I've been asked several times over the last month if ship owners should be worried about rising inflation. I take this to mean two things. Firstly, does inflation (i.e. a decline in the value of a unit of money) signal a weaker freight market? And secondly, does inflation suggest higher interest rates and a higher cost of capital for ship owners, increasing the total cost of ownership?
And when we talk about inflation, what inflation are we talking about? I guess most people are referring to consumer price inflation – the cost of goods in the shops. But we might refer to CPI in the US, or another nation, or group of nations, or globally. We might refer to commodity price inflation, or changes. We are probably referring to the US dollar though, and we imply US retail inflation, and the Federal Reserve's monetary policy response, i.e. how it adjusts the Federal Funds Rate – the interest rate at which banks lend to each other – to try to manage economic activity and, according to Monetarist theory – manage inflation.
Nonetheless, it may be worth considering how different types of inflation relate to freight markets. As our benchmark for the latter, let’s use the Baltic Dry Index. Using data from the IMF's World Economic Outlook, we can compare the BDI with different measures of inflation. On an assumption that they might be relevant, I chose to compare the BDI with inflation in emerging markets, in emerging Asian markets, in advanced economies and in the US.
I have used annual averages of the BDI and annual inflation data from 1986 to 2020, years in which the two time series overlap.
Here are the correlations between the different inflation time series and the BDI:
Price Index BDI
Advanced Economies Inflation -9%
Emerging and Developing Economies Inflation -19%
Emerging and Developing Asia Inflation -7%
US Inflation 20%
The biggest correlation with the BDI is to US inflation, a 20% positive correlation. This means that when US inflation goes up, there is a weak positive link between it and freight prices. This makes sense intuitively: inflation in the US is a result of strong demand and loose monetary policy. More dollars in circulation tend to imply a weaker dollar, which pushes up commodity prices. Shipping freight prices are traded like a commodity and priced in US dollars, so they tend to go up as well.
For 20 years now I’ve regularly shown people a chart displaying the link between a weak dollar and stronger shipping prices, like this one:
The chart shows that a weaker dollar (more dollars per euro) tends to coincide with higher BDI levels. Correlation of course is not necessarily causation. But this relationship has been fairly steady over time. You can use it to make predictions about freight markets, because while freight markets are hard to predict, most banks make predictions about the value of the USD versus the euro. So if your bank is predicting a weaker dollar later this year, then past evidence suggests that there is a good chance that the BDI will go up.
The next biggest correlation is a negative one of minus 19% between inflation in the emerging and developing economies and shipping prices. What’s going on there? Well, those economies had volatile inflation until the 1990s when they began to globalise, relaxing labour market controls, allowing foreign direct investment and releasing central banks from government control so they could adopt monetarist dogma. This resulted in lower inflation and more stable economic growth – just the conditions in which demand for agricultural and industrial raw materials grows, hence the shipping booms of the 1990s and 2000s.
The bottom line on the relationship between inflation and freight markets seems to be that shipping markets are cyclical and that they react to cycles in in inflation rates and monetary policy, roughly in phases like this:
1. Freight markets do well when the global economy is growing above its long-term average (about 3.4 per cent per year).
2. Stronger than average economic growth tends to result in higher inflation as demand for stuff goes up – including ships ordered using the profits earned in the above-average growth phase of the economic cycle.
3. Central banks manage inflation using monetary policy by increasing the cost of borrowing, reducing economic growth rates back to (and often below) their long-term average.
4. Slower economic growth rates tend to result in weaker freight markets.
5. The weaker freight markets are compounded by the arrival of ships ordered during the second phase.
6. Central banks react to slower economic growth by lowering interest rates, reducing the cost of capital goods investment, leading to greater production and stronger economic growth.
Inflation does tend to result in higher interest rates. So should ship owners seeking capital at the moment be worried? After all, the Fed and other central banks appear sanguine about high inflation levels at the moment. They think that these are the result of higher demand for infrastructure and raw materials, demand based on loose fiscal policy as governments try to spend their way out of the pandemic. So interest rates don’t look like they are going up any time soon.
In a ship owners’ panel pre-recorded this week for an upcoming conference, which I was moderating, I asked the panellists if they thought higher inflation might prevent more contracting of ships, or reduce investment in second-hand vessels. The consensus was negative. As one panellist put it, if a prospective investment depends on low cost of finance, then the business case probably isn’t very strong. Put another way, the cost of debt is not top of ship owners’ concerns when they plan fleet renewal. Perhaps if interest rates go back into double figures one day, that rule of thumb might be updated. But for the foreseeable future, there does not seem to be a good reason for ship owners to fear inflation.
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