It's Friday the 17th of July and this is your capital economics weekly briefing. I'm David Wilder coming up. China's economic struggles wider Beijing's policy makers sound more concerned. But first, Group Chief Economist Neal Shearing is with me to wade through another week in global macro and market. I Neal, bye David. I was thinking about what we could start talking about on the podcast and one day we will talk about anything but what's happening in the Middle East. But this is not going to be today. It's not going to be today. I was talking to Jenny McEun on the podcast last Friday about whether we should be dusting off our adverse scenarios for this conflict. You know, when it kicked off, you and the team formulated these baseline and adverse scenarios depending on how everything went. Cease fire got signed. It looked like the baseline scenario is where we're heading. We acknowledge the fragility of that Cease fire. Nonetheless, things were looking better. Jenny's point was it's too soon to dust off that adverse scenario where we have a much worse outcome for this conflict and macro implications. But in the time that we spoke Jenny and I, the Strait of Hormuz was effectively closed. We know what the Hooties threatening to close. Another key shipping route out of the Red Sea. So I guess my question to you to kick off is just things are clearly getting spicier again, but how spicy? Yes, indeed. I think there's a couple of questions here. Indeed, I wrote a note, published a note earlier this week trying to unpack exactly what's going on. First question is really what a market is, it's helpful to kind of benchmark where we are and to what markets are currently anticipating. And if you look at, say, options pricing in the crude market, it's clear that the contracts say three months ahead prices have increased by a bit, not by a lot, but by a bit. So we've kind of gone from $70 a barrel to just over $75 a barrel, three months ahead. The really interesting point though, I think is that when you look at the distribution of probabilities for prices three months ahead, the right hand tail of that distribution has shifted out. So trade is a start into price and the possibility of substantially higher prices over the next two or three months. So that's another point that we've talked about on this podcast at length, which is so far the oil markets and by extension, the global economy has been relatively resilient in the face of what has been quantitatively one of the biggest shocks in global oil supply on record. And that's because of the large drawdown in inventories and particularly commercial stocks in the OECD in China that we have seen, but clearly you can't do that indefinitely. So the fact that we've got a renewed supply shock, the fact that that comes against the backdrop of inventories now being at historically low levels, that helps to explain why markets are now starting to price in the possibility of the increased possibility of a substantial spike in prices over the next two or three months. So that's where we are in terms of what market is pricing and now are they right to price that in? I mean, it feels that way, doesn't it? It feels that that's the direction of travel. And I think the thing that perhaps concerns me more now than was the case say two or three weeks ago is the, I worry that actually it's the IRGC that holds more of the cards. Can we have to talk with these days in terms of who holds the cards? Is the IRGC that seems to hold more of the cards? And therefore what's the off-ramp here? If they're doubling down in the conflict, then where's the off-ramp and how do we get the straight reopened? So that's where I think developments have become more concerning over the past, say, a week, 10 days. That's the key point, isn't it? There's the market sentiment question here. But also fundamentally, there is a physical reality that the supplies that were coming through the Stray of Hormuz on February 27th were closed off. They were reopened to some extent a monthish ago. Those supplies now appear to have been choked off again. Whatever tankers were in the straight, at least some of them have managed to exit. But reserves being drawn down, Chinese imports are down, but eventually there's going to be a crunch point. This tipping point that I think you just alluded to, my question is, is there any sense of when we're going to be there, when we really need to worry? But obviously the bigger question is what happens then? What are the macro implications of that tipping point? In terms of when that comes, I think it's probably important for us not to think in precise terms, frankly. It's not going to be on the 16th of August, the 3 o'clock in the afternoon. The point is more in general terms, I think, that you can't draw down inventories indefinitely. Now, OECD