The impact the Ukraine war is having on energy prices and global inflation draws strong similarities to the fallout of the Yom Kippur War in 1973. While the war only lasted 19 days, OPEC’s oil embargo against the countries which assisted Israel in the war resulted in the oil price increasing from $3 to $12 over the six months of the embargo. While US inflation had already increased from 3.2% to 7.4% in the 12 months prior to the war, the oil embargo exacerbated cost pressures and pushed inflation to a peak of 12.3% in 1974.
To bring inflation under control, the US Fed raised the repo rate from 5.5% to a peak of 13%, which caused the worse bear market since the Great Depression, with the S&P500 declining 48% over 1973 and 1974. We don’t think the current energy shock will be as severe as the early 1970s when OPEC produced roughly 60% of the world’s oil vs Russia producing 10% of the world’s oil today. However, we similarly face an energy shock amidst a pre-existing inflation problem, with the US inflation rate reaching a 40-year high of 7.9% due to Covid related supply chain disruptions and surplus consumer demand. And like in 1973 when the S&P500 traded on a relatively high P/E of 19.4x, the current market P/E remains at an elevated ratio of 23.4x. Yet, the largest difference between 1973 and now is the behaviour of the Fed, which remains surprisingly more accommodative, having only stopped quantitative easing at the end of March and raising the repo rate by a mere 25bps thus far. The possibility that the Fed will be forced to aggressively hike interest rates to curb inflation, similarly to what triggered the 1973 bear market, remains the largest risk faced by the market today. Positively still, despite such a draconian scenario, the market continued to reach new highs as soon as 1980, and the ordeal provided the opportunity to accumulate positions in numerous high-quality companies at discount prices.