A global economist weighs in on inflation, upcoming elections, and deglobalization.
Our guest this week is Neil Shearing. Neil is group chief economist at Capital Economics, a London-based research firm. He is also an associate fellow at Chatham House, an International Affairs think tank. In his Capital Economics role, Neil manages a team of economists and is a well-known voice in the investment community. He has served as chief emerging markets economist and once managed Capital Economics’ New York office, having joined the firm in 2006 from the United Kingdom’s Treasury Ministry. He holds economics degrees from the University of London and the University of York.
Background
World Economy, Globalization, and Elections
“China, Inflation, Trade Wars—Your Frequently Asked Questions,” by Neil Shearing, capitaleconomics.com, March 4, 2024.
“Maintaining Market Confidence Is Key to Managing ‘Snowballing’ Public Debt,” by Neil Shearing, capitaleconomics.com, April 8, 2024.
“Pivoting Central Bankers Must Face Down the Ghost of Arthur Burns,” by Neil Shearing, capitaleconomics.com, Jan. 29, 2024.
“Ignore the Straight-Line Forecasts. These Forces Will Shape the Global Economy to 2050,” by Neil Shearing, capitaleconomics.com, Feb. 26, 2024.
“In the China Vs. US Size Stakes, It’s What You Measure That Counts,” by Neil Shearing, capitaleconomics.com, Jan. 15, 2024.
“Trump Trade Wars, Stock Market Bubbles, Japan’s Market Comeback, and the World in 2050,” Capital Economics Weekly Briefing podcast, capitaleconomics.com, Feb. 15, 2024.
“World Economy Is Fracturing, not Deglobalizing,” by Neal Shearing, chathamhouse.org, Feb. 8, 2023.
“It’s All Connected—Why Investors Can’t Ignore the Global Economy’s Megatrends,” by Neil Shearing, capitaleconomics.com, Oct. 2, 2023.
Artificial Intelligence
“From Upbeat to Apocalyptic: Making Sense of the AI Headlines,” by Neil Shearing, capitaleconomics.com, Jan. 22, 2024.
“How to Get a Handle on AI’s Many Implications for Economies and Markets,” by Neil Shearing, capitaleconomics.com, July 10, 2023.
Other
“Read My Lips: No New Tax Cuts,” by Paul Ashworth, capitaleconomics.com, Feb. 12, 2024.
Dan Lefkovitz: Hi, and welcome to The Long View. I’m Dan Lefkovitz, strategist for Morningstar Indexes.
Christine Benz: And I’m Christine Benz, director of personal finance and retirement planning for Morningstar.
Lefkovitz: Our guest this week is Neil Shearing. Neil is group chief economist at Capital Economics, a London-based research firm. He is also an associate fellow at Chatham House, an International Affairs think tank. In his Capital Economics role, Neil manages a team of economists and is a well-known voice in the investment community. He has served as chief emerging markets economist and once managed Capital Economics’ New York office, having joined the firm in 2006 from the United Kingdom’s Treasury Ministry. He holds economics degrees from the University of London and the University of York.
Neil, thanks so much for joining us on The Long View.
Neil Shearing: Thanks very much for having me.
Lefkovitz: Absolutely. Let’s start by getting the view from London. I’ve always enjoyed the Capital Economics research format where you display your views versus consensus. So maybe we can start off by having you run through where you’re most different from consensus currently. And it also would be helpful to understand how you determine what consensus is.
Shearing: Good question. Actually, this is fundamental to how we approach all of our work. A good place to start any forecast is to think about what the consensus is and then to think how it will be wrong because nine times out of 10, the consensus normally is wrong. And when you approach it that way, I think there are three big calls that we’re making across the global economy this year. Each of those have market implications.
The first is that although we see the US economy having a soft landing and the eurozone economy muddling through stagnating for the first half of this year, picking up bit of pace toward the second half of this year. That’s pretty consensus, I would say. But where we’re different is that we think that inflation will fall a bit further and faster than most expect over the second half of this year. And so, when you look over the next 18 months or so, we have slightly larger rate cuts in our profile than what is currently priced into markets. So that’s the first big call, if you like.
The second call relates to China. I think there’s a lot of gloom about the outlook for China at the moment. And actually, we have our own in-house proprietary measure of economic growth in China, our China activity proxy. And that suggests that growth has actually picked up a bit over the past couple of quarters, the economy is gaining some momentum. We can get into the reasons why that’s the case. But the second nonconsensus view is that growth in China accelerates over the first half this year in our forecast. And actually, the bigger problems and challenges in our views are the structural headwinds facing China’s economy.
