This is a milder form of the 70s oil shock

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Oil prices have been at the forefront of most investors’ minds, with the specter of the 1970s oil shock making a comeback. The crucial difference between the 1970s oil shock and now is that some households are sitting on substantial asset gains from housing and the stock market. This means that even with elevated inflation, the need to ask for a pay increase is not acute for those with access to wealth, but this is not the case for many living from paycheck to paycheck. The next point is that global household incomes have been steadily rising over the past decades while oil prices have generally stayed in a range, generally below 100 dollars, which means oil prices need to be substantially higher to trigger the same pain. The final point is that Europe is divesting to some extent from fossil fuels – but we are very early in this process.

The question is how will inflation develop from here? That is a function of oil and wage price dynamics. On the wage front, the pain of higher inflation for low income workers steadily builds triggering moves to higher paying jobs increasingly stronger calls for higher wages. When the pressure of this dynamic builds to a meaningful point, it can lead to a wage inflation spiral. The dynamics of oil prices are difficult but most analysts seem to assume that without a move to increase quotas by OPEC+, oil prices will remain very expensive.

Faced with this slow burn of inflation for low skill workers, the ECB is only very slowly turning more hawkish. For now, two hikes are penciled in after the end of the APP program in Q3. The odds are that this process of tightening will be earlier and include a third hike in the next few weeks.

What does it mean?

The European economy should prove more resilient to this oil and inflation shock than is currently expected. Indeed, it is expected to run at 3.3% this year (see quarterly forecasts below). This suggests that European equities, which are fairly cheap, should outperform.

Source: Nordea Investment Funds S.A. and Bloomberg

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