countries, we can see from the commercial stocks data they still have, although historically low levels of stocks, they're not out of inventory altogether. And there's Chinese stocks are a bit more opaque, so it's more difficult to get a handle on exactly what's happening there. But the mechanism by which this starts to play through to the real economy is that you don't get to run that all of your stocks and then suddenly something happens is that prices start to rise in anticipation of the fact that there is a supply squeeze happening in the physical market. So we're not there yet. We have seen an increase in prices of which talking currently at $85 a barrel. There are abouts and we've seen an increase in European natural gas prices too. So we're back up from the low 70s to the mid 80s, but we're not quite at the triple digit rates of oil prices that the moment, the level of stocks that we're seeing in the OECD would be consistent with. So the mechanism is through prices rather than the level of stocks itself. The tipping point insofar as when it comes is difficult to pinpoint. But we'll start to see this playing through prices first and not quite there yet, but my senses were not very far away. And then of course that might force something else to happen. So you're going to be spiking prices. Maybe that's the event that leads us to an off ramp that we can't quite see at the moment, but that might come into focus if we start to see oil prices surging again. But also at the same time, that's when we see much, much higher inflation, much, much slower growth. That's when we're starting to talk about recessions in at least parts of the global economy. Indeed, yes. And then we get ourselves into a world of different scenarios. Is it adverse scenarios, extreme scenarios? Now in our global economic outlook, which we published a couple of weeks ago, we included some tables of forecasts in there in which we modeled what $150 oil would look like in terms of the economic implications in Q4. And it gets pretty ugly. So you end up with UK inflation at 7%, Eurozone inflation at 6.5%, US inflation back over 5%, US growth kind of slows really sharply to 1% Q1 Q and I's a bit below that you've got the UK and the Eurozone flirting with recession. China's economy is starting to cover this in pressure too. Now, you might say $150 oil is a pretty extreme scenario and it would be, but then bear in mind that taking at face value, the level of stocks at the moment would historically have been consistent with oil at say $120 a barrel. So it's quite extreme, but it's not implausible. So if you're talking about how bad things get, that's how that, I think, is an extreme but still plausible, possible scenario. So ECB governing council members getting ready to meet in the coming week. How do you think this is playing out in terms of their deliberations? What they're going to be thinking about for the July meeting, but also perhaps thinking ahead to the September meeting? Well, I think the first thing to say is that at the July meeting, nobody, including ourselves, is anticipating any change in interest rates. So I think insofar as the upcoming meeting is concerned, makes left unchanged and ECB kind of decams for the summer holidays. Now, the question then becomes, as you say, what happens beyond that into in September and beyond and how does the war and the Iran play into that? A lot of debate has been given over to so-called second round effects. So when will we start to see the impact or will we start to see the impact of higher energy prices on broader wage and and prices of behaviour? We've not yet seen much evidence of that in the Eurozone or in details where, but then I don't think we necessarily would have expected to either given the timeframes we're talking about. Now, as it happens, we don't think that even given some time, we'll see much in the way of second round effects, certainly compared to say the energy shock in 2022, given the labour markets in advanced economies in particular are now a lot less tight. So I think that inflationary backdrop is one that's less concerning in the context of an energy shock, a global energy shock now than was the case in say 2022. And of course, as we've discussed, there's not much such a way it can do about energy inflation in and of itself. The spike in energy inflation that we're seeing is the function of the war in Iran, not a function of monetary policy. Nonetheless, my sense is that if we do see a further increase in in our price from here, central banks will probably end up responding. They will feel the need to respond. So it's possible that we end up with a rate hike in play in September in the autumn and the eurozone, but that's not yet our central scenario. Our base case remains that we kind of muddled through this crisis.