And then the third nonconsensus view is we’ve said for a long time, actually for more than six months now, we thought that the S&P 500 was heading to 5,500. Obviously, there’s been several attempts at ratcheting up forecasts for end-year, end-year stock price forecasts done by analysts over the past several months. So, we’ve had this big acceleration in US stocks in our forecast for a while, principally on the grounds of AI hype. So, it probably is, in our view, the formation of a bubble, but the bubbles tend to inflate for a lot longer than investors can stay solvent, as Keynes famously said.
Benz: We want to dig into all of those points during the course of this conversation. But I’d like to know whether this particular period has been particularly difficult to forecast. It seems like there have been a lot of mixed signals about what sort of landing we’ll have here in the US, and China’s economic state, as well as inflation. Does this strike you as you reflect on your career as a particularly tricky environment to find your footing on some of these things?
Shearing: Yes, I think that’s fair to some extent. I’ve been doing this for 25 years or so. And I think one point I would make is that there’s a tendency in every period to say the outlook is unusually uncertain. If we go back to 2008, for example, we were debating the fear whether capitalism had a future in the teeth of the global financial crisis and the collapse of Lehman’s. So, I think there’s always been an element of uncertainty. Then there’s the future of the eurozone, would the eurozone break up and Greece leave? And since then, we’ve had US-China fracturing in the end of globalization. So, there’s always uncertainty.
I think what marks this cycle as being different—if it indeed is even a cycle—is two things. And I think this is what’s led economists down the wrong path where they’ve been thinking about their forecasts. The first is that normally, manufacturing and services tend to move in the same direction through the cycle. Manufacturing tends to be more cyclical than services, but they tend to move in the same direction through the cycle. Yet this time it’s been different because we had this surge in manufacturing demand, the demand for manufacturers’ goods during the pandemic when we were all locked down and we’re having to furnish our home offices and so on and buy flat screen TVs and iPads with our stimulus checks. And the service sector was locked down, and then the service sector reopened and demand for manufacturing goods fell and demand for services picked up. And what that meant was that when we looked at the usual kind of recession indicators, for example, the ISM, Manufacturing New Orders balance has been a pretty reliable indicator of recession in the US. Actually, this time around it wasn’t a good indicator of recession because there was a manufacturing recession without there being an accompanying services recession. Actually, service sector strengthened. So, the difference between manufacturing and services in this cycle has been a key reason why I think it’s been difficult to forecast.
And then the second point is that the supply side has played a much greater role in this cycle. So normally what tends to happen is, the way economists think of the supply is, it’s essentially, it’s flat here. There are no supply changes to a meaningful extent through the cycle. Supply just is what it is. There’s a certain number of workers and there’s a certain level of productivity and that gives you your supply potential. Whereas in this cycle, because we essentially shut down the economy, we ended up with an enormous amount of dislocation on the supply side of economies. Workers leaving jobs, some sectors diminishing, shutting down, other sectors, growing, people moving location, big surges in goods demand and then services demand. So that creates enormous problems on supply sides of economies. And then that’s taken some time to work through. I think we’re getting to that point now where it is working through. What that’s meant is that we’ve been able to have a fall in inflation without there being necessarily a big contraction in demand. So, normally, the Larry Summers thesis is, you need a contraction in demand to get on top of inflation once it gets to the rates that it got to in 2022. But it’s been possible to get inflation down this time because of the response on the supply side.
Lefkovitz: That’s interesting. And going back to your view that inflation will fall further and faster than consensus, what do you see as the main driver there?
Shearing: Well, again, it comes back to this idea of the supply side being critical and the repair on the supply side doing a lot of the disinflation work. I know that over the past month or so, there’s been, particularly in the US, the core PCE and the CPI numbers have been a bit troubling for anyone thinking there’s going to be this big disinflationary wave coming. I think to a large extent, that’s about some quirks in the OER data, the Owners’ Equivalent Rent, part of the PCE numbers. If you look at the three-month-on-three-month annualized rates of inflation in the UK, in the eurozone, they’re already back at 2% core inflation. Two-month or three-month annualized is already back at 2% or so in the UK and the eurozone. In some senses, I think the fact that we’ve not yet seen the year-on-year rate come down, and that’s obviously what we forecast— that’s obviously what we tend to look at—it’s an artifact of the way we tend to view inflation in these year-on-year terms. If you look at the three-month-on-three-month annualized rates, it’s already back at 2% or so.
