March 2026: The conflict in the Middle East involving the United States, Israel, and Iran has resulted in the closing of the Strait of Hormuz for all shipping. Daily, 20 million barrels of oil, or one-fifth of the total oil exported globally, flowed through this narrow passage between Iran and Oman. Now, they do not. Oil is above $90 a barrel, and for the first time since the 1970s, stagflation is back in the conversation.
The closing of the Strait of Hormuz is not a regional problem, it is a structural problem for the world economy, occurring at a time of geoeconomic weakness. The supply chains have already been strained from the pandemic and trade wars. Now, they have been hit by the biggest shock of all – oil.
What Stagflation Is And Why It’s So Bad
Stagflation in trading is the combination of stagnation in the economy and inflation. Most of the time, these two phenomena do not go together. Inflation usually accompanies growth. People have more money, spend more money, and demand exceeds supply. Prices go up. When the economy slows down, inflation should slow down too.
But when a supply shock occurs, like an increase in the price of energy, the world becomes unbalanced. Prices go up not because consumers have more money to spend, but because everything becomes more costly to produce. Businesses contract, and unemployment increases. And yet, even in these difficult times, prices continue to rise. That’s the problem: simultaneously, economic growth slows, and inflation accelerates. And there’s no obvious escape.
The world has already gone through this in the 1970s. The 1973 oil embargo by the Arabs against the West caused oil prices to quadruple. Production costs soared. Businesses reduced operations and fired employees. Yet, inflation did not decrease, it sped up. In the United States, inflation rose to 14 percent, and unemployment remained over 9 percent. The economist Arthur Okun came up with a formula to capture the misery of these economic times – the Misery Index, which is the sum of inflation and unemployment. The higher the number, the more miserable life becomes for average citizens. In 2026, the Misery Index will be computed once again.
The International Monetary Fund has calculated that every 10 percent increase in oil prices causes a 0.1 to 0.2 percent decrease in global GDP, and an increase in global inflation of 0.4 percent. If oil prices have gone up by 30 percent, then the impact in terms of inflation would be 1.2 percent. This does not even include other secondary effects.
However, Europe is in a particularly precarious position. The ECB has already delayed its plans for rate cuts and raised inflationary expectations, while also lowering its economic growth estimates for the region. Germany and Italy, Europe’s largest industrial powerhouses, are on the brink of a technical recession. Chemical and steel producers throughout the Eurozone are charging customers a 30% surcharge due to rising energy costs. This is a devastating blow to an economy that never fully rebounded from the pre-pandemic boom.
The Central Bank Trap
Central banks have two key levers: they can increase interest rates to reduce demand in the economy if inflation is running too high, or they can reduce rates to increase demand in the economy if growth is stagnating.
Stagflation, however, renders neither of these two key levers of monetary policy effective. Increasing rates to reduce inflation will kill off an already ailing economy, potentially tipping it into a recession.
Cutting rates to boost growth will fuel inflation, further erode the value of the currency, and reduce what little purchasing power consumers have left.
The situation is further complicated by the high levels of sovereign debt in both the US and Europe: a significant increase in interest rates would make debt unsustainable, effectively hamstringing regulators before they’ve even taken action.
In reality, central banks are left with just three options:
- Wait and see. This is, in fact, what most central banks are doing, and what they are doing now. Hold off on raising rates, and wait to see which of these two forces, inflation or recession, wins out. This is not a solution, merely a decision not to make a bad situation any worse in a hurry, while waiting to see what happens. The situation in Iran, according to Nomura economists, “strengthens the case for a pause for many central banks.”
- Prioritize inflation at any cost. Fed Chairman Paul Volcker raised interest rates to 20% in the early 1980s. He knew it would cause a severe recession. It did, but inflation came down. At what cost? Mass unemployment, business failures, and political backlash. Would this strategy work in today’s environment? With today’s debt levels, it would be very difficult.
- Targeted Intervention. There have been some attempts by central banks to subsidize loans for specific industries or employment. The efficacy of these actions is questionable. Their impact is minimal.
