It's Friday the 13th of February and this is your capital economics weekly briefing. I'm David Wilder coming up the UK's political drama. It's by no means over but how much of a threat is it to the economy and markets. But first, Neil is off this week but I'm happily joined by North America economist extraordinaire, Stephen Browell. Hi, Stephen. Hi, David. We're hours away from the release of the January CPI report. With that in mind, I wanted to catch up on the story of the US economy so far. Last week or so, we've gone from the disappointments of various jobs measures, those December retail sales numbers to the joys that were January non-farm payrolls. Pull all of this together. Where does all of this flow of data leave us in terms of the health of the US economy? Well, I think the big pitchers were still in a good place. We did have the fairly weak retail sales reading for December. That comes after quite a string of positive readings. It still means that consumption growth is on track for a pretty positive fourth quarter. Indeed, our GDP estimate is still north of 3% annualised almost 4% for the fourth quarter. Where the story may start to look a little bit different is when we start talking about the first quarter. The weak growth in retail sales in December provides a weak hand over for the first quarter. We also know that motor vehicle sales fell quite sharply in January, maybe due to some extreme weather effects, but nonetheless, that's going to weigh on consumption. It does look like we're heading for a much softer first quarter for consumption, but with the usual caveats that some of that could be weather related. I think the big picture is that we're still seeing risk resilience in consumption. Although we've had one week retail sales report, that's not really enough to change about future share. What about all of this talk about a K-shaped economy? There is this idea that this K-shaped, the idea being that there's the top of the K, which is a higher income consumers who are also benefiting a lot from strong gains in the XC market until recently. Then there's the bottom of the K, the idea being this is lower income consumers. They don't really hold any assets. They've seen weight growth slow and obviously had to kind of born the brunt of the prior high inflation environment. There is some truth to this idea that the bottom of the K is struggling. Over the last year, we can see weight growth per income quartile and that's fallen fastest for the lower income group. We also know that inflation for that group is a touch higher on average. Their real purchasing power has taken the largest hit of any income group. We can also see things like credit card delinquency rates, which tends to be lower income consumers, those are still relatively high and indeed the kind of a stock of credit card that's highly delinquent is continuing to edge higher. There is this idea, I think there's some truth to the K-shaped narrative, but I think our sense is that it tends to be overdone when we look at what drove the earlier weakness in 2025, for example, that followed the crash on the stock market after liberation day. There was probably a lot more to do with higher income consumers rather than the bottom of the K. As long as we were in a situation where layoff are not picking up, which still seems to be the case, I don't think the bottom is going to fall out of the bottom of the K, is it worth? I guess against that backdrop, taking a face value, that January employment report is good news. It does show that there is life in the US labor market. That being said, though, I mean, there was also a lot of grumbling about that report as well, specifically revisions to last year's jobs estimates, which suggest that there was actually minimal jobs growth at best. How much of a good news story is the January report? How confident are we that it won't just get revised away? Yeah, I think the big picture is it was definitely positive, but nowhere near as positive as it looked, but there's a whole host of caveats really. On the revisions, those were substantial. We saw jobs grow, revised down from just under 50,000 a month on average in 2025 previously to now just 50,000 per month. But the kind of a bet of a silver lining is that where those revisions was that most of those happened in the first half of 2025. So when we look at the last couple of months of 2025 in particular, so November and December, the payrolls gains were revised down only modestly. So it does seem that there was a bit of momentum building. But some of the revisions to the sectors were quite encouraging too. So for instance, economists tend to look at temporary help as a kind of a sick co-indicator. The idea being those workers are easiest to lay off, but also easiest to start hiring again once demand picks up. And revisions mean that Bose temporary help workers that were previously falling, temporary out payrolls, I should say, at the end of last year, they're actually now picking up again and point to some further strength and broader payrolls going forward. Now that does also come with a caveat that that's not been a brilliant guy to be overall labor market in recent years, but I think it's still one positive sign. For January specifically, I mean, we had the big rise in private sector payrolls of 170,000, but 120,000 of that was healthcare. And you know, that's just a continuation of the story we've seen for almost two years now where healthcare has been driving the big picture. That still means private gains elsewhere, we're stronger than we have seen for a while. And again, there's the caveat that some of that is possibly weather related. So even though we had extreme bad weather at the end of the month in the US during the actual payroll period, which includes 12th of the month, it was slightly warm and unusual. And that may have explained