Why is it that we have some confidence it will stay there? There’s lots of things that could go wrong, but if you look at the way that labor market conditions are easing, I think that gives us a bit of confidence. So, job vacancy rates down, the quits rates in the US—which is perhaps the best barometer of forward-looking indicator of wage growth—that’s fallen, the employment PMIs, they’re off too. So, labor market seems to be calling, yes, there’s some signs that prices, paid balances in the business surveys are going up because of supply chain disruption caused by shipping problems in the Red Sea. But at the moment, that’s a pretty small increase in those balances. It doesn’t really point to a big inflationary surge coming. So, I think you put all that together, and we still have some confidence that by the end of this year, inflation is going to be back at target in most of the major advanced economies.
Benz: We wanted to delve into the monetary policy element of this. We’ve had these very significant interest-rate increases in the US, the sharpest tightening in four decades. And you’ve written about the ghost of Arthur Burns, who I believe was a Fed chairman back in the 1970s. Can you talk about that, talk about how you’re thinking about the interest-rate environment here in the US and then perhaps globally?
Shearing: Yes. I think when you think about the outlook for monetary policy and for interest rates, you’ve got to get three things right. You’ve got to get what’s happening in the real economy right, you’ve got to get the links from the real economy to inflation right, and then you’ve got to get the links from inflation to monetary policy right. In other words, the so-called reaction function of the central banks—how do they respond to the inflation numbers? We’ve already spoken about inflation is coming down, and we feel reasonably confident that it’s going to be back at target in most advanced economies by the end of this year. The question then becomes, OK, so how do central banks respond to all of that? I think that is the key challenge. You mentioned Arthur Burns, he was the Fed chairman in the ‘70s. He was widely—but I suspect probably unfairly—criticized for letting the inflation genie out of the bottle in the ‘70s. And then along came Paul Volcker in the late ‘70s, early ‘80s, and jacked up interest rates and squeezed inflation out of the system. He finally vanquished inflation.
So, if you’re a central banker now, you do not want to go down as history’s Arthur Burns. You want to go down as Paul Volcker in all of this, which I think means that you’re a bit slow to cut interest rates than might otherwise be the case. The danger, of course, in doing so is that you inadvertently start to defeat from the jaws of victory when it comes to the soft landing because you keep monetary policy a bit too tight for too long. But I think that’s where we are right now, is that no central banker wants to be Arthur Burns. So, they’re just pushing back and making sure that they’re extra, extra sure that the inflation is under control before they start to think about cutting interest rates.
Lefkovitz: Neil, I wanted to ask, it seems like we’ve reset to certainly higher rates than we’ve become accustomed to after the global financial crisis. And we have had some things break, some bank failures, and some tremors in the real estate market and private markets. But I’m wondering if you see any other implications. Are there other dominoes that haven’t fallen yet?
Shearing: The great puzzle, I think—I think you’re right, it is a puzzle—is why have we seen this enormous tightening of monetary policy and yet the real economy is just soldiered on irrespective? I think there are a couple of reasons for that. But the most important is that we’ve seen the terming out of debt, the locking in of low interest rates, a fixed-rate maturity, fixed interest rates, and locking in low interest rates during the pandemic. That’s been particularly the case for US households, of course, given that we have genuine 30-year fixed-rate mortgages. So, the fact that households remortgaged during the pandemic, locked in low interest rates, that helps to explain why there has been less dislocation in the financial system as a result of the subsequent jacking up of interest rates by the Fed and other central banks. So, the question then becomes, are we through the worst, will we start to see problems emerging in some places? I suspect we will start to see problems and continue to see problems emerging in parts of the financial system. SVB, obviously, 12 months ago is the second largest banking collapse in US history. And I suspect there will be other casualties of higher interest rates.
Likewise, if we look at the shadow banking system, the private credit system, there’s potentially some vulnerabilities there, given the buildup of debt and leverage, and of course, commercial real estate, particularly the office market—we think there could be somewhere in the region of $40 billion of loan losses facing banks in that sector in the US over the next year or so. So, all of that are areas where I think that there could be potential problems.
Set against that, there’s about $2 trillion of equity capital in the US banking system. So those loan losses from CRE start to look rather smaller and that the system as a whole is pretty well-capsulized in the core banking area. So, my sense is that individual institutions may run into problems, individual funds, credit funds may run into problems, and do think both of those things are likely? But whether that translates into a systemic shock, a systemic problem, I think is less likely because the system is pretty well-capitalized, it’s been pretty well stress-tested by the collapse of SVB. Like I said, it’s the second-largest banking collapse in US history, yet the US economy grew by 2.5% or so last year. So that gives you a sense of the kind of order of crisis that we would need to see in order to really bring down the economy.
