An economist’s guide to Red Sea risks

The ongoing conflict in the Middle East is first and foremost a human tragedy. My thoughts below purely cover the potential economic impact of the Red Sea hostilities.

I am worried about disruptions to Europe-Asia trade from hostilities in the Red Sea. Rather than risk attacks off Yemen’s coast, freight is being diverted around Africa instead of the usual route via the Suez Canal shortcut. This is increasing travel times and shipping costs have soared.

I’m concerned the consensus is downplaying the risks. I’m often told that although shipments will be delayed, they’ll get there in the end and there’s plenty of inventory in the meantime. Alternatively, people try to estimate the rise in shipping costs as a share of final sales.

What happens Next?

However, this is fundamentally a quantity shock not a cost shock. A disruption to supply chains can have unexpected knock-on consequences. We saw this following the start of the Ukraine war when a shortage of wire harnesses disrupted car production. We’ve already seen Michelin* (citing a lack of rubber for tyres), Tesla* (batteries for autos) and Volvo* (unspecified) announce factory stoppages.

Clothing company Next* has warned that some sizes might not be available. So even if shipping represents only a few percent of total costs, firms will have significant pricing power if there’s a shortage of spring clothes when the weather improves. Here’s a worked example:

• A 30% increase in travel time = 23% less freight capacity per year
• A round trip from Asia to Europe via the Suez Canal takes 52 days = seven round trips per year (365/52)
• A 30% increase in travel times via Africa = 68 days. So 5.4 round trips per year (365/68)
• Conclusion: each ship can only bring 5.4 cargo loads per year instead of 7, a 23% reduction

In other words, a sustained shock to supply routes doesn’t just delay this month’s shipment, it reduces the amount of goods that can be shipped from Asia to Europe in a given period. Demand will exceed supply unless production or sales are also reduced by 23% (assuming all ships get diverted).

Solutions?

The counterarguments within our team are that there’s spare capacity in the shipping industry. Speeds can be increased and other ships diverted to the Asia-Europe route. Market forces should also eventually prioritise high-value intermediate shipments (e.g. Tesla* batteries are less shipping-price sensitive than less expensive goods from Temu*).

The Suez Canal route accounts for around 30% of container freight capacity, according to most estimates. To offset a longer route we need ALL ships to boost their speed by around 7½% and some of them being diverted to the Asia-Europe route. This seems feasible, though there are concerns about refuelling capacity in South Africa.

We should also benefit from ships ordered during the COVID-19 goods boom coming on stream this year. On the negative side we’re also experiencing drought problems in the Panama Canal, leading to bottlenecks there.

Monitoring the situation

Given the uncertainties, we will monitor shipping data to assess the situation. Not only can we see how many ships are going via the Suez Canal or Cape of Good Hope (South Africa), but we can also see how many ships are arriving at European ports. The data are volatile and seasonal. Our analysis, using IMF Portwatch data shows a 33% reduction in ships going through the Suez canal and crucially a 16% reduction in ships arriving at European ports.

If sustained, this ‘negative supply shock’ should reduce output and boost prices. Thankfully, it’s currently offset by a sharp drop in natural gas prices following another mild winter. This could depress headline inflation and boost real incomes. For ‘core’ inflation, it remains to be seen whether ‘asymmetric passthrough’ of cost shocks means firms highlight difficulties from supply-chain disruptions or benefits of lower energy costs.

*For illustrative purposes only. Reference to a particular security is on a historic basis and does not mean that the security is currently held or will be held within an LGIM portfolio. The above information does not constitute a recommendation to buy or sell any security.