The Decisive | Season 7 | Ep.3 - Global Growth on Uneven Ground: AI Tailwinds and Fiscal Headwinds

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Kristen Hallam   00:00:00

Welcome to the Decisive. I'm your host, Kristen Hallam. Today, we're bringing you highlights from the S&P Global Market Intelligence July 15 Global macroeconomic Webinar. The discussion features Ken Wattret, Vice President of Global Economics, along with Economics leads, Ben Herzan, Hanna Luchnikava-Schorsch, Rafael Amiel and Raj Badiani. Together, they examine how lower oil price assumptions, persistent inflation pressures shifting monetary policy expectations, AI-related investment and geopolitical uncertainty are shaping the global economic outlook for the second half of 2026 and into 2027. Let's listen now.

Ken Wattret   00:01:03

Now before we dig more deeply into what we expect at national and regional level, I want to take a moment to highlight that having recently passed the midpoint of the year, our core theme for 2026 of shaky economic foundations remains very much on track. Now that theme was prominent in our thinking for 3 key reasons. First, the potential for geopolitical events to impact on economic conditions. Obviously, we see that day-to-day currently. Second and related, some prior economic anchors, including low inflation, low and stable interest rates, frictionless trade, they've become much more unstable and uncertain. And third, we wanted to highlight that there are many underlying vulnerabilities that pose a threat to economic prospects, one of which is the poor state of the public finances in many major economies. And we've seen the oil shock adding to upward pressure on sovereign yields, constraining government's ability to mitigate its negative effects. Also, several of our top 10 predictions for 2026 have been borne out over the first half of the year. They include still solid U.S. economic conditions, Western European growth underperformance, weaker expansions in Mainland China and India, upward pressure on long-term interest rates and divergence of monetary policy. The jury is still out on a few other predictions, and we'll be digging into some of those over the next half hour or so. And with that in mind, we're going to begin with the U.S. Ben, over to you.

