2024-01-16 09:30:00 ET
Summary
- Houthi attacks in the Middle East have heightened tensions and raised concerns about the safety of maritime traffic in the Bab el-Mandeb strait.
- The Suez Canal and Bab el-Mandeb are major chokepoints in global shipping, and disruptions to these routes have repercussions for international trade.
- Disruptions to supply chains and shipping routes have contributed to inflationary pressures and may require investors to consider hedging strategies.
Since at least the middle of the last century, the Middle East has been a focal point for global players. It has played a pivotal role in shaping global affairs, particularly due to its vast energy resources and strategic location. The former helped to satisfy the world's growing demand for petrochemicals in the post-World War II period. The latter is closely tied to the Suez Canal, acknowledged as one of the primary chokepoints in global shipping and, consequently, trade.
What Happened so Far?
The Houthi attacks have included the use of missiles, drones, and naval mines targeting commercial vessels, military ships, and oil tankers. These attacks have heightened tensions in the region and led to concerns about the safety of maritime traffic passing through the strategically important Bab el-Mandeb strait.
The Houthis
The Houthis, officially known as Ansar Allah, are a rebel group based in Yemen that emerged in the early 2000s. They gained prominence for their role in the Yemeni civil war, controlling significant parts of the country and engaging in conflicts with both local and international forces.
Suez Canal
The Suez Canal was successfully completed and opened in November 1869 linking the Mediterranean Sea to the Red Sea. The canal's construction revolutionized global maritime trade, providing a shortcut for ships traveling between Europe and Asia. Before the canal was constructed, ships had to navigate around the southern tip of Africa, which added thousands of miles to the journey. The Canal, by providing a direct passage, shortened the distance between the Mediterranean and the Red Sea by approximately 4,300 miles (6,920 kilometers). This reduction in distance not only saved time but also made transportation more efficient and cost-effective for international trade routes. The Suez Canal has played a crucial role in numerous historical events, including the Suez Crisis of 1956 and ongoing geopolitical considerations due to its strategic significance in international trade.
Bab el-Mandeb Strait
Bab el-Mandeb is a strategic strait connecting the Red Sea to the Gulf of Aden, located between Yemen on the Arabian Peninsula and Djibouti and Eritrea in the Horn of Africa. Its geostrategic significance lies in its role as a major maritime chokepoint, controlling access to the Suez Canal and impacting global shipping routes.
Primary Chokepoints to Global Shipping and Markets
Both the Suez Canal and Bab el-Mandeb Strait are, given their respective shares in international shipping trade, considered major chokepoints. A disruption of these vital lifelines of international trade has, with a time delay, repercussions for businesses and consumers worldwide.
statista own illustration with data from IMF Port Watch
The linkage between disruptions to supply chains and consumer prices, for example, became evident during the COVID-19 pandemic. It significantly impacted global shipping in several ways. Lockdowns, restrictions, and reduced economic activity led to disruptions in the production and transportation of goods, causing a decrease in demand for shipping services. Ports faced operational challenges, labor shortages, and logistical bottlenecks, affecting the smooth flow of maritime trade. Additionally, fluctuations in consumer behavior and supply chain disruptions resulted in imbalances in container availability and shipping routes, contributing to delays and increased shipping costs - see chart below. Ultimately, all of the above has contributed to inflationary pressures.
Bloomberg Finance L.P.
Not surprisingly, both the Consumer Price Index ((CPI)) and the Producer Price Index ((PPI)) track the increase in container prices. A time lag of up to six months is observed. Due to the heightened inflation rates, market participants anticipate a corresponding response from central banks. As a result of the expected and implemented interest rate hikes, global bond markets are adversely affected, as illustrated in the graph below by the Bloomberg Global Aggregate Total Return Index. Consistent with the outlined chain of actions and reactions, the time lag for the bond market to react to an increase in container prices is higher, recently amounting to approximately one year.
Both temporal shifts—six months for the price increase and twelve months for a significant downturn in bond prices—are confirmed by respective regression analysis. In these regressions, the container price serves as independent parameter, while CPI and the Bloomberg Aggregate are used as dependent variables, respectively.
It is interesting to observe that inflation expectations have not been adjusted upward since the most recent escalation of the conflict which basically started with the Hamas attack on Israel at the beginning of October. On the contrary, since the third quarter of 2023, inflation expectations for 2024 have generally tended to decline, with Japan being an exception. Hence, the question arises as to the extent to which market participants are aware of the risk of a resurgence of price increases.
