supply shocks, stagflation and navigating a new economic regime

There has been almost nowhere to hide in markets since the outbreak of war in Iran. The S&P 500 sold off about 6% but the impact elsewhere has been even greater with the Eurostoxx 50 down over 10% at one point. What’s more, traditional safe havens such as bonds and gold have also taken a hit.

The difficult situation is compounded by the fact that there is no obvious road map for the current conflict. Yes, the memory of Trump’s about-turn on tariffs last April is still fresh in minds, encouraging a belief that there may be an abrupt US climb down. But reversing on tariffs was much easier than the current complex situation. It is hard to see how a sustainable negotiated settlement will be achieved.

Supply shocks and stagflation

The war represents the worst kind of shock for markets. It’s what economists call an adverse supply shock. Higher energy prices raise production costs and reduce real incomes, simultaneously slowing economic growth while pushing up inflation – what’s called stagflation.

Adverse supply shocks also create a policy dilemma for central bankers. Should they cut rates to stimulate growth or raise rates to dampen inflation?

ECB President Lagarde has already indicated higher rates may be coming in Europe, possibly as early as next month. But the ECB has struggled with supply shocks in the past. In 2008, it raised interest rates when oil prices spiked in May of that year only to have to cut rates later in the year when the Global Financial Crisis unfolded. Post-COVID, another supply shock, the ECB was initially too slow to raise rates and then had to tighten aggressively in 2022.

The Fed has to walk an even narrower tightrope, balancing credibility with maintaining their mandate. Keep policy too tight and their independence could easily come under attack from an administration which constantly demands lower rates. Ease too quickly and inflation may take off, undermining their credibility. It means the risk of policy error is much greater.  

The abrupt change in the outlook for inflation and interest rates is at the root of the sell-off for government bonds and gold. UK Gilts have been one of the hardest hit with 10-year yields touching above 5%, as the pass-through from energy prices to UK inflation is particularly high. But the trend of rising yields has been the same across all markets, including Irish government bonds. Irish investors using government bonds as a portfolio diversifier will have felt that impact directly.

The sell-off in gold, long seen as a haven asset and a hedge against inflation may seem counter intuitive.  But students of market history will know that gold often suffers, at least temporarily, in crisis periods when volatility spikes and funds de-lever. Higher interest rates and a stronger US dollar, as we have had in the last month, have also historically been associated with lower gold prices. Given the fiscal problems in the US, the longer-term positive case for gold is still valid but investors need to size it accordingly in portfolios.

The bigger challenge for investors is that most portfolios remain positioned for the economic regime of disinflationary growth that had persisted in the decades after the fall of the Berlin Wall. It was characterised by globalisation, geopolitical stability and the peace dividend from the end of the cold war. The result was falling inflation, falling interest rates and stable growth benefiting bonds and equities.  But that era has been displaced by a new regime of deglobalisation, heightened geopolitical risk, constrained supply and more volatile inflation.

Navigating a new macroeconomic regime

How can investors rebalance portfolios for greater resilience given the uncertainty?

Past supply shocks such as the 1970s or 2022 provide some clues as to what investors can do. The key is being diversified beyond bond and equities and having a portfolio that can systematically adapt to new regimes often with changing relationships between asset classes.

Having exposure to commodities is one way to insulate a portfolio from inflation. The energy sector has been one of the few performers through this crisis. However, commodities are particularly volatile – last year base and precious metals rose sharply but they are struggling this month.  That suggests accessing commodities via active rather than passive strategies. 

More importantly, the missing element in most portfolios is exposure to regime-adaptive strategies such as systematic trend following designed to adapt as market regimes and tends change. These strategies were the standout performer during the last supply shock in 2022 because they can be long or short in bond and equity markets and provide exposure to commodities and currency markets.  

At the outset of the war the consensus view was that it would be brief.  After all, higher fuel costs and a prolonged war are not in the US administration’s interest in an election year.  A resolution is still possible, but investors cannot rely on an optimistic base case.  

In the new economic regime of macroeconomic and geopolitical instability investors will need to prioritise adaptability, resilience and genuine diversification as much as return potential to be positioned for the uncertain times ahead.  

This article was published in the Business Post online on 27th March 2026.