markets, necessitating vigilant monitoring and strategic decision-making by investors and policymakers alike.