Benz: You’ve been nicely focusing on the US, which is helpful for US listeners, but I’m wondering if you can dial out and talk about the US recovery relative to the rest of the globe. It does seem to be stronger. And maybe we can take it large region by large region, starting with China, which is an area or a country that you mentioned at the outset is one that you’ve been watching, and it’s obviously not recovered quite as well from covid as the US has. So maybe you can talk about that?
Shearing: Yes, I think all of these things are relative. So, if you look at the level of output in China relative to its pre-covid level, it’s substantially above its pre-covid level, just like it is in the US. Actually, it’s Europe that has really lagged behind in the recovery from covid stakes. But I think China, as so often with China, it’s a case of performance versus expectations, and there’s often a disconnect. And sentiment toward China tends to oscillate between extreme bullishness, so the Asian century, the BRICS future narrative, or extreme pessimism. The property system is about to collapse. It’s going to bring the banking system down with it, and China is facing a hard landing. And I think very often the truth lies somewhere in the middle. And as I alluded to at the start, I think in this instance, the near-term outlook is not nearly as bad as some of the more gloomy headlines suggest.
So, if you think back to the summer, in August we had the announcement of some fiscal support by the Chinese government, they then announced further support in October. All of that’s worth about just under 1% of GDP. And we’re starting to see that fiscal support come through and benefit the real economy. And I think that’s what explains, at least on our measure, why we’ve seen economic momentum pick up. And I think that helps to explain, at least on our measure, why we’ve seen economic momentum pick up over the second half of last year and then into the first quarter of this year. And I think that’s going to continue over the course of the second quarter of this year too.
However, you raised the point about, can this continue? And I think the point that’s often missed when it comes to China was the potential growth in the economy. So, the rate at which the economy can sustainably increase its level of the goods and services that it can produce is diminishing. And it’s diminishing for a couple of reasons. One is that the demographic outlook is pretty horrific. But most importantly, it’s the fact that the economy has reached the limits of this high savings, high investment-growth model that’s served it so well over the past couple of decades. So, the economy is still investing just over 40% of GDP. And when you’ve got a capital stock as modern as China’s, investing 40% of GDP is incredibly difficult to do in a productive way, particularly when the government is playing an increasing role in determining where their capital goes. So, I think that the biggest challenge facing China is this structural slowdown in growth, not the near-term outlook. I don’t lie awake at night thinking about what the second-quarter GDP in China is going to look like; I suspect it will be fine. But when somebody gets to the end of this decade, I think the economy’s growth rate will be somewhere around 2% or so. And that’s the thing that investors are not focusing on enough.
Lefkovitz: And going back to Europe, Neil, you mentioned the economy there has really been stagnating. Could you explain why and give your outlook for Europe?
Shearing: I think there are broadly three reasons why Europe has lagged behind the US in the postcovid recovery. One is that although all households, and to some extent, businesses have been successful in shielding themselves from higher interest rates is because they’ve switched to fixed-rate debt, that’s been particularly the case in the US. So, in the UK, for example, we’ve gone from situation where most households have floating-rate debt on their mortgages to ones where they’ve fixed mortgages for two to five years. Of course, two to five years is a lot shorter maturity than the 30-year mortgages that we have in the US. So, some of those two- to five-year mortgages are now rolling off from maturing and households are having to refinance at higher rates. So, yeah, households have shielded themselves against higher interest rates to a much lesser extent than is the case in the US. That’s the first reason.
The second reason is that Europe, of course, is a large net energy importer and it experienced a substantial terms-of-trade shock in the wake of Russia’s invasion of Ukraine. The US in contrast is a small net energy exporter and didn’t have that terms-of-trade shock that Europe had. And the third, and perhaps the most important, is that the degree of fiscal support that was put in place during the pandemic in Europe was in the order of magnitude smaller than it was in the US. So broadly speaking, US fiscal support was about double the size of relative to GDP of the fiscal support packages in Europe. They were still large in Europe. It’s just that the US fiscal stimulus and fiscal support was so much bigger. I think when you put all those three things together, that helps to explain why the US economy has outperformed Europe’s economy since the pandemic. And then, of course, on the supply side of these economies in Europe, you’ve just got a lower trend rate of growth, partly for demographic reasons, but also because productivity growth is just a lot lower.
