One week / one topic: Hotter Europe

What happened?

Markets spent much of the week debating whether geopolitical tensions around Iran and the Strait of Hormuz would trigger another oil shock.

Will they, or won’t they?

While Brent crude has remained relatively contained, a more important development has occurred beneath the surface of energy markets: refined products such as diesel, gasoil and heating oil have continued to strengthen, while European natural gas prices have also remained firm.

At the same time, Russian refining disruptions and ongoing uncertainty around Middle East shipping routes have also contributed to tighten product markets across Europe.

And of course, even air conditioning has turned into a political debate… because why not?

Meanwhile, the US inflation story continues to improve.

Recent CPI (Consumer Price Index) and PPI (Producer Price Index) releases reinforced the disinflation narrative, reducing fears of near-term Fed tightening and supporting risk assets despite recent underperformance of semiconductor stocks – which until recently had been the main engine of growth.

The contrast between easing US inflation pressures and rising energy costs in Europe has thus become increasingly notable, and it is perhaps the next shoe to fall in terms of implied rate differentials.

Investors might then be looking at the wrong energy price, and in the wrong place?

The more important signals are coming from European natural gas and other refined products, and not so much from the global price of crude oil – despite US approaching midterm elections and the perennial debate around gas prices at the pump.

In short, the most relevant question might well no longer be "Will oil spike?" but rather "Could Europe's energy complex reignite inflation pressures just as markets become comfortable with the disinflation narrative?"

And if that’s the case, is it priced in?

Our observations

• Fundamentals: The inflation battle does not look to be fully won, especially for Europe… despite the irony that the decision to start the Iran conflict came from somewhere else, and Europe remains a price taker.

  As this is not yet reflected in rates expectations (as per above), European equities also don’t look to be fully pricing this in yet.

• Price action: Tightness in refined products could well spur more volatility in risk assets once a certain pain threshold is crossed either in price terms, or as we simply spend enough time above certain levels.

  Is the current heatwave a distraction from such matters, or perhaps the catalyst that might eventually precipitate a repricing?

• Investor beliefs: Headline fatigue and the summer lull make for a potentially dangerous combination.

  While equity relative performance has remained rangebound as of late – despite huge sector and factor rotations – the sharp inflection point about the start of the Iran war should be reason for caution.

So what?

If Europe indeed remains more vulnerable to energy-driven inflation surprises, there are going to be consequences at some point.

Yes, the lag with which higher energy costs usually feed through provides some wiggle room for investors to hope think that eventually this will be resolved.

That said, European bonds markets already show signs of not liking this – and the risk is that they drag local equities lower with them.

All in all, another reason to remain vigilant – heat wave or not.

Mood music: Steve Wonder – I Ain’t Gonna Stand For It

By popular demand, here is the One week / One topic playlist

The information provided should not be considered a recommendation to purchase or sell any particular security.