Global Weekly Economic Update | Deloitte Insights

Week of May 15, 2023

US financial market conditions are a source of concern

• While the Federal Reserve and the US Treasury have successfully stabilized financial markets following the collapse of a handful of medium-sized banks, the Fed is worried that the crisis will create enough of a credit crunch to slow the US economy. This is according to the Fed’s latest report on financial stability. In addition, the Fed’s survey of banks indicated that they intend to tighten lending standards, in part due to fears of deposit flight.

The Fed’s report on financial stability found that despite “decisive actions” by authorities, the bank crisis could undermine the “economic outlook, credit quality, and funding liquidity” and could cause “banks and other financial institutions to further contract the supply of credit to the economy.” It also said that “a sharp contraction in the availability of credit would drive up the cost of funding for businesses and households, potentially resulting in a slowdown in economic activity.” 

Meanwhile, the Federal Reserve’s survey of bank loan officers found that the share of banks that are tightening lending standards increased moderately from January to March. However, the latest survey was taken only shortly after the collapse of Silicon Valley Bank. It is likely that the next survey, which will be released in July, will indicate the degree to which the crisis has affected bank-lending intentions. 

The irony of all this is that the crisis in the banking system is mostly in the minds of investors and depositors. There is no systemic problem in the banking system, at least not one that should lead to a seizing up of credit activity. It is very different from 2008 when excessive leverage led to a near collapse of the banking system. This time, a handful of medium-sized banks, with roughly half a trillion dollars in assets (in a system with US$23 trillion in assets), failed, in part when depositors got scared and moved their money elsewhere. This, in turn, led to a larger exodus of deposits from smaller banks. The shrinkage of smaller banks means less ability to deliver credit to small and medium-sized businesses, thereby hurting the economy. Sheila Bair, a former US bank regulator, said that the turmoil is “overblown” and that “there is no crisis, unless media hype and short selling pressure undermine confidence so that depositors flee otherwise health banks.”

Although the banking system remains relatively safe, there is a problem involving the balance sheets of some medium-sized banks. Many face troubles due to excessive exposure to commercial property, especially the market for office buildings as well as nongrocery shopping centers. This is exacerbated by higher interest rates. Following the pandemic, many office workers continue to work remotely, leaving many office buildings only partially occupied. Many companies are gradually reducing their office footprint. Consumer online shopping accelerated rapidly during the pandemic, a trend that has not reversed. This has rendered many retail properties troubled. The result will likely be a decline in office building and shopping center revenue and greater difficulty in servicing bank loans for office and retail construction. There will also likely be a tightening of lending conditions for office space and shopping center space on the part of banks. 

Two possibilities emerge. First, some banks may face problems, potentially requiring rescue by authorities. This could have a further negative impact on credit conditions. Second, troubles in the property market can have a negative impact on construction activity and the range of industries that supply the construction industry. Still, there might also be opportunities to acquire property inexpensively and repurpose it. 

US inflation heads in the right direction

• Investors were likely relieved when the US government reported that inflation continued to decelerate in April. There had been concern that the progress seen since last June might be reversed. That fear was exacerbated by the fact that progress was, indeed, reversed in the Eurozone. Instead, US inflation did continue to ease. On the other hand, core inflation (which excludes the impact of volatile food and energy prices), although falling slightly, appears to be more persistent. 

Let’s look at the numbers. The government reported that consumer prices were up 4.9% in April versus a year earlier, the lowest rate since April 2021. Inflation had peaked in June at 9.1% and has been declining ever since. Consumer prices were up 0.4% from the previous month. Core prices were up 5.5% from a year earlier, down from 5.6% in March and the same as in February. This was the lowest rate of core inflation since late 2021. Still, core inflation has been in the range of 5.5%–6% since November, receding much more slowly than headline inflation. Meanwhile, energy prices were down 5.1% while food prices were up 7.7%.

Inflation appears to be sustained by the sharp rise in the price of shelter, up 8.1% from a year earlier. This reflects the lagged impact of last year’s sharp rise in home prices. However, April’s shelter inflation was slightly lower than in March. Thus, shelter inflation appears to have peaked. Now that home prices have declined, it is expected that the shelter component of the consumer price index will continue to recede throughout this year, thereby helping to further reduce inflation. In any event, if shelter is excluded, consumer prices were up a modest 3.4% in April versus a year earlier.

