Weekly global economic update
What’s happening this week in economics? Deloitte’s team of economists examines news and trends from around the world.
China faces a labor shortage in manufacturing
- One reason China grew so rapidly in the last 40 years was that it saw an enormous migration of workers from rural to urban areas. Moving a worker from a farm to a factory generally leads to a big increase in labor productivity. China’s rapid growth was largely fueled by such productivity gains. However, in recent years, the pace of migration slowed, and in fact there is evidence that it may be reversing. This is an important reason why China is growing more slowly than previously.
Meanwhile, the large pool of migrants is aging. Of the roughly 297 million migrants working in China’s urban areas, 31% are over 50, about three times the share in 2008. The average age of the migrants is 43, up from 34 in 2008. As workers age, many are shifting from manufacturing work to less labor-intensive service work. And some are simply retiring. One result is that the share of migrants working in manufacturing has fallen from 38% in 2008 to 28% now.
The situation with migrant workers is causing a shortage of labor for the vast manufacturing sector, even though manufacturing employment has been declining for the last two decades. The aging of migrants is not the only reason. Another is that an increasing share of urbanites are obtaining university degrees, many of whom prefer to take white collar jobs in the services sector.
The shortage of labor in the manufacturing sector has led to a sharp rise in the cost of labor. According to the Japanese government, base compensation at Japanese-owned factories in China is now 40% higher than at Japanese factories in Thailand. Ten years ago, they were the same. Thus, labor arbitrage is no longer a good reason to invest in China. Moreover, the evident shift of supply chains away from China and toward Southeast Asia is not only about geopolitical risk. It is also about labor costs. China’s government, meanwhile, is promoting manufacturing in high technology and clean energy, likely exacerbating the shortage of labor.
Chinese trade patterns continue to shift
- China’s exports grew modestly in April after having fallen sharply in March. When measured in US dollars, Chinese exports fell 7.5% in March versus a year earlier. In April, exports were up 1.5%. The rebound was principally because of stronger demand for automobiles and other high-tech products but was offset by weaker demand for apparel and steel.
In line with recent trends regarding changed trade patterns, Chinese exports were up 4% to Taiwan and 8.1% to Southeast Asia. That is, Chinese trade with neighbors other than Japan is rising. On the other hand, exports were down 10.9% to Japan, down 2.8% to the United States, and down 3.6% to the European Union (EU). Exports to Australia, South Korea, and Russia were down as well. Thus, it appears that trade with Southeast Asia was the reason for China’s overall growth. Also, export growth was helped by a low base from a year earlier. That is one reason to expect weakness in export growth in the months ahead.
Meanwhile, imports were up 8.4% in April versus a year earlier, the second biggest increase since February 2022. It has been reported to be largely due to a surge in demand for AI-related equipment. Imports of automatic data-processing equipment, which includes computers and components, were up 50% in the first four months of 2024 versus a year earlier. This reflects the effort of Chinese companies, encouraged by the government, to quickly become a major force in gen AI. Meanwhile, many other import categories declined, including agricultural goods, coal, and cosmetics.
By country, April imports were up 9% from the United States, 2.5% from the EU, and 5% from Southeast Asia. In the first four months of 2024, imports were up strongly from Taiwan, Southeast Asia, South Korea, India, and Hong Kong. Imports from the United States, EU, and Japan were down.
The latest on European-Chinese economic relations
- “The world cannot absorb China’s surplus production.” So said EU Commission President Ursula von der Leyen after meeting with China’s president in Paris. A serious trade dispute seems to be bubbling between China and the EU. China’s strategy for economic growth party involves boosting investment in key technologies, including electric vehicles (EVs) and related products. Yet China’s strategy does not include boosting consumer demand within China. Thus, the only way to justify the extra production is to export.
Meanwhile, the EU is concerned about a flood of inexpensive EVs and other products entering the European market. The EU worries that China is dumping (selling below cost due to government subsidies). China’s producers say that they are simply good at producing low-cost and high-quality vehicles. The EU is investigating China’s imports and could decide to impose restrictions. In response, China is investigating dumping of EU products in China, such as high-end alcoholic beverages.
