From the Economist's Chair: Freight costs underpin surging inflation

Author David Fyfe, Argus Chief Economist

Sustained inflationary pressures will likely pull interest rate rises forward in 2022, albeit central banks must tread carefully to avoid derailing post-pandemic recovery.

Underpinning these gains in inflation has been resurgent world trade that has pushed freight costs up by between two- and eight-fold relative to pre-pandemic levels. Container, dry bulk, air freight and LNG shipping costs could all remain elevated well into 2022, although depressed crude oil tanker rates may see only modest recovery.

Eye-watering inflation data for November have again raised the prospect of central banks, in the Atlantic Basin at least, further tightening monetary policy in early-2022. Expectations are now that the US Federal Reserve could move as early as the second quarter to raise interest rates. Of course, conditions vary between nations and regions, with Asia less beset by consumer price inflation than the Atlantic Basin.

Nonetheless, supply chain bottlenecks continue to bedevil the movement of merchandise goods and commodities alike, a phenomenon that may be further exacerbated by the Omicron variant of the virus if this delays a more complete re-opening of the global economy.

Further partial lockdowns, while less disruptive than early-2020 levels, would not only strain existing logistical fragilities, but may defer the demand-side rebalancing of consumer spending, back towards greater outlays on services, and less spent on merchandise goods. Many observers consider such a normalisation of spending patterns as key to subduing current extreme inflationary pressures.

The slope of the V-shaped recovery in trade since the depths of the pandemic in early-2020 was steeper than the recovery after the Great Financial Recession over a decade ago. It also highlights how a demand-side rebound has at times outstripped the ability of the supply-side to respond, with a global logistical industry that is still adjusting. Combined with weather-related supply disruptions and sporadic re-impositions of, albeit successively weaker, mobility restrictions as new variants emerge, the world remains a long way from normality as regards supply-chain functioning.

Unfortunately, so long as there are risks of renewed pandemic-related disruptions to commodity and manufactured goods production and shipment, so distributors and consumers will continue to stockpile, worsening what economists refer to as the "bullwhip" effect. In such circumstances, Information asymmetries can render the synchronisation of shipment and distribution problematic, so driving up prices as unpredictable shortages emerge along the length of the supply chain.

While such physical issues could potentially ease as rapidly as they have emerged, sporadic hoarding and stockpiling episodes towards the distributor/consumer end of the chain could sustain prices as long as the risk of renewed lockdowns persists. And with inventories for many goods and commodities still relatively low when compared to end-user demand, erstwhile expectations of short-lived inflation are being revised towards longer time horizons.

Container freight tightness underpins broader shipping surge

Container freight rates began rising in late-2020. Surging consumer goods demand, as personal spending remained skewed away from travel, tourism and entertainment, combined with a post-lockdown dislocation in vessels, containers and crews. Together these saw container rates rise nine-fold through summer 2021, and while rates have since stabilised, there is little sign of them falling back towards more normal levels.

Inflated container costs arguably represent the most significant cost pressure deriving from transportation bottlenecks. Some 90% of the world's merchandise trade moves by sea. Analysts estimate that in November around 11% of the world's loaded container volumes were stuck in logistical bottlenecks of some description, almost double the normal level of delay. The causes of delay are manifold.

Maritime, port and trucking workforces have been reduced by lockdowns, illness or migration to other sectors. Port loading and unloading delays are being caused as much by process and productivity shortfalls as by truck or driver shortages. The Port of Los Angeles, a key entry point for Asian imports to the US, reports 115,000 empty containers sitting idle at the port.

Moreover, ship brokers see little prospect of sizeable new-build container tonnage hitting the water before 2024. So elevated container freight rates could persist for much of 2022, at least until stockpiles become replenished. Normalising demand, as much as incremental supply, likely holds the key for lower container rates in the short to medium term.

