FEBRUARY 2024
The Middle East conflict has escalated in recent weeks with the Houthi rebel group targeting merchant vessels in the Red Sea. The vast majority of all international trade in goods travels by sea with around 15% of that usually passing through the affected region.
The unrest is already having a profound impact on trade with many insurers refusing to cover freight sailing through the Suez Canal, forcing a growing number of ships to opt for a longer, safer alternative route around the Horn of Africa.
This lengthens the typical journey time by several weeks and significantly increases travel costs. The chart below shows how the cost of transporting a single container from China to Northern Europe has spiked by almost 6-fold since the Israel/Hamas war began in early October.
This risks triggering another wave of imported goods inflation in the UK and Europe, although the disruption and associated cost increases are a fraction of what we saw during the pandemic.
It is striking how well the oil market has digested the recent events in the Middle East. Brent crude prices have been trading in a tight range around U$75-80/bl since early December, when the Houthi rebels began escalating their attacks against commercial ships travelling through the region.
This is partly because oil tankers are not being targeted, limiting the supply disruption for energy markets. But it also reflects the fact the impact of geopolitics on markets is often overstated.
This certainly wasn’t the case in the 1970s when multiple supply shocks, stemming from the Arab Oil Embargo and Iranian Revolution, sent oil prices sharply higher. Yet, in more recent years, major events like the Iraq wars, the Arab Spring and Russia’s invasion of Ukraine have typically seen any price spikes quickly unwind.
There are many reasons for this. One being that world oil supply is less concentrated in the Middle East compared to 50 years ago. Another is that developed economies now hold larger strategic oil reserves, which help to alleviate the pressures of any temporary supply squeezes. However, the main reason is that the global economy has become much less dependent on oil over the past few decades with services (rather than commodity-intensive industries) dominating most economic activity.
The past year has seen major changes unfold in oil markets, especially on the supply-side. With the OPEC/Russia alliance opting to extend production cuts until March 2024, the US has emerged as the world’s largest supplier, thanks to its booming shale industry.
In late December, US daily oil supply reached a record 13.2 million barrels, comfortably surpassing the next two largest producers; Saudi Arabia (12 mbpd) and Russia (11mbpd). This is helping to keep a lid on the oil price, despite the escalating tensions in the Middle East.
The US Strategic Petroleum Reserve (SPR) should be another beneficiary. In an effort to quell domestic inflation, the Biden Administration drained the reserve by almost 50% from its 2020 peak, leaving the stockpile housing just 350 million barrels by mid-2023.
Replenishing the SPR has since become a priority and the surge in US oil production will ultimately help to achieve this, but progress has been slow so far; only 10 million barrels have been added since that July low.
Inflation expectations play a vital role in setting Central Bank policy, although deciding on what metric to use can be a challenge. Some policymakers refer to survey-based measures, which simply asks consumers and businesses what they think the inflation rate will be over the coming years.
Another approach is to use market prices calculated by backing out the implied future inflation rate from inflation-linked bonds. This captures what market participants anticipate inflation will likely be going forward with the 2-year swaps based inflation expectation (shown below) one of the preferred indicators.
Whatever the measure, policymakers like to understand what people are thinking about inflation because expectations tend to become self-fulfilling. For instance, if future inflation is expected to be high, workers demand higher wages, businesses tend to raise prices and consumers will adjust their spending patterns accordingly.
This is more than a theory. As the chart below shows, US inflation expectations surged in the immediate aftermath of the pandemic with the 2yr rate peaking close to 5% around the start of the Russia/Ukraine war. This elicited a strong response from the Fed, which unleashed one of the most aggressive rate hike cycles on record.
However, inflation expectations have fallen sharply over the past 2 years with the 2yr rate back to around 2%, close to its pre-Covid norm. The Fed will find this encouraging and providing inflation expectations remain relatively contained, there is no reason to doubt the start of US rate cuts later this year.
The content of this document is for information purposes only. The authors believe that, at the time of publication the views expressed and opinions given are correct. No guarantee in performance of investment can be given to readers intending to take action based upon the content of this document. It is reminded that this document is a matter of opinion and any person wanting to invest in this market should first consult with the professional who can advise on their financial affairs. Any such investment will see your capital at risk, and you may get back less than you invest. Any companies cited in this report are used to support the view of the authors and should not be construed as recommendations to purchase or sell the underlying securities. Neither the publisher nor any of its subsidiaries or connected parties accepts responsibility of any direct or indirect or consequential loss suffered by a reader or any related person as a result of any action taken, or not taken in reliance upon the content of this document.
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