At the meeting in Paris, both von der Leyen and French President Macron urged China to ease entry of EU goods in China and reduce regulations that are seen as protectionist. Von der Leyen hinted that protectionist measures could be necessary to defend EU companies and economies. On the other hand, the French worry that Germany might undermine the EU investigation into dumping because of German reliance on exports of automobiles to China. One solution to the perceived imbalance is for Chinese EV producers to invest in production in Europe. Indeed, French Finance Minister Le Maire said that “BYD is welcome in France,” referring to the China-based EV producer. BYD is planning to build a factory in Hungary.
In any event, trade tensions between China and the EU, as well as between China and the United States, are likely to persist so long as China follows its current policy. This policy places strong emphasis on moving China up the value chain by investing in key technologies but does not include policies meant to absorb excess production in domestic markets. At the same time, protectionist sentiment in both Europe and the United States is on the rise, fueled in part by geopolitical concerns about China’s rise, but also due to a desire to boost domestic capacity in key technologies.
- Meanwhile, European companies are increasingly pessimistic about doing business in China, according to a survey conducted by the European Union Chamber of Commerce in China. According to the survey, only 15% of respondents said that China is a top investment priority—a record low. Also, only 13% said that China is their top future destination—also a record low. Meanwhile, 68% of respondents, a record high, said that doing business in China has become more difficult. On the other hand, 45% said that there has been market opening in their industry.
The pessimistic viewpoint reflects several factors. The Chamber reported that “China’s structural issues—including sluggish demand, growing overcapacity and the continued challenges in the real estate sector—along with market access and regulatory barriers, continued to negatively impact European companies.” Indeed, 55% of respondents said that China’s slowdown is among their top three business challenges. That was up from 36% a year ago. Of particular note is the concern about overcapacity in China, which means that European companies are facing significant competition from Chinese companies.
In response to the perceived challenging environment, 52% said that they plan to cut costs in China, with 26% planning to reduce headcount. In addition, 13% said that they are already taking steps to exit investments out of China. Still, 42% are considering expanding investments in China. Yet that is a record low. The survey results could partly explain why there has been a sharp decline in inbound foreign direct investment into China.
Bank of England leaves rates unchanged
- The Bank of England (BOE) left the benchmark interest rate unchanged at 5.25% but strongly signaled a possibility that the rate will be cut in June. Andrew Bailey, governor of the BOE, said that “it’s likely that we will need to cut bank rates over the coming quarters, possibly more so than currently priced into market rates.” He said that a cut in June cannot be ruled out but that it is not a fait accompli. The vote to leave the rate unchanged was seven to two, with the two wanting to cut the rate. At the previous meeting, there was only one member of the committee voting to cut. Thus, sentiment is evidently shifting.
Meanwhile, the BOE offered a slightly more optimistic forecast about the trajectory of inflation than in February. Bailey said that, although he is optimistic that inflation is moving in the right direction, the committee will need to see more evidence of progress before cutting rates. The committee said that it will look at “forthcoming data” to determine if persistent inflation is receding.
In addition, Bailey said that decisions will, in part, be dependent on how the BOE sees the labor market. However, the BOE indicated that there is “considerable uncertainty” about the reliability of official labor market statistics. This makes it more difficult to assess whether the labor market is becoming less tight, which is seen as necessary before cutting interest rates.
Whatever the BOE decides in the coming months, it will surely have a political impact within the United Kingdom. The government of Prime Minister Sunak is eager to demonstrate that interest rates are declining before it faces voters in an election that must be held no later than January. Moreover, there is the issue of whether the BOE cuts rates before the European Central Bank (ECB). Already two major European central banks (Switzerland and Sweden) have cut rates, but a reduction by the BOE before the ECB will put downward pressure on the pound. That could be inflationary.
British economy starts to recover
- First-quarter data suggests that the British economy is starting a strong recovery. The government reports that, in the first quarter, real GDP increased 0.6% from the previous quarter. This follows two quarters of negative growth and was the fastest growth of GDP since the fourth quarter of 2021. Real GDP was up only 0.2% from a year earlier.
