Presentation

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Kristen Hallam

According to our strategic report on key themes for 2024, the prolongation of existing and emergence of new armed conflicts will likely remain a major source of geopolitical instability in the world economy. Following Iran's recent strike on Israel, we posed the question, what could an escalation mean for the global economy?

I'm Kristen Hallam, Lead Content Strategist for Global Intelligence and Analytics at S&P Global Market Intelligence, and your host for this episode of the Economics & Country risk podcast. Joining me for this discussion is my colleague for Market Intelligence, Ken Wattret, Vice President, Global Economics. Ken, welcome back to the podcast, and thank you for being here.

Ken Wattret

Kristen, great to be here. Thank you for inviting me.

Question and Answer

Kristen Hallam

Always a pleasure to have you on. Ken, have we made any adjustments to our economic forecast to reflect these recent events in the Middle East and the potential for further escalation?

Ken Wattret

We have been making some adjustments here and there to reflect various recent developments, including the shift in expectations for U.S. policy rates and its knock-on effects. But for a few reasons, we haven't made radical changes to our forecast following the missile strikes in Israel and Iran. First and foremost, we need to take a little time to assess how the situation in the Middle East will evolve from here.
And also the base case from our geopolitical experts is that a region-wide conflict will probably still be averted. And consistent with that, we've had so far a very muted reaction to the news from commodity prices and financial markets. I mean if we look at the price of Brent crude, for example, it's actually declined to a little below $90 a barrel, and it could be argued that an increased risk of escalation had already been priced in with oil prices gradually rising through most of the year so far.

Kristen Hallam

And what is our current base case for the economy?

Ken Wattret

Well, we've actually been revising up our growth forecast for this year in quite a few countries over the last few months. Our global growth forecast, for example, has risen from 2.3% back in January to 2.6% in the latest update. And it incorporates a gradual pickup in momentum quarter-over-quarter growth rates this year are actually forecast to be higher than in the second half of last year. So that requires some explanation given the increase in uncertainty that we've seen.
And in part, it reflects the recent resilience of the U.S. economy. It also reflects our expectations for a pickup in Europe, albeit a rather insipid one. And also, we see continued strength in some outperforming economies, including India. And it's also important to flag that our PMIs, our purchasing managers indices, they've been telling us for several months now that the global growth momentum is actually improving and it's becoming more broad-based.
So if we look at the global composite PMI output index, which is a bellwether for global growth, it's improved in each of the 5 months to March, and the flash data that we've just had released for April suggests that the pickup was broadly maintained despite the missile attacks that we've seen and related risks. Now this all being said, we do need to keep a bit of perspective because the forecast of 2.6% global real GDP growth this year is nothing to shout about. And actually, the peak quarter-over-quarter growth rate in our profile is well below those that we've seen in prior economic cycles. So the direction of travel is upwards, but there are still various headwinds expected to hold economic growth back.

Kristen Hallam

Got it. So positive trajectory, but nothing to get too excited about yet. And as you suggested earlier, I imagine it's really challenging to incorporate geopolitical shocks into our economic analyses. But I also imagine that we've had quite a bit of practice in the last few years at doing that. How do we approach that in a way that doesn't result in volatile swings in our forecast?

Ken Wattret

Well, as you said, it can be very challenging. We clearly want to avoid huge swings back and forth in our economic forecast. But at the same time, we also want to avoid an excessive inertia where the forecasts are not reflecting emerging development and our expectation of how things will evolve in the future. Now one advantage we have is that most of our forecasts have run through a global macroeconomic model that's called the Global Link Model or GLM.
So we can actually run alternative scenarios to try to calibrate the economic effects of various shocks. And we have, in the past, looked, for example, at spikes in oil prices, changes in inflation conditions, changes in monetary policy conditions and a wide range of other different shocks, and we can pull levers in the model to try and calibrate the effects. So we don't necessarily have to change the base case. If this is a tail risk event, which is low probability, but high impact, we can use the GLM to try and ascertain what the economic implications of that shock would be.

