Why oil shocks matter for portfolios

Oil shocks drove inflation higher and growth lower in the 1970s, unsettling central banks, reshaping markets and realigning international relations. The recent Middle East conflict has caused fresh economic and market disruption, but we believe the worst of that earlier period can be avoided, thanks to AI-driven investment, more effective monetary policy and a more diversified energy system.

Even so, we think five themes from the 1970s could still shape policy and markets in the years ahead.

A new incidence of 1970s-style stagflation is not our base case. Inflation in the US and euro area is around 3%, far below the double-digit peaks of that period, and the latest oil shock has had a much smaller effect on growth and unemployment. For us, a key difference comes from the surge in enthusiasm for AI and the sharp run-up in investment. This has given the economy far greater resilience in the face of external shocks.

But that earlier decade still offers important lessons: shifts in economic power, defence arrangements and financial architecture can reshape savings and investment flows and alter which assets investors naturally favour.

Large shocks can change perceptions of how policy works and what is important. The failures of “stop-go” policies in the 1970s helped form a new conviction that low inflation must be pursued seriously and that independent central banks were the best vehicle to achieve that goal.

Today, one area where policymakers’ opinion differs is how to handle the initial stages of a supply shock. For years, the view, especially in the US, was that central banks should largely “look through” supply shocks. However, since the Covid-19 pandemic, many central banks, especially in Europe, now appear inclined to tighten pre-emptively for fear that repeated shocks could unsettle inflation expectations. By contrast, some countries – Japan among the most notable – prefer to reduce indirect taxes such as VAT to relieve the symptoms of higher energy and food prices while raising interest rates as slowly as possible.

The evidence from the 1970s is that policy divergences can have a large impact on currency valuations and relative economic performance.

New Federal Reserve (Fed) Chair Kevin Warsh may yet play an important role in how the US responds to supply shocks. The US Administration’s pressure for lower interest rates shaped market expectations in 2025, but markets now see core inflation pressures as strong enough to conflict with the Fed’s preference to look through a supply shock, challenging Mr Warsh to define when he is ready to act to demonstrate that “inflation is a choice.”

Rebuilding energy infrastructure, defence arrangements and supply chains after the Middle East conflict could challenge the dollar’s dominant position, supporting assets such as crypto, gold, the euro and the Chinese yuan. Since 2022, de-dollarisation has been gaining momentum and may strengthen further, pointing to a move from a dollar-dominated system towards a more multipolar order shaped by gold, crypto and other real assets.

A key uncertainty is how the sharp rise in US tariffs, China’s growing willingness to use access to resources as a trade bargaining tool, and the rebuilding of energy infrastructure after the conflict will reshape trade patterns and the terms of international commerce. The effects on competition and the global economy’s inflation sensitivity could be significant.

Mr Warsh has also floated the possibility of a new accord with the US Treasury, which matters given the administration’s broader aim of preserving the dollar’s role by using regulation to boost stablecoin demand for Treasuries. Closer coordination between fiscal and monetary policy could become a powerful response to countries seeking to reduce their reliance on the dollar, though we expect that contest to remain intense.

Although economies are less dependent on fossil fuels than they were in the 1970s and energy supplies are more diverse, the latest oil price shock is still likely to accelerate electrification and improve energy efficiency across industry, regardless of climate goals.

In that earlier decade, Japanese manufacturers disrupted the global market with fuel-efficient vehicles and increased their market share substantially; today, Chinese Electric Vehicles (EVs) are performing a similar role, fundamentally altering the global energy and automotive landscape.

Falling renewable energy costs strengthen the push to reduce reliance on conflict-prone fossil fuel suppliers and encourage more investment in battery technology. Ironically, US President Donald Trump’s support for fossil fuels may help speed the transition to renewables in some markets outside the US by intensifying conflict with Iran.

The experience of the 1970s helped popularise the broader concept of multi-asset investing. Stagflation highlighted the need for commodities in a mixed asset portfolio, both to have exposure to assets that do well in the expansion phase of a cycle as well as to gold as a safe haven that performs in periods of high inflation. In both cases, they offer diversification relative to other safe havens, such as core government bonds or even long duration credit.

We have previously argued that gold is emerging into a new era where structural forces elevate the metal’s role as an alternative to US Treasuries and as a strategic portfolio asset. Against that backdrop, a key consideration for investors is how much weight inflation-protecting assets such as commodities, particularly gold, should carry in a portfolio relative to equities.

