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16 Jan 2024 | 5 minutes to read
With markets having focused on monetary policy prospects over the Christmas period, geopolitics once again asserted itself as a key concern last week. Trade data from a German trade institute revealed the extent to which global trade declined in December, in part due to attacks on merchant ships by Houthi rebels. The Houthis are a Shia militia group from Yemen, controlling its Red Sea coastline. The Houthis oppose Saudi Arabia’s influence in Yemen, which has led to Iranian support for the Houthis, and Houthi support for Hamas in Gaza.
Soon after hostilities intensified in Gaza, Houthis began attacks on ships in the Red Sea, a globally significant shipping channel. By November, Houthis declared all vessels with a perceived connection to Israel and its allies to be “a legitimate target for armed forces.” For the most part, these attacks were thwarted, but some have been successful and the elevated risk led to more cargos taking the longer and more costly course around the Cape of Good Hope, and a higher cancellation rate for sailings.
It’s unclear how long these attacks will persist, but currently hostilities are intensifying rather than abating. Aside from the risk of geopolitical spillovers, the attacks are causing trade disruption. German trade institute IfW Kiel found that Red Sea container volumes fell by more than half in December, and are currently almost 70% below normal volumes. This contributed to a 1.3% decline in global trade overall in December. Goods shortages may impact retail sales volumes, and European industrial production is likely to be held back. Prices could also be impacted, with higher freight rates putting upward pressure on goods inflation. However, freight costs would have to rise substantially to have a material impact, and prices – though still much lower than during the height of the pandemic – are already elevated compared to pre-pandemic levels.
A key question remaining is how these attacks impact energy prices. The attacks are not expected, on their own, to drive energy prices significantly higher but the escalation of hostilities, particularly regarding Iran, could reignite worries about Iranian oil supply that first emerged in October last year. For now, we don’t expect these events to disrupt the prevailing trend of falling inflation. However, they could weigh further on growth in the first quarter, a time when global growth is already expected to be weak.
A topsy-turvy week in the US proved supportive for US bonds, despite a stronger-than-expected inflation print. Headline inflation came in at 3.4% in December, ahead of forecasts and up from 3.1% in November. However, a 0.4% month-on-month rise in energy prices was a significant driver of this, along with a 0.2% rise in food prices. Core inflation, which excludes these volatile elements, declined to 3.9% from 4% in November. Admittedly, the core basket also held pockets of strength, with shelter costs rising by 0.5% month-on-month and new autos up 0.3%, but autos are a smaller share of the Fed’s preferred inflation measure, the Personal Consumption Expenditures index.
US inflation slowed dramatically over 2023, in part due to base effects but also as a result of Fed tightening and cooler economic activity. Inflation is expected to slow further still this year, with consensus forecasts averaging 2.4% in the final quarter of the year. The pace of this slowing will continue to depend on energy prices, but these are expected to be range-bound this year. Broader consumption activity will also be key, which in turn relies on the labour market. A continued cooling in labour demand should dampen wage growth further. Coupled with a less supportive fiscal backdrop, this is likely to squeeze consumption early on this year, giving the Fed greater confidence that it is safe to cut interest rates.
While the Fed, in public at least, remain cautious on this issue, market pricing suggests that market participants are confident in the likelihood of rate cuts. While expectations have been pared back from their most extended point, in late December, today markets still price around six cuts in 2024, compared to two cuts indicated by the Fed’s own dot plot. Given the continued resilience of the US economy, six rate cuts seems ambitious.
We expect that extended expectations, even in an environment of increasingly supportive monetary policy could continue to be a source of volatility as a result.
As expected, Taiwan’s Democratic Progressive Party won Saturday’s election, with Lai Ching-te succeeding Tsai Ing-wen as DPP leader. The election outcome has underlined the conflict between western nations, including the US, which congratulated Taiwan on “once again demonstrating the strength of their robust democratic system and electoral process” and China, which threatens “inevitable” absorption of Taiwan into China.
China’s economic troubles at home have likely allowed tensions with the US and other nations to sit on the back burner in the last year. However there is always a risk that, if Beijing are not able to revive growth, the escalation of hostilities with Taiwan could distract attention from troubles at home. Nonetheless, militarily, Taiwan would be a challenging geography for China to attack and key intellectual assets would be lost in the process, hurting China further.
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