Energy prices continue to play an important role in the global economy and financial markets. Movements in oil, natural gas and electricity prices affect more than just companies’ operating costs and household expenditure. They can influence inflation, shape central banks’ monetary policy decisions and alter investors’ expectations regarding the economy and financial markets.
For this reason, markets closely monitor developments in energy prices, particularly during periods of heightened geopolitical uncertainty or imbalances between supply and demand.
Energy as a source of inflationary pressure
Energy is essential to virtually every sector of the economy. Companies use electricity, fuel and gas to produce, transport and distribute goods and services. When energy costs rise, the impact can be felt in two ways.
Firstly, there is a direct effect, through higher expenditure on electricity, fuel or gas. Secondly, there is an indirect effect: as production and transport costs rise, some of this increase may be passed on through higher prices for goods and services.
When rising energy prices spread throughout the value chain and are reflected in the final prices of goods and services, this is commonly associated with cost-push inflation. In these circumstances, inflationary pressure results from higher production costs rather than necessarily from an increase in aggregate demand.
For financial markets, it is not only current inflation that matters, but also what investors expect to happen in the future. When energy prices rise persistently, markets may anticipate higher inflation and, consequently, a more restrictive approach from central banks.
In this scenario, interest rate expectations tend to become increasingly important, as they influence financing conditions across the economy and the valuation of financial assets.
What is the relationship between inflation and interest rates?
Central banks use interest rates as one of their main tools for seeking to control inflation. When inflationary pressures remain elevated, central banks may choose to keep interest rates higher for longer. Conversely, when inflation declines on a sustained basis, there may be scope for a less restrictive monetary policy.
For this reason, investors closely monitor economic data and signals from central banks as they seek to assess the future direction of interest rates.
Why do markets react to energy-related news?
Markets seek to anticipate the impact that future developments may have on the economy.
A significant change in energy prices may therefore lead investors to revise their expectations regarding inflation, central bank decisions, economic growth and corporate earnings.
As a result, markets may react quickly to energy-related news, even before its effects become visible in economic indicators.
How can these factors affect investments?
The impact varies depending on the asset class.
Bonds
Bonds tend to be particularly sensitive to inflation and interest rate expectations. In general, the prospect of higher interest rates can place downward pressure on bond prices, particularly those with longer maturities.
Equities
For equities, the effects may vary across sectors and companies. Businesses that are highly dependent on energy may face higher costs, while other companies may be able to pass those costs on to customers through higher prices.
Interest rates also influence companies’ financing conditions and the way investors assess their growth potential.
Deposits and savings
Periods of higher interest rates may result in more attractive returns on deposits and other savings products. Nevertheless, it is important to assess the real return on an investment, meaning the return generated after accounting for the effects of inflation.
What does this mean for investors?
The relationship between energy, inflation and financial markets demonstrates how different economic variables are interconnected. Understanding these mechanisms does not mean attempting to predict short-term market movements. Instead, it can help investors better interpret the economic and financial environment in which investment decisions are made.
During periods of heightened uncertainty, it remains important to maintain a strategy that is consistent with the objectives established, respect the investment time horizon and ensure that the portfolio is appropriately diversified.
This communication has been prepared by Banco Finantia for information purposes only and does not constitute investment advice or a recommendation to invest. In preparing this communication, no consideration has been given to any investor’s investment objectives, financial situation or specific needs. Accordingly, the information has not been tailored to any actual or potential investor, nor have any particular circumstances relating to such investors been taken into account.
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