2026: towards a multi-engine world | Think Macro by H2O AM

Description

Between the loss of effectiveness of economic policies in the United States, European resilience, China's transition and the rise of emerging markets, our new episode of Think Macro explores the macroeconomic dynamics that are reshaping the global balance. A two-way discussion with Vincent Chailley, CIO of H2O AM Group, and Thomas Delabre, portfolio manager and macro specialist, on a more diverse world, where growth no longer depends on a single engine.

This podcast is distributed for informational purposes only and does not constitute advice, an offer or solicitation by or on behalf of H2O AM to buy or sell any securities, related financial instruments or other products, or to engage in any trading strategy in any jurisdiction. The analyses and opinions contained in this document represent the views of the author(s) referenced as of the date indicated and are subject to change without notice.
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Transcription

Speaker #0
Hi everyone and welcome to our Think Macro where today we are going to discuss with Thomas, a macro expert and portfolio manager at H2O, we're going to discuss what 2025 told us for the world economy and what we can expect for 2026 with two very different situations. On the one hand, the US, where we see quite a lot of uncertainties, a lot of questions, and the rest of the world where On the contrary, you have a lot more certainty on what's going on and what's going to develop for next year. So let's start with the US. We were expecting a slowdown for 2025. That happened, at least in the first part of the year. We were expecting back a year ago also some market participants and households also being a bit skeptical. on the policy of the new government after two, three months of euphoria on the policy past the election. And we had that as well. And we had that as well, particularly on the bond market, where investors took a defensive tone on their participation there when the Fed said, I'm going to focus more on growth. Rather than inflation, the curve steepened. Participants took long rates higher, essentially saying, guys, I need a higher premium for my investment if inflation is not to be as much under control. And same for the fiscal policy. When the government moved from cutting costs to spending more, so a complete reversal of its policy. Bond investors reacted in taking long rates higher. And in that sense, they sort of suppressed the policy when the Fed cuts rates and it doesn't translate all across the curve. Of course, it weakens the policy when long rates go up, when the government spends more, what the government gives from a hand, the market takes from the other. So in that sense... Our monetary policy, fiscal policy in the U.S. have been weakened by market participants. You are now in this rare situation in the U.S., something we haven't seen for decades, where investors do participate in macro developments. They are the police here basically saying to the Fed and to the government, you can't go too far. and we can... weaken, if not neutralize, the impact of your policy. And in that sense, the U.S. economy is now more fragile compared to a year ago. And we are in this new situation where whatever happened in the U.S., you've got these safety nets are now a lot less efficient in the way they can accompany the cycle, or in case of a shock, in case of a weaker setup, counterbalance. the negative forces. Now, that's what bond markets are saying in 2025. Equity markets are saying the opposite. They're taking the opposite stance, saying basically, okay, inflation, creditworthiness of the US economy, independence from the Fed, all that is secondary to the profits we're going to make with our very strong companies and the potential the big productivity gains we're going to have from artificial intelligence. So you have a situation where you have the bond market players that are skeptical and equity investors that are a lot more optimistic on the take on the US economy. So who is right, basically, is the question. So Thomas, what's your take on that?
Speaker #1
Yes, hi Vincent, thanks for having me. I guess the way I would describe the US situation is a bit of the economy being on a thin line and where you can stay on that thin line but you have downside risk which is growing as we go further down the cycle. Why is that? You described very well and you mentioned the fact that the policy framework and the economic policy mix in the US is becoming more and more constrained, the fiscal risk. you know, is constrained. The monetary policy has loosened, but you know, the margin for further loosening is getting... harder. And at the same time, we are well ahead in the economic cycle in the US in the sense that as we have seen, the job market has normalized a lot, we have come down from a very high level of job creation. In the past four or five years, we are now to a level which is more, you know, on average to the breakeven point, I would say, and the unemployment has increased. So there is no broken level yet of the drop market but it has deteriorated quite significantly. It's not to say that it should be deteriorating much further, but clearly we're not in the position of strength that we have been experiencing so far. So clearly it matters for confidence for the consumer. It matters for the total income generated by the U.S. economy through the job market and the salaries, of course.
Speaker #0
Okay, but one may argue, yes, you have less hiring. on the US economy, but you don't have that many layoffs either. So you are in this unusual situation where both are actually down. One may argue that companies are just staying put in front of the uncertainty driven by tariffs and the policy in the US, and because immigration has been completely stopped. And in that sense, actually quite a few companies are just explaining that. They're just waiting for more certainty, more visibility on the outlook to potentially higher gain. And you can see that to some extent in productivity numbers when you can see that companies may just squeeze their labor force just as they wait for more visibility to potentially higher. So it's not necessarily negative, is it?