is the global economy medals through energy markets medal through, we do find an off-ramp somewhere and the bank giving them the ECB managed to hold the line and get through this without raising interest rates. Similar question, but for the Fed, because on the one hand, I've been hearing very hawkish noises from some key FOMC members, on the other hand, we're talking at the end of a week where we've had a couple of fairly benign inflation reports. So how does that all fit in in terms of this hawkish shift on the FOMC that we've been talking about, but also what we're seeing in the actual data? Well, let's deal with the data and then let's deal with how policymakers appear to be responding and reacting to that in a minute. You're right, that we've had statements and speeches from several Fed governors, including, of course, washes, testimony to Congress over the past week or so. On the data front, things, as you say, look a bit better. So we've had both CPI and PPI data over the past week, core CPI inflation flat in month-to-month terms, core PPI inflation, just creeping up by 0.2% month-to-month. The headline CPI numbers collapsing in when we look in year-on-year terms. So from 4.2% year-on-year to 3.5% year-on-year, that's many energy-price story. It's the core numbers that policymakers are going to care more about. And of course, in the case of the Fed, it's not really CPI or PPI, it's PCE that they're looking at, but our models are pointing to on the basis of the CPI and PPI numbers, an increase in core PCE prices of just under 0.2% month-to-month in June, which would leave the core PCE number at 3.3% year-on-year. So some better news from the data particularly when we look at the kind of month-to-month numbers and that leaves core PCE, which is the Fed's preferred inflation measure growing at a target consistent pace in June. So better news there. But as you say, the question is, is this sustained through the summer and into the fall and how are policymakers responding? Because we have had more hawkish noises, Christopher, while assigning more hawkish over the past week or so, Lisa Cook signed more hawkish too. And then just before we've been speaking, yesterday, Laurie Logan at the Dallas Fed actually advocating for further rate hikes, albeit a relatively modest ones. So there is a sense that there's a hawkish shift underway on the Apple MC despite the fact that we've had this slightly softer data on the inflation fund in June. But also, you mentioned Warsha's testimony. I mean, he's not talking about a cyclical spike in inflation. He's talking about inflation in terms of it overshooting the target for five years and he wants to put an end to that. So what does that imply in terms of where the Fed goes from here? Yes, just on Warsha's testimony. There were several points that stood out for me, but I think three in particular, that the first, and perhaps I could be the most important was that he kind of re-reaffirmed the Fed's independence said that the Fed would set interest rates without taking political factors into account. I think that's the bare minimum he could have done, but I think it's important that we got that. He spoke a bit more about AI, but painted a relatively bullish picture in terms of the potential macro consequences of AI and its ability to potentially raise productivity growth and economic growth is consistent with the law and the work that we've put out to. But interestingly, whereas in the past, he talked about it being a potential disinflationary force and signed it a bit more equivocal on that front in terms of the immediate inflationary implications of AI. I talked about how actually it may be contributing to higher inflation. And then, as you say, perhaps the most striking part of his testimony was when he started to talk about inflation in a kind of more structural context, medium term context. He said the Fed has no tolerance for persistently elevated inflation, which I think is an unusual thing to say in the context of inflation having been above target for the past five years, it appears to have some tolerance. I'm for persistently elevated inflation, but clearly, warship is keen to push back against the idea that the Fed might do in a kind of double-down on inflation fighting credentials. I think taken together that for me means that there was a relatively hawkish testimony. There's this idea that he's trying to tighten financial conditions just through verbal guidance to markets. At the same time, he's talking about shrinking the balance sheet. There's obviously this question about where rates go from here. So in terms of just practical policy applications, how is this testimony going to translate into action? Well, I think it was striking that he didn't actually consistent with his previous views about the Fed, not issuing forward guidance, so that the pitfalls of issuing forward guidance, he didn't really commit in terms of one way or another in terms of whether there might be rate heights in the coming months or so. And on this idea that the policy makers might be able to influence financial conditions and by extension monetary conditions by pushing markets up or down one way or another based on whether they're hawkish or duffish, I'm pretty skeptical on the ability to do that in the medium term, frankly. I hesitate to bring up Maradona in the week that Argentina have dumped England out to the World Cup, but this is the kind of famous Maradona effect that Mervyn King, the former Governor of the