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January 22, 2024 | U.S. Equity
Red Sea Rising: The Investor Impact

PORTFOLIO SPECIALIST

Rob Lanphier, partner, is a portfolio specialist for William Blair’s U.S. growth and core equity strategies. Previously, he was a portfolio manager on William Blair’s Mid Cap Growth, Small-Mid Cap Growth, and Small-Mid Cap Core strategies, all of which he co-founded. Before that, Rob was with William Blair’s sell-side institutional sales group for eight years. He joined William Blair in 1987. Before joining the investment industry, Rob was with Emerson Electric Corporation for nearly six years. He received a B.S., with honors, from Purdue University and an M.B.A. from Northwestern University’s Kellogg Graduate School of Management.

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While globalization has benefited consumer and commercial establishments for thousands of years, it has begun to slow down in recent years, facing increased backlash as supply chains experience various kinds of disruption.

COVID-19, tariffs, geopolitical tensions, government-driven financial incentives, narrow cost spreads with developing regions, and increasing demands for just-in-time (JIT) deliveries have all contributed to contracting supply chains, which we believe to be accelerating and secular in nature.

As 2024 gets underway, global supply chains are facing a new hurdle, as tensions in the Red Sea have caused severe shipping disruptions and delays.

Below, I answer several critical questions about the Red Sea crisis to better understand the potential global financial impact.

Daily news demonstrates a deteriorating situation for commercial shipping in the Red Sea, especially over the past month. Why is this happening and how long might this continue?

At a high level, the Yemen-based Houthi rebels are one of several militant groups that the Iranian government finances in its fight with Israel and its allies, and the group has been attacking vessels passing through the Red Sea. Because of Yemen’s strategic geography at the southern mouth of the Red Sea, the rebels can effectively bottleneck international shipping through the Suez Canal.

Roughly 15% of total global sea trade goes through this corridor, and shipping rates from Asia to Europe have tripled since October 2023. How long this can last is unknown, but the trend in recent weeks suggests a broader regional conflict may be emerging.

How is this disruption affecting container ships, which are the primary means for globally transporting supplies via oceans, as they navigate the Suez Canal?

Container shipping through the Red Sea has essentially ended at this time, despite the United States and Western allies implementing Operation Prosperity Guardian, a multinational military operation, to safeguard vessels through this region.

With container shipping traffic being reduced by an estimated 90% already in January, what initial implications does this have for the shipping industry and the movement of goods on a global scale?

It is true that there has been a substantial reduction in Suez Canal container traffic in January, but as of this writing, dry bulk carriers holding chemicals, grain, steel, and coal and tankers carrying oil and liquified natural gas have seen a reduction of closer to 50%.

Regardless, the trends are clear: If this crisis continues, the ongoing impact of rerouting shipping traffic around the Cape of Good Hope will be significant. We’ll likely see weeks-long delays, higher fuel and labor costs, restricted insurance and reinsurance offerings, higher air freight rates, and global supply chain disruption.

If this crisis continues, the ongoing impact of rerouting shipping traffic around the Cape of Good Hope will be significant.

Carriers (companies that transport product) will likely pass these costs through to shippers (companies that pay to have product transported) via surcharges, despite many shippers having longer-term contractual agreements in place. And depending on the length of this conflict, consumers could ultimately see higher prices, as these events are inflationary in nature.

The Red Sea crisis also furthers the secular shift to onshoring in both U.S. and European companies. European manufacturers and consumers will be more exposed to these inflationary pressures, as a disproportionate amount of Suez Canal traffic is destined for European, rather than U.S., ports.

And should this conflict continue, all global markets will likely be negatively impacted. Already in January, we’ve seen European automobile and tire manufacturing companies announce plant closings given disruptions to their tight JIT supply chain requirements.

What remains unaddressed thus far is the financial impact on companies receiving delayed shipments. While carriers are presumably transferring these costs, how might this uncertainty affect the financials of shippers?

As for the financial impact on shippers, we likely won’t see much evidence in fourth-quarter reporting. However, to the extent companies have direct, or even indirect, exposure to these supply chain disruptions, we should begin to hear cautionary management comments in their outlooks for 2024.

Companies that have pricing flexibility due to differentiated products or services will most likely be in a superior position than the average company, especially if cost pressures mount.

What can we expect to learn in the coming weeks as companies release their fourth-quarter earnings results? Could earnings and revenue be at risk?

We can expect to learn more after fourth-quarter reporting wraps up and questions emerge over Middle East exposure. If the Red Sea conflict persists and broadens geographically, the hypothetical canary in the coal mine may well be oil and gas prices within European markets, which have yet to inflate, but these markets receive significant volumes of energy through the Suez Canal.

As of this writing, oil and gas is abundant due to soft demand and excess supplies globally, but investor fear of a sudden energy disruption could turn this on its head.

Quality companies tend to have the ability to better navigate more turbulent environments by raising prices to offset higher costs.

How is this crisis different from the pandemic disruption for the global supply chain?

Unfortunately, the difference is unknowable today. But we can conclude that if the Red Sea conflict broadens and lengthens in duration, freight rates will likely further escalate—whether by sea or air—and insurance/reinsurance underwriting tightening could continue. In general, global supply chains are likely to face increased pressure and incremental inflation and thus, the global economy could suffer.

What are the potential portfolio implications?

Our portfolios are not immune to global conflicts that impair supply chains and hit consumers’ wallets. However, understanding the extent of this exposure, both within companies’ supply chains and customer bases, will be critical.

Equally important is the pricing flexibility that above-average quality companies often enjoy. While this may not guard against top-line pressure in a potentially slowing economy—inflationary pressures could keep interest rates higher for longer—it does create some relative margin protection. Quality companies tend to have the ability to better navigate more turbulent environments by raising prices to offset higher costs.

Rob Lanphier, partner, is a portfolio specialist on William Blair’s U.S. growth and core equity team.

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PORTFOLIO SPECIALIST

Rob Lanphier, partner, is a portfolio specialist for William Blair’s U.S. growth and core equity strategies. Previously, he was a portfolio manager on William Blair’s Mid Cap Growth, Small-Mid Cap Growth, and Small-Mid Cap Core strategies, all of which he co-founded. Before that, Rob was with William Blair’s sell-side institutional sales group for eight years. He joined William Blair in 1987. Before joining the investment industry, Rob was with Emerson Electric Corporation for nearly six years. He received a B.S., with honors, from Purdue University and an M.B.A. from Northwestern University’s Kellogg Graduate School of Management.

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