Red Sea Disruptions Could Dampen the European Economy

The recent attacks in the Red Sea have led to shipping disruptions and increased costs; on routes between Asia and Europe the costs have more than doubled.¹ According to research by the International Monetary Fund, when global freight rates double, inflation tends to pick up by 70 basis points (bps) in the subsequent 12 to 18 months.² Furthermore, prolonged disruption in the Red Sea may force some European companies to downsize or halt production altogether.³ Many investors are considering if and how this all could affect the European Central Bank’s (ECB’s) policy-rate trajectory.

We examined two possible downside-risk scenarios related to surging freight costs:

• Delayed rate cuts: Higher freight costs push up inflation and ECB rate cuts are not expected before the third quarter of this year. The impact on the economy and risk assets is muted.
• Minor economic damage: Surging freight costs contribute to higher inflation but also cause some damage to the European economy. The ECB rate cuts come later than current market expectations, but sooner than in the first scenario because of the economic slowdown.

The scenario shocks, shown below, are propagated to a hypothetical portfolio of European equities and bonds. The loss on such a portfolio could range from 2.5% to 5.1% under the “delayed rate cuts” and “minor economic damage” scenarios, respectively.