The impression that a sudden return of inflation due to the conflict in the Middle East receives little societal attention is further supported by an analysis of Google Trends (see below). These illustrate that there has been no sustained increase in the search query "inflation" since the third quarter of 2023.
In this regard, it is consistent that market expectations regarding future interest rate developments continue to assume a declining trend. This is illustrated by the yield curves (1) spot, (2) in 6 months, and (3) in one year. As a reference, we have chosen the USD swap curve.
U.S. Dollar Swap Curve (Bloomberg Finance L.P.)
Trade Volume Through Bab el-Mandeb Strait and Suez Canal is Falling From a Cliff
The chart below depicts the evolution of the simple moving average ((SMA)) in trade volume through the Suez Canal and Bab el-Mandeb since 2019. Significant disruptions, such as the impact of COVID-19, the Suez Canal blockage by the Ever Given, and the recent events, are highlighted. It's notable that compared to their local highs, the volume shipped through Bab el-Mandeb has already decreased by more than 50%, while for the Suez Canal, it is slightly lower. During the Ever Given incident in March 2021, which was resolved within a week, the decrease was more pronounced (-98% and -71%, respectively).
own illustration with data from IMF Port Watch
Critical Aspects to Consider
The question of whether the U.S. can or should resume its role as the global policeman is a complex one, especially considering the strain on its military capabilities from ongoing conflicts such as Ukraine and, to a lesser extent, Israel. The balance between maintaining a global presence and managing stretched resources poses a critical challenge.
Furthermore, the question arises as to what extent the recently observed precise airstrikes on Houthi positions in Yemen will have effects. Is it merely a flash in the pan, or is the Western alliance capable of sustainably disrupting the capacities of the Houthis in this manner? What will the Houthi retaliation look like? To what extent might Iran get involved?
Additionally, the impact of the pandemic on globalization is a noteworthy consideration. Since March 2020, has there been a significant shift towards disglobalization? Has the economy become more resilient in response to the disruptions caused by the pandemic? Evaluating the extent of these changes is crucial for understanding the current state of global affairs.
Furthermore, the shipping industry, marked by the typical bust-and-boom cycle, has witnessed a surge in demand post-pandemic, leading to new orders for containers and ships. It's important to assess how many of these orders are now in play, given the 18-month construction period for cargo ships. Additionally, understanding the number of retired or replaced ships and the overall capacities in the industry should provide insight into the sector's dynamics.
An intriguing aspect is the self-enforcing circle created by increased tensions in regions affecting oil prices and tanker traffic. This, in turn, is expected to impact freight pricing. Understanding the interconnectedness of these factors is essential for anticipating future developments in the global economy and trade.
Lastly, turning attention to the Middle East, the question of whether the current situation might escalate into a full-scale war is significant. The geopolitical landscape and ongoing conflicts in the region contribute to the complexity of forecasting future events. Analyzing these multifaceted dynamics is crucial for policymakers, businesses, and individuals alike.
Investment Implications
At the end of the day, investors must assign their own probabilities to specific scenarios. Cautiously stated, one can argue that the situation in the Middle East has, at the very least, not made a resurgence of inflation less likely. Another round of inflation could, in the best case, lead to stagnant interest rates and, in the worst case, to further increases — all against the backdrop of market expectations for several interest rate cuts in 2024.
Therefore, the question arises as to whether and when a rotation into short duration bonds/ assets is warranted. For instance, (NEAR) might represent an opportunity if the usual mechanics, i.e., rising interest rates to fight an increase in prices, come into play once we see an uptick in inflation. ((NEAR)) would benefit from such an environment as it can help to diversify an investor's portfolio towards lower duration in the fixed income space. This allocation tends to be less sensitive to higher interest rates in terms of price movements.
It is worth considering whether equity investments should be gradually hedged via options, if not taken directly short (for instance (TBF)). Assuming the mechanics of higher inflation rates work out as expected, the usual dynamics suggest a weight on equity prices. Hence, actively engaging into options (selling covered calls for example) can help investors to counterbalance falling equity prices.
Moreover, betting on falling bond prices via the ((TBF)) is another alternative to benefit from any scenario that implies another spike in inflationary pressures. ((TBF)) will gain from falling bond prices particularly from high duration bonds (20+ years) which are most vulnerable to an (expected) increase in rates.
For further details see:
Houthi Attacks On Global Shipping In The Red Sea Might Represent A Catalyst For Inflation