The Growth Split

Why economic conditions are spurring growth in some regions and shrinkage in others.

Conventional economic wisdom holds that countries with strong currencies underperform those with weaker currencies because a strong currency makes manufacturing less price competitive. But the world has been turned upside down by the Covid-19 pandemic, the fight against inflation, and a potentially explosive Middle East conflict: The US economy grew at a surprisingly robust 4.9% in the third quarter despite a strong dollar, while Europe entered a technical recession and China saw evidence of deflation and crumbling growth.

Welcome to the two-speed global economy: The US appears to be going from strength to strength, despite the vigor of its currency, while Europe and Asia are slowing. What is the explanation for this apparent paradox? The most likely reason is simple: consumer sentiment. Although the pandemic affected consumers all over the world, and many governments responded with financial stimulus, consumer sentiment has since diverged sharply. Why is this important? The consumer accounts for two-thirds of US GDP and more than half of European growth.

“We do see a notable drop-off [of sentiment] in the UK and the euro area [around the same time as the start of the Russia-Ukraine war and ensuing energy price increases] with no equivalent fall in the US,” Joseph Lupton and Maia Crook, analysts at JPMorgan, said in a June note to clients. “With so much heightened uncertainty in Europe, households could be engaging in ‘precautionary saving,’ more so than in the US.”

The result has been dramatic: Consumer spending has increased in the US every month of 2023, up 0.7% in September alone, according to the US Department of Commerce. On the other hand, retail sales declined in the euro area by 1.8% year over year (YoY) in September, with overall consumer spending registering a fall between June and September, according to Trading Economics.

“I think a key driver of US economic resilience this year has been consumer spending that has driven the economy higher,” says Ginger Chambless, head of research for Commercial Banking at J.P. Morgan. “There are also indications that US consumers are acknowledging a little more relief from inflationary pressures than their counterparts in Europe.”

Another important factor in the split between economies is that the Federal Reserve raised interest rates to a range of 5.25% to 5.50%, from near zero in 2022, causing the value of the US dollar to soar against a basket of other major currencies. Since commodities are largely priced in dollars, companies in Europe and Asia felt a big pinch in the pocketbook.

To be sure, while a strong dollar may benefit US shoppers, the strength of the greenback is hurting US multinationals that repatriate overseas profits. According to financial data firm FactSet, companies in the S&P 500 that earn more than 50% of their revenue outside of the US saw their revenue decline by an average of 4.7% in the third quarter. Apple, for example, said in August that the dollar’s strength had cut four percentage points from revenue. UPS said in September that its international revenue had declined 13% compared to the previous year, in part because of higher fuel costs and the dollar’s strength.

To further split the US and other economies, Russia’s invasion of Ukraine sent prices for oil and natural gas higher. As an energy exporter, the US is largely immune to the problem. Europe, on the other hand, had received most of its energy from Russian suppliers, now embargoed. Since war also broke out in the Middle East in October, companies around the world have worried that the new conflict might push energy costs even higher.

One other headwind for Europe is that the continent’s business depends on exports to generate a quarter of GDP, far more than in the US. And Europe’s biggest export customer is Asia, especially China, whose imports have fallen sharply as a result of a slowdown in its domestic economy.

China GDP Growth Slowing

China’s downtrend was especially surprising, because it had earlier registered very high growth rates as it became the “workshop to the world” and threatened to overtake the US economy as the world’s largest. That prospect seems more remote now that GDP growth on the mainland slowed to 4.9% in the third quarter from 6.3% in the previous three months.

Why is 4.9% a sign of health in the US but weakness in China? It’s the trend lines. US GDP growth is trending upward. But while the International Monetary Fund (IMF) sees the Chinese economy improving slowly, reaching 5.4% GDP growth this year, it expects a slowing to 4.6% next year, due in large part to weakness in the property market and subdued external demand. This represents an upward revision from the fund’s earlier forecasts. The relatively upbeat IMF study came after China’s financial authorities announced a package of stimulus measures in October, including issuing $137 billion in sovereign debt for infrastructure projects, an increase in the country’s budget deficit, interest rate reductions, and lower mortgage costs to help the beleaguered property sector.

One worry is that consumer prices in China declined by 0.2% in October, raising concerns about possible deflation. This is in sharp contrast to the US and Europe, where fighting inflation has been the biggest concern. On the other hand, Japan, which has been fighting deflation for two decades, has finally managed to produce a slight burst of inflation because of higher import costs.

“While headline inflation in China remains low, this largely reflects lower food and energy prices,” says Siddharth Kothari, a senior economist in the IMF’s Asia and Pacific research department. “In our baseline forecast, we do not expect persistent consumer price deflation in China. The expectation is that inflation will pick up as the drag from commodity prices wanes and economic activity recovers gradually.”

In addition to falling consumer prices, Chinese shoppers are increasingly reluctant to open their pocketbooks. US cosmetics firm Estee Lauder, for example, reported that operating income fell 85% from a year earlier because of an 11% decline in sales, mainly in China and the rest of Asia.

The Chinese yuan has also declined by 5% against the US dollar this year, which should have boosted exports; but US imports from the mainland in the first nine months of 2023 were 24% lower than the comparable period of 2022. A lower yuan makes imports of commodities such as oil and coal more expensive. One solution has been for China to strike a deal with Russia to import oil at discounted prices.

China’s Exports Falling

Apart from the property crisis, China’s decline in exports has affected countries across the Asian region that supply China’s manufacturers. China’s overall exports fell for six straight months in 2023, with exports to Southeast Asia and the EU in October falling by double digits and shipments to the US down about 8%.