the strength of construction payrolls in the report. But again, even looking through that, we had some health gains elsewhere, professional services in particular despite all the narrative about AI related job cuts. And I think the big picture is there does seem to be some momentum building, even if it's maybe not quite as strong as the headline figures suggest. Yeah, I, the professional services hiring, I, you know, as you say, this is just one report, but it is coming off the back of this acute anxiety about AI as a threat to the US economy. A day after we've had another grim day for US stocks because it fears about what AI is going to do to industry. So when we look at the labor market, there's been this big fear that we've been in a hiring freeze, I'm calling it a hiring recession. That activity we're seeing in, in professional services hiring. I guess the report goes some way to relieving that. Yeah, I think so. I mean, there's a lot of debate about to what extent AI would be negative for that sector. So on the one hand, obviously, we can all see the clear labor saving potential, particularly with the latest developments with some of the latest as well as sending the models away and just letting them work in the background. Clearly there's scope for that to displace some labor. On the other hand, when we look back at previous kind of tech booms in particular, the dot comb boom, the professional service sector did extremely well during that period because, you know, there's a new technology that companies need to learn to implement. That's not necessarily something that every company can do on their own. There's lots of scope for consulting work, for example, an all the work that will be done by the AI companies to promote their products to try and compete with the other offering. So in theory, there should be both positives and negatives for the labor market. And I think the latest data may be hints at the idea that some of the narrative are on the negatives is a bit overdone. That being said, you know, this is something we've looked at very closely and we can still clearly see the strong productivity effects, but negative labor market effects in the core tech sector, say things like software development, data system design, those sectors in aggregate are still shedding jobs and they have been for most of the past year. I wanted to get into that because what I think you're referring to there is that most recent quarterly GDP report, we have this big improvement in productivity growth. He said, this looks like at least some of this is the result of the diffusion of AI. There was a surprising amount of pushback from the market. Lots of people saying, no, no, no, this is just labor market dynamics of work. You've been suckered in by the AI narrative. So talk a bit more about what's happening there in terms of productivity growth and AI because it's critical, isn't it, in terms of the US economic outlook? Yeah, it's critical because the driver of the current strength of productivity tells us something about the possibility of that being sustained. One viewer's that this is just a cyclical upswing, almost a mechanical effect really. We had this hiring freeze in the first half of the year partly because there was quite a lot of excess hiring for one of the better term during the pandemic. So firms could afford to put the brakes on a bit. Because of that, as output has continued to expand, you get this mechanical increase in productivity. That's almost the bare case as it were because that would suggest that this strength of productivity isn't going to be sustained. And if anything, it could be swiftly reversed. Now we're seeing these signs of the pickup in payrolls. Our view is more positive in that we've dug into the sectors. So things like software, engineering, data processing, computer systems design. We can really see them in those sectors in particular. So the output is surging and payrolls are declining modestly. So it's really the case that the output is surging part, but it's encouraging that that's what's lifting productivity. And only modest job loss is really so it's not really feeding through to the wider labor market. There is still a lot of people.
bit over a new one. Some of that is, again, it's about, for example, we also include high-tech manufacturing and in most sectors it's a bit more of the uplift and demand, maybe lifting productivity, but eventually that could find a ceiling as it were. But then in the service sectors, it's a lot more about these advances in the models, allowing these firms to do a lot more with fewer staff. And that is really giving, I think, as a picture of what this could mean for other sectors, you know, other white collar professionals, other sectors in particular, that are only really getting to grips with some of this technology now. So we've encouraged that we're seeing it in the sectors that are designing and using the technology to begin with, and we expect that to broaden out in the next couple of years, therefore keeping overall productivity growth strong. And then the broad impact on hiring is, as you say, there's this concern that the ability to do much more with fewer workers, you would assume would leave companies think they could just slash payrolls, but the pictures much more nuanced than that. Yeah, exactly. And to some extent, it's as this technology arrives and there's a few kind of low-hanging fruit, we can automate a few basic tasks. We don't need to hire quite as many, maybe lower-level people, though that maybe only applies once, and then once you get a better understanding of how you can integrate with a technology and augment what your workers are doing more so, then you actually find your staff members are quite valuable, and you possibly even find other roles for them and other areas of expansion. So you know, there's two