When looking at GDP from the supply side of the ledger, output of services was up 0.7% from the previous quarter. The biggest contributor was a 3.7% increase in transport and storage services, led by a big increase in land transport services via pipeline. The second biggest contributor to services growth was a 1.3% increase in professional, scientific, and technical activities.
Production was up 0.8%, which included a strong 1.4% increase in manufacturing output. That, in turn, was fueled by a big 5.7% increase in output of transport equipment, including automobiles. This was offset, however, by a 0.9% decline in construction activity.
On the demand side, real consumer spending was up a modest 0.2% from the previous quarter. Gross fixed capital formation was up a strong 1.4%, which included a 0.9% increase in business investment. Government purchases were up 0.3%. Finally, net trade made a positive contribution to GDP growth as imports fell 2.3%, more than the 1% decline in exports.
Thus, Britain has exited recession. Moreover, Britain’s first-quarter growth was stronger than that of the Eurozone or the United States. The rebound was good news for the government, which hopes to offer voters evidence of economic strength later this year. On the other hand, after three quarters in which real GDP did not grow, real GDP has barely grown over the course of a year.
US investors keep shifting their expectations about the Fed
- In the past two weeks, investors have revised their expectations regarding Federal Reserve policy. The futures markets’ implied trajectory of short-term interest rates has shifted, with investors now expecting the Fed to loosen monetary policy a bit faster than had been expected two weeks previously. Why? The latest data on the US jobs market convinced many investors that the labor market is starting to loosen, even though it remains historically tight. Last week’s slower-than-expected job growth, combined with a decline in the job openings rate and the slower-than-expected GDP growth in the first quarter, suggest the possibility that the Fed’s tight monetary policy may finally be having an impact. This, in turn, suggests that inflationary pressures may ease in the months to come, and likely allowing the Fed to cut rates a bit faster than previously anticipated.
The change in investor expectations explains why the yield on the US Treasury’s 10-year bond has fallen slightly. This follows a period in which the yield increased when many investors became convinced that the Fed wouldn’t cut rates soon. Investors were influenced by the surprising strength of the economy and the persistence of inflation. Now, however, they are starting to see indications of slower growth, if not an easing of inflation. Also, revised expectations of Fed action also explain the modest upturn in US equity prices. Finally, the Japanese yen has appreciated. This was likely due to intervention by Japan’s authorities, but it might have been influenced as well by changing expectations of Fed policy.
Another data point that might spook investors is a sharp decline in US bank lending in the first quarter. It is reported that, in the first quarter of this year, bank lending declined US$36 billion from the previous quarter, the sharpest decline in three years. The decline was mainly due to a drop in credit card lending. Lending to businesses, including for commercial property, was up. The drop in credit card lending follows a period in which credit card debt increased sharply from the historic lows that followed the pandemic.
The decline in credit card debt in the first quarter could presage an easing of consumer spending growth. Delinquencies on credit card debt are now at the highest level in 13 years (although much lower than the peak reached during the global financial crisis), suggesting that an increasing number of households are feeling financial stress. This is despite low unemployment and rising real wages. Part of the problem is that the average interest rate on credit card balances is at an historic level.
US GDP and job growth decelerate, but inflation is stuck
- The US government reported that real GDP grew at an annualized rate of 1.6% in the first quarter of 2024, slower than investors had anticipated and the slowest rate of expansion since the second quarter of 2022. The relatively weak growth was mainly due to a decline in business inventories, a decline in Federal government purchases, and a sharp rise in imports that led to a negative net contribution from trade. Other components of GDP did well. This included consumer spending, business investment, and investment in residential property. Here are the details.
In the first quarter, real (inflation-adjusted) consumer spending grew at an annualized rate of 2.5% from the previous quarter. This included a 1.2% decline in spending on durable goods (fueled by a sharp drop in automotive spending), no change in spending on non-durable goods, and a big 4% increase in spending on services.
