Will rising interest rates slow investment in newbuildings?

The US Federal Reserve increased interest rates by 0.75% last week, as has the European Central Bank, while the Bank of England followed with a 0.5% increase before being blindsided by the government raising borrowing to pay for tax cuts for the highest earners, which has crashed sterling. Some 16 countries globally are reviewing their interest rates last week and this week. I’ve been asked by several contacts if the rising cost of debt will slow down investment in newbuildings, particularly with new technology. This question arises from time to time. Most investors I’ve spoken to over the years say that the interest rate on debt won’t deter them from an investment unless it’s extremely high. How high is high? Well, back in the 1980s and 1990s when interest rates were above 10% for years, newbuildings were still being built, though the freight markets were “pretty crummy” in the memory of one broker I spoke to.

According to analysis by Bloomberg (see chart 1), interest rates are rising faster than they have in any previous economic cycle since the 1982 recession. That recession was caused by the conscious efforts of the US Federal Reserve, then chaired by arch-monetarist Paul Volcker, to cut inflation by reducing money supply, even if that meant a recession and rising unemployment. The Federal Funds rate (the cost of borrowing for US banks) went from 11.2% when Paul Volcker arrived in post at the end of 1979, to 20% by June 1981. Accordingly the US S&P 500 fell for 451 days from 28 November 1980 to 22 February 1982. US unemployment rose to a peak of 10%. And as we now know, its steel and auto manufacturing cities never fully recovered.

Chart 1 – Up, Up and Away!

The same monetarist medicine was prescribed by the UK’s Thatcher government. It led to 3 million unemployed and the closure of large portions of what remained of the UK’s manufacturing sector, including most of its shipbuilding capacity in a decade which the UK began as a top three ship building nation and a top five global exporter overall. Was that a good idea for the UK? Another Conservative government won the 2019 general election in part on a ‘levelling up’ policy aimed – 40 years later – at overcoming some of the lasting income disparity caused by the loss of manufacturing jobs in the North of England. The latest iteration of Conservatives under Liz Truss has quietly dropped the levelling up agenda and is focusing on what it describes at Thatcherite tax cuts, though its fiscal lassitude has caused tut-tutting among orthodox Monetarists.

There are some other parallels between now and the early 1980s. There was then the backdrop of the 1979 Iranian revolution and sky-high oil prices. Now we have the Ukraine War and sky-high natural gas prices. There was strife in Eastern Europe as the Polish trades union Solidarity was causing problems for Poland’s hard-line communist government which later declared Martial Law. President Carter introduced a “selective service” draft in the US for all men aged 18-25, after Russia invaded Afghanistan on 24 December 1979. 66 countries boycotted the summer Olympic games in Russia in protest at the invasion. The Cold War reached its anxious apex as US intermediate range cruise missiles were deployed in Western Europe, much as Russia is deploying its versions to Kaliningrad today.

The early 1980s like today was an era of technological advances relevant to shipping. The first NAVSTAR satellite was launched in 1978, becoming the foundation stone of today’s GPS hardware. Personal computers were on sale to consumers by 1980, though one had to type in the binary codes or use BASIC programming language to get them to do anything. CDs and VCRs became available, and were quickly being used to record and store ships’ operational data, economic data or industrial data for analysis. Graphical User Interfaces such as Microsoft Windows launched in 1985, nearly two years after the Apple Macintosh was released, releasing humanity from having to type commands into PCs. Computers as we understand them – devices for communicating and for modelling reality - began to appear on the desks of shipping executives and on the bridges of ships.

Following the oil price crises of the 1970s, ships’ fuel efficiency improved considerably. Between 1977 and 1987, for instance, tanker sizes increased while their speed and main engine power decreased, according to Jasper Faber and Maarten ‘t Hoen of consultants CE Delft, in their 2015 report “Historical Trends in Ship Design Efficiency”. They report that bulk carriers became 28% more efficient during the 1980s, while “the most efficient container ships were built in the 1980s. In the subsequent decades the design efficiency deteriorated.” Until alternative, carbon-neutral fuels become available at scale, decarbonisation is all about efficiency, be it from fuel use or non-fuel technology.