impactors, there's kind of a, as this technology gets cheaper, it does enable some labour-saving uses, but it also enables more output, and that output creates its own kind of demand for more workers elsewhere in the economy. So this productivity good news is presumably, if you're Kevin Wars, you're thinking this is all good news, aren't you? If he does get confirmed as the Fed chair to replace Jerome Powell, and he is charged with running the economy heart, especially in an election year, is this another reason for him to think that rates can be cut, and is he going to get his lower rates? We ask this question every week on the podcast, but just in light of the productivity numbers, in light of the payroll numbers, where do we stand in terms of where rates are going? There's two interesting parts of this. I think from the pure perspective of productivity numbers, that was kind of creating this idea that the labour market is looking a bit loose, but productivity is picking up, therefore unit labour costs, so basically the labour costs per GDP is growth and that is coming down, which is kind of a disinflationary indicator that typically proceeds softer inflation. So from that perspective, productivity gains are quite good news for Wars in terms of trying to push through some further cuts, but I think getting maybe a sense of a narrative shift, so again, it's only one month of data, but the other key thing in the January employment report was to drop back in the unemployment rate to 4.3%. Now again, there's a big caveat here, that it was driven entirely by youth unemployment and that sub sector tends to be very volatile, it may well just be reversed in the February report, but if that were sustained, or even if we saw the unemployment rate coming down again, then people would maybe start talking about actually AI is having these broadening demand effects, or at least we're seeing a reversal of some of these other factors that were weighing on demand of 2025, and in fact, we could be heading for a repeat of the dot-com boom in that we had this big tech investment at the same time as lower interest rates, with supporting the rest of the economy, that drove the unemployment rate down, kind of far below estimates of its long run level, and eventually caused the Fed to hike again. Now obviously that isn't our forecast, we still have one cut in, a little less on market to expect, but I think we should definitely be on the lookout for these narrative shifts in the labour market, given what we've just seen in January. I mean, is there a risk that we won't get any rate cuts at all? Yeah, I mean, certainly there is, but conscious we're speaking ahead of the January CPI data, so that's obviously a potential narrative changer again, but the big picture here is that the unemployment rate is broadly in line with its long run level, or at least with a Fed's estimate of a longer level. The Fed thinks inflation is on a path back to 2%, once we take out tariff effects, and in that environment, the Fed would typically set up the Fed funds at its estimate of a neutral level, which typically implies one or two more cuts, which indeed is the reason the Fed is projecting that over the next couple of years. What could change to mean the Fed doesn't cut? Well, there's a few things, one is that the unemployment rate could just keep falling. Another one would be that something else changes to make the Fed concerned that inflation isn't coming down as quickly, so if in January's print or in the next few prints, we see say services price growth pick up again, that would go against this idea that high productivity is actually set to drive down services inflation. And then the final factor would be the Fed could just decide that actually the neutral rate isn't quite as low as it currently estimates, so it might do that, for example, with GDP growth, where to remain very strong in the first half of this year. But again, given that we just had that kind of week retail sales report for December, it does seem likely that GDP growth is going to slow a bit further. It's clear, isn't it, that Trump wants the economy to be run very hot? And so whatever constraints come through in terms of the labor market or inflation, they're not going to wash in the overloathe. No, exactly. And I think from the administration's perspective, there are still areas of the economy that are doing quite poorly, partly due to higher interest rates, so housing construction are the obvious examples. The debate therefore becomes, do those sectors need to be kind of operating below their potential in order to keep the overall economy in line with its potential because of the AI boom? Or actually, is the AI boom not that inflationary at all, when it's anything a bit disinflationary? Which of a moment it looks like it could well be. And therefore you could afford to run the economy a bit harder by lifting these sectors that are still doing a bit poorly at the moment. And that seems to be the narrative that's going to win out among the FRMC this year, which is why we're still expecting a cut despite some of these green shoots now emerging. Stephen Brown on the Fed on AI on the latest data and on the US economic outlook. After we spoke, we got that January CPI report, which showed the annual rate of course CPI inflation falling back to 2.5% from 2.6%. But Paul Ashworth, our chief North America economist, warned in his response that our estimate of the Fed's preferred core PCE inflation measure jumped to 3% in January. The next official PCE data will be out next Friday, so do stay tuned. A few reports from the capital economics team for the past week worth highlighting. First is about what's happening in US equities. It's been a volatile start to the year and a lot of perceived risks to the outlook and a lot of that linked to AI. So it's head evaluations or mad