Real business fixed investment increased at a rate of 2.9%. This included a 2.1% increase for business equipment (the first increase in three quarters, fueled by investment in information technology and offset by a sharp drop in investment in transportation equipment), a 0.1% decline for structures, and a 5.4% increase for intellectual property (which includes software and R&D). Real investment in residential property was up at a rate of 13.9%. On the other hand, a decline in business inventories reduced real GDP growth by 0.35 percentage points. The rise in investment in information technology was the strongest since the first quarter of 2022. This bodes well for demand for consulting services.
Meanwhile, although real exports of goods and services were up 0.9%, imports were up 7.2%. This means that net exports made a negative contribution to GDP growth. In addition, while state and local government purchases were up at a rate of 2%, real Federal purchases were down 0.2%.
Although real GDP grew more slowly than expected in the first quarter, the core components did very well. Final sales to private domestic purchasers (which excludes the impact of trade, government, and inventories) were up at a rate of 3.1%. This was the second-fastest rate of growth since the fourth quarter of 2021 when the economy was bouncing back from the pandemic downturn. Thus, the news on economic growth remains relatively good. Moreover, the news suggests that the United States remains a prime engine for global economic growth. Still, the weak headline number evidently spooked investors.
- The US government also published data on household income, consumer spending, and the Federal Reserve’s favorite measure of inflation. Although the news on household spending was good, investors mainly focused on the inflation numbers.
Specifically, it was reported that the personal consumption expenditure deflator (PCE-deflator) was up 2.7% in March from a year earlier, up from 2.5% in February. This was the first acceleration in the index since September 2023. However, when volatile food and energy prices are excluded, the core PCE-deflator was up 2.8% in March versus a year earlier, the same as in February. Core inflation has been relatively steady for four months, suggesting that the previous deceleration has halted.
The inflation problem remains one of services, which are labor intensive. Thus, the problem is the tight labor market, which is generating significant wage gains. Specifically, prices of durable goods were down 1.9% from a year earlier while prices of non-durables were up only 1.3%. This included food, which was up just 1.5%. Yet prices of services were up 4% from a year earlier, roughly unchanged over the past five months.
As such, it is not surprising that futures prices are implying a 60% probability that the Fed will start cutting rates in September. Plus, they imply only a 50% chance of a second rate cut in 2024. This is a sea change from just a few months ago when investors expected the Fed to start in June and undertake three to four cuts in 2024. The shift in investor expectations reflects the persistent tightness of the labor market and strong underlying demand in the economy. Investors evidently believe that the Fed will not loosen monetary policy while the economy is so strong and underlying inflation is stuck.
Meanwhile, the US government also reported that, while real disposable personal income was up 0.2% from February to March (the fastest growth since December), real personal consumer spending was up 0.5%, the same as in the previous month. Thus, households continue to reduce savings to enable strong increases in spending. The personal savings rate fell from 3.6% in February to 3.2% in March.
- The Federal Reserve intends to keep interest rates high for longer, largely because the US labor market has remained unusually tight, thereby generating wage gains that propel inflation in services. Thus, any indication that the labor market is loosening would be welcome news for the Fed. The latest data suggested that labor market tightness is easing. The government reported a sharp slowdown in employment growth in April, although it remains higher than the expected long-term trend. Plus, wage growth in April receded. Let’s look at the data.
The US government report on employment includes results from two surveys: one is a survey of households, and the other is a survey of establishments. The establishment survey found that, in April, 175,000 new jobs were created. This was the slowest job growth since October 2023. On the other hand, the growth for March was upwardly revised to 315,000, an unusually strong number. One month does not make a trend. However, if the slower growth seen in April persists in the months to come, it will likely signal an easing of labor market tightness. That, in turn, might influence the decisions of the Federal Reserve.
By industry, there was very modest job growth in goods-producing industries (mining, construction, manufacturing). There was a decline in employment in information as well as professional and business services and there was very modest growth in financial services, leisure and hospitality, and government. Moderately strong growth took place in wholesale trade, retail trade, and transportation. But the strongest growth took place in health care and social assistance. Overall, April was a relatively poor month for job growth.