The question is particularly acute given the unusually high volatility in equity markets after the recent oil shock. One important consideration – and key difference from the 1970s – is productivity. Today, optimism that AI can lift productivity stands in sharp contrast to the weak productivity growth of that decade, even as unemployment rose. We see this as a major reason equity earnings have stayed resilient and why equity returns have outpaced inflation, unlike the low real-return environment of the 1970s.

Still, we think the volatility of the current era needs to be carefully monitored.

The S&P 500 has already tested both the upper and lower ends of its historical price bands (see Exhibit 1). In this environment, we favour tactical flexibility while remaining structurally constructive on both equities and gold. But investors need to be agile. Higher inflation, stronger demand for diversifying assets and greater investment needs in a more geopolitically fragmented world are all likely to push real interest rates higher, weighing on returns in less productive areas of the economy and on the currencies of countries unable to match rising expected returns.

In summary, we see echoes of the geopolitical changes of the 1970s in the current market environment. But the difference to that period is that AI investment, proactive monetary policy and a more diversified energy system can help soften the impact on inflation and growth. As economic and market forces realign, multi asset investing remains a valuable source of diversification, while active positioning is essential to manage volatility risk.

The 1970s were beset by poor growth, persistent inflation and largely ineffective economic policy (see Exhibit 2). At the same time, changes in the balance of power in oil markets created new capital flows as well as shifting security arrangements[TA1.1][SS1.2][TA1.3] that ultimately transformed capital markets and how investors approach portfolio construction.

We can isolate the driving forces for these changes in the following key events.

In August 1971, US President Richard Nixon "closed the gold window," suspending the convertibility of dollars into gold (a decision caused by high US military spending and budget deficits, a persistent trade deficit as well as rising inflation). The move ended the Bretton Woods Agreement that had pegged the US dollar to gold at USD35/ounce. Foreign nations lost confidence in the dollar which, with the price of gold now determined by market demand, ultimately led to a staggering increase of over 2,300% over the decade as gold went from USD35/ounce to a peak at USD850/ounce in early 1980.

Oil prices went from USD 2/barrel in 1970 to USD 12/barrel in 1974. By restricting oil supply, Middle Eastern countries quickly built large current account and budget surpluses that needed to be reinvested. Over a period of several years, the US reached a series of agreements with Saudi Arabia to price and sell their oil exclusively in US dollars as well as benefit from US military protection and hardware. This created natural Middle Eastern demand for dollar assets, creating capital flows into US Treasuries and assets and expanding the role of US capital markets.

The immediate impact of pricing oil in dollars was to restore an element of dollar demand that had been lost when the Bretton Woods agreement ended. As a result, gold halved in value from USD 200/ounce to USD 100/ounce between 1974 and 1976. However, this was only a temporary reprieve for the dollar, as a new round of higher oil prices at the end of the decade as well as fresh challenges to US influence through the Iranian revolution and the Soviet Union’s invasion of Afghanistan pressured US assets.

The challenging economic environment forced some tough choices for central bankers. Credit problems and rising unemployment meant US monetary policymakers were typically slow to raise interest rates and quick to bring them back down when inflation subsided.

Large cycles for interest rates were part of a “stop-go” policy era that prioritised demand management as the way to deal with inflation problems, via fiscal, credit and monetary policies (see Exhibit 3). Looking back, it is notable that the US Federal Reserve (Fed) rarely allowed real interest rates to turn positive, catalysing demand for non-US assets. Ultimately, persistently too loose monetary policy contributed to a rise in inflation expectations over time to the detriment of the dollar (and US asset valuations more broadly), ultimately forcing a change in policy.

Responding to popular discontent over inflation, US President Jimmy Carter introduced new leadership at the Fed. Paul Volcker’s appointment in 1979 presaged a major change in the conduct of monetary policy with a crescendo of rising interest rates approaching 20% in 1980-1981. In contrast to the 1970s, cash rates ran 5% or more above inflation at their peak. The result – in part because of restrictive credit policies as well – was that inflation was brought down while the dollar’s performance was transformed by tight US monetary policy (and by the adoption of more stimulatory fiscal policy under President Ronald Reagan). The dollar doubled in value compared with gold and European currencies by the start of 1985.