Speaker #1
Yeah, well, it's true what you're saying. The issue is... You know, I think the likelihood of having a strong upside in the market with strong job creation, as we've witnessed in the past, is quite low. You mentioned the uncertainty. It might be declining a bit, but we're still looking at what you described in your introduction. We are still in a world which is quite uncertain in terms of policy framework and the room to put further stimulus in the U.S. economy. from the economic policy mix is cross-constrained. So I think this uncertainty might be declining a bit, but it's unlikely to be fully lifted. And from that standpoint, I do agree that we may have a situation where some companies have been waiting to hire a bit, but net-net, it's unlikely to provide the stimulus to the market that we have seen in the past. And remember that thanks to tariffs this year, we've got an increase in inflation. which has eroded quite significantly the purchasing power in the U.S. for the consumer. So clearly here we have a situation where what has been driving a lot part of the U.S. economy over the past three, four years is eroding as well. You know, it's fading out. Yeah,
Speaker #0
but there again, Thomas, it's temporary, right? Inflation is taken higher by tariffs, but companies are already absorbing the tariffs, adapting to the tariffs. We may expect that inflation spike to, well, a few more months, maybe even one or two more quarters. But past that, purchasing power will just come back positive to the consumer.
Speaker #1
Well, yes and no, because it will a bit if salaries, you know, are getting back on a positive trend, which is if the market is not accelerating is unlikely. And I say I would say that I think the way we see inflation is in terms of regime. beyond the cyclicality of the next few quarters is that we are in a regime post-COVID where inflation is ticker than it was in the past. So we should be landing at a level of inflation, which is higher than, let's say, you know, in the pre-COVID period. So from that standpoint, it's constraining, once again, the policy mix for, you know, the Fed in terms of the way and the pass forward in terms of cutting rates, but also in terms of the actual level of real salaries, real wages for the U.S. consumer. So the consumption at best is going forward, is going at a similar pace. But it's hard to see a very strong uptick in the consumption going forward from the private consumption or the public consumption via the fiscal. They might do some fiscal, but it's very much constrained by what you mentioned before.
Speaker #0
Yeah, yeah. I mean, that's fair. I mean, it's fair to say that if you are to trust the inflation numbers you see across... the world economies, the lending zone is definitely higher than it was before COVID. So indeed, there you have some permanent drag to purchasing power that is here to stay. Now, what about the other upside possibility, you know, which is the innovation cycle? We're just starting, and AI particularly. I mean, there's massive investments in the U.S. That supports growth. And we have some big productivity gains down the road there. Of course, we don't know exactly what they are going to be, and they're going to spread over an extended period of time, but they will be there. And that's really strong potential growth for the five, maybe 10 years to come. Is that not enough to say, okay, I've got these fragilities in my economy. Part of the economy is slowing down. Consumption is going to be... dragged down or pressured down to some extent. But I've got this productivity cycle that is just starting now that will support my growth for the years to come.
Speaker #1
Yeah, that's true, Vincent. I'm sorry to say that, but I think this is not the right way to ask the question, in a sense. It might be true that, you know, we are, you know, on the eve of a very strong and prolonged productivity cycle in the US. But first, if it's true, It's not going to be only in the U.S. It's going to be spread out in the world. So here, I think the question we are trying to answer here for us as an asset management company and for our listeners is whether the U.S. is able to pursue a growth path, which is much higher than the rest of the world, as it's been the case in the previous cycle. This is the key question here, and whether you have upside and downside risks. So if I would say that... If you have upside risk, you may have upside risk on that. We don't know, but it's likely and is very likely to benefit to the rest of the world. So the question of the outperformance of the U.S. then become secondary in a sense. We have strong growth globally. It's perfect. It's a good environment for assets and so on, but not only in the U.S., but for the rest of the world. The second thing, and I think it's important to remind that, is that AI in the U.S. and in the rest of the world, but in the U.S. is important. But it's not the key driver for growth in the US. By itself, AI can't be the sole driver of the US growth. You need to have consumptions. You need to have all the parts of the US economy growing in order to reach this potential growth level, whether it's 2%, 2.2% for the US. We don't really know. It doesn't matter either. The point is that we are growing close to potential or above potential. So that's, I think, a key point here where You need to have the other part of the U.S. economy growing as well, consumption, unemployment, confidence to be driving this U.S. growth. The second thing is that we are moving out of the phase of the initial phase of innovation in the U.S. with huge investment. This investment will be, you know, continued in the near future. We know that, you know, according to figures, we're going to be moving from 500 billion maybe to 700 million, 900 million. But... The growth of the investment going forward is less because we're not starting from zero. So the marginal impact on the U.S. growth will be, in a sense, lower than it's been in the past. So this impact of AI, it's probably going to be important, but it can't be by itself the sole driver. I think the link here might be through the equity market, which is driving, I would say, in a circular way, consumption in the U.S. And this is where we have uncertainty. whether it continues or not.