Bank of England, used to talk about, which is that by influencing market expectations for interest rates, you could influence financial conditions and in the real economy in real time. But the problem, of course, is that at some point markets are going to test that. And this was grounded in the idea that Maradona's famous goal in the 1986 World Cup actually just ran in a straight line towards the goal and that was the England defenders that kind of moved out the way because they thought he was going to jink one way or the other. But I don't think it managed to really works that way. I think at some point the markets are going to test you if you're siren hawkish and you say you're you're determined to kind of double down on your inflation fighting credentials. You have no tolerance for higher inflation and persistently elevated inflation as as Walsh says, then at some point the markets are going to test that. If indeed you're a real preface for higher inflation by the virtue of the fact that inflation has been above target for the last five years. So I'm somewhat skeptical of the idea that the Fed can just influence by influence of market expectations for interest rates can influence monetary conditions in the real economy without altering actual interest rates and monetary conditions and a monetary policy. At some point they're going to have to act. And to that end, our view is still that the Fed's going to have to raise interest rates over the next six months or so given the underlying strength of the US economy and the underlying strength of core price pressures that's in the pipeline. So and that's I think we just talked about the ECB. I think that's a kind of really striking difference between how the markets are pricing rates in the US and in Europe. By and large they're still pricing in 40, 50 basis points of hikes both in the eurozone in the UK and in the US. And if we end up in a world where traffic through the straight starts to resume, oil prices come back down to the kind of 80 dollars barrel range that's in our forecast for Q3, then my sense will be that the ECB in the Bank of England won't end up delivering the tightening that is priced into markets. But the Fed, where markets are still pricing in fully basis points of rate hikes over the next six months or so, well actually probably have to move a bit more than that and we'll end up having to deliver a bit more tightening. So I think there's a slight difference between our view and what's priced into the market on that front. Neil Shearing on a spicier situation in the mid-least, the risks of a tipping point in oil markets and how central banks could respond in the coming weeks and months. That note he mentioned on the straight of Hormuz, I will add that to the podcast notes along with our most recent global economic outlook. Suffice to say we're watching this all very closely and we'll have more analysis and online briefings as this developed so you're on top of this fast evolving situation. If you're not already getting our analysis from instant reactions to breaking events like what's happening in the straight to deep dives into how AI is shaping the long-term inflation outlook, then do drop us the line at
[email protected] and we can quickly get you set up with trial access. For the coming week, one thing worth highlighting is our drop-in on whether an anti-burner government can revive UK growth. This short online briefing is on Tuesday at 2 o'clock, London, 9 o'clock, New York and there's an accompanying report all about the next PM's diagnosis about what's wrong with the UK economy and how he plans to fix it. Again, details in the show notes. Now, China's government reported this past week that the economy grew by a slower than expected 4.3% year on year in the second quarter. To find out what's really going on in the economy and what policymakers plan to do about it, I spoke to Julian Evans-Prichard, the head of our China coverage. There's a fashion among analysts these days to talk about K-shaped economies and summer applying it to what's happening in China. My chat with Julian started with me asking if K is a letter that really fits the shape of China's economy. Well, when people normally talk about a K-shaped economy in the case of, say, the US, they're usually thinking about wealthier households continuing to spend and do well, but those sort of lower down the income distribution, not doing so well. I think that doesn't quite apply to China actually. If you look at spending across the income distribution, actually, it's lower income households that are doing better. So when people talk about K-shaped economy in China's case, what they really mean is not