Benz: So how about the UK? You have described the economy as flat lining. What’s going on there?
Shearing: Well, the UK, we’re in a bit of a sorry state. And in some ways, coming out of the pandemic, we had the worst of the really tight US labor market conditions and inflationary wage conditions, coupled with Europe’s energy shock. So, had the worst of both worlds. And you see that coming through in the performance of GDP. So, the US outperformed the UK and Germany right at the bottom at the lead table since the pandemic. And to some extent, I think, as I say, that reflects the fact that we’ve had this very, very tight labor market, shortage of workers, rapid wage growth, but even faster inflation and a much sharper fall in real incomes as a result. I think that largely explains it. Of course, there’s Brexit on top of all of that. That’s not been helpful. But I think it’s not been the major driver of the UK’s underperformance.
I think the big challenge for the UK is that the growth model of the UK economy just looks structurally flawed at this stage. There’s lots of discussion here in the UK about the need to raise investments, which of course, no one really opposes. More investment is never a bad thing in the low investment economy. There’s no discussion whatsoever about how do we fund that? How do we finance that? And the key issue facing the UK is that we have a chronically low domestic savings rate. So, households do not save very much. So, as a result, there’s not much funds left over in the banking system for investments. So, the investment rate is low. And what investment we do have, we have to finance by borrowing from overseas. So, we have a large current account deficit. And all of that, that macro mix is just wrong, frankly. We need to have a higher savings rate, higher investment rate, lower share of household consumption in GDP. And all of that requires some pretty deep structural reforms. And frankly, no one at this stage, certainly none in the government is talking about that.
Lefkovitz: The UK equity market certainly seems like a shadow of its former self. Switching to Japan, that’s a market that a lot of investors have been excited about lately. And it seems like there’s been a newfound dynamism, corporate reforms, corporate governance has improved. But I just saw that the economy slipped into recession early in 2024. What do you see is going on in Japan?
Shearing: Yes, so the economy slipped into recession—a technical recession. The labor market is still tight, at least by Japanese standards. I would say this is true, by the way, of the UK and Germany. Technical recessions, but not real recessions. I tend to think of recessions as having this element of reflexivity, whereby demand weakens, unemployment goes up as a result, because people are spending less and so demand weakens even further. And then unemployment goes up even further because spending is even lower. And the cycle is only broken by policymakers, either providing fiscal or monetary support. So that’s the kind of classic recessionary dynamics. And those dynamics are just not present in Germany, the UK, or indeed Japan, despite the fact that all three economies have had this so-called technical recession, which is just really a kind of definition of just two successive quarters of GDP falls, because economists see the definition of a recession rather than the fact that this is a useful definition, I think.
But the key issue really is the tightness of the labor market and the rebound that we’ve seen in wage growth and underlying inflation. Is it sustainable? And does it mark a big break, a meaningful break with the last 20 years, 30 years where deflation has been the biggest threat? And I think to some extent, it is meaningful. I think our view is that there has been a shift in wage- and price-setting dynamics in Japan, but it’s not a very big one. So, it’s probably enough for the bank of Japan to get out of negative territory, get interest rates out of negative territory. If you’re a central banker, you’ve got 2,000 years of financial history, and you know that negative interest rates are an anomaly, so you want to get out of negative interest-rate territory, I think, if you can. And I think there’s a window for the Bank of Japan to do that this spring. I think they’ll take it. But I don’t think those wage- and price-setting dynamics have changed so fundamentally as to mean that there’s going to be a series of large interest-rate increases. And so, I suspect that actually rates will end up going up by a bit less than is currently priced into markets.
Benz: Since we have you zipping around the globe, we’re hoping you can discuss emerging markets other than China. You were an emerging-markets economist. When you survey emerging markets today, besides China, where do you see pockets of trouble as well as pockets of strength?
Shearing: Pockets of trouble is an interesting idea, I think, in emerging markets, because if you just said to an EM investor 25 years ago, OK, the Fed has just raised interest rates by 500 basis points, what’s happened to EM debt markets, EM currencies? There would have been an absolute apocalypse, you would have forecast. But instead, we’ve not seen that. And indeed, in many respects, central banks in the emerging world have played the inflation shock and spike a lot better than the central banks in the developed world.