It’s a structural problem. Central banks are designed to control demand. The oil price increase is a supply problem. No interest rate can reopen the Strait of Hormuz or replace the 16-20 million barrels per day that remain at risk according to the IEA, even with bypass routes open at full capacity.
“The situation in Iran is causing the Fed to be even more reluctant to cut rates,” said a former US Treasury Secretary Janet Yellen. And then there is the inflationary impact of the US administration’s tariff policy. The Fed risks finding itself trapped: unable to cut, but aware that holding rates high is grinding the economy down.
How Assets Behave: A Field Guide for Traders
Equities are under broad pressure. High interest rates weigh heavily on the technology sector, which is valued based on future cash flows discounted back to the present using current interest rates. Increasing input costs affect every sector. In the stagflation scenario, the S&P 500 is seen falling by 12 percent by MSCI. The European indices will fare even worse, falling by 16 percent. Europe is much more dependent on oil imports, and its equity markets, the DAX and the CAC 40, are the vulnerable ones. The European stock market, in the context of this conflict, is the weakest link in the developed world.
Forex is a flight to safety. The US dollar is a strong performer in a stagflationary environment, as it is a safe-haven currency and a global safe-haven asset. As per Morgan Stanley, a strong dollar is offsetting some of the inflationary pressures in the US economy. The Swiss franc is another currency that performs well in a global economic crisis due to Switzerland’s neutral stance in global conflicts, a strong banking system, and low energy imports. Historically, both the USD/CHF and EUR/CHF exchange rates fall during a stagflationary environment.
Euro and pound are on the losing side. These two currencies fall in a stagflationary environment due to a weaker economy compared to the dollar and the Swiss franc. If the ECB is unable to increase interest rates due to a fear of a recession in Europe, then there is little support for the euro in a global economic crisis.
Gold is the underperforming asset in a global economic crisis. Gold has historically been a strong performer in a global economic crisis due to its hedging qualities against inflation and due to geopolitical tensions in the world. However, since the beginning of the Middle East conflict, gold has been moving downwards. Why is gold moving downwards? The reason is a little too scary: institutional investors are moving out of gold into cash positions. And as is widely understood, a flight to safety is a precursor to economic disaster.
Energy stocks are the rare winner. In a world where equity markets are crashing, energy stocks are a standout performer. When the raw material in which they deal is the very material that is fuelling this crisis, their sales increase. Companies like Exxon, Shell, BP are the winners in this situation, and Morgan Stanley, along with other investment banks, is already recommending increased investment in these stocks, along with other sectors like defense, energy, and industrial, as a thematic play in line with current events.
Digital assets and emerging markets are caught in the crossfire.
Digital assets, EM equities, high-yield debt, and commodity-linked currencies like the aussie and kiwi are getting hit hard by this flight to quality. The correlations that were so beneficial in diversifying a portfolio are no longer holding, and what was a hedge is now a source of pain.
Three Variables That Will Tell You Where This Is Heading
Stagflation is not just a simple economic phenomenon, it is a complex situation that affects everyone, from consumers to businesses, governments, and economies. What this means for traders is a situation in which macroeconomic analysis takes a backseat to technical analysis, and diversification is the key risk management strategy. To determine if this situation escalates to a full-blown stagflationary situation, keep an eye on these three variables:
- The duration of the oil shock. Experts at the Chicago Council on Global Affairs say, “Even if a peace deal is signed tomorrow, restoring oil infrastructure will take months, which would keep oil prices high for a long time.” If oil prices stay above $85 per barrel for more than two months, then the macroeconomic damage will already have started to show in revisions to GDP growth, PMI numbers, and earnings reports.
- Signals from central banks. The minute the central banks start to ease up on monetary policy despite inflation, it means that they have made up their minds to favor growth over inflation. At this point, inflation is in danger of spiraling out of control. Look for changes in dovish tone from the Fed and ECB before any interest rate changes.
Labor market data. High unemployment and persistent inflation, or stagflation, in economic terms, means a clinical diagnosis. Therefore, unless and until the labor market in the US continues to perform well, we can say that we have an inflationary situation devoid of a recessionary element. The employment report, however, will eventually reflect the impact of high business costs. It is the last line of defense, which will either confirm or deny the diagnosis.