Ben Herzon   00:02:42

Thanks, Ken. So let me expand on the theme of U.S. resilience and just a quick reminder about what the U.S. economy has expanded through. The tariff rate reached an historic high last fall and uncertainty about trade policy surged. Then this spring, the war in the Middle East brought surging energy prices. The combination of elevated tariff rates and energy prices raised consumer prices and is weighing on real measures of income and wealth, which are the 2 key drivers of consumer spending. Still, the U.S. economy has remained resilient. So what's behind this resilience? Part of what's going on is the U.S. economy is becoming less exposed to energy price shocks as it becomes increasingly more energy efficient. It takes roughly 1/2 the energy to produce $1 of real GDP than it took back in 1990 when the U.S. economy was grappling with the oil price shock that resulted from the first Persian Gulf war. Another source of resilience is what's happening in the AI sector. Real non-res fixed investment was decelerating through 2024. Then in early 2025, AI-related investment began to accelerate. And so by AI-related investment, I mean this is spending on data centers, computers, software and R&D. The acceleration in the AI sector has more than offset slowing investment spending elsewhere and total non-res fixed investment through the first quarter of 2026 was rising rapidly. And it's not just the investment spending that supported the economy, it's also valuations of AI-related companies. Since early 2024, roughly 1/2 of the gain in the S&P 500 has been concentrated in a handful of AI-related companies. So the AI valuations are boosting overall share prices and household net worth. And this, in turn, is helping to keep consumer spending rising at a healthy clip. So let me say a few words about developments at the Fed. Kevin Warsh took over as Fed Chair just prior to the June meeting, and you probably have heard that he has assembled 5 task forces to investigate various aspects of the conduct of monetary policy. Those task forces will focus on Fed communications, balance sheet policy, data quality and timeliness, productivity and jobs and inflation frameworks. So what does the assembly and existence of these task forces tell us about changes that may be coming at the Fed and what it might mean for the macroeconomic outlook. We've already seen a change in Fed communications. the policy statement that was issued after the June meeting of the FOMC was very short and did not include what had been a long-standing practice of communicating a statement of forward guidance. Furthermore, Federal Reserve policymakers since the June meeting as a group have made roughly 1/2 the public appearances that they had in prior intervening periods. So Fed communications have already diminished quite a bit. What this means is market participants and indeed all of us will need to rely more on signals coming from the economic data about the likely path of Fed policy and less on communications coming directly from the Fed. This will make policy surprises and financial volatility on FOMC meeting days more likely. With regard to balance sheet policy, what we're thinking about is what it would look like if the Fed were to reduce the size of its balance sheet. A smaller balance sheet amounts to quantitative tightening. Recently, the Fed's holdings of treasury notes and bonds stabilized at roughly 11% of GDP. And for the Fed to reduce these holdings to say, 8% of GDP, all else equal, this would raise the 10-year treasury note yield by roughly 25 basis points. That's the quantitative tightening. And if the Fed wanted to shrink the size of the balance sheet while at the same time, preventing a tightening of financial conditions, they would need to simultaneously lower short-term rates by an offsetting amount. So we're thinking about sort of the trade-off between balance sheet policy and interest rate policy that would exist the leadership of Warsh. On data quality, not much to say here. Everyone would certainly benefit from improved data quality. On productivity and jobs, the focus here, this task force will be focused on gaining a better understanding of how AI is likely to influence productivity, employment, the neutral interest rate and inflation. Now this is important because Mr. Warsh has expressed an optimism about AI technologies boosting productivity and aggregate supply enough to make it appropriate for the Fed to lower interest rates to stimulate the demand side of the economy to keep pace with rapidly expanding aggregate supply. There's a lot to say here, but not a whole lot of time to say it, but suffice it to say for now that a better understanding of the timing and magnitude of the productivity gains that will ultimately result from AI will certainly help to guide the appropriate stance of monetary policy in the near term. And finally, on inflation frameworks, the one thing that we're thinking about is the role that trim to mean measures of inflation will play in the Fed's deliberations of the policy rate. Some of these measures are running below core PCE inflation. So were the task force to conclude that trimmed mean measures of inflation deserve consideration, say equal to that of core PCE inflation, this might argue for easier monetary policy than we are showing in our forecast. So let me wrap up with a few words on the dollar. Since the beginning of the war, the trade-weighted dollar has strengthened by roughly 2%. This has occurred in tandem with and perhaps because of a roughly 50 basis point increase in the 10-year treasury note yield. So that begs the question, what has caused treasury yields to rise? A likely candidate is shifting perceptions about the probable path of the federal funds rate this year. Back in early March, futures markets had assigned a 0 probability of a hike in the federal funds rate -- any hike at all in the federal funds rate this year. Indeed, the majority of the probability in futures markets were assigned to at least 1 rate cut this year and more. So since then, the probabilities have reversed. Futures markets currently or at least recently, we were assigning a probability of at least 1 hike this year and a 40% probability of at least 2 hikes this year. So that's why we think treasury yields have risen and the dollar has strengthened, but we don't think that the recent strengthening of the dollar will hold up. We show the dollar weakening over the next couple of years, and this is a model-driven result. One of the key drivers of the dollar in our model is the differential between U.S. and foreign sovereign yields. The wider the gap between U.S. and foreign yields, the higher the demand for dollar-denominated assets and the stronger the dollar. In our forecast, U.S. treasury yields drift lower while a trade-weighted aggregate of foreign sovereign yields drift up. This narrowing differential lowers our model's target level for the U.S. dollar and contributes to roughly a 2.5% weakening of the dollar over the next 3 years. And with that, I will leave it there, Ken, and pass it back to you.

Ken Wattret   00:10:11

Thank you very much, Ben. We're going to move to Hanna and Asia Pacific.