Part of the reason for that is because they saw high inflation in the ‘80s and ‘90s. And they didn’t wait to see whether inflation in the 2020s was transitory or not. They just got on with tightening policy. And so, as a result, they managed to shore up their currencies and they managed to get on top of inflation, I think, a bit better than the central banks in the developed world. But the fundamental thing that has changed is they were able to do that because there’s been the shift from fixed to floating exchange rates and in the debt markets from foreign currency to local currency debt. So, there’s been a structural improvement in the balance sheets of emerging economies. And this has been the first real cycle where that has played to their benefit, I think, in a very general sense. So, there’s pockets of weakness. Argentina is the obvious one. Turkey is going through its own particular adjustment at the moment. And there’s, of course, more wrenching adjustments and crises playing out in sub-Saharan Africa. But the major EMs, the economic outlook, I think, is relatively benign.
The question we get all the time is, in a world where there’s greater geopolitical competition between the US and China, which EM can emerge from China’s shadow and become the next China, the next motor of global growth? I’m not sure that’s the right way of framing it or thinking about the issue. But I do think that India is, of all the major economies that we track here at Capital Economics, is the one that we’re most bullish about, both in the near term but also in the long term. The demographics are good. It’s well placed to capitalize on the fallout from the US-China fracturing. The Modi government has pushed through some economic reforms. They’ve not been particularly aggressive on that front, but they’re moving in the right direction. Put all that together, and I think the medium-term outlook for India is amongst the brightest of any major economy.
Lefkovitz: You mentioned exchange rates. The US dollar has had a long run of strength. Do you see anything that can reverse that course?
Shearing: I think to some extent, the US dollar has been in this position where either way it’s won. Either there’s been concern about the global economic outlook, in which case there’s been a fight to safety and the US dollar has benefited, or the global economy is in a pretty good position because the US economy is in a good position. The US has been the driver of global growth and therefore the US dollar has benefited. I suspect that that situation continues for a while to come actually. Certainly, when you look against advanced economies, I think the US will continue to outperform most of Europe. So that will give some support to the dollar.
It’s already looking pretty strong when we look at fundamentals, the dollar is already looking quite strong, and valuations quite stretched. So, I’d be surprised if we saw another major leg up for the dollar. By the same token, it’s difficult to think it’s going to fall substantially if we’re right in thinking that the US economy will be a relative source of strength within the developed world.
Benz: 2024 is a huge year for elections across the globe. Maybe we can start with the US. Your team has written that the stakes are higher than normal for the 2024 election. Why do you think that is?
Shearing: Well, I think the starting point is to go back to 2016 and think about the types of policies that were talked about in the campaign trail and then ultimately enacted when Trump was elected, in particular some of the tariffs that were imposed. And actually, the impact that those measures had on the global trading system and on China’s economy and indeed on the US economy and US inflation was pretty modest. You can’t really see it in the data.
Why is that the case? I think there’s two things going on. The first is that some trade was rerouted and so as a result that circumvents the tariffs that were placed on China. But the second point, I think, is that currency markets blunted the impact of tariffs to a large extent. So, if you remember, the renminbi fell 6.3 against the dollar all the way to 7.2-ish at one point after the tariffs that were imposed in 2018 on China. That helped to blunt the impact of the tariffs. However, when we look at the scale and the scope of the measures that are being proposed, at least on the campaign trail by Trump at the moment—so 60% tariff on China and a 10% unilateral tariff on all US imports—both of those have been mooted. They’re far greater, both in terms of the size and the scope than anything we saw in 2016. So, I think the idea that all of those measures can therefore be offset by currency moves is much more difficult to envisage. So, for example, a 60% tariff on all imports from China, we estimate the renminbi would have to fall to something like 8.5 against the dollar in order to offset the effect of those tariffs. And I think that’s difficult to envisage that that would be politically or economically viable from the perspective of Beijing.
Lefkovitz: I saw a capital economics piece about the election called “Read my lips: no new tax cuts.” Why don’t you envision any more tax cuts even if Trump is reelected?