Kristen Hallam

You mentioned the oil price shocks there. And I imagine that would be one of the key transmission channels if there were to be an escalation of the conflict in the Middle East. What would be other transmission channels that we might expect to see?

Ken Wattret

Yes, that's a really important point. And I think in this particular issue, there are various transmission channels to consider, and that means it could be a multifaceted economic shock with significant adverse effects. So the obvious one, as mentioned, is higher energy prices, particularly crude oil prices, given the importance of the region for global oil supply.
But then there's lots of other channels. Think about financial conditions, they could become much less favorable, be that via higher-short or long-term interest rates than otherwise, or tighter credit conditions from financial institutions, or more volatile financial market conditions in general. Then we have trade and supply chain disruptions.
The trading routes would be affected by a broader conflict, then there's negative confidence effects and that would likely be aggravated by declines in asset prices, should interest rates end up remaining higher for longer and uncertainty persists. So there are lots of different channels for how a shock like this could impact on economic activity, and we can pull those levers in our Global Link Model to try and, again, gauge what the economic implications would be.

Kristen Hallam

And what would the implications for our forecast be if we saw some of these transmission channels that you mentioned like tighter credit conditions and so on.

Ken Wattret

I think it's probably easiest to think of this as a series of impact, a bit like a chain reaction. So higher oil prices would mean higher consumer price inflation that squeezes household real incomes and hits consumer spending. And with labor markets still generally tight, Central Bank fees of second round effects on inflation via stubbornly high wage growth. Those concerns would limit the scope for interest rate cuts and in some cases, might necessitate additional monetary policy tightening.
We typically see in a period of high uncertainty, U.S. dollar appreciation that would actually intensify those inflationary worries because the currency weakness elsewhere would not only aggravate the increase in oil prices, but it would raise import prices more generally. And then against the backdrop of less favorable financial conditions, equity prices would probably fall sharply from their current elevated levels.
That means negative wealth effects, weaker consumer confidence, further damaging consumption prospects, and related to that, uncertainty over future demand and again, less favorable financial conditions hold back corporate investment and so on.
So the bottom line is a very unfavorable combination of circumstances and economic growth prospects becoming much, much weaker than in our base case. There are variations, of course, in the impact depending on the breadth of the conflict and in turn, the duration and scale of the effects on oil prices, confidence, financial conditions and so on. But clearly, that would be a material change in economic growth prospects for the worse.

Kristen Hallam

Lots to keep an eye on there for sure. And Ken, what types of economies would be hit hardest by an escalation?

Ken Wattret

Yes, that's also a really important point because given these various transmission channels we've been talking about, the aggregate effects on global economic activity, we think would be substantial, but they wouldn't be evenly spread. And probably the area to focus on there is to think about whether an economy is a net energy importer or a net energy exporter.
The net energy importers would be hardest hit particularly those most reliant on oil supplies from the Middle East, and that includes many of the larger economies in Europe and Asia Pacific. But if you're a net energy exporter and you're not located in the region that's being hit by the conflict and the disruption, then your economy will be less adversely affected, and that includes these days, the U.S. economy, which now has a net energy exporter status.
Now there are some caveats to that because the U.S. household sector tends to be more sensitive to negative wealth effects related to declines in equity prices. And also, the Federal Reserve sounds more worried about inflation in the U.S. than some other major central banks. So probably in the U.S. case, the argument for tight, for longer financial conditions is particularly appropriate.
But for other energy exporters who are not in the Middle East, they get the potential benefit of higher prices and no disruption to supply. So we need to think about those differences across countries and regions depending on their structure when we think about the fallout from a scenario like this.

Kristen Hallam

Yes, with so many different transmission channels, it's hard to imagine that any economy would remain untouched in the event of an escalation.

