Declining oil prices may spark a stock market rebound before the economy picks up

Financial markets look ahead. Stock prices often climb before the economy genuinely improves. Even with inflation still high and central banks hesitant to lower rates, equities can advance simply because traders start to believe the worst outcomes are less likely.

In today's context, oil prices are crucial to this because energy serves as a main channel for the geopolitical shock to affect inflation, growth and monetary policy.

Oil is a cost for businesses, a large part of household spending, and a key driver of short-term inflation. So a sustained rise in oil prices can hit the most important part of a central bank's job: price stability.

If a geopolitical crisis threatens oil output or blocks a major shipping route, traders begin to price in possible supply cuts, pushing crude higher. Even before the disruption fully touches physical supply, higher energy costs can shape inflation expectations and markets.

The first effect is on inflation. Higher oil directly makes fuel and other energy products more expensive. It can also indirectly raise costs for transporting goods, manufacturing and services. If companies pass those costs to consumers, the initial energy shock can spread into broader inflation.

The second effect is on growth. Households have less to spend on non-essentials after paying more for fuel and energy, while companies face higher operating costs and possibly thinner margins. If the shock lasts, consumption and investment can weaken.

This puts central banks in a tough spot: they may see rising inflation and slower growth, making it harder to justify easier policy even as the economy weakens.

The main point is that an oil shock can be both inflationary and damaging to growth. That is generally bad for equity markets because it can push rates up and hurt earnings prospects.

When oil prices fall, some of that pressure can reverse. Traders lower their inflation forecasts, reduce expectations for future rates, and become more willing to pay higher valuations for stocks.

The lesson is that traders focus on whether the decline also changes the expected path for inflation and policy. If a geopolitical crisis gets resolved tomorrow, for instance, traders would immediately start to reprice negative growth expectations and buy equities. That is because they would expect inflation to fall with oil and the central bank to turn less hawkish.

Falling oil prices can trigger an equity rebound because they reduce the perceived risk of a damaging mix: persistent inflation, tight policy and weaker growth. But the impact depends on why oil is falling. If the decline is only temporary, the outlook changes little and the rally eventually fades. If it is durable, it drastically shifts prior expectations, making the rebound solid and long-lasting.