As the Iran conflict continues, the discussion concerning oil prices has been constant. This is for good reason and a client asked why the equity market seems to move in the opposite direction of oil prices.

As we’ve written about in past weeks, given the location of Iran near the Strait of Hormuz (where a considerable amount of the world’s energy is transported thru), there have been meaningful disruptions in the supply/flow of oil and natural gas. As you will recall from economics, if demand stays the same and supply falls, prices rise. Energy pricing is far more complex than a supply and demand equation given the role of derivatives and future contacts but you get the general idea. The conflict is causing considerable uncertainty and disruptions in the energy market and that is causing oil and natural gas prices to gyrate.

While it is not an exact correlation, it is a pretty consistent pattern that when energy prices rise, equity markets fall. Why is this?

One high level reason is that oil prices seems to move sharply higher when there is an event (launch of the initial attacks, retaliatory moves, comments by the Administration, etc). Any impactful event leads to uncertainty about the event – and that can cause a risk-off move.

A more granular read of the inverse relationship is the market attempting to price the carry-thru effects of higher oil prices. Namely, what such increases will do to prices consumers pay for a variety of items, most notably gasoline and natural gas to heat their homes. Upward pressure on these prices have the potential to raise inflation yet again – just when it seemed that the Federal Reserve had the issue under control for the first time since COVID. If inflation does move higher again (it remains an if at this time, but the longer the conflict goes, the more concerning it becomes), there is a lower likelihood that the Federal Reserve will lower interest rates. Higher-for-longer rates are bad news for equities so that fear is also putting downward pressure on equities whenever oil prices rise.

This conflict will reach a conclusion at some point in the future but for now, there is simply no way to predict what that resolution will look like and when it will occur. In the meantime, equity markets are likely to remain beholden to moves in energy prices.