Spill-over to dry bulk & air freight

Dry bulk rates strengthened earlier than container rates, moving sharply higher from mid-2020 as Chinese manufacturing and commodity import demand rebounded. Dry bulk strengthened further in first-half 2021 as iron ore imports took off and as China also sought incremental coal imports to offset a collapse in domestic production.

Recovering Chinese coal production from the autumn, easing port congestion, power rationing, and industrial output limits to meet annual emission targets have since seen dry bulk shipping rates ease.

However, they remain four to five times higher than pre-pandemic levels. Shipping companies also report some spill-over from the container freight squeeze, as products like grain and scrap metal normally moved by container have shifted to Handysize bulk vessels.

Dry bulk rates could remain high by historical standards in 2022, as knock-on impacts from container freight inflation persist, the dry bulk vessel order book remains modest, and if a potential uptick in infrastructure spending post-pandemic boosts demand for cement and steel. The bulk shipping sector will be watching with interest both the trajectory of the Omicron variant and any negative spin-off from China's evolving property sector liquidity crisis.

Dry bulk shipping is not the only segment to benefit from container shipping delays. Freight spill-over has also occurred into the air cargo sector, where rates per kg transported on the China-US route have risen four-fold since the pandemic. Incremental demand has confronted a 10-15% reduction in air cargo carrying capacity in the last two years.

Traditionally, 50% of global air cargo moves in the hold of passenger aircraft, and while short-haul passenger aviation has recovered during 2021, long-haul flights remain largely grounded. Nor does a rapid or imminent recovery in long-haul travel look to be on the cards, suggesting that air cargo rates could remain elevated for much of 2022.

LNG shipping rates bullish too, but crude freight is the poor relation

Not to be out-done, LNG freight rates have trebled since September, as spot prices for the super-cooled fuel into Asia rose from early-year lows around $5/mmbtu to nearly $40 in October. The durability of higher LNG freight will hinge on prospects for Asian LNG demand itself.

Competitive coal prices and returning nuclear units, plus currently benign winter North Asian weather forecasts, suggest a high point may already have been reached.

However, limited upside flexibility for gas supply into both Europe and Asia through first-quarter 2022 could place a floor under both spot LNG prices and LNG freight rates in the short term.

No such windfall has accrued for a beleaguered crude oil freight segment. Tanker operators have been unable to pass on the near-doubling in bunker fuel costs seen in the last 12 months as incomplete global oil demand recovery and an over-supplied fleet continue to weigh on profitability.

Argus analysis suggests from a sample of a dozen major tanker operators that $200 million of 3Q2020 profits transformed into a $400 million loss in 3Q2021.

Admittedly 2020 performance was supported by a floating storage boom, and 3Q21 may represent the nadir for returns, with prospects for a gradual recovery moving forward.

On the positive side, OECD oil inventories need replenishing, transportation and petrochemical feedstock demand will continue to recover and Middle East Opec+ production volumes should rise at least through mid-2022. Long-absent Iranian exports could also potentially re-enter the market.

However, optimism is tempered by what looks like a slow US shale oil recovery, currently unattractive Atlantic Basin-Asia crude arbitrage economics and a dirty vessel fleet overhang that looks likely to persist into 2023. Tanker rate recovery could prove modest in the short term, the more so if Omicron stifles oil demand growth in early-2022.

The tide will eventually turn

Central bankers have begun to row back on earlier claims that inflation will prove a short-term phenomenon that eases as post-pandemic recovery proceeds. Many in the maritime sector similarly now see elevated freight rates (crude oil aside) persisting through much of 2022.

Controlling Covid-19 infection rates via broader global vaccination will be key. Not only would this help in normalising commodity and merchandise goods demand growth and stockpiling behaviour, but also in easing the bottlenecks that persist along the supply chain.

Eventually, post-pandemic labour market dynamics and wage claims may take over from supply chain issues as they key driver of inflation trends. However, ongoing cargo bottlenecks and the need to replenish inventory could sustain cargo shipment costs a while longer in 2022.

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