Steno's Signals: What the Red Sea Crisis Means for Inflation

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0:54How to understand the troubles in the Red Sea. Welcome to this special edition of StenoSignals here at Real Vision amidst the Education Month. Today, we're going to address the troubles in the Red Sea and the ramifications for global inflation. And I'm joined by the partner here at my company, Steno Research, Miguel Rosenwald. Welcome to you as well. Thanks for that. You're the head of geopolitics. I'm Andreas Dino. For those of you who haven't seen me before on platform, it's been a few weeks since I was on air the last time. If we look at the situation in the Red Sea, I think the first question to address is who are the Houthis?

1:33The Houthis are attacking ships basically right, left, and center in the Red Sea. Miguel, Please fill us in on this Houthi movement. Who are they? Yeah. So the Houthis are basically a clan-based militia. So to understand where they come from, it's kind of like one of the houses in Game of Thrones, you could say. It's a family-based structure that evolved into a militia. They played a big part in the ongoing Yemeni civil war and now control large parts of the country. So they are sort of a pseudo-government of large parts of Yemen. On top of that, the Houthis are closely linked to Iran. They've been financed and backed by Iran over the years.

2:12And they have a lot of international networks to Hamas, Hezbollah, etc. So next question, I believe, is why are they throwing missiles at ships and throwing drones at ships? Well, for three reasons. First of all, Iran told them so. Iran has a heavy interest in stirring up trouble within the region, had a big hand in the Hamas terrorist attack against Israel. So that is the main reason that Iran is basically giving them the weapons and telling them where to shoot it. The second reason why the Houthis are in on this is because they kind of have to. If you look at their motto, it is glory to God, death to America, death to Israel, curses upon the Jews, and triumph for Islam.

2:51When you have a motto like that, you can't really stay dormant while Hamas and Hezbollah are attacking Israel. So they kind of felt perhaps that they needed to do something to not look weak and inactive in this. And the third reason is that this is very popular within Yemen. As I mentioned, they're part of the Yemeni civil war, so everything they can do to shore up domestic and internal support within Yemen is very good for them. And this is hugely popular. One of the only things that the Yemeni population can all agree upon is that they dislike Israel. So when the Houthis are taking part in the fight against Israel in the way that they can do, it's very, very popular inside Yemen.

3:27So this is really a win-win-win for the Houthis, basically. And if we look at the current situation in the Red Sea and the Suez Canal, it's a pretty dire situation, to be honest. We have some data on the amount of crossings of container ships in the Suez Canal. And as you can see, we have seen a large drop in the amount of crossings basically since just before New Year's. So this has been ongoing for three to four weeks already. and essentially there are no signs of improvement right now. Just a couple of days ago, a couple of Maersk ships, Danish company, by the way, where we situated, were attacked.

4:08They were basically traveling with cargo for the U.S. Navy. So they were man-miked by the U.S. Navy when these attacks took place and they had to turn around. So it is essentially more or less impossible to travel through the strait outside of Yemen right now. and it's very visible from the daily data points on the amount of container ships crossing the Suez Canal. This is an issue for the shipment of global goods, basically, since the Suez Canal is, well, the easy route between Asia and Europe in particular, but it carries repercussions for freight rates and shipping routes across the globe. If we look at a satellite photo of it right now, I think it's very telling to use that as an explanation for what's ongoing.

4:58This satellite photo shows container ships with a destination in Europe. As you can see, there is basically a large rerouting happening south of Africa instead of using the Suez Canal. And if we zoom in on the region with the Suez Canal, we basically see more or less zero ships. We see a couple of ships traveling through the region right now, but they're sailing under Russian flag. That's important to bear in mind. The Houthis are not striking against the Russians. But Mikul, when we look at the Arabian Peninsula, right, on the map here, maybe we can bring it up again. What we're currently talking about is the Red Sea and the small strait between Yemen and Djibouti.

5:41Over the weekend, we had stories emerging around potential strikes from the Houthis on the other side of the peninsula, in the Strait of Hormuz outside of Iran. That is basically a strait used for a lot of energy transportation. So what do you make of that story? Is it feasible that they start striking against tankers as well? Against tankers, yes. The Strait of Hormuz would surprise me if they carry out large-scale attacks there. A lot of things have surprised me in this, but that would really surprise me. First and foremost, because this is very, very close to the Iranian coast, could very easily strike into Iran or hit Iranian ships.

6:22And second of all, because most of the exports there are either Iranian, which they won't be trying to hit, or from the Gulf states in Saudi Arabia. And to involve them directly in these attacks would be a huge escalation and risk direct involvement from the neighboring states. So it would surprise me. On the other hand, that is the worst case scenario to really see this spill over into the international shipping lanes of energy. Yeah. It is not only the Suez Canal that we're talking about currently in terms of the global shipping malaise. We're also talking about issues in the Panama Canal. Those are unrelated to the geopolitics surrounding this situation in the Red Sea.

