Welcome to Asset World
(Article originally published in Jan/Feb 2022 edition.)
Asset prices are on the rise, signaling a new wave of inflation.
Federal Reserve Chairman Jerome Powell and his counterparts like European Central Bank board member Fabio Panetta have described inflation as “transitory” again and again, but that well-worn term is starting to sound almost as out of place as “fifteen days to slow the spread.”
Maybe inflation is here to stay? Nobody believes that prices will go back to the level they were at in 2020. That would require deflation, where the cost of goods and services trends down, not up.
In that scenario, consumers delay purchases and save money because whatever they are planning on buying will be cheaper down the line. This puts pressure on businesses facing top-line revenue reductions, compelling them to cut their bottom-line costs to stay afloat. That means negotiating lower prices with their suppliers, which perpetuates the same problem downstream. Or what is far more likely, businesses cut costs by firing workers and shutting down sites.
Friendly reminder: The goal is to have stable, Goldilocks prices. This traditionally has been understood as prices rising two percent or less in a given year. The U.S.’s 10-year inflation average for the years 2011-2020 was 1.75 percent; for the Eurozone, 1.28 percent. In other words, in Europe and America central banks have done a decent job.
We’ve all gotten used to the idea that, from one year to the next, prices may go up a little, but there won’t be any sudden or surprising movements.
At least until now. Year-over-year inflation for 2021 hit five percent in the E.U. and seven percent in the U.S., shooting well past anything anyone regards as acceptable. Quarter by quarter, both economies racked up numbers not seen since the 1980s. Is this still “transitory”?
Word on the street is even more dire. Some older cars are selling for more than they cost when they were new. And dealerships are selling out of new stock as soon as it arrives, perhaps because the manufacturer’s suggested retail price for a new car is cheaper than buying a used one. Martin Weiss of Deutsche Automobil Treuhand (DAT) remarked: “The price increases are often five to 15 percent. In individual cases they can be significantly more. It’s crazy what we’re seeing.”
And that’s another facet of inflation: If prices don’t move up fast enough to stay in line with the market, the result is a shortage. People snap up assets because they immediately feel the value. This depletes the supply chain, which has trouble replenishing itself with new product because the cost of production has, in the meantime, gone beyond the revenue generated at the final point of sale.
When this self-reinforcing price spiral becomes sufficiently powerful, it compels companies to increase prices faster and faster – quarterly or monthly, rather than once a year.
Take Hyundai Heavy Industries (HHI), South Korea’s largest shipyard, where newbuild prices are up 12 percent year-over-year. HHI was paying more for steel plate to fill its existing orders, so it suffered a loss. Steel plate makes up 90 percent of the material used in fabricating a typical commercial vessel.
HHI’s situation – prices for its products are up but its bottom line is underwater – is what triggers the inflationary spiral. Shipbuilding contracts are normally divided into four parts with specific triggers: a down payment due upon signing, a second installment due upon cutting the first steel plate, a third installment due upon keel-laying, and the remainder due upon launch. All of these installments add up to a single, total price for the newbuild, which is usually non-variable.
This model works in a low-inflation environment with stable costs. An owner could calculate a price, obtain financing and then, ideally, amortize the vessel via a long-term charter party after paying the shipyard. To avoid the situation HHI is in now, wherein it absorbs the shock from rising steel prices, it will need to contractually offload those price problems onto the owner.
Two possibilities are available. First, the price of the newbuild doesn’t need to be quantified up front; rather, it can move in line with the market and the owner will only know what his ship will cost after it finally launches. Typically, this construct is achieved by building price adjustment clauses into the shipbuilding contract requiring the owner to cover costlier materials or even higher labor costs and new taxes and fees.
Second, cost-plus contracts may come into vogue, which require the owner to reimburse the shipyard for all of the vessel’s building costs plus guarantee a fixed, predetermined margin of profit for the yard.