Speaker #0
Yeah, indeed. And you may add to this reasoning that it's anyway going to spread over time. And unlike the web or previous revolutions, it's going to take real time for AI really spread out through the economy and get these productivity gains we're talking about. There, there's probably a mismatch between, as you said, the impact itself relative to consumption. and the speed at which it develops. So it helps, but it helps over the next 10 years. It can't be enough to support in 2026, 2027, the U.S. economy if consumption is to come down. But that boils down to one last thing, one thread that today holds the U.S. economy, which is equity markets. If you are in this context of a mechanical slowdown of the U.S. economy and fragilities, with a less efficient monetary policy, fiscal policy, absence of savings buffer. the U.S. economy now holds on that little thread, which is equities. Now, that's a powerful one, and that's where maybe I would not entirely agree with you. Yes, productivity and AI infrastructure investment cannot explain or explain a small part of U.S. growth, but they take a confidence, and we know the role confidence plays in the U.S. economy and in the current cycle. So as long as you have trust in that theme, Equity markets hold, you get some positive wealth effect, as well as confidence that make people consume more. And you get that consumption we are talking about now derived from just that trust in this new theme. So is there not room for some upside for the U.S.? I mean, once again, I mean, as we had in 23, 24, that sort of surprised us to some extent. Can we have that again?
Speaker #1
Yeah, agreed. But the thing is that... This is where I'm getting back to the thin line. I think the issue here is that if you have, you know, buffers around that, and you're holding up on, you know, one single factor, it might be, you know, a bit stressed to summarize that one single factor. But, you know, it's true that the key thing, the key strength of the US economy and the rest of the world has been post-COVID, that there was a transfer of private leverage to public leverage. John Z. C. White. that public debt to GDP has increased so much and private debt to GDP has decreased so much. The thing is that then here, for me, you have a U.S. economy and a U.S. consumer, especially, you know, the wealthy people, which are highly leveraged on the equity market. So it's another form of leverage. So it can last, you know, it can last. The Fed is cutting rates. It's easing financial conditions. it can last. But I would say that at some point, you know that this game is going to break to me. And then, you know, it's very likely to break. We don't know. We don't really need to answer that question about the timing rightly, because when we are trying to, you know, look at all this piece of this puzzle of global growth, what's important for us, I think, in terms of the message we want to convey is the US can be okay, but the risks to the downside are increasing. So the anchor around this confidence interval are weakening as well. And I think that's the key.
Speaker #0
No, no. I mean, yes, it's a very, very fair point. Yes, households are less leveraged, but the portfolio mix of their savings is riskier than it has ever been with a lot of equities, private debt on equities skewed towards innovation, which is fantastic, of course. in good moments, but also makes it more vulnerable to reversals. So maybe to conclude on what we see on the U.S. economy, we are probably in this situation where either the equity market prices, these fragilities we are depicting here, these less efficient policies, and then you get back to that slowdown, regular slowdown that we see. started to see in the first half of the year. Or alternative scenario, you have an equity market that continues with its sort of overconfidence in the theme. Not that it's not there, but in that it's going to spread over a longer period than the market expects and cannot really carry by itself growth for the next two years. And then you have... That's sort of excess on equities. You push growth to higher levels for some time, but then the next phase would be a sharper slowdown. So you are in this sort of duality in the U.S. market. And I guess portfolio and investments will have to be managed along these two possible scenarios we have in the U.S. Now, if we are to move to the rest of the world, comes the question, does... Can this uncertainty have a strong impact, as has always been the case historically? Can this uncertainty and potentially a substantial slowdown of the U.S. economy, how far can it impact the rest of the world, you think?