Consumers purchase three types of categories: durables, nondurables, and services. Prices of durables were down 0.2% in April versus a year earlier. This reflects weak demand for durable goods combined with improvements in supply chains that deliver such goods. Prices of nondurables less food were down 1.3% in April. Prices of services less shelter, however, were up 5.2% in April. Thus, the persistence of inflation is largely related to trends in the service sector.

Finally, some categories saw sharp price declines in April. These included the following: car rentals (down 11.2%), used cars (down 6.6%), health insurance (down 15.8%), and airline tickets (down 0.9%). 

The bottom line is that goods inflation has largely disappeared. To the extent that inflation remains persistent, it mostly has to do with shelter and other services. This likely reflects consumer demand shifting sharply away from goods and toward services now that the pandemic is over. Going forward, given that the economy is weakening due to Fed tightening, it seems likely that inflation will continue to decelerate. From the perspectives of the Federal Reserve, the inflation report is favorable news and increases the likelihood that interest rates will be kept steady. This expectation explains the rise in equity prices following release of the inflation report. However, the Fed has indicated that its decisions will be data-driven. Thus, future decisions will depend, in part, on future inflation data. 

The latest on China

• In recent months, much has been written about the tense relationship between China and the United States, especially given US export controls and China’s threats of retaliation. Now it appears that the relationship between China and the European Union (EU) is becoming more fraught. 

The EU is proposing sanctions on specific Chinese companies that are said to support Russia’s war effort. This would be the first such measure by the EU to sanction China. In response, China is threatening to retaliate. A Chinese official said that China is not supplying any weapons to Russia and that economic relations between China and Russia are normal. Moreover, he said that “we are against states introducing extraterritorial or one-sided sanctions on China or any other country according to their own domestic laws. And, if that were to happen, we would react strictly and firmly. We will defend the legitimate interests of our country and our companies.” 

Two Chinese companies that the EU might target are already sanctioned by the United States. German Foreign Minister Baerbock said that it is important that sanctions on Russia not be undermined by actions of third parties. She said that China is not being targeted, but only those companies that sell sanctioned goods to Russia. 

Meanwhile, Chinese investment in Europe has fallen sharply. In 2022, Chinese investment in Europe was 22% below the year earlier level, hitting the lowest level in nearly a decade. In part, the decline reflects more stringent governmental rules in Europe about Chinese inbound investment. For example, a study by the Rhodium Group found that, in 10 of 16 infrastructure and technology projects sought by Chinese firms, governments stopped the projects from taking place. The governments were the United Kingdom, Germany, Italy, and Denmark. In many instances, governments rejected deals in which Chinese companies would acquire companies that make products with potential military applications. 

• There are signs that China’s recovery is weaker than previously anticipated. At the Canton Fair, there have been far fewer orders than expected. The Canton Fair is one of China’s biggest trade shows. Activity at the Fair has often provided an indication of global demand for Chinese goods. This year the Fair returned to full operations after the pandemic. The volume of orders, however, was down roughly one-third from 2019, the last year of full operations. This is an indication of weak global demand for Chinese products.

In addition, it is reported that US and European companies are pointing to weaker-than-expected sales in China as an explanation for weaker-than-expected profits. Many had anticipated that, after China dropped COVID-19–related restrictions, and after the initial wave of infections dissipated, Chinese demand for goods and services would soar. Some analysts even worried that an overheated Chinese economy would lead to a surge in oil prices, thereby fueling a rebound in global inflation. Instead, China’s economy has recovered only modestly. 

Why is China’s growth subpar? One explanation is that Chinese consumers are holding back. They are being cautious, in part, because they have been pummeled by volatility in the property market, which is an important source of their wealth. In addition, global demand for China’s exports is weakening due to the weakened global economy. Also, trade tensions between China and the United States and other Western countries have a negative impact not only on trade of goods but also on cross-border investment. 

China’s weakness is important to the global economy. A weaker Chinese economy has negative implications for export growth for other major economies. It likely implies somewhat slower global economic growth this year than previously anticipated. However, weaker growth in China could help to suppress energy prices, thereby further enabling inflation in the West to decelerate. 

• There is more evidence of China’s economic weakness. First, iron ore prices have fallen sharply, reflecting a decline in Chinese demand. The price of iron ore delivered to Chinese ports is down 23% from early March. When China ended pandemic-related sanctions and reopened, there was optimism that China’s growth would soar. It did not. Instead, steel production (in which iron ore is the key input) fell sharply in April as demand waned. Given China’s property market problems, this is not entirely surprising. The weakness in demand for steel is emblematic of the overall weakness of the Chinese economy.