levels of cap expending or the idea that this technology is a sector killer. So Tom Matthews, our APAC markets head has pulled together some thoughts on why we think that the tech led rally can resume and why that's going to mean another year of double digit returns for the S&P 500. The end of this rally will come but not this year is the team's message. Still, when the market does properly correct, is that going to plunge economies into recession? Jennifer McEun, our chief global economist, had a report out about that a couple of days ago. And finally, China's trade surplus, $1.2 trillion last year. Most think that this surplus is going to flatline this year, but William Jackson, who's our chief emerging markets economist, has a new note out explaining why we think different. One of the points he makes is that emerging markets are now absorbing the bulk of China's trade surplus, not developed markets. That marks a huge change in the global economy and it's one with profound consequences for the outlook. I'm going to link to all of these reports in the show notes, but if you do want copies, send me a note at
[email protected] and I can get you them. Now, as much as we want to look away from the seemingly endless and grim fast that is UK party politics, we can't. It can have implications for the economic outlook and for UK financial markets. The challenge to the leadership of Kierst Starrmer has faded as another tumultuous week comes to a close, but this drama is by no means over. Even if a semblance of calm is restored, and that's a big if, time seems to be running out for the Prime Ministers so investors need to know what the risks are of what follows. To find out, I spoke to Ruth Gregory, our deputy chief UK economist, and I started basking how long before this government falls. Yes, Starrmer has fended off the latest challenge to his leadership, but I think it's clear that his premiership does hang by a thread. If you look at the prediction markets, they're assigning more than a 50% chance that he'll be ousted by July and almost a 70% chance that he will be ousted by the end of the year. Now, if he is removed, I don't think we know how long it would be before he were replaced. I think if you look back, Theresa May was deemed to be finished after the 2017 Conservative election campaign, yet she staggered on for two more years. And I think if Starrmer is able to hang on in the coming weeks and months, then it's possible the economy may give him a bit of a helping hand we do this.
that inflation will fall to 2% in April and the interest rates will fall a bit further. But I think there are many more flashpoints which will really underline the precariousness of Starmer's position including the Gordon and Denton by election, which is on the 26th of February. The Chancellor's Spring Statement, which is on the 3rd of March and the local elections which are on the 7th of May. And I think politics does have its own timetable, doesn't it? We just don't know there could be another revelation in the Epstein files, there could be changes in Angela Reiner's tax situation for example. But I don't think it would be a huge surprise to anyone if Starmer and Reeves were not leading the government by this time next year. If they do get booted out, resign, stand out. What follows? What's the spectrum of risks? Because we're not political strategists, but there are clear macroeconomic implications here. So what is the spectrum of risks to the economy, to UK financial markets in terms of who could replace the Prime Minister and Chancellor? I think much will have much more clearly depend on who Starmer and Reeves are replaced by and what policies they run. But we have set out three main scenarios for the economy and the financial markets. The first is a status quo scenario in which Starmer is replaced by someone from the fiscally cautious wing of the Labour Party and fiscal policy is tightened as currently planned. And I think in that scenario, GDP growth, inflation, and great, they were very similar to our current forecasts. The second scenario is a model through scenario in which a top team is more inclined to raise public spending and less concerned about fiscal discipline. And I think in that scenario, fiscal policy might be slightly looser than currently planned. The implication for the economy is that GDP growth, inflation, and bank rate would all be a bit higher than otherwise. Now the third scenario is a, what we've called a mini, mini budget scenario. And that's a scenario in which a left-leaning top team weakens the fiscal guardrails, promises big increases in public spending and borrowing. And that might lead to a big loosening in fiscal policy. But if that is followed by a spike in guilt yields, which forces the government to reverse course and tighten fiscal policy to restore credibility in the eyes of investors, I think one way to characterize that scenario is, I think a political and market outcome that's worse than the 2024 Reeves budget debacle, but not as bad as Trostonomics in 2022. And I think the result would be GDP growth, inflation, bank rate, or all a bit lower than otherwise. Now, in terms of which scenario, I think, which, which scenario is most likely, I think, you know, since the new leadership would probably want to move in a new direction, if Starmer moves replaced, then our model through and our mini, mini budget scenarios are perhaps more likely than the status quo scenario. And that does mean that if Starmer and Reeves are replaced, then the odds are very much tilted towards looser fiscal policy and higher guilt yields. And a small move in that direction might mean GDP growth, inflation, interest rates are all a bit stronger than we expect. But if there were a big loosening in fiscal policy, then that could dampen the economy if it were to result in a spike in guilt yields in a