Hanna Luchnikava-Schorsch   00:10:16

Thank you, Ken. And with that, let me take you to the other part of the world in Asia Pacific, and we'll start about talking about China. The economic growth in China has moderated quite substantially during the second quarter of the year to 4.3% in annual terms from 5% in the previous quarter. And notably, we have seen increasing imbalances within the economy itself with external supporters to growth being reinforced by strong exports, whereas domestic demand softness continues to persist in the face of weak private consumptions as well as a drag from the property and construction sectors. Another notable factor in the latest GDP data is the increase in GDP deflator, which stood at 1.5% in annual terms during the quarter, ending 13 quarters of deflation, which was mainly driven by increases in upstream prices due to the Middle East shock as well as the strength in the technology demand and technology-related prices. Having said that, we still expect that the price environment is likely to remain soft and the question remains as to which extent the reflationary environment is sustainable. The capacity utilization rates in most of the traditional sectors declined, which is an evidence that beyond the immediate price shock caused by the Middle East war, we may still be seeing soft price environment precisely caused by the increasing weakness in domestic demand. Now as we look more closely to drivers of export strength versus the weakness in domestic demand. We continue to see that strong exports, which grew by over 17% year-on-year during the first half of the year, support export-oriented industries as well as investment, particularly in industries related to AI and technology products as well as this new energy products driven by energy transition. And this demand is also being reinforced by additional demand coming from the emerging markets. On the domestic front, however, again, retail sales continue to remain soft, even though we have seen some expectations of improving momentum in the latest high-frequency data in June, whereas the weakness also persists on the investment front, particularly from the local governments as well as the traditional industries. On the export front, while the resilience persists overall, we see also a clear indication that exports continue to be driven by a number of industries, particularly related to AI technology up cycle as well as energy transition, the substitution of supply chains due to the Middle East and the emerging markets demand. At the same time, we also have seen acceleration in domestic imports, which, in fact, has lowered the trade surplus during the second quarter, diminishing the contribution of net exports to growth. And this is a trend which is likely to persist from the third quarter onwards, where we still continue to see exports remaining the key growth driver, but the contribution of exports to growth will be diminished, whereas we might see some stabilization in domestic demand by a preview of the government's accelerated fiscal stimulus as already has been communicated during the 15th 5-year plan in July policy communication. In fact, the government assumes that the policies to support domestic demand will raise retail sales by an average of about 3.5% annually compared to only 1.5% that we have seen during the first half of the year. Now our projections for China remain for a gradual slowdown in growth where annual real GDP is projected to remain at about 4.5% during the current year and marginally slow to 4.4% during the next year, with structural imbalances expected to persist and the government policy is expected to remain directed at its anti-involution efforts or efforts to restore price profitability and reduce overcapacity in a number of industries. Now if we look at the rest of the region, here, the story in some ways resembles the trends that we have seen in China. In fact, economic outcomes during the first half of the year have been stronger than many have anticipated, given Asia's vulnerability to the Middle East shock. With real GDP during the first quarter of the year, this is the data that is already available for across all economies, generally being stronger than the same outcomes during the first quarter of the last year. The exception here being Thailand and Philippines and particularly because of its strong vulnerability to the Middle East shock and the lack of domestic policy buffers in the form of subsidies in particular. But the strength in overall Asian growth has been in most part driven by resilient export demand, particularly for AI-related and adjacent technologies. In fact, exports for a number of economies, which are the most integrated in the AI supply chains have risen by over 30% year-on-year during the first quarter as well as during the first 2 months of the second quarter, continuing to support overall growth and offsetting the impact of the Middle East shock on domestic demand. We still expect exports to remain resilient in the second half of the year. However, we do see the increasing risk of a slowdown, particularly coming from the technology sector. And this is driven by a number of reasons. One red flags that we currently see is that the increase in exports is largely driven by prices, whereas volumes have started moderating in a number of economies. For example, South Korean exports of semiconductors, if we look at prices, have risen by over 150%, whereas volumes have, in fact, only increased by more than 3%. If we look across the value chain for other products like storage and servers, we also see that this trend holds with a number of economies already starting to report declines in volumes exports. And one of the reasons for increase in prices has been shortages of a number of critical components, also in part caused by the Middle East shock, particularly for helium and some of the other noble gases as well as increases in freight rates and insurance costs and the lengthening of supplier delivery times, which have been also putting a halt on some of the key components of this important supply chain. So going forward, the risks to the overall Asian growth become increasingly imbalanced where growth remains dependent on technology experts, whereas domestic demand continues to be at risk of moderation, not least because of the stickiness in prices, which Ken already alluded to in his section. Despite softer oil prices, we continue to see the pass-through of previous price increases into the domestic economy. We also see increased risk from food prices on Asian economies. And with that, inflation overall is still projected to remain above our expectations at the beginning of the year for most of the Asian economies with the central banks remaining vigilant and policy tightening still expected in a number of economies, including India as well as Japan towards the end of the year. And with that, over to you, Ken.

Ken Wattret   00:19:35

Thank you very much, Hanna. We're going to move to Latin America now where we think there are some political changes, which could have some significant economic effects. Rafael?