7:02But if we look at the current data from the Panama Canal, we're also talking about much fewer crossings compared to normal levels. And why is that? Well, it is basically driven by a lack of rain. So essentially, it's not possible to transfer as many ships as usually through the Panama Canal due to a lack of rain. So we essentially need some rain in the region to get the Panama Canal back at full capacity. So we're currently stuck with a situation where both of the most important canals on Earth, in terms of making shipping lanes swift and efficient, They're both more or less effectively closed relative to historical standards.

7:47And therefore, we're currently seeing this shipping malaise spreading from container ships, which were sort of originally the sort of center of attention, towards the dry bulk space and even to energy tankers. So slowly but surely, this story is sort of building from being a very isolated event to container ships in the Red Sea. So now being a global shipping lane relevant story, freight rates are up on right about every possible destination on Earth within every possible subsector of the shipping industry now. So it is of major relevance to solve this as soon as possible for the Biden administration, Mikkel.

8:35We obviously have a lot of contacts within the shipping industry since it is so heavily based out of Denmark. But Mikkel, what's the outlook for a solution to this situation with the Houthis? Is it feasible to hope for a solution within a few weeks from here? Hey, everyone, we're going to take a quick break right now to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing. Have you ever wanted to trade Bitcoin but haven't dared try? With Plus500 Futures, you can trade crypto without the hassle of opening a wallet. With just a few clicks, you can register and start practicing with their free and unlimited demo.

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10:04Possibly. To give a little glimpse into our thinking on this, we've been working a lot, talking to a lot of soldiers. We have sort of a matrix that I use for this. So basically, the U.S. tried initially to reassure shipping companies. That's the second front-top solution here. To reassure the shipping companies by deploying massive naval forces into the Red Sea to basically tell them, we're here, we're in control of this. That initially seemed to work up until Christmas, between Christmas and New Year's, where the Houthis upped their attacks, sent in more drones, and then all the shipping companies went south of Africa instead.

10:37So that basically failed tremendously, the initial effort to reassure shipping companies. The next step in that effort was to begin bombing the Houthis within Yemen. That didn't really work either. The U.S. have tried to place direct convoy support on certain ships, as we mentioned before. That's A, not really scalable. B perhaps doesn't even work, as we've seen in the past couple of days, and evidently it doesn't reassure the shipping companies. So we're left with the two button options for solving this crisis. One is to outright invade North Yemen, where the Houthis are situated, put boots on the ground.

11:17That's an absolute worst case scenario for the US, which would carry huge financial and political costs. So I view that as sort of a no-go scenario. that leaves only one solution, in my opinion, and that's the truce between Hamas and Israel. Because even though, as I mentioned, the Houthis have a lot of reasons for attacking ships in the Red Sea, it all stems back to the Hamas-Israel conflict. If that's solved, then the Houthis have no cases, Billy, to keep attacking ships. And a couple of weeks ago, this seemed like a, yes, that's a good solution, but is that really realistic? Is that really the easiest way to solve this?

11:53Well, now it may actually be. In my opinion, we're looking at one to two months, perhaps, before a peace deal is realistic. It's being worked on a lot. The pressure in Israel is immense. So there are chances that it could go quicker, but it's not going to be a quick fix. And even if it's fixed, we might still be looking at some trouble. Yeah. Once this Red Sea issue is over, we're not necessarily out of the woods. And I have to remind you of some anecdotal evidence that we have from 2021 on that subject. Back in early 2021, the ship Ever Given basically blocked the entire Suez Canal. Some of you may remember basically the pictures of a ship blocking the entire canal.

12:40And once the canal was reopened, it led to traffic jams across ports, both in the US and in Europe. We see the amount of ships anchored outside of LA here post that ever-given event in the Suez Canal. And I think something similar is very likely this time around. Should the Suez suddenly reopen, we have a lot of jams to be expected both in Rotterdam, LA, Genoa and other big port cities as a consequence of a lot of ships currently either being redirected or in a waiting position. We also saw similar traffic jams in the North Sea. If you show the next chart, it's basically kind of a similar picture just from North Sea ports on Accroquet.

13:24So this is something that will last for, say, three, four months from here, even in the very hopeful scenario of some kind of solution being found within the next week or two. And therefore, yeah, Mikkel? Yeah, just one point. We are looking at some seasonality here as well, because we know that this is mainly affecting the Shanghai Rotterdam or Shanghai Europe routes. And that route carries a lot of the Christmas presents that you and I are going to be giving and receiving this year. And they're not going to be shipped out in December. They're going to be shipped out before the summer to retailers, to stock, to warehouses across Europe.