Shearing: Well, it’s possible that he’ll try. I think we can be pretty sure that he will try, and he might even get his own way and get some tax cuts if there’s Republican control of Congress too. But I think it will require Republican control of Congress. The question in our minds really is whether or not the bond market allows this. And part of our thinking here goes back to what happened in the case of the UK government in 2022. If you remember then, we had this disastrous so-called mini budget under Prime Minister Liz Truss. She lasted all the 44 days because of the disastrous budget. But back then, actually, that episode was notable as much for what the government didn’t do as what it did do. So, in the run-up to the budget, the market was already pricing in some pretty significant tax cuts. And actually, what was announced on the day was a bit larger, but not dramatically larger than the market had expected. The key thing that upset the market was the way these tax cuts were enacted, and the fiscal forecast were put together. So, the independent Office for Budget Responsibility was sidelined. The permanent secretary, the senior civil servant of the UK Treasury was sacked. The bond market wobbled on the Friday after the budget on the Thursday. And then the chancellor took to the airways over the weekend and said, “If you thought that was impressive, you’ve not seen anything yet. We’ve got much bigger tax cuts to come.” And then, of course, Sterling fell out a bed on the Monday morning and the gilt market collapsed. And so it was about the fact that the government was perceived to have lost all sense of fiscal responsibility.
I think that is the danger when it comes to the US situation. It’s not so much the fact that the deficit is large. It is large. It’s not so much that the debt burden is large. It is large. The risk is that if the bond market gets a sense that the government is not taking fiscal responsibility seriously and does not have a plan to get on top of the deficit and bring it down in an incredible way, then things can get ugly quite quickly. We start to see term premium going. It’s already gone from being negative to broadly neutral. We start to get very strongly positive because of high risk in bond markets. I think that’s the key break, I think, on the Trump administration and the ability to push through new tax cuts. It’s will the bond market allow it? And there’s much less fiscal space for tax cuts now than was the case in 2016, partly because interest rates are so much higher, but also, of course, the deficit is bigger too and the debt burden is larger as well.
Benz: What other elections beyond the US are you keeping your eyes on?
Shearing: So, big year for elections. The Indian election is kicking off in April, lasting probably through to June, something like that. No great surprises expected there, but this will be obviously the biggest election this year.
The Mexico election is worth keeping an eye on. And then, of course, the UK election to follow probably later this year. It’s not exactly clear when that will happen, but probably around October, maybe November time. Actually, the choice of governments in the UK and the policies being put forward by the two leading parties—the Conservative Party, the Labor Party—they have narrowed dramatically since the last election in 2019. So, the 2019 election was a choice between Tory government promising unbridled Brexit on the one hand, and Labor government threatening to nationalize the commanding heights of the economy. Since then, both major parties have tacked toward the center. I think this is a sense that the adults are back in charge a little. So, I suspect that even the UK election may not be quite the defining moment for markets that some expect.
Lefkovitz: I wanted to shift and talk about artificial intelligence. I know your team has done quite a bit of work. It has really been the theme powering investment markets, certainly in the US. And we’re all, I think, trying to figure out how to harness it or how to avoid being disrupted by it. How are you thinking about AI and its impact?
Shearing: I think the first thing to do is to separate out the market’s impact from the economic impact. We can come back to the market’s impact. But on the economic impact, the key question really facing economists is, is this a general-purpose technology? Because if it is, then we know from history that general-purpose technologies have a tendency to lead to much faster rates of productivity growth, burst of productivity growth, as they’re diffused through economies. So, general-purpose technology is a technology that has a wide range of different applications across different sectors. So, the three classic examples are the internet, electricity, and steam power. And we undertook a big piece of work, major piece of work looking at AI. And our conclusion was, yeah, this probably is a general-purpose technology when we look at things in the round. And so, therefore, we should expect it to have a similarly transformative impact on productivity growth.
However, that comes with a couple of caveats. The first is that it’s going to take time for that productivity growth to show up in the real economy and in the GDP figures. I mentioned earlier that the US has seen faster productivity growth than Europe, but that’s not because of AI, I don’t think. That’s just because the economy’s been allowed to run hot. And the second point is that when this wave of productivity growth eventually arrives, I think it will arrive in different levels, different rates, different orders of magnitude in different economies. In particular, I think the US and countries like Singapore, maybe even the UK actually, are pretty well placed to benefit from the AI revolution. In contrast, the likes of France, Italy, and even China actually, less well placed to benefit because of the structure of their economies, their ability to diffuse this technology, their ability to adapt to the technology because it’s going to cause enormous structural dislocation—all kind of play against those economies to some extent. So, it’s going to take time for the gains to come through. And then when the gains do come through, they’ll come through at different rates in different economies. But this could be a big deal for the US. We think it could boost productivity growth by 1 to 1.5percentage points a year, but probably not until the end of this decade.