In addition, after a surge in March, China’s trade with the rest of the world is easing. In April, imports fell at a record pace while exports grew at a more modest pace. Imports were down 7.9% in April from a year earlier. Exports were up 8.5%, far slower than the March numbers. Moreover, April’s numbers were distorted by very weak performance in April 2022. 

The weakness of imports likely reflects both weak domestic demand as well as weak external demand. The latter implies fewer imports of inputs used in producing exportable goods. The weakness of external demand reflects the weakening of the economies of the United States, Europe, and many emerging markets. Notably, South Korean exports to China were down 26.5% in April versus a year earlier. South Korea supplies China with inputs used to produce exportable goods. In addition, China’s imports of coal, copper, and natural gas were all down in April, likely due to weak domestic demand. 

Xu Sitao, chief economist of Deloitte China, offers his thoughts on the latest inflation report for China:

• It is becoming increasingly clear that disinflation warrants more potent monetary easing in China. April consumer price inflation came in at just 0.1% year over year (YoY), compared to 0.7% YoY in March. Such disinflation is likely to persist due to severe slack in the Chinese labor market. In addition, there was a sharp decline in producer price inflation in China (–3.6% YoY), down from a fall of 2.5% in March, suggesting that downstream sectors lack pricing power.

Even before the US Federal Reserve was approaching the end of its tightening cycle, it made sense for Chinese monetary policy to take precedence over fiscal stimulus because the latter tends to skew to large infrastructure projects. In light of decelerating headline inflation in the United States, a compelling case can be made for the PBOC (China’s central bank) to lower interest rates. Today, all Chinese banks were asked to lower the ceiling on the rates of “agreement” and “call” deposits starting on May 15. This can be seen as a prelude to the reduction of interest rates. Meanwhile, given that interest differentials between the RMB and the USD are likely to widen with expected easing in China, some minor weakening of the RMB is necessary for the PBOC’s monetary easing to gain traction.

Russia’s evolving economic situation

• There is growing evidence that the Western sanctions on Russia are being violated. This is important because many of the sanctions were meant to weaken Russia’s economy and, consequently, its ability to wage war. Moreover, some sanctions were meant to keep sophisticated technology away from Russia, thereby limiting its ability to produce sophisticated weapons. 

The Institute of International Finance (IIF) says that there has been a surge in exports from key countries to Russia’s neighbors. Specifically, it found that exports from China, Germany, Japan, and the United States to Belarus, Kazakhstan, Turkey, and Georgia have increased sharply in the past year. Particularly noteworthy was the tripling of Chinese exports to Belarus in the past year. The IIF says that it does not know what products were shipped, but it suggests the possibility that such exports are undertaken to avert sanctions on Russia. 

Meanwhile, Nikkei found that US-made semiconductors are flooding Hong Kong and then being sent to Russia. The G7 group of industrial nations is discussing ways to limit this flow. The G7 is also concerned that, although G7 trade with Russia has fallen sharply, Russian trade has increased sharply with China, India, and Turkey. Specifically, G7 exports to Russia were down 50% in 2022 versus a year earlier and imports were down 10%. That represented a US$52 billion decline in trade. Yet that was more than offset by a US$103 billion increase in Russian trade with China, India, and Turkey. Although the West shut off Russia from US dollar denominated transactions, Russia has substantially increased transactions in Chinese renminbi. 

• When the war in Ukraine began, the surge in oil prices led to an increase in tax revenue for the Russian government. This enabled Russia to fund its war effort despite onerous sanctions from the West. Yet late in 2022, the G7 initiated a price cap on oil of US$60 per barrel, meant to hurt Russia’s ability to wage war. The result is that, in the first quarter of 2023, oil and gas tax revenue for the Russian government was down 45% from the same period one year earlier. 

In response, Russia has increased taxes on oil producers. However, this will have an onerous impact on the ability of energy producers to invest in new capacity. Thus, Russia is attempting to boost short-term revenue to wage war, even at the expense of a longer-term loss of energy capacity. Moreover, as European governments take steps to obtain alternative sources of oil and gas, and as they accelerate investment in clean energy, Russia’s long-term prospects diminish.

In any event, the mix of sanctions and the oil price cap have already wreaked havoc with the Russian economy. This is despite Russia’s efforts to boost sales of energy to India, China, and elsewhere. In three of the four quarter of 2022, real GDP fell from a year earlier. It was down 2.7% in the fourth quarter. Retail sales were down 5.1% in March versus a year earlier and have been declining ever since the start of the war.