The establishment survey also includes data on wages. The report says that, in April, average hourly earnings of all workers were up only 3.9% from a year earlier, the smallest increase since March 2021. Thus, wage pressure is evidently easing. However, it remains too high given the Fed’s goal of 2% inflation. If productivity were rising rapidly, then businesses could increase wages without increasing prices as they would be getting more out of each worker. Yet as indicated below, productivity growth stalled in the first quarter.
Finally, the household survey indicated that, in April, employment grew more slowly than the labor force, thereby leading to an increase in the unemployment rate to 3.9%, still a very low level.
- The US government also reported on labor productivity in the first quarter. Recall that, in the three most recent quarters, labor productivity (output per hour worked) increased rapidly. This was helpful in reducing inflation. It also contributed to strong economic growth. The rise in productivity in 2023 was likely related to business investments in labor-saving and labor-augmenting technologies, a response to the tight labor market.
Yet, in the first quarter of 2024, labor productivity nearly stalled. Productivity increased only 0.3% from the fourth quarter of 2023 to the first quarter of 2024. This followed strong growth of 3.5% in the previous quarter. The result was that, with wages continuing to rise, unit labor costs (ULCs) accelerated sharply in the first quarter. ULC denotes the labor cost of producing a unit of output. It is calculated as real (inflation-adjusted) hourly compensation divided by productivity. Thus, if productivity rises at the same rate as real wages, then ULCs are unchanged. That implies that companies needn’t raise prices in line with wage increases.
In the second half of 2023, ULCs were basically unchanged as productivity gains offset real wage gains. Yet in the first quarter, ULC was up 4.7% from the previous quarter. Moreover, ULC was up faster for services than for manufacturing. This is not good news for suppressing inflation, especially given that most of the remaining inflation is the services sector.
Federal Reserve indicates that rates will remain high for longer
- As expected, the US Federal Reserve left its benchmark interest rate unchanged for now. However, Fed Chair Powell indicated that inflation has been more persistent than anticipated. He said: “It’s likely to take longer for us to gain confidence that we are on a sustainable path to 2% inflation. I don’t know how long it will take.” Consequently, he said that rates will remain high for longer. On the other hand, he said that the Fed will soon start to lighten its program of quantitative tightening. That is, it will slow the pace of asset sales. Doing so will put downward pressure on bond yields. Moreover, he said that an increase in interest rates is “unlikely.”
Investors were evidently not surprised by this announcement. Bond yields and equity prices moved very little. Investors had already shifted their expectations based on the latest data on inflation and economic growth.
Although Powell said that rates will remain high for longer, it is not clear if the current level of rates is having the necessary dampening effect on labor markets. As I note below, the job openings rate has been declining, indicating an easing of the tight labor market. Yet that might not be the result of Fed policy. There are likely other factors at work. Still, given the surprising strength of the US economy and US labor market, and given that core inflation has stabilized at a rate too high for comfort, it would likely not make sense for the Fed to cut rates at this time.
One result of the new trajectory of Fed policy will likely be higher bond yields in the coming year than would otherwise be the case. Indeed, bond yields have risen in the last few months due to changing expectations about Fed policy. Higher yields will likely have a negative impact on merger and acquisition transactions. Moreover, the longer the yields remain high, the bigger the impact as businesses face the need to roll over debts.
Eurozone economy accelerates while inflation recedes
- The Eurozone economy finally accelerated in the first quarter of 2024 after a prolonged period of stagnation. In the first quarter of 2024, real GDP was up 0.3% from the previous quarter, the strongest rate of growth since the third quarter of 2022. Real GDP was up 0.4% from a year earlier.
By country, the quarter-to-quarter growth of real GDP was 0.2% for Germany and France, 0.3% for Italy, and 0.7% for Spain. Most notable was the sharp rebound of the German economy, which had seen real GDP decline 0.5% in the previous quarter. German GDP growth in the first quarter of 2024 was the strongest in since the first quarter of 2023. Germany’s government attributed the rebound to strong business investment and exports. These offset weakness in consumer spending. In addition, Italy’s relatively favorable performance was, in part, related to strong exports.
