Danger near the Suez Canal

Traffic in the Suez Canal, the waterway in Egypt which connects the Red Sea to the Mediterranean Sea, has plummeted. Iran-backed Houthi militants have been attacking commercial ships on this key trade route that connects China with both Europe and the U.S. East Coast. The militants said their attacks are in retaliation for Israel’s war with Hamas in Gaza.

RBC Capital Markets, LLC’s Head of Global Commodity Strategy Helima Croft estimates that around 12 percent of global trade (the equivalent of 10 percent of OPEC oil production) usually transits through the Red Sea, with most of the traffic being en route to or from the Suez Canal.

Data collated by the International Monetary Fund and Oxford University point to a 40 percent drop in daily Suez crossings compared to peak 2023 levels.

As a result of the Houthi attacks, most container ships are being rerouted, with many opting for the alternative route around the Cape of Good Hope at the southern tip of Africa. Eric Lascelles, chief economist at RBC Global Asset Management, said this diversion can add as much as 25 percent more time to trips, swelling the cost of goods being shipped.

Drought in the Panama Canal

In a strange twist of fate, one of the world’s other artificial waterways, the Panama Canal, a key route for goods from Asia heading for the U.S. as it connects the Atlantic and Pacific Oceans, is also struggling—though not for geopolitical reasons.

According to Bloomberg, $270 billion worth of merchandise passes through the Panama Canal annually with 40 percent of all U.S. container traffic travelling through it. Lately, unusually low water levels have limited the number of ships passing through, while a mismanaged expansion of the canal completed in 2016 exacerbates the problem.

As the traffic jam has worsened, authorities have had to limit access to the waterway. Only 22–24 vessels now pass through each day, which is down from 36–38. In some cases, ships are also forced to reduce their cargo size in order to sit higher in the water. It thus takes longer for merchandise to reach the desired destination.

According to Lascelles, the reduced ship throughput is anticipated to remain at just half the normal level through February 2024 at least, with repercussions set to linger well into the year.

Freight rates surge

As a result of these disruptions, particularly the attacks in the Suez Canal area, spot shipping costs have been on the rise this year. The Drewry World Container Index, a barometer for the spot rate for shipping a 40-foot container on major East-West trade routes, has increased more than 139 percent so far this year, although it is well below the peak rates during the COVID-19 crisis.

40-foot container freight rates spike, now twice their average 2023 levels

Drewry WCI composite container freight benchmark (spot rate per 40-foot container in USD)

Line chart showing the Drewry WCI composite index which represents the U.S. dollar average cost of shipping a 40-foot container on the eight major East-West routes. The cost is up some 139 percent so far this year and is now more than twice the average 2023 level of $1,674. The chart shows the index peaked above US$10,000 at the height of the COVID-19 pandemic in 2021 and currently stands at $3,964.

Source - RBC Wealth Management, Bloomberg; weekly data through 1/25/24

In reality, few companies will feel the complete impact of the spot rate increase. Shipping costs tend to be long-term contracts which are less volatile than the spot rates. Yet even companies with long term contracts may have to face higher costs in the guise of the cost of diversion as well as foot the bill for higher insurance costs.

Corporate sector good news/bad news

On one side of the spectrum, global shipping companies will likely benefit from higher freight rates. Logistics companies and air freight companies may also benefit as some shipping customers choose to transport cargo via air.

On the other side are the companies which may face higher transport costs and/or delivery delays. Some will try to pass the cost increases to consumers through higher prices. But those whose pricing power deteriorated in 2023 may have to absorb these higher costs, eroding margins.

Moreover, shipping delays may result in temporary shortages. For sectors which operate on a “just-in-time” basis, such as auto manufacturing, this can become problematic very quickly as inventory levels for components are kept at a bare minimum. Tesla recently announced a two-week production halt at its German plant as it awaits delivery of components.

In contrast, companies which keep large inventory in warehouses, as many retailers do, may be in a better position to bide their time. If disruptions and shortages persist, however, stockouts may result in lost sales.

Inflationary pressures?

With part of the corporate sector reluctant to pass on higher costs to consumers, the direct risk to inflation of higher transport costs may be mitigated. With Europe most affected by the Red Sea attacks, Lascelles calculates that the higher shipping costs could add as much as half a percentage point to inflation in Europe over the coming months if the disturbance persists.

However, we still believe that the key risk to inflation is a further escalation of the Middle East conflict through an increased involvement of Iran. In this case, Croft thinks regional energy supplies could be jeopardized due to Iran having important energy assets. Iran could also, as it has done during previous times of conflict, imperil maritime traffic passing through the Strait of Hormuz, a passageway from the Persian Gulf to the open sea which is critical for global energy supplies. With regional energy supplies compromised, oil prices could surge, feeding inflation.

New risks

So far, the recent disruptions in the Suez Canal have had little impact on financial markets overall. Markets seem to believe that Houthi attacks will recede now that the U.S. and UK are sending warships to the Red Sea to protect cargo vessels and the countries are making targeted attacks on Yemen.

Yet the disruption in the two key waterways could eventually result in an increase in inflation and have an impact on global supply chains. Equity markets’ recent resilience as the soft landing and declining inflation narratives gained traction may be put to the test.