14:01So if this reaches into Q2, it even worsens the problem and the bottlenecks. So one thing is that we have an issue within the shipping industry. The shipping companies are, by the way, pretty happy with this. They can increase margins. Just have a look at their average stock returns over the past couple of months here. But when freight rates are on the rise, it also matters for inflation. So if we take a look at freight rates across the globe first here, this is a heat map of some of the most important shipping routes across the globe. For example, Shanghai to LA and Shanghai to Rotterdam. and the freight rate between Shanghai and Rotterdam is up almost 400 % if you look a couple of quarters back, but 350 % just since mid-December or thereabout.

14:52That's obviously directly linked to what's ongoing in the Red Sea, the lack of passings through the Suez Canal. But you should also note that the price of freight from Shanghai to LA is on the rise swiftly as well. So why does that make sense since it's not directly impacted? Well, we've basically asked our sources within the industry why that is. Basically, they redirect capacity towards the Shanghai to Rotterdam route as a consequence of higher prices, first of all, but also as a consequence of delays given that they have to redirect ships south of Africa. So they simply need more ships to take care of the situation.

15:35That's one thing. So therefore, there's an indirect spillover to the Shanghai LA route. Secondly, currently, it's kind of the global price setting mechanism, this route between Shanghai and Rotterdam, as a consequence of larger margins on this route. So essentially, why would you choose another route unless you get paid as well traveling another route? So that's essentially why we see these spillovers, global freight rates now. and everything is now impacted, we should essentially expect freight rates between China and the US to sort of play catch up with the increase that we've seen in Europe.

16:20Does this matter for inflation? If you move a couple of charts ahead, there's a chart on the freight rate relative to the PCE price of coal goods in the US consumer basket. It's called the trouble in Suez is not helping US importers. And there's actually a pretty neat correlation between freight rates and subsequent inflation in goods. I think it makes a ton of sense that an increase in transportation costs will ultimately, to a certain extent, end up being passed through to the ultimate consumer of the good. So why is there a lack on this chart? It seems like freight rates actually lead the development here.

17:11Well, first of all, it takes a while for a ship to go from Shanghai to LA. There's a very clear time, like just because of the travel time. Secondly, you typically price your goods based on the goods you have in inventory, meaning that current prices are based on lower freight rates from a couple of months ago. And thirdly, you probably monitor this situation with a bit of urgency initially. Is it feasible to hike prices immediately because of freight rates? Probably not. You look at it and assess whether it's a temporary situation or not. if freight rates drop back within a couple of weeks, then it's probably not feasible to hike prices.

17:55But now that everything points towards, say, another couple of months, maybe three, four months of shipping troubles, I think it's fair to assume that we will see a pass through to consumer prices. The IMF did a study on this in 2022, and they reached the conclusion that for every doubling of global container shipping freight rates, you should expect an impact of 0.7 % on consumer inflation. With an increase of more than 200 % in global benchmarks now, we should probably expect this to impact inflation globally with a magnitude of, say, 1.5%, at least, maybe even a couple of percent. And I guess this arrives at the worst possible timing for central banks now, slowly but surely trying to guide markets towards rate cuts.

18:50And, well, we need some disinflation in other cost categories than goods to sort of make up for this account of this inflation scene due to freight rates and due to this conflict with the Houthis. So Mikkel, your best guess from here. Now, I'm talking about a time like of, say, three to four months before this is ultimately seen in Walmart and other retailers in the US. Your best guess, is it feasible to find a solution within a month or two from here? Or what would be the best guess here? Absolutely, because that will be, as I mentioned, the ultimate solution, a piece between Hamas and Israel.

19:27I believe that will come within one to two months. There's a chance it could come even quicker, but that's my guess best between one to two months. And that should alleviate this situation. If the Houthis keep up their attacking, even with the Hamas-Israel truce, then it's a whole different situation. But I don't really believe that's realistic. So that is my base case prediction for me. We're going to take another quick break to hear a word from our partners. We'll be right back with more of the day's top analysis on the Real Vision Daily Briefing.

19:59So Mikkel, this Red Sea situation is obviously a supply shock. given that shipping lanes are troublesome and so on and so forth. But what about the demand side? The demand side will obviously also have its say on whether this turns into an inflation spike or not. And I think there's a divergence between Europe and the US worth mentioning here. The US economy is running on Coke, pardon my French here, but it relates to the cost of living adjustments, the so-called COLA adjustments, made every 1st of Jan. in the US. So if we look at the first chart on the US economy in relation to these COLA adjustments, it's worth mentioning that just as a consequence of these mechanic adjustments to tax brackets, first of all, the average household in the US will see an increase in their spending power 1st of January.