Going forward, there is reason to expect continued modest growth of the Eurozone economy. Real (inflation-adjusted) wages are rising, thereby creating the conditions for a boost to consumer spending. In addition, an expected easing of monetary policy by the European Central Bank (ECB) will likely have a positive impact on investment and interest-sensitive consumer spending. Meanwhile, a strong US economy and better-than-expected economic performance in China can help to stimulate exports.
- Inflation in the Eurozone is getting better. Although headline inflation in March was unchanged from the previous month, core inflation continued to decelerate. This potentially sets the stage for an easing of monetary policy by the ECB. However, investors are increasingly expecting the ECB to wait a bit longer before acting. Here are the details.
In March, consumer prices in the 20-member Eurozone were up 2.4% from a year earlier, the same as in February. However, when volatile food and energy prices are excluded, core prices were up 2.7% in March versus a year earlier. This was the lowest core inflation since February 2022. Recall that core inflation peaked at 5.7% in March 2023. Thus, significant progress has been made.
As in the United States, the main inflation problem is in services. While prices of non-energy industry products in the Eurozone were up only 0.9% from a year earlier, prices of services were up 3.7%. Europe’s labor market remains tight, generating wage gains greater than the rate of inflation, especially when it comes to labor-intensive services. This is the principal concern of the ECB. Still, given that underlying inflation continues to decline, and given that economic growth remains sub-par, it seems reasonable to expect the ECB to start cutting interest rates sometime this year.
By country, annual inflation in March was 2.4% in Germany and France, 1% in Italy, 3.4% in Spain, 2.6% in the Netherlands, 4.9% in Belgium, and 0.6% in Finland. The numbers for Germany and Spain were higher than in the previous month. This raised questions as to whether inflation is becoming sticky. For the ECB, this implies that the last mile toward the 2% target could be difficult and might require tighter policy for longer. In response to the inflation news, bond yields in Europe were up as investors reassessed the timing of a rate cut.
Mexico-China trade tensions increase
- Geopolitical tensions and uncertainty have led to a decline in foreign direct investment in China, especially on the part of US-based companies. Global companies are diversifying supply chains with resilience and redundancy in mind. One country that has attracted attention is Mexico. That is because it has relatively low labor costs (lower than in China), low costs of transporting goods to the United States, free trade with the United States, and relatively good political relations with the United States.
Consequently, some Chinese companies are investing in Mexico, importing components from China to be assembled in Mexico for export to the United States. The US Mexico Canada Agreement on trade requires that a certain amount of value added be created in Mexico for goods to qualify for tariff-free entry into the United States. Still, the United States has pressured Mexico about the surge in Chinese exports to Mexico. Notably, Chinese exports to Mexico were up 34.8% from 2022 to 2023. From China’s perspective, trade with Mexico serves two purposes. First, it contributes to the production of goods in Mexico that are exported to the United States. Second, Mexico is seen as a valuable market in its own right.
Mexico, however, is concerned lest the United States clamp down on trade with Chinese entities based in Mexico. Already, Mexican-US trade has increased significantly, with Mexico now the largest trading partner for the United States. As such, Mexico is now imposing tariffs on imports from countries that do not have free trade agreements with Mexico. Mostly, that means China. The tariffs, ranging from 5% to 50% will affect 544 product categories including steel, aluminum, textiles, and apparel.
Mexican tariffs come as other countries consider restrictions on trade with China. In many countries, there is concern that China is dumping cheap products on global markets due to excess capacity and weak domestic demand. For China, tariffs will likely damage the ability to boost exports as a source of economic growth.
Meanwhile, although the United States has expressed concern about Chinese investment in Mexico, the reality is that the numbers remain relatively small. In the first quarter of 2024, the United States accounted for 57% inbound foreign direct investment in Mexico, with Germany accounting for 17%. China, on the other hand, only accounted for 6%.