Ken Wattret

Yes. I think we need to think about the direct and the indirect effects of this, and we've touched on many of these already. If you're thinking about the energy implications then some economies might benefit, but if you're thinking about the broader implications, we're talking about potentially a rather significant hit to global demand, then, of course, even if you're not directly affected by the conflict, then it can have an impact on your ability to grow the economy through the export channel, for example.
And these differences are really quite important. Now, some economies don't have much effect through the wealth channel. Consumer spending is not particularly sensitive to changes in asset prices. Others are very sensitive. So these differences in structure and differences in transmission channels are really important.

Kristen Hallam

So earlier, I mentioned that we had some experience with incorporating geopolitical shocks, and I was thinking about the Russia-Ukraine war. How does that conflict compare to what we could potentially see with an escalation in the Middle East?

Ken Wattret

Well, there are some obvious parallels, including disruptions to energy supply related to that higher energy costs, higher inflation, and impact on monetary policy conditions globally, increased uncertainty, more volatility in financial markets and so on.
But I think with the Russia-Ukraine conflict, it was very much concentrated on Europe, and particularly manufacturing sensitive areas like Germany, where we've really seen economic conditions remaining very weak for quite a long time. Now many economies in Europe had become very heavily dependent on cheap energy supplies from Russia.
So the effects were particularly pronounced there. A crisis in the Middle East would have much broader effects on the global economy, including to many economies around the world, which have become very dependent on oil supply from that region.
And as mentioned, this includes many in Asia Pacific, which were comparatively unscathed by the aftereffects of the war in Ukraine, but which are highly dependent on oil supplies from the Middle East. So I think we should think of this as a much more global shock. It doesn't mean that Russia-Ukraine didn't have implications more broadly. But I think given the importance of oil supply for different regions in the Middle East, this has the potential to have much more wide-ranging effects.

Kristen Hallam

Yes, some good points there. So what indicators should we be keeping an eye on as the situation in the Middle East develops, Ken?

Ken Wattret

Well, there are some obvious ones, which we've mentioned already. I mean you look no further than the evolution of crude oil prices, for example. And then there are things that we would also see some effects coming through quite quickly. Think about various measures of financial stress.
I mean we did see some metrics of financial market volatility pick up markedly in mid-April when the tension started to escalate, including the VIX Index, a measure of volatility in equity markets and there are other things that we would typically look at inflows into safe haven currencies like the Swiss franc or safe-haven assets like U.S. treasuries, for example.
And that's quite interesting also because so far, we've seen a very muted impact on the U.S. treasury market. Yields are still close to their highs for the year, and yields are up by about 80 basis points year-to-date. So it looks like the focus for the U.S. treasury market still is very much firm recent U.S. inflation data and the reduced scope for Fed rate cuts rather than the potential risk of escalation in the Middle East.
Now of course, that could change and could change very quickly, but these are the kind of indicators that we would typically keep a close eye on. As for the economic effects, we'll see any impact in our own PMI data much more quickly than in an official data. The flash PMI figures are published before the end of each month.
So they're giving us a real-time gauge of what's happening across a wide range of areas, be it output, orders, prices, delivery times and so on. So in terms of reflecting the economic effects quickly, we'd be keeping it very close on the PMI data.

Kristen Hallam

All right. We'll have our PMI economists on the podcast in a few weeks, so I'll be sure to ask them about that. So Ken, it's time to wrap up our discussion. Any final thoughts for our listeners?

Ken Wattret

Well, we live in more uncertain times. The days of low and stable inflation, low and stable interest rates, and generally favorable and predictable economic conditions feel like a rather long time ago. Still drawing on the wide range of experts across our business, we can help our clients to navigate a path through these much more uncertain times.

Kristen Hallam

Well, thank you for that, Ken. I really appreciate you joining us on the podcast again to share your insights on the global economy, and thanks to you, our listeners for tuning in. Please join us next week to learn more about the forces creating risks and opportunities for businesses in 2024.

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