Rafael Amiel   00:19:46

Thanks very much, Ken. Yes, indeed, we have recently witnessed significant changes in voters' preferences in the region, moving away from left leaning administration towards government that favor market outcomes, private investment. And this all started in Argentina. President Javier Mile was shown in very late 2023, and he inherited an economy with a 5% fiscal deficit, which if we add a quasi fiscal deficit from the Central Bank of 3% on the interest payments he was making on notes it issued, that was 8%. And this deficit is a deficit finance printing money. That lead to inflation. Inflation was in triple digits going to 200%. And the macroeconomic adjustment was significant -- and nowadays, Argentina costs primary fiscal surpluses. It has inflation around 20%. Of course, the adjustment is not complete, but we've seen some improvements on the investment side. And this is the key point of the adjustment process that an economy that was mismanaged is moving into the path where investors can take risk can take lower risk. Elections happened in lately 2026, and we have seen this moving to the right to market-oriented policies in Peru, Colombia, Chile, Bolivia, Ecuador, even in Central America, Costa Rica, Honduras. So this trend is showing that economies in the region can move towards macroeconomic prudence and -- we want to highlight this because even there are governments in Colombia and Peru that have not been zoning. Peru will have the new government in a few days and Colombia in August. And we know that this fiscal adjustment has to be executed anyway. I have a question mark because Brazil will have elections in October this year. And Brazil needs a fiscal adjustment, a deficit of 8% of GDP going to 9% of GDP is not sustainable. And -- even if the incumment party is reelected or the opposition, which is deriving in Brazil wins, we see in our baseline scenario that this has to change. But certainly, we assess that things can move to a better outcome. Colombia is a country that also needs significant adjustment. The current administration in Colombia declared that they will not follow the fiscal rule for the next 3 years. So they are just going into higher deficits and to higher debt because they need -- they think the priority for them is to spend the money and have they needed or do social spending. Mexico, to a certain extent, is going on a wider fiscal deficit, and we expect that if they continue to do so, we don't see any risk of default. We don't see any risk of issues with their debt. But certainly, they will have to pay higher interest rates on that. And we will, in our country default risk scores, adjust accordingly because Mexico is not behaving as they should. And in all of this, we can certainly not compare apples-to-apples when we talk about emerging economies to develop economies in their debt levels. And the fiscal deficit, the debt is not a problem until it is a problem as many people say, the outcome of these elections tell us that governments are ready to execute changes. And this is positive news. Of course, when these governments have been elected on their platform, security was a major issue, but this is all in line with what we are arguing here that if there are lower security risks, also the business environment improved, business sentiment improved, investment improved and the growth outlooks can improve as well. We don't have in our baseline scenario a massive capital outflows. We don't have in our baseline scenario that economies are going to boom in the near term, but certainly, this is a call for an upside risk for economic growth, and we think that this is positive news for business investment. Look at the upside risk for possible changes in policy and likely future higher investment. Back to you, Ken.

Ken Wattret   00:25:00

Thank you, Rafael. So we're going to move now to Europe, obviously, one of the regions which has been struggling to generate growth. Raj, please tell us your latest thoughts.