Speaker #1
Well, you know, as always, you know, the U.S. has some leadership from that standpoint. So the rest of the world is not immune from a sharp slowdown in the U.S. but the reaction of the authorities in the US would be quick and sharp. So probably there is some room here to face that issue. But I would say that when we look at the framework we just described, and for example, if we look at Europe first, we have more certainty about the scenario and the risk around the scenario. So contrasting to the US, with the US, we have a situation where Europe is likely to grow at potential or slightly above because there are some autonomous factors that are driving this growth. And the first, of course, we've been describing for some time now is a fiscal German plan, which is something which is here to stay, to continue and to have some strong, I would say, a spillover effect on Europe, on Germany and the rest of Europe. And remember, you know, remember that the debt in Europe, except few exceptions like France and Italy, the level of the debt at the aggregate level in Europe is quite low. So there is some room to do that without questioning or jeopardizing the bond market as it is maybe in the US where questions are rising. So here we have certainty. We know that the excess savings that has been built after the COVID in Europe has not been spent fully. even more so in France because of the situation, but even in other countries. So you have those buffers. The question is whether those buffers will be used or spent in the coming years. I think, to me, it's still a question mark. But knowing that you have those buffers, that it helps a lot to anchor the scenario around some certainty, which is not the case for the US. I think it's important.
Speaker #0
Yeah, Europe is in a situation of basically strong buffers to absorb. An external shock. Actually, we've seen it with the Ukraine, the war in Ukraine, or more recently, volatility you had coming from the US or trouble, political trouble in France. And yet you had positive growth, not fantastic, but no recession. So you have that resilience here pertaining to a high saving buffer, monetary flexibility. absence, maybe a lot less inflationary pressure, endemic inflationary pressure in Europe.
Speaker #1
Even so, if inflation is sticky, it's going to be sticky in Europe as well. But it's at a lower level probably in the US. Yes,
Speaker #0
giving more flexibility to the central bank. The fiscal aspect, there's a lot more room there indeed. And there's one last aspect that maybe beyond that 2026 scenario where, yes, we can expect a growth in Europe with decent certainty there. to come above potential. So, of course, that's European standards. You're talking maybe 1.5% growth, so sort of half a point above potential for Europe and fairly organic growth. But now beyond that, maybe, potentially, and we can't know yet, but there's that option, there's some further upside, maybe first from a resolution of the situation in Ukraine, where Without knowing really how that will unfold, really something positive may be expected there. And maybe more medium term, the way capital is used in Europe, capital is essentially frozen in Europe, as we saw essentially money markets, short-term investments. And part of this German plan, I find interesting, goes along that route of putting the capital at work. Trying to find ways, they develop pension funds, they've got incentives to make people invest in equities and particularly in small and medium companies targeting the innovation sector. You have all these measures, regulation as well is getting looser to facilitate these investments, cheaper access to capital. So you've got that sort of mechanism that is being implemented in Europe coming from Germany. that maybe will make capital work better. And considering the low level you're starting with on productivity, these 25 years of much lower productivity gains than in the US, for instance, starting from a low base, we know that it doesn't take that much to have a substantial catch-up. So my take would be that, yeah, okay, we have just 2026, but maybe there's room for more potentially in the years after that.
Speaker #1
I wish you were right. And I know that, you know, you would like and I would like that, you know, all this potential is going to be unleashed. I think from the macro scenario standpoint, it does matter for the medium run. But in the short run, we have enough uncertainty around the scenario that I would say those questions can be answered later. I mean, and then you describe a potential which is real, but it's not that important for us. To answer to that question, at that moment, it's important to, you know, set up the debate with the potential. But, you know, we've been disappointed a few times, but I think we have the initial condition for Europe to maybe unleash some potential. Yeah,
Speaker #0
to make the link with the US. In the US, still decent, but downside risks that are accumulating, weaknesses that are accumulating. When in Europe, there's upside risk, maybe, you know, it may not materialize, but risks. lie to the upside.
Speaker #1
Yeah, and once again, you know, in this AI innovation cycle, Europe might be benefiting less than the US, but it will benefit from that because we are going to the user face. And so even though Europe is not developing its own model, it will benefit to this user face. And that's important. That means that, well, this is, it's part of that game as well.
