Middle East conflict raises energy-driven inflation risks
Oil prices surge, impacting Wall Street indexes and volatility
Fed rate cut expectations tempered amid inflation concerns
Updates throughout, changes date
By Laura Matthews, Lewis Krauskopf and Suzanne McGee
NEW YORK, March 4 (Reuters) - Investors are starting to brace for a prolonged Middle East conflict that could stoke fresh inflation fears, threaten economic growth and undermine the case for interest-rate cuts in coming months.
While whipsawed global markets found steadier ground on Wednesday, after the previous day's sharp selling, inflation worries remain at the top of the worry list. MKTS/GLOB
Disruption to the Strait of Hormuz - a chokepoint that carries roughly one-fifth of the world's oil supply - has raised the risk of an energy-driven inflation surge.
"The reality is setting in that a prolonged conflict could dampen global growth and re‑ignite inflation pressures," said Joseph Tanious, chief investment strategist at Northern Trust Asset Management in San Diego.
SOUTH KOREAN MARKET TUMBLES AMID OIL SPIKE
Oil prices jumped for a third straight day on Wednesday, although U.S. stock futures ESc1 pointed to a positive open and European shares rallied .STOXX. O/R .EU .N
Energy import-dependent countries such as South Korea have also been hit hard, with South Korea's KOSPI benchmark closing down 12% on Wednesday, .KS11 its largest drop on record.
The S&P 500 .SPX briefly hit its lowest level in more than three months on Tuesday and all 11 of the index's sectors declined, indicating a broad selloff.
Global government bonds have weakened this week, with U.S. 10-year Treasury yields 2.5 basis points higher on Wednesday at around 4.08% US10YT=RR.
The Cboe Volatility Index .VIX, Wall Street's "fear gauge", also hit its highest level in more than three months.
"The reaction has become more intense... there's no sign of a quick resolution," said Que Nguyen, chief investment officer of equity strategies at Research Affiliates in Newport Beach, California. "People are waking up to the fact that this is a lot more complicated than they assumed."
INFLATION BACK TO THE FORE
Investors zeroed in on the potential pressure on inflation stemming from a sustained rise in oil prices. Brent crude LCOc1 was last near $83 a barrel, up from around $60 at the start of the year.
The five-year U.S. breakeven inflation - a market-based measure of inflation expectations - is trading at around 2.51% USBEI5Y=RR, the highest in almost a month.
Goldman Sachs economists estimate that a sustained 10% increase in oil prices boosts the consumer price index - a closely watched inflation measure - by 28 basis points.
No wonder, Wall Street has tempered its expectations for U.S. interest-rate cuts.
Fed Funds futures on Wednesday indicated a roughly 43% chance the Federal Reserve would cut rates by June, after markets had priced in a greater than 50% chance of a cut by that meeting as of late last month.
"The biggest issue that (investors) are trying to weigh gets back to the intertwining of inflation and interest rates," said Chuck Carlson, chief executive officer at Horizon Investment Services.
Gauges of European inflation have also nudged higher, and notably, markets have moved to start pricing in the chance of a European Central Bank rate hike by year-end.
"We're multi-asset investors and the worst nightmare for a multi-asset investor is that your bonds and equities move in the same direction," said Justin Onuekwusi, chief investment officer at St. James's Place in London.
"When they move in the same direction, it's when you have inflation fears and inflation expectations rise significantly."
Other geopolitical volatility involving the United States, such as situations with Venezuela and Greenland, have failed to significantly undermine stocks. Some investors were already eyeing any weakness from the Iran conflict as a possible buying opportunity.
"We are taking cash we raised from tech to aggressively get more positioned for a global acceleration of economic growth," said Eddie Ghabour, CEO of Key Advisors Wealth Management, whose firm has been buying emerging markets ETFs this week.
Despite the declines this week, the S&P 500 remained only slightly more than 2% from its all-time closing high.
Andrew Slimmon, senior portfolio manager at Morgan Stanley Investment Management, said the market's resiliency "suggests to me that investors might be underestimating the geopolitical risk".
(Reporting by Laura Matthews and Lewis Krauskopf in New York; additional reporting by Suzanne McGee, Saeed Azhar, Gertrude Chavez-Dreyfuss and Stephen Culp and Dhara Ranasinghe; editing by Megan Davies and Alex Richardson)
((Laura.Matthews@thomsonreuters.com))