Raj Badiani   00:25:12

Thanks, Ken, and hi, everyone. And the first point really is one of a certain degree of positivity since the outbreak of the U.S.-Iran conflict, the Eurozone and U.K. economies actually have performed better when compared to previous supply shocks. Excluding the Irish economy, which has very volatile GDP movements, real GDP in the Eurozone actually gained some ground in the first quarter of this year, while the U.K. enjoyed a stronger start to this year. And to add to this, the latest survey results suggest continued expansion in the second quarter of both the Eurozone and the U.K., albeit at a gradual pace. I think the resilience of the Eurozone and U.K. economies this time around does reflect certain factors. I think this time around, European economies have lower energy intensity compared with 2022. When you look at oil prices in euros and adjusted for inflation, the increases are a lot smaller. We've also seen a lower spike in European natural gas prices this time around, which is obviously key for electricity generation and costs. Also going into this energy price shock, labor markets across the Eurozone and the U.K. are in relatively good shape. There are 1 or 2 exceptions, for example, Spain, unemployment rate is still at about 10%, but it's coming down. After this sort of semi-positive start, obviously, the ceaswine agreement between the U.S. and Iran in mid-June has shifted the dial favorably on the U.K. and Eurozone inflation and growth prospects. Certainly, the declining crude oil prices that we've seen since the agreement have given the Eurozone and U.K. economy some space. And certainly, that is reflected in some of the latest survey results, which show stabilization or in some cases, mild improvement. Certainly, the moderation in energy prices following the agreement has seen a tentative improvement in economic sentiment across Eurozone and the U.K. Inflationary pressures appear to be diminishing selling price expectations declined for industries in June following a large jump in May, while household expectations for price developments over the next 12 months have also eased. Also, activity indicators have shown some improvement in German IFO Business Climate Index reflecting business confidence across industry, services, trade and construction also posted a broad-based modest recovery in June. And our sort of PMI or purchasing managers index showed that Eurozone and U.K. growth stabilized in June following several months of increasing weakness. So as I said, the story now is that we have projections of lower oil prices in the July update than what we had in the June update. And this has actually resulted in some changes to our forecast numbers. In our July update, for example, we have revised our consumer inflation forecast in 2027 downwards when comparing the June and July forecast. Now these projections still stand above what they were pre-conflict, but the fall in July in terms of the projections of '26, '27 are certainly welcome. we'll see real GDP growth forecasts have gone in the other direction for most of Europe, including the U.K. Although the U.K. and the Eurozone economy have shown some resilience to the energy price shock and carry-on effects of high U.S. tariffs, we're still clearly, given the growth numbers I've just stated, still expecting growth prospects in the second half of this year in 2027. And I think this reflects several persistent factors strike headwinds. Despite the welcome fall in energy prices, they remain at historical highs, and they were already high before the start of the conflict in the Middle East. And clearly, some of the renewed regions we've seen over the last few days in the area highlighted by fresh U.S. and Iran in tax in the region suggest that you can certainly paint a scar where oil prices start rising quite sharply again. And obviously, that's bad news for most European economies being net energy importers. And clearly, that then accentuates the risk of shortages, particularly of diesel and jet fuel over the coming months. Clearly, these are vulnerabilities drove downside risks. Another vulnerability for the Eurozone and U.K. economy has been consumer spending, which has evolved quite sluggishly since end of the COVID-19 pandemic. Households are saving more than usual, driven by increased uncertainty due to the Middle East war, high inflation and elevated energy prices, which has slowed the recovery in private consumption and the return of savings rates to its pre-COVID-19 levels. One of the main reasons is the households have ramped up their precautionary savings because of the uncertainty related to economic policy in their countries, geopolitical and trade tensions. Also, households in some countries are now seeing diminishing real wage growth, which I think will become an increasing weight on domestic demand. But in terms of the baseline, we're not assuming a rapid return of the euros and U.K. saving rate to earlier levels, pre-COVID. We need to see an improvement in economic fundamentals for that to happen. So I'd say we -- the scenario for the next 6 months and probably spilling into 2027 is that increased consumer caution with saving rates remaining elevated, which means modest demand for sort of high-value consumer durables and many services. Another weakness, I would suggest for the Eurozone going forward is industrial activity. And we have seen some front-loading by many firms across Europe in anticipation of higher prices and shortages, which has given a surprisingly strong industrial production numbers at the beginning of this year -- the first half of this year. But this obviously is not sustainable and at some point, will have to be reversed, which suggests another drag on economic growth over the next few months. Also Eurozone and U.K. economies are vulnerable to external shocks. And certainly, the uncertain global trading environment for both the U.K. and Eurozone will remain an issue. Both the region and the country are trying to -- are in the process of realigning their trade relationships, the EU in terms of facing higher U.S. tariffs. And obviously, the U.K. is continued struggles with the implications of Brexit. And lastly, fiscal policy, as Ken said earlier, can offer little support. A lot of countries will now need to enter to a period of gradual fiscal consolidation. And at the same time, the ECB's rate cut cycle is nearly at an end. We are expecting one final cut in the middle of next year, but then that's it. I think it's also a good idea to maybe talk about some of the upsides. Could Eurozone U.K. growth surprise on the upside in 2027 and 2028 -- for that to happen, I think one major thing needs to happen. I think domestic demand needs to step up to offset some of the existing global trade challenges. Maybe a calmer geopolitical environment and the resolution to the conflicts in Ukraine and Iran would bolster consumer confidence across the Eurozone and the U.K. allowing consumers or allowing consumers confident enough to reduce their level of precautionary savings. And that also might be triggered by the fact that labor markets, as I said earlier, are in good shape across the region and in the U.K. Another bright spot is despite fiscal constraint across the region and the German expansive fiscal plan announced last year is a bright spot. They put together a fund amounting to EUR 500 billion, around 11% of nominal GDP, and that is now showing signs of supporting economic growth. However, there is an issue here that I think the pace of implementation of the plan needs to increase. It certainly fell short of its targets in 2025 according to the finance ministry. So that's something to watch out for. I think that will be an important game changer for Germany and obviously, it will be a trickle effect for the Eurozone. In terms of AI, there's a little evidence to suggest that it's been a major driving force of European investment in the first half of this year. I think it's fair to say that Europe has enjoyed less of a boost to growth from AI from the AI boom compared to the U.S. And any sort of AI investment in Europe has really been concentrated in large U.S.-based organizations. Investment in Europe has been by an uncertain economic climate, lower rates of venture capital investment and relatively high energy prices. I mean that's not going to be -- that situation will not be forever. So hopefully, when that turns around, AI will emerge as an important driver of European growth and long-term productivity improvement. Certainly, a survey conducted by the European Investment Bank signals that around 37% of show some degree of adoption, but this obviously varies widely across countries in the EU and the U.K.

Kristen Hallam   00:34:17

Thank you for listening to the Decisive podcast from S&P Global.