differences between spending patterns in different levels of the income distribution. What they're talking about is different sectors of the economy performing in very different ways. And that's certainly true. I mean, if you think about the procty sector, for example, it's been on this downwards trajectory for a number of years, and that was no difference in the latest data construction sector in particular, continue to contract in Q2, the retail sector also struggling due to weak domestic goods demands. That's partly sort of a story of general weakness consumer spending, although it's been exacerbated for goods recently by the the unwinding of the consumer goods trade-in scheme. And on the other side of the coin, you have the export sector doing extremely well, and anything related to AI, basically any part of the AI supply chain, including chips, but also general electronics equipment all the way to building out data centers, and even sort of the some of the services surrounding the AI stack and the models, etc. So some parts of the economy doing very well, other parts of the economy clearly still struggling or even outright contracting. So from that perspective, it is fair to characterize China's economy as a bit K-shaped at the moment. Yeah, I want to get on to the impact of AI on the economy. And what you said, I mean, certainly the most recent trade data bears out this idea that you do have this strength of one part of the economy. But then that Q2 report, that Q2 GDP report, we've had this past week, falling short of expectations, very much bearing out the weakness in the economy. Now, but what I wanted to draw on was a comment that you made in your response to that data release in which you were talking about our China activity proxy, and you went on to say basically that it this slowdown that we've seen in the Q2 report, it may be less that the economy actually slowed in Q2 and more that the government is willing to acknowledge the reality of that slowdown. Can you explain what you mean by that? So basically, our China activity proxy has been suggesting for a while now that growth is quite a bit weaker than what the official figures show. And that's because over the past couple of years, the economy we think on our measure at least has slowed more sharply than what the official figures showed. And for the past year or so, it's been growing it around 3%. Now, obviously, the annual growth targets that the leadership set every year have made it very difficult for the statistics bureau to acknowledge the full extent of that weakness. But this year, they did lower the growth targets to some extent from around 5% to a target range of 4.5% to 5%. Initially, when they did that, they gave mixed signals, though. They set at the time back at the NPC in March that they would still strive for better in practice. So it wasn't entirely clear when they set that target, whether they'd be comfortable with publishing growth figures at the bottom of that range. But I think the message from the Q2 GDP figure is that, yes, they are comfortable with growth figures around the bottom of that range. And so, I think, as is often the case with the official GDP data, it's not just a question of trying to forecast how the economy is going to perform. It's also a question of forecasting what the government is comfortable publishing. So I think in the case of the second quarter, our China activity proxy actually suggests that the economy wevid the shock from the Iran war pretty well. There clearly was some hit to activity in heavy industry, electrochemicals, that sort of thing. But there was an offsetting pickup in activity, particularly related to AI. And so on our measure, at least, the economy didn't really slow all that much in Q2, although, as I said, we do think that the growth rate is a bit lower still than what the official figures show around 3%. And I should be mentioning, Q2 wasn't great, but June actually didn't look too bad. The June activity numbers. Yes, June was a bit better actually across the board, which is encouraging. And it also follows on the back of PMI surveys, which have actually been picking up in recent months. So there's very much a mixed picture from different data sets. I think, despite what happened to the headline GDP growth, I don't think it's a clear cut case that the economy actually lost much momentum last quarter. Clearly, there are some headwinds to growth, but there are also some areas to be positive about. But this broader idea of acknowledging the reality of what's happening within the economy, it leads me on to talk about the credit story. There was a time when China's to outsize growth numbers were all about what was happening in credit activity. Now this past week, we've had total social finance, which is this broad PBOC measure of credit activity in the economy. It becomes every month. The growth of that hit a new low in June. On the other hand, PBOC doesn't sound too worried about this trend. It's talking about slowing the growth of credit, raising its quality that this is a new normal for credit in China. What does this all mean? So the relationship between credit growth and economic activity in China has weakened quite substantially in recent years. So as you say in the past, if credit growth had slowed to this extent, I think that would be a flashing red light. Warning us that the economy was about to enter a shop downturn. I think that's less the case these days. The reason credit growth is slowing has a lot to do with the fact that the most credits intensive parts of the economy are the ones that are contracting, particularly the property sector. The parts of the economy that are doing well, particularly exports, do not rely on credit to drive demand. It's partly a consequence of the shift in the drivers of growth in China, which have helped to make growth less credit intensive, which I think is a positive development and is a key reason why the PBOC is not overly concerned by the slowdown in credit growth. As you say, I mean that their argument is we've entered this new normal where the focus should not be on the overall speed of credit growth but the quality of lending. Now, I would say that the jury is still out as to whether they've substantially improved the quality of lending. We've still seen in recent