This week in the markets: equities and bonds fall after a historic surge in the oil price as the Middle East conflict enters its second week.

Markets turned sharply lower on Monday as the relative calm of last week evaporated in the face of a dramatic surge in the oil price. The price of crude jumped as high as $119 a barrel as concerns about global oil supplies intensified.

Equity markets fell heavily in Asia, with markets that have performed strongly in recent months hardest hit. South Korea’s Kospi index was 6% lower at the close, Japan’s Topix was 3.8% down and Taiwan’s Taiex index fell 4.4%. The Hang Seng in Hong Kong fell 1.9% and Mainland China’s CSI 300 was 1% down.

In Europe, shares were also sharply lower in early trading. Markets in both France and Germany fell more than 2.5% and the FTSE 100 was 1.9% lower.

The new peak in the oil price is the highest since the Russian invasion of Ukraine in 2022, with some analysts suggesting that prolonged uncertainty about supplies through the Strait of Hormuz choke point could see the price rise further to $150 a barrel.

That would stoke inflation, reversing recent moves back towards central bank targets. Bond markets responded with higher yields on government debt as investors looked for greater compensation for the inflation risk on fixed income streams in the future.

In currency markets, there was a modest flight to the perceived safety of the US dollar. The pound fell by just over half a percent to $1.33. The euro was down a similar amount to $1.15. That was the lowest level for the single currency since November. Gold was broadly unchanged at around $5,100 an ounce.

The price of oil moderated after it was reported that G7 finance ministers will meet later on Monday to discuss a release of reserves to help meet global demand. But at around $107 a barrel the Brent contract is 16% up on the day. Brent has risen from around $70 a barrel just before hostilities began just over a week ago.

The spike in oil prices followed news overnight that Iran has named Ayatollah Mojtaba Khamenei, the second son of Iran’s former supreme leader, who was killed on the first day of the conflict, as his successor.

The appointment is a defiant signal from Iran that it intends to continue the fight to defend the country’s Islamic state against a US and Israeli-led attempt to topple the current regime. That raises the prospect of a prolonged conflict with consequently more significant economic implications.

European gas prices jumped by as much as 30% when trading opened after the weekend. A high proportion of global liquefied natural gas supply flows from Qatar through the Strait of Hormuz. With many tankers trapped in the Persian Gulf and others unable to enter it, supplies have dwindled in recent days.

The change in sentiment this week reflects financial markets pricing in a less benign outcome than they had hoped for a week ago. It marks a reversal of the Goldilocks scenario of strong earnings growth, AI-fuelled productivity gains and easing monetary policy that had sent markets sharply higher in the first two months of the year.

For now, investors are still pricing in a relatively quick conflict, similar to the Gulf War of 36 years ago. But a less optimistic view - with echoes of the stagflation of the 1970s, also fuelled by Middle East conflict and regime change in Iran - is starting to overshadow markets.

Looking back to various oil price spikes over the years, they have always been associated with falling equity market valuations. The most significant of these was the double hit of the Yom Kippur war in 1973 and the subsequent oil shock in 1979 after the ousting of the Shah and the start of the current Islamic regime in Iran. Then the US stock market valuation fell from over 20 times earnings to under 10 in the most difficult decade for investors of the post-war period.

The 1990 Gulf War, after Iraq invaded Kuwait, saw a short-lived spike in the oil price and a relatively contained derating of shares from a high to mid-teens multiple of earnings. The run up to the financial crisis in 2008 was also associated with an oil price spike but the collapse in share valuations then had other drivers than simply rising commodity prices. 
Most recently, the invasion of Ukraine in 2022 had an impact on energy markets which triggered an equity market reset, although that too was notably different - more focused on gas prices than oil.

Historical analogies are complicated by a much lower sensitivity to commodity prices today than in the past as the focus has shifted from a manufacturing to a knowledge-based economy. A rising oil price is less damaging to growth than it was in the 1970s, but it can still be expected to have an impact on inflation and so on interest rates. Markets are pricing in a much lower expectation of falling interest rates than they were just a couple of weeks ago.

An important feature of the past week’s price action in global equity markets has been an unwinding of the recent convergence between US and non-US markets. Markets in Japan and emerging markets have been hit harder than the US due to their greater dependence on imported energy than the US, which since the Shale revolution has become more self-reliant in terms of oil and gas.

The S&P 500 index has essentially moved sideways over the past six months while many other markets around the world - Japan, Korea notably but also Europe and the UK - have spiked higher and now given up some of their recent gains.

The relative resilience of the US market also reflects something of a flight to safety. Investors spent much of last year looking for alternatives to the relatively highly-valued, and AI-focused US market. In a more uncertain world, hot money is retreating to more familiar territory.

It is worth noting that even the hardest hit markets over the past week have only fallen back to levels that they first reached within the past couple of months. The FTSE 100 remains above 10,000 a level it first reached in early January. The Nikkei 225 index in Japan meanwhile almost doubled between its low point last April in the wake of the Liberation Day tariffs and its recent high. It too remains in positive territory for the year as a whole.