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The Houthi attacks on shipping in the Red Sea represent a worrying step toward escalation of the conflict in the Middle East. But while the effects on supply chains and inflation may cause some dislocation in the short-term, we believe they will largely be manageable—barring the extreme tail risk of a regional war leading to the weaponization of energy against the West via restrictions on oil and gas tankers' rights of passage through the Strait of Hormuz.

What We're Watching

More frequent and sophisticated attacks by Yemen-based Houthi rebels on maritime shipping are creating a bottleneck in a vital supply route that sees about 10% of global seaborne trade. Since mid-November, the Houthis have launched more than 25 drone and missile attacks against commercial vessels. Recently, attempted strikes have also been directed toward naval protection vessels escorting ships through the area. So far, the attacks appear to have been repulsed with no casualties.

Nevertheless, many shipping companies are prioritizing safety and either suspending voyages through the Red Sea and the Gulf of Aden or diverting to the longer route around the Cape of Good Hope. Containership tonnage traversing the Red Sea faced a sharp correction falling more than 80% in the second half of December compared to the first half, according to Clarksons Research. The longer transit time around Africa increases fuel and crew costs and disrupts supply chains. For instance, diverting a containership via the Cape of Good Hope typically adds an extra 10 days to East Asia-Northern Europe sailings and two weeks to East Asia-Mediterranean trips.

What We Think And Why

Longer unplanned voyages and disruption to the shipping network amid heightened uncertainty has led to a tighter shipping market—particularly for container vessels. This has caused a surge in freight rates in recent weeks of about 300% on the more affected routes like Asia to Europe, and potentially doubling again if the announced rate hikes by some container liners from mid-January (of $6,000-$7,000 per a 40-foot-long container) are sticky. This would provide a windfall for shipping liners' profitability after a sharp drop in carriers' earnings in 2023, when rates abruptly normalized from pandemic-induced record highs. We expect freight forwarders and carriers of air freight will also receive some indirect financial benefit.

Despite their significant rise, we don't expect freight costs to reach COVID peaks—instead, we anticipate they might decline, starting in the second half of the year. The economic environment now is quite different than in 2020-2021, when consumer demand for goods was exceptionally high during lockdowns, stimulated by government support measures. Today, spending on tangible goods is relatively weak and more balanced against services. We also don't expect the tightness in the supply-demand balance in the container shipping market to last due to significant deliveries of new ships. The current orderbook—equating to 27% of the total global fleet, according to Clarksons Research—suggests container liners' total capacity might grow 7%-8% over the course of this year (at a similar rate as in 2023).

Tankers and liquefied natural gas (LNG) carriers transporting OPEC and Russian oil and Qatari gas appear to have not been targeted by the Houthis. We believe that this—combined with Saudi Arabia's ability to reroute oil supply to Europe via its 7.5 million barrels per day Yanbu terminal to the north of the Gulf of Aden—has resulted in oil and gas markets not pricing in significant risk premiums. This is because, while shipping Qatar's 12% share of Europe's LNG imports (and 5% of Europe's total consumption) through the Cape of Good Hope is somewhat costlier, risks of physical lack of gas resulting from hostilities in the Gulf of Aden remain low. On the oil side, the voyage represents under 3% of total oil costs. As of Jan. 17, the price of LNG landed in Europe has dropped to $8/thousands of cubic feet (Mcf), a six-month low and about the level of mid-2021, before Europe's energy crisis; LNG tanker chartering rates remain moderate.

What Could Change

Regional escalation of the conflict could occur. Sustained military reprisals against the Houthis in Yemen, or any attack on commercial shipping or the naval protection vessels resulting in loss of life, could lead to a broader escalation of the regional conflict—potentially opening up a second front between Israel and Hezbollah in Lebanon and potentially dragging Iran and the U.S. deeper into the confrontation.

The extreme tail risk remains a severe energy supply shock. This could arise if Iran chooses to weaponize the energy market against the West by restricting transit through the Strait of Hormuz. As around 30% of seaborne crude oil exports and 20% of LNG pass through the Strait, even a partial closure would prove highly disruptive to the global market—and would not be welcomed by important trading partners of Gulf producers such as China and India. This will be even truer when Qatar raises LNG exports by some 42 billions of cubic meters (bcm)—i.e., as much as three times its current exports to Europe—which energy markets factor in by 2028. In comparison, restricting transit through the Gulf of Aden delays, not prevents, delivery onto the world market; LNG rerouted to APAC frees up U.S. cargoes for Europe's supply.

The situation complicates central banks' efforts to reduce inflation. Even barring an extended energy or food-supply shock, disrupted supply chains and the associated passthrough of higher costs—including energy costs—could make it harder for central banks to restore price stability and may require a recalibration of the pace of rate cuts that market participants have priced in.

Writers: Joe Maguire and Molly Mintz