years a pretty persistent rise in the debt GDP ratio in China, which is a sign that credit is still being misallocated to some extent. But clearly that's the lens through which the PBOC is now thinking about credit growth. In the past, slowdown credit growth might have triggered significant monetary easing, but recent communication from the PBOC suggests that they're now focusing more on the level of interest rates, which they argue is already very low. So the monetary starts as already a commutative. And so there's not really a need to loosen policy significantly even with credit growth slowing. So given the report, given the broad messaging in the report, you said that not going to expect much on the monetary stimulus side of things, would we expect a bigger response on the fiscal stimulus side of things? So I do think the week GDP figure in Q2, even if it's just a case that acknowledging pre-existing weakness in the economy still strengthens the case for a bit more urgency around policy supports. As I said, I think we're not likely to see a great deal on the monetary policy side. We do have one sort of token, ten basis point rate cut, pencil for the second half of the year. We may get something around reserve requirement ratios being cut, that sort of thing. But I think the bulk of the supports will have to come from fiscal policy as has been the case in recent years. Now, in terms of the fiscal situation, one recent headwinds to domestic fNIC activity, certainly in Q2, was quite a sharp pullback in fiscal spending. And the actual, the fiscal deficit actually contracted in Q2. And that's not really what the government had in mind when it laid out its annual budget, so the NPC back in March. And so we've seen a bit of a premature tightening of fiscal policy in recent months, but it does mean that they have some space already built into the current budget to allow them to step up fiscal spending again over the second half of this year. And that's what we anticipate. So I don't think we should necessarily expect any major new announcements in terms of policy support, but I do think that they will signal renewed efforts to make sure that they make full use of the fiscal space that they do have for over the rest of the year. And so we should see a bit of a pick up in fiscal spending, supporting domestic activity to some extent.
over the rest of the year and provided that the export picture remains strong, that I think will be enough to prevent the economy from slowing any further over the rest of the rest of this year. So we're actually anticipating a relatively resilient economic picture for China at least over the next few quarters. What about this AI question? You said a bit before about how important AI is now in driving growth in China. What happens if that AI investment story fades? What does the Chinese economy look like without the AI investment boom? So AI has become hugely important to the Chinese economy on our calculations. Growth from AI related sector, so ICT manufacturing and ICT services contributed more than a third of China's GDP growth in year and year terms in Q2. And if you look at the growth in Q1Q terms, which is a more timely measure, then over half of that growth came from AI related sectors. So it's really become the main engine of the economy recently. And that reflects demand both overseas and domestically. We've obviously seen a huge increase in exports of semiconductors and computing equipment. And lately on the back of the AI boom and the CAPEX boom, particularly in the US. But domestically, there are also clear signs of a ramp up in data center usage in CAPEX spending on data centers. So it's not just an export story. It's a domestic CAPEX story as well. And really a lot of the near-term economic outlook for China rides on whether this can continue or not. Now clearly judging from what's been happening in markets in recent days, there's some concern around the sustainability of the AI boom globally. And those concerns may be justified to some extent. But our sense is that we're still in the relatively early stages of AI being adopted and rolled out across the global economy. And so there should be an extended period in which demand for AI related goods and services continues to grow very strongly. Assuming that's the case, then it really comes down to the supply side of the equation. Because at the moment demand is significantly outstripping supply, particularly for things like memory chips. And so the degree to which this can continue to drive, therefore, depend on how quickly they can ramp up supply of these kind of products. The good news is that they already have investments underway to try and do this. And in fact, there are a few new chip fabs or expansions of existing fabs that are due to come online in China in the next few quarters. And that could potentially, for memory chips, at least boost production by over a fad. So could potentially provide a major boost output in the electronic sector. So I think there are reasons to be positive, at least in the near term, and reasons to believe that this tailwind will remain in place. But there are clearly risks as well. As you say, if we do ever shift from an AI boom towards an AI bust and cap expending, either in China or outside of China, starts to slow or even fall sharply, then the Chinese economy will be very exposed to that simply because so much of its current growth is coming from the sectors.
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