“The rapid growth of China was a very important driver for Southeast Asian exports for things like commodities and intermediate goods, and even tourism,” says Rajiv Biswas, chief economist for the Asia-Pacific region at S&P Global Market Intelligence. “All of those things have become a growth drag for China, so demand for Southeast Asia exports will be more moderate.”

Nonetheless, Biswas contends that the outlook for Southeast Asian exporters will improve because of two factors: the rise of India, with growth of 7.2% last year and a projected 6.3% in 2023, as a competitor with China; and domestic growth in Southeast Asian markets favoring local companies.

One indicator of how much China’s anemic growth has affected global trade was the announcement by Danish shipping giant A.P. Moller-Maersk in early November that it had a sharp fall in revenue in the last quarter and was laying off 10,000 employees. Container ships are used to bring Chinese exports to the US and Europe, as well as Mercedes-Benz cars and wine from Europe to the US. “If the fourth quarter does not deliver some type of improvements, then I think we’re looking at a pretty dire situation in 2024,” Maersk CEO Vincent Clerc said at the time on an earnings call with analysts.

Because Chinese firms that make electric vehicles (EVs) have been struggling to increase sales at home, they have been exporting excess capacity to Europe, where hard-pressed consumers appreciate the high quality and low price tags of the Chinese EVs. China exported two million cars in the 10 months ended October 2023, overtaking South Korea and closing on Japan’s auto shipments. This has raised hackles in Europe, where automobiles are big business, with the EU announcing on October 4 that it had launched an “anti-subsidy probe” of EV imports from China. Punitive tariffs are being considered.

The European Commission (EC) says China’s share of EVs sold in Europe has risen to 8% of the total, with prices that are often 20% less than comparable European models. “Global markets are now flooded with cheaper electric cars. And their price is kept artificially low by huge state subsidies,” said EC President Ursula von der Leyen in September in her annual address.

Europe’s concern came after the continent entered a technical recession at the beginning of the year, when growth slumped by 0.1% for the second consecutive quarter. The IMF said in its Regional Economic Outlook for Europe, published in November, that growth in the region is expected to eke out an anemic 1.3% GDP growth in 2023 and improve only marginally to 1.5% next year.

“Within advanced European economies, service-oriented economies will recover faster than those with relatively larger manufacturing sectors, which face low external demand and are more exposed to high energy prices,” says the IMF analysis.

For instance, China has been Germany’s main trading partner for seven years, but Germany’s exports to China declined by 2.3% in November after a 4% fall in the first quarter, according to the Kiel Institute for the World Economy. In addition, the war in Ukraine has impacted German businesses because Russia once provided cheap natural gas that powered many industries, but now supplies have been curtailed by sanctions against Moscow.

Worryingly, the quarterly survey of bank lending in the eurozone by the European Central Bank (ECB) showed that demand for loans by companies wanting to make investments has fallen off a cliff. Demand for loans by firms fell 36% in the third quarter, following a 42% decline in the second quarter, nearing the low level at the height of the 2008 financial crisis. High interest rates and a decline in fixed investment were mainly to blame, the ECB says.

In an effort to support German business, the government of Chancellor Olaf Scholz in November unveiled a package of tax subsidies worth up to about $30 billion over the next four years. “The federal government is massively relieving the burden on manufacturing in terms of electricity costs,” said Scholz; but this may face opposition from other European countries opposed to government intervention in the economy. Germany is Europe’s biggest economy, with GDP of $4 trillion, while second-place France comes to only $2.8 trillion.

In late October, Italian Prime Minister Giorgia Meloni announced a €24 billion (about $26.2 billion) package of tax cuts and increased spending on things like pensions, government contracts, and the country’s health system, all designed to boost the economy against headwinds like higher energy prices.

Higher Energy Prices Squeeze Corporate Profits

Looking ahead, one of the biggest concerns for global companies is the risk of higher oil prices because of the war between Israel and Hamas that began October 7th. A survey of global firms by analysis firm Oxford Economics shows that nearly 60% of companies say they view the conflict as a “very significant risk.”

However, Jamie Thompson, head of Oxford’s Macro Scenarios, says that the impact of a disruption to oil supplies would be a lot less damaging to companies now than many people think. Even in a severe scenario of oil prices rising to $150 a barrel from the current $82 for Brent crude, he says, the global economy would be less vulnerable to an oil-supply shock than it was after the 1973 Yom Kippur War.

“A key part is the energy intensity of output has fallen massively over the decades,” Thompson says, adding that many advanced economies now generate more revenue through services than manufacturing, requiring less energy.

However, not everyone agrees with this scenario. “Europe is in a very bad situation because we are net importers of energy,” says Erik-Jan van Harn, macro strategist at Rabobank Global Economics & Markets in the Netherlands. He says that if the Russia-Ukraine war escalates to a regional conflict, Europe could see a spike in energy prices more damaging than the initial surge when hostilities commenced. “Last time around, we had low interest rates, we had a lot of public finances that could be used to ease the blow, and we had consumers with pandemic savings,” he points out. “But now the savings have gone and governments are curbing their spending.”

The ultimate outcome in the Israel-Hamas conflict remains unclear, but the lack of escalation to neighboring countries or a boycott by Arab exporters has seen the price of Brent crude, the oil benchmark, fall from a spike that reached about $92 a barrel on October 19 to about $82 a month later.

While European consumers were traumatized by the outbreak of the Russia-Ukraine war and the sharp increase in energy prices—Europe now gets a substantial amount of oil from the US and Qatar rather than Russia—that may soon be easing. In fact, Europe’s inflation slowed dramatically to 2.9% in October, the first time it has been below 3% since the summer of 2021. If consumers begin to feel more optimistic, they may start reducing their “precautionary savings” and resume buying at Europe’s stores. And that would be good for the global economy.