Both of these contractual mechanisms protect against inflation but make life hard for the buyer. Especially tricky is the fact that the owner will only be able to quote a charter party rate after the newbuild is launched since any risk in the commitments made to the shipyard will need, in turn, to be passed on to the charterer. Thus, the charterer will necessarily pass that risk on to the cargo side, i.e., to shippers, who will, spiral-style, ask consignees for more money. This is what is meant by “perpetuating the same problem downstream.”
While the global orderbook for newbuilds was at a 31-year low in January of 2021, this has totally reversed since. Peter Sand, BIMCO’s chief shipping analyst, summarized the situation by saying, “Going into 2021, the orderbook only stood at 2.5 million TEUs. Since then, a record-high 3.3 million TEUs have been ordered.”
A byline from Lloyd’s List recently warned: “New capacity on order risks flooding the market when it arrives in 2023.” From zero to hero, shipbuilders are looking back on what has been called a “spectacular year.” It’s just a pity that inflation has taken the profit out of it.
So why not just buy an older vessel and avoid all of this hassle and uncertainty? Well, in April of 2021 Clarksons reported that its secondhand index was up 33 percent year-over-year – as the overall total value of the global merchant marine fleet surpassed $1 trillion. That 33 percent increase is even higher than the 12 percent premium you’d be paying as a customer of HHI, so maybe waiting for the yard is worth it.
This is starting to feel very familiar – like deciding between a new or used car, maybe? The fact that, as time passes, these problems are being identified industry by industry is a bad sign. Because the reality is that they are shared, that they affect all sectors and that they are becoming secular.
In terms of the global economy, practically all the control panel status lights are blinking red. The IMF reported at the end of 2021 that the response to COVID-19 in 2020 was the “largest surge” of public debt in 40 years, spiking sharply to just under $250 trillion worldwide. And that doesn’t account for 2021, a year in which spending was even higher.
At the same time, global incomes are down for the second consecutive year. Irrespective of whether you are rich or poor, you’re worse off now than you were two years ago – again. The biggest declines perversely affected the poorest quintile of earners with a 6.7 percent drop in 2021. And military tensions, like those between Russia and Ukraine, are rattling energy markets.
Other problems, like port congestion and cargo chaos, are no better than they were last year even though time has passed and solutions were tried. In fact, while last year’s focus was on blue water shipping, now truckers and railways are at risk too.
For two years now, the word “transitory” has been used to describe all kinds of problems –lockdowns, shutdowns and quarantines, shortages, shipping delays, inflation, runaway spending. Anything “transitory” is relatively easy to rationalize. But when it becomes apparent that a situation is not “transitory” but rather reflective of a new status quo, of a new normal, it can trigger a shift in thinking and perspective that may often lead to different behavior.
How should we act in a world that is staring down the barrel of heavy inflation and higher taxes in order to both dilute the value of and help service debt? In the face of price uncertainty, where money spent now is worth more than money spent later, and assets store value rather than depreciate? Of shortages that are worsened by the knowledge that shortages are all but inevitable, so buyers will walk out with everything that’s available for sale – and it’ll cost more tomorrow, anyway?
When incomes grow lower every year as one Band-Aid after another fails to fix the fundamental problem, which is that the delicate Humpty Dumpty of the just-in-time economy is broken and there’s no decent replacement yet, will we just have to make it work with the bits and pieces?
A feedback loop is when a part of a system’s output is used as input for that system’s future behavior. The worldwide reaction to COVID-19 has become a latticework of externalities that are now governing our day-to-day decisions.
The way out will be hard, but it will probably first be found in the price of a container from Shanghai to Rotterdam. All the upstream and downstream risks and all of the costs – for the vessel, bunkers, labor – will be priced in. Unlike governments and central banks, that container will be telling us the unvarnished truth.
That’s going to be one expensive container. And it will only be the first of many.
The opinions expressed herein are the author's and not necessarily those of The Maritime Executive.