20:54Tax brackets are nominally increased by an average of 5.4 % by 1st of January, meaning that you simply have less taxes to pay given the same salary compared to in December. The same holds for those on the receiving end of social benefits. If we look at transfer receipts in social security, we've also seen a roughly 5.5 % increase to those. And as you can see from the chart here, we're talking a three-digit billion number a month here. So it is once again something that adds to an already large deficit of the US federal government and something that sort of holds an embedded inflation mechanic in it, given that these adjustments are based on historical inflation, but they also ensure that consumers will keep spending, even in an inflationary environment.

21:51And if we look at live gauges of retail spending in the US from the get go of the year, we have a gauge from Redbook with us today. It seems like we're off to a flying start in sharp contrast to most economists' expectations just a few quarters back. And this introduction of large revisions to the tax brackets, to the social benefits received by regular Americans. It seems like a new kind of seasonality is introduced to the US economy because every 1st of Jan, you get a massive boost to the spending power and it slowly but surely fades throughout the year, meaning that the sort of Q4 will be weaker than Q1 on average.

22:40And by the way, the Q4 report on the gross domestic product was pretty decent out of the US today. And it's kind of in sharp contrast to the Eurozone because we have very few countries with the same sort of mechanical increase and the same mechanical cost of living adjustments, first of gen. France is an example of a country that does more or less the same as the US. But other countries in Europe do not do it. So you don't get that automatic spending increase in Europe. And as you can see, the divergence between retail sales in the US in light blue and what we see both in the UK and in France in red and dark blue here is quite striking and the divergence is increasing.

23:21That leads me to the conclusion that it's much more likely that we will get a consumer goods inflation spike in the US due to this because of the demand side also being on the increase while the supply shock is happening in the Red Sea. So I guess that's the major takeaway from a financial market perspective. Europe is, from a demand perspective, still stuck in the abyss, while the US is re-accelerating right now, meaning that the risk of a re-emergence of inflation in the US by late spring, thereabout, given the lead lags that we showed you earlier, is much larger than it is in Europe. I think it bodes well for US equities.

24:05Equities tend to thrive through the first sort of phase of inflation because it means that companies basically increase their pricing power relative to consumers. But it doesn't bode too well for US treasuries. It bodes reasonably well for European fixed income, I'd say, given that we don't have the same demand dynamics, while European equities are much less likely to outperform US peers. By US equities and European fixed income, that's probably the cocktail that makes the most sense here if you're into investing in both kind of instruments. I'll leave you with one final chart, and I'll allow you to comment on it also as well, Mikkel.

24:55The deficit of the federal government in the US is out of control in many ways. These cost of living adjustments add to it. This is a very, very simple study. The light blue is based on the unemployment rate and also the current growth gauge, basically. So the current growth rate of the US economy. Given those two, you would expect the budget to balance. We're currently seven, seven and a half percentage points away from that. That is extraordinary. And as long as you have that gap, it's very unlikely that you'll see a recession. So in an election year, Michael, Biden holds no incentives to close this gap.

25:41Not at all, not at all, no. I think the Biden administration will keep this spending up. There are political reasons to do so, obviously. The big question is, when we get to the other side of an election, can the coming administration, be it a Biden or Trump administration, can they keep this up? I think they will have to, to some extent, slam the brakes. How they do it could be through spending cuts, could be through revenue reforms, but this is untenable in the long term. It's like nothing we've seen before. And just on a final note, a lot of people are speculating in how does the market usually react to these primary elections, to the general elections.

26:23I think all those historical evidence is out the window because this is like nothing we've seen before in the economic scale. So this is new territory. It's going to be new territory for a new administration to enter into an artificial deficit, you could probably call it this large. Yeah. And it will be very interesting to see how the new administration, if we assume that Trump wins the election by the end of the year, probably the base case for bookmakers right now, whether he will slam the brakes or not. I'm not certain myself, but let's see. Yeah, and it's got to be tricky. There are a lot of political stopgaps to do that.

27:00Yeah. I guess this was all for this session on the Red Sea, the ramifications for inflation around the globe. I sadly think that you should expect a new wave of goods inflation in the US, also to a larger extent than what we'll see elsewhere around the globe. But it's pretty good news if you're an equity investor. And for now, we lean heavily into US stocks, in particular in the tech space, paired with some exposures in the shipping industry, because they like this scenario, even though it creates inflation for the end consumer, ultimately. My name is Andreas Steno. I was joined by Miguel Rosenwald from our geopolitical research department here at Steno Research.