While the communications technology has evolved unimaginably in 40 years, monetarist orthodoxy has not. There are relatively minor differences between central bank practices now and in the 1980s Granted, interest rates are currently negative in real terms (that is, well below the rate of inflation) whereas in the 1980s they kept pace with inflation, wiping out borrowers but pleasing savers. Most banks today expect the Fed Funds Rate to peak at between 4% and 5% in late 2023 – considerably lower than their peak of 20% in 1981.

The key similarity is that monetarism is still the dominant economic theory. It states that inflation is always and everywhere due to a surplus of money supply. To cut inflation, central banks cut the money supply. This raises the cost of borrowing, kills off indebted and unproductive businesses, cuts investment and cools demand in the economy. Eventually inflation falls and central banks can open the monetary tap again.

If the Federal Reserve and other central banks – regardless of the political system in which they operate – apply monetarist orthodoxy, then interest rates could swell past 4% until they meet inflation coming the other way. The cost of most industrial commodities and metals has already peaked, back in March this year, as predicted by the Baltic Dry Index which peaked about 90 days earlier.

Chart 2: Shipping Freight Rates and Industrial Metals Prices

Borrowing money to build ships is becoming more expensive, just as input prices (steel, energy) may be peaking. Newbuild prices have been fairly flat since March this year though at elevated levels, with a new Capesize bulker costing perhaps USD 67 million, compared to a low of mid-30s back in 2016. VLCC newbuilding prices are rated by most brokers at around USD 120 million compared to lows of perhaps USD 80 million a few years ago. Even if input prices fall, we might expect ship yards to keep prices high and improve their margins rather than pass on discounts to customers. After all, newbuilding berths availability is low until 2024. When lead times are above 24 months, ship prices tend to rise. When they decline to around 18 months, prices tend to slump. We are not in a falling price scenario today.

So a ship owner looking at ordering a newbudling will look at interest rates, but will be more interested in the price of the newbuilding. Which brings us to foreign exchange rates.

In the last 12 months, the Japanese yen has depreciated by nearly 30% against the USD. To put this another way, a ship paid for in yen is 30% cheaper for a USD buyer than it was a year ago, if it is the same price in JPY. The incentive to talk to Japanese yards is clear. In fact the yen has fallen so far – it is at the lowest level since the Asian financial crisis - that the central bank has intervened and begun to sell dollars for the first time since the late 1990s.

Chart 3: JPY per USD, 12 months to 22 September 2022

Meanwhile the Korean Won has fallen 20% against the greenback over the last 12 months, breaching 1,400 to the dollar for the first time since the global financial crisis of 2008. South Korea’s finance minister, Choo Kyung-ho, said on 22 September that the central bank would seek to stabilise short term volatility in the currency. This presents a problem for Korean shipbuilders, who tend to quote prices in dollars. They do not enjoy the same forex benefit as their Japanese competitors, though they have suffered similar levels of input cost inflation in 2021 and 2022.

Chart 4: KRW per USD, 12 months to 22 September 2022

The Koreans must also compete with the Chinese, whose central bank allows the currency to trade within only a limited band against the USD. Even so the CNY has breached the 7:1 level against the USD in September 2022, a level reached last in February 2020 as the pandemic spread world-wide. Before then, the CNY was last this cheap in May 2008 as the GFC spread world-wide.

The biggest difference in shipbuilding between 2008 and today is that Japan has lost first place in output to China, falling to third behind South Korea which retains second place. Japanese shipyards might enjoy their weak yen benefit, but more than half their orders are for domestic buyers now, so the benefit is limited.

Chart 5: CNY per USD, 12 months to 22 September 2022

So, ship owners considering an investment in a newbuilding will pay a bit more in interest but the actual cost of the vessel is of greater concern to them. They will be even more interested in how the ship will be employed. Will it be on time charter? Rates for tankers are rising but falling for containerships and may have bottomed out for bulk carriers. Will it go into the spot market? If so, will an A, B or C rating on the Carbon Intensity Index give it competitive advantage, and earn it a premium on the spot market, to ships scoring