repeat of the Liz Truss episode of 2022 or albeit on a smaller scale. So that's what we're expecting to happen. Sounds like when, not if they're replaced. The next leadership that comes down, what kind of economic picture are they going to be faced with? How has the UK economy been performing a vote? Yeah, well, if we look at the GDP figures that were released this week, the, I think, the big picture is the economy still has very little momentum. We saw a 0.1% quarterly rise in GDP in Q4, that disappointed expectations. And the drivers of growth look very narrow with most of the strength coming from the government sector. So I think the big picture is that private sector activity is still extremely subdued. And of the 1% growth that we expect this year, it's striking that we think that 0.8 percentage points of that will come from the public sector. Now the economy does seem to have started 2026 on a stronger footing. If you look at January's activity PMI, that suggests that growth on track to meet our forecast of 0.4% on the quarter in Q1. But the big pictures that consumer confidence are still pretty fragile. The labour market is quite weak. External demand is subdued. So we're not expecting any strength in the first quarter to be sustained throughout the year. And we do think that the economy will grow by a below consensus 1% this year and 1.2% next year. And we expect the Bank of England to cut rates further than most expect to 3% this year rather than to the lower 3.5% that investors expect. So certainly no great shake whatsoever. I mean, got a load of data in the coming week. Is any of that do you think it had changed the narrative for the better or worse? So we're expecting inflation, CPI inflation to perhaps tick down from 3.4% in December to 3.1% in January. But we're not expecting the big fall in inflation to 2% to come until the until the April figures. It's quite interesting on the public finances. I think January's public finances figures. I think it will be make or break month for the public finances. And that might show that public borrowing is finally coming in below last year's monthly totals. But I think that the risk of borrowing overshooting our forecast further ahead have grown with Starrer and Pley. A Reef's political vulnerability really casting doubt on whether that planned fiscal tightening over the next 5 years or so will be achieved. Does feel like even if Kierst Starrer gets replaced, even if the Labour Party gets replaced, that all of this dysfunction just isn't going to go away. Yes, there are political scandals, there are governance issues as well. But it feels to me like all of the what's happening in the UK is being fed by structural issues to do with the economy. The fact is you say that growth is basically going nowhere, even as spending demands just keep growing. It's not just a UK story, is it? But for the UK itself, whether it's the Labour Party, the Conservatives, the Reform, Under Nigel for us, whoever we get, we're going to be dealing with these structural issues, aren't we? Yeah, I think that's absolutely right. We don't think that the fiscal arithmetic will improve anytime soon. If you look at our forecast for guilt yields and for nominal GDP growth, we actually think that the 10 year guilt yield will exceed nominal GDP growth in the UK until the early 2030s. And that does mean that the government needs to reduce the budget deficit to keep the UK's debt to GDP ratio stable. The pressure to increase government spending will only grow, as you said. The aging population puts upward pressure on healthcare and pension spending. We've got geopolitical risks putting upward pressure on defence spending. And defence spending will need to rise significantly if the government's going to meet its ambition to raise it from 2.3% of GDP in 2023 to 24 to its ambition of 3.5% by 2035. And that would cost about £32 billion in today's money. And all this is happening at the same time as the pressure to deliver better public services in the UK is rising. So it's certainly a very challenging fiscal picture there. I've won area where we're perhaps a little bit more optimistic is our expectation that GDP growth in the 2030s might rise to an average of around 2% in the UK as our AI economic impact index suggests that the UK might benefit by more than most other economies from an AI fueled booster productivity growth. So that does have the potential to offset the negative impact on on labour supply from things like the aging population. Now of course we're already beginning to see an AI investment boom driving growth and powering growth in the US. We're not quite at that stage yet in the UK but I think perhaps the most pleasant surprise for the UK economy over the next few years would be if that boost would have started to be felt a bit sooner in the UK. I'm so glad that Ruth Gregory ended that conversation on an optimistic note. It's so easy to get despondent about the UK economic outlook. So as I hope you heard there is a chance for a breakout from the current low growth morass. The capital economics AI economic impact index or CEAII as no one is calling it measures nearly 50 of the world's biggest economies by their ability to develop diffuse and adapt to this emerging technology. The latest refresh of our country rankings is going to be published in the coming week and it's a really interesting read given what's been happening in the US China AI arms race over the past year or so. Vicki Redwood our senior economic advisor was on the podcast last week talking to Neil about the findings so do check out that episode for a sneak peek. But if you're a capital economic subscriber you'll get the full report when it's published and if you have advanced so our premium tier access you get all of the data as well to plug into model.
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