After oil prices surged to over $100 a barrel on Monday morning and bond yields rose on forecasts of a prolonged conflict in the Middle East, investment managers discuss the outlook for inflation, potential interest rate hikes and asset allocation.

Oil prices rose sharply yesterday morning, as a result of the Middle East conflict, with Brent crude oil, the international benchmark, climbing over 25 per cent to more than $100 per barrel. The dollar was also higher, bond yields were up, and gold prices were slightly lower.

With fears that rising oil prices will push up inflation, markets are predicting that the Bank of England will hold interest rates in 2026, or even increase them. Even after the surge in oil prices yesterday, Paul Diggle, chief economist at Aberdeen Investments warned that the oil price impact of the conflict is a "non-linear function of its duration." “So, there may potentially be further moves higher, before the eventual decline. We think $120 per barrel is easily in reach. If prices do then fall back, the global economic cycle would have a more stagflationary feel but wouldn’t be fundamentally derailed,” he said.

Mark Haefele, chief investment officer at UBS Global Wealth Management expects volatility to remain elevated in the near term as the conflict disrupts markets and energy flows. But his base case is that the conflict will be relatively short-lived, given the rapid degradation of Iranian military capabilities and US political incentives to avoid a prolonged period of higher energy prices ahead of the midterm elections. He believes that a relatively rapid end to hostilities and a resumption of normal oil flows would likely cause prices to fall quickly, although they may remain around pre-conflict levels.

Yesterday, Norbert Rucker, head of economics and next generation research at Swiss private bank Julius Baer also said that oil prices had entered panic mode but his base-case scenario remains a short-lived intense spike in energy prices; he reiterated his neutral view on oil and natural gas exposure.

Bond markets
“The bond market is very focused on the problems that could be coming down the line from higher hydrocarbon prices, in particular the natural gas price impact on Europe and the UK,” Luke Hickmore, investment director, fixed income at Aberdeen Investments, said yesterday. “Gilts have been a very poor performer during the move, with 10-year gilt yields moving higher by around 0.5 per cent during this conflict, and shorter dated gilts now moving to price in a rate hike by the Bank of England in June.”

Craig Veysey, head of fixed income at Guinness Global Investors, highlighted how gilts had already rallied to their lowest yield levels prior to the conflict on expectations of further Bank of England cuts, and that has now been abruptly reversed. "Since the month-end, the move has been very sharp. UK 2-year yields have risen from 3.52 per cent to 4.17 per cent, 5-year yields from 3.68 per cent to 4.35 per cent, and 10-year yields from 4.23 per cent to 4.80 per cent. Those are very large moves in a matter of days, and much bigger than we have seen in most other major developed bond markets," Veysey said. “The UK is especially sensitive to higher energy prices, so a Middle East-driven energy shock feeds much more quickly into inflation concerns here than in the US, for example. At these levels, I do think gilt yields are becoming attractive again. There is clearly a risk that energy prices stay higher for longer if the conflict drags on, and central banks are far too early in the process to react." However, if yields move further out of proportion to the underlying UK economic data and/or energy prices begin to stabilise, Veysey's bias would be to be a buyer of gilts.

Meanwhile, David Zahn, head of European fixed income at US-headquartered investment manager Franklin Templeton said he remains underweight in short-duration gilts. 

“Contrasting this, investment grade credit has not been moving to price in economic stress in any major way, reports from the market are that spreads – the extra yield for corporate credit – have moved a little but still reflect the excellent fundamental quality of most large businesses in this environment,” Hickmore continued. “That is likely to be where the risk lies in the next few weeks, if we see continued supply issues in oil and gas, that have a lasting scaring impact on corporate quality, expect corporate credit to underperform.”

“We have been moving to better quality in credit markets for the last few months, reducing risk and holding more cash than we would normally have. It is not yet the time to be putting that cash to work,” he added.

Meanwhile, Mark Munro, investment director, fixed income at Aberdeen Investments, said that higher government bond yields are doing some of the heavy lifting and preventing credit spreads from moving wider as much as was anticipated before the conflict began. “It’s too early to be adding risk, you require de-escalation headlines (we have had the opposite), enough time to pass that a de-escalation feedback loop emerges (we have clearly not had enough time for that yet) or extreme valuations (as mentioned above credit spreads have not moved enough yet),” he said.

“Many are now dusting off the historical playbooks as to what is required for a worsening of the situation. We would note that the energy price spikes have to be sustained over several months, a hawkish policy response from central banks or signs that it is damaging macro data pointing towards recession. That is not to say that some of these markers are not realised but none of them are in sight right now,” Munro added.

Investors fear that rising oil prices will push up inflation in the UK and Europe, which import most of their energy and fuel. A rise in inflation could force central banks to freeze interest rates, and even push them up.

Zahn believes that inflation will probably be higher in Europe. “We don’t expect rate hikes immediately, but our overall thesis has been for around the last six months that the European Central Bank (ECB) was done, and that they were going to be starting to hike rates at the end of this year or beginning of next year. That may be brought forward,” Zahn said at a London media event last week. “It won’t be an aggressive hiking cycle, but we do think that will be the case. In that environment, having lower rates and lower inflation seems challenging. One of the good things about the European economy is that it is growing quite strongly,” he continued. “You can see that from the German GDP numbers in the fourth quarter. They were 1.3 per cent. We expect that Germany will grow at least 1.5 per cent this year, 2 per cent next year, so growth is doing well in Europe, which means it can handle rates a little bit higher, or the euro a little bit higher over time.”

Portfolio manager, Oliver Blackbourn, and global head of multi-assets, Adam Hetts, at UK-American asset manager Janus Henderson, said that concerns about a jump in European inflation or simply prolonged stickiness in the US are lifting bond yields. “US Treasury yields have moved higher as markets have taken out one of the US Federal Reserve interest rate cuts that were anticipated by the end of the year,” they said. “Yields on 10-year Treasuries have seen less movement than their European counterparts, as US jobs numbers on Friday served to offset some upward yield pressure from expected inflation.”

“Concerns about inflation have seen surges in German and UK breakeven rates, with market pricing for the European Central Bank interest rates at the end of 2026 now looking at over 1.5 hikes,” they continued. “Since the end of February, expectations for the Bank of England have shifted from two cuts by the end of 2026 to a better than 50:50 chance that there will be an interest rate hike – a marked shift in the outlook. Markets are now pricing in higher oil prices for the foreseeable future, with concerns mounting about a stagflationary outcome, should higher energy costs stall a re-acceleration in economic growth.”

“Higher bond yields and a stronger greenback have dampened gold’s ability to rally in the current environment, following strong performance during other recent periods of volatility,” Blackbourn and Hetts added. “Gas prices remain Europe’s geopolitical Achilles heel and markets are clearly concerned that the region is overly exposed again.”

They believe that this demonstrates the value of well-diversified multi-asset portfolios. It is rarely easy to gain complete clarity on geopolitcal events, with the current US administration apparently embracing uncertainty as a negotiation strategy. “What we can take away from the events of the last few days is that it is likely the conflict could last longer than many had initially hoped. This means there is the potential for greater economic impact – and markets have moved to price in this change.”

“There is the potential for faster inflation and slower economic growth, with assets focusing on different aspects thus far. However, risks remain two-sided,” Blackbourn and Hetts added. “US political pressures means that a quick “victory” should not be ruled out. Asset prices, driven by energy prices, are likely to swing violently as investors alter their expectations for either outcome.” See more about the conflict and the impact on emerging markets here.