Escalation risk in the Red Sea and GCC economies

Reuters

What does the Houthi leaders’ threat of a “big response” to the US and UK airstrikes in Yemen mean for the escalation risk to the global economy, and the economies of the GCC?

The Anglo-American airstrikes on Houthi missile launch sites, weapon depots and command bunkers in Yemen were well-telegraphed, which accounts for the muted response in the price of gold and other safe haven assets.

Even Brent was not able to hold its initial rise to $80, and closed the session at $78.30. However, the latest twist in the Red Sea saga represents an escalation in the fragile geopolitics of the wider Middle East, given the violence in Gaza, south Lebanon, Iraq, Syria and even Iran which we have seen in the past month.

• The Red Sea: a cautionary tale
• Fears of supply disruption push crude prices over $80
• Geopolitical risk will shape next twist in crude oil prices

While the supply and demand fundamentals in crude oil are unquestionably bearish, the coalition’s airstrikes in Yemen increase escalation risk.

The Houthis have promised to retaliate against international shipping in the Red Sea and could even target US and British military assets in the wider Arab world.

This implies that geopolitical risk will move Brent above $80 a barrel. If the conflict is protracted, threats to the oil supply may even take prices as high as $90 a barrel. 

This is a classic exogenous event that increases inflation risk in the industrialised West. It reduces the odds of a Federal Reserve rate cut until at least the June Federal Open Market Committee meeting and unsettles business sentiment in Saudi Arabia and the Gulf states.

The Wall Street consensus is that Jerome Powell at the Federal Reserve in Washington has successfully navigated a lower glide path to consumer inflation without a significant increase in the unemployment rate.

A spike in oil prices threatens this Panglossian “soft landing scenario” because it raises inflation risk and at the same time undermines consumer and business confidence. IMF projections for global economic growth in 2024 are in any case hardly optimistic, at 1.5 percent. 

Return of recession

If the Houthi leaders’ threat of a “big response” to the US and UK airstrikes escalates into a military quagmire in Yemen, recession will return to haunt the global economy.

A recession in 2024 will likely be far less brutal than the tech meltdown of 2001 or the housing and credit debacle of 2008, let alone the Covid pandemic slump of 2020. But it will come at a time when the US budget deficit is $1.8 trillion in a $25 trillion economy, and where Federal debt is a staggering 125 percent of GDP.

In the foreign exchange market, the US dollar has fallen 5 percent on a trade weighted basis since November. The GCC currencies are pegged to the US dollar.

So the GCC economies face higher inflation as the greenback depreciates, because the region’s imports primarily originate from Europe, Japan and Asia.

A rise in crude oil prices mean a mini-inflation shock in the US. If this happens, US interest rates will move higher. If the yield on the 10-year US Treasury bond rises to 5 percent, the entire planet’s cost of capital will ratchet up, to the detriment of risk assets such as equities, corporate bonds and real estate trusts.

For the GCC, the logic of the US dollar currency peg means that central banks are forced to shadow US interest rates.

If the Red Sea crisis forces the Federal Reserve to postpone cuts in its overnight borrowing rate and Treasury bond yields move sharply higher, the Gulf central banks will also be forced to opt for tight money and engineer a liquidity squeeze in the local banking system.

This means the burden of macro adjustment is borne disproportionately by the equity and property markets.

There is also a distinct macroeconomic linkage between the Red Sea crisis, on the one hand, and the planned multi-billion dollar Saudi tourism projects and the off-plan property euphoria in New Dubai on the other.

The Red Sea crisis has exposed the Achilles heel of world maritime trade, threatening the oil tanker traffic routes from the Gulf’s oil terminals via the Suez Canal to refineries in the Mediterranean.

Houthi attacks on commercial shipping in the Red Sea impose stress on both global supply chains and threaten seaborne exports of crude oil, LNG and petrochemicals from Saudi Arabia, the UAE, Kuwait, Qatar and Oman.

It is no coincidence that dozens of nations have signed up to the US-led naval flotilla which is confronting the Houthi threat in the Red Sea.

Matein Khalid is the chief investment officer in the private office of Abdulla Saeed Al Naboodah and the CEO designate of a venture capital firm. He is also an adjunct professor of real estate investing and banking at the American University of Sharjah