The second point is then, so what does all that mean for markets? One of the lessons from history when we looked at this is that markets tend to try to crystallize the benefits of new technology ahead of those benefits actually accruing in the real economy. And this seems to be exactly what’s playing out in the equity markets now with the “Magnificent Seven.” So, my sense is this probably is the early stage of irrational exuberance around AI and the inflation of a bubble. But as I mentioned at the outset, bubbles tend to inflate for a lot longer than anyone anticipates. And so, if this is a bubble, then I think we’re only in the early foothills. We’re only in the early stages. It has a lot further to inflate. And I suspect this will be a story that will run over a matter of years rather than months.
Benz: When you and your team look at the S&P 500 today or like US Total Market, are you concerned about the level of concentration of the US market in those big technology names? Does that seem like potentially something that’s a little bit perilous for US investors?
Shearing: Yes, we are. And it does look like this rally has been unusually concentrated, as you suggest. But it comes back to the point I was making that this is the nature of the bubble, if you like. Unlike the dot-com boom in the early 2000s, the AI boom and bubble has been concentrated in companies that already exist, and they’re already world-leading. They’re already cash generative. They’re already highly profitable. I think that has played into this concentration. The AI boom has been led by a handful of companies that are already large and they’re already profitable. And so that has fed this bubble, cured this bubble, and meant that we’ve seen a substantial amount of concentration in the equity market. So, thinking it’s a concern, I just don’t think it stops the bubble from inflating further for longer.
Lefkovitz: You’ve referenced global fracturing several times. I know that’s another area where your team has done a lot of work. We hear about friend-shoring and nearshoring. Do you see globalization in decline or is it just changing?
Shearing: I think it’s a bit of both, if I’m being honest. I’m giving you the classic economist answer. I think this is a classic way in which economists get things wrong. If you ask someone for their views on globalization, it will typically fall into two camps, one of two camps. Either there will be those that view globalization as impossible to unravel and essentially, it’s here to stay. Or there will be those that view the world as deglobalizing. Supply chains unravelling, production being moved back to the US or to Europe and out of emerging economies. I think neither of those things are true. You only have to look at examples from history to know that globalization can be unwound pretty rapidly. Look at what happened in the early 20th century. We had a period of the small burst of globalization after the Second World War that then stalled in the 1970s. So, there’s lots of examples from recent history where we’ve had integration that’s now either unwound or stalled. Equally, I don’t buy the idea that the world is deglobalizing either. The poster child for reshoring was going to be Foxconn’s plant in Wisconsin. And look how that’s played out.
So, I think rather what’s happening is, as you suggest, that there’s this fracturing in the relationship between the US and China. And why is that happening? It’s because what drove into the integration of China into the global economy was the idea that it would become economically liberal, perhaps even politically more liberal, more like the US and other European economies, democratic economies. Instead, of course, this emerged as this strategic rival to the US. And so, we’re in this era of geopolitical competition. And what that means is that the US and China are breaking apart because of this geopolitical position, and other countries are having to choose which camp to side with, which camp to go into. Even countries that would prefer to keep their head down are being forced to pick a side. And then decisions within those blocks are being increasingly made on the grounds of geopolitics and national security.
And that’s the key part. Because if you’re thinking about supply chains globally, there’s no good geopolitical reason not to buy toys or furniture or flat screen TVs from China. But there’s lots of really good reasons if you’re sat in the US or you’re not to have your mobile phone manufactured in China or not to have lots of dependence on Chinese batteries for electric vehicles or chips or data or biotech. There’s lots of areas of manufacturing where you can imagine that there will be good reasons on national security grounds to break apart from China. And that’s where the deglobalization will take place. And it won’t go back to the US. Production in those areas won’t go back to the US. It will go to a more-friendly nation—this idea of friend-shoring. Indeed, that’s what we’re seeing starting to play to play out.
So, my view is the world is not deglobalizing, but by the same token, the era of hyper-globalization is behind us, and we’re in this world of fragmentation, fracturing. And that will have really wrenching effects in some sectors and consequences in some sectors. But in others— like, say, toys manufacturing, low-end manufacturing goods—the impact might be minimal. If it’s about manufacturing, if Trump, on the other hand, is in office and he is starting to put 60% tariffs on the Chinese goods and maybe turn away from Europe as well and to the US inward, then the situation becomes far more malign and potentially economically damaging.
Lefkovitz: Well, that seems like a good place to stop. Neil, thank you so much for sharing your views with us.
Shearing: Thanks for having me.
Benz: Thank you for being here, Neil.
Lefkovitz: Thank you for joining us on The Long View. If you could, please take a moment to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
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Benz: And @Christine_Benz on X, or Christine Benz on LinkedIn.
Lefkovitz: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
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