Speaker #0
Yeah, it's always, it's an important point indeed, yes. productivity gains are going to be made by the user of AI and not the engine maker. And we're all users of AI and we're all going to be users of AI, including Europeans, of course. So, yeah, so that's it for Europe, positive for 2026. Now, for the rest of the world, and let's move maybe east to China, where maybe there the planets are even more aligned than with Europe and with potentially... the beginning of a longer and more solid cycle, sort of a new phase of the Chinese growth. We have seen that the Chinese new plan in China is all about reorientating growth towards consumption and innovation. Now, we have seen China for a few years now really putting a lot of effort. in innovation sectors. We know that on the consumption side, there's a number of measures as well, as well as mechanical factors that will push consumption up. But there's still some risks. So I'd like to hear you on what you think on the remaining risks of China after 15 years of adjustment. You still have a big pile of debt. You still have some overcapacity in the manufacturing sector. housing market? Is it really, you know, balance? Will it not continue to be a drag? And last, but not least, demographics, which is a permanent drag to the Chinese economy. Are we in a situation where these risks are manageable enough to go to that next phase? Or are they still present? And will they continue to drag growth?
Speaker #1
I think that's the point. I mean, and to to To better understand, I think, the situation in China at the moment, we need to look back a bit of what happened in the past, you know, 15 years. Clearly, post-GFC, China has undertaken a very long phase of cleaning up, of deleveraging its economy, you know, zombie companies, zombie sectors. You know, I'm not saying that it doesn't exist anymore, but it's been purged and, I would say, cleaned up. in that long phase of deleveraging of the Chinese economy, of course. And it's also true for the real estate sector, which was one of the main drivers.
Speaker #0
of growth in the past and clearly you know there was a year-long adjustment which has been painful with other capacity in that sectors and we can see that thanks to prices and supplies that the sector is more balanced at the moment it's not going to be the key driver for growth in china over the next few years i think this is not the intention you know of the chinese authorities but clearly Here it's a drug which is much less that it has been the case because China has undertaken, and it was in this plan in 2010, this long phase of the leveraging of its economy and I would say to clean up its balance sheet. So now when we look at debt, debt has increased indeed, more at the state level than at the federal level. So there are room here. to have some buffer at the federal level if there are some issues. And I think what is important in China to understand is that this debt is owned locally. So that's, in a way, a domestic system where you have strong savings.
Speaker #1
Unlike the U.S., yeah.
Speaker #0
Unlike the U.S., which is very much depending on the rest of the world, which was not the case because the U.S. was able to offer the rest of the world, you know, outperformance of its assets and returns, which is at the end of the day, what we are kind of questioning now, you know, in that podcast. So here you have a situation in China where the debt is manageable because it's owned locally and you don't have the risk of capital flows or people fleeing out, not financing you anymore. So this is something which is manageable and under control, as you mentioned. I think on demographics, what is interesting is that indeed, the There is an aging population in China, as in many countries. But when you look at the demography in China, the issue is that you have still a lot of people in the countryside, which could be, you know, said as an internal immigration, as we've seen in the U.S., to, you know, accumulate new labor force, which are increasing your potential growth and so on. So here you have a huge potential for... that labor force to move from the countryside to the cities and to jobs which are more, you know, not productive, but in a sense more.
Speaker #1
Well, basically, yeah, they participate in the labor force and they offset sort of the demographic pressure you have on the Chinese economy. So basically, yeah, there's still risk, but clearly a lot's been cleansed. And it makes sense to move to the next phase of growth, right? Now, interestingly, it's not just about the state impulse for that new phase of growth. Of course, there's a plan, but there's also a mechanical aspect in this reshuffling of growth towards consumption and innovation where consumption will mechanically increase. I mean, savings have been very high, 35%, 40% of gross revenue. But a big part of that was precaution, precaution against housing, against the absence or lack of... education system, health system, all that now is a lot less risky. You need a lot less savings, precautionary savings against these risks. On top of that, you have this old generation that provided cheap labor to the world that is now retiring. That also is a factor that makes you consume more. Of course, retirement age is now time to... to spend these savings you've accumulated over your career. So you have, mechanically, you will have a saving rate that goes down. And that will increase the share of consumption in the economy a bit towards more, say, developed market standards. Now, beyond that, interestingly, what the state does is about not just having people consume their savings, but also reorientate their accumulated savings. towards more productive investments today. Like Europe, to some extent, savings are just in defensive assets, money markets, short-dated bonds. And the state is organizing a transfer of these savings, incentivizing investment in equities, particularly in targeted innovation sectors. It's developing the pension industry also that has. by construction along horizon and can invest in these sectors. So you are in regulation, of course, plays a role there. So China is creating that positive loop. The US developed in the 80s, 90s, where basically savers will have more, will get more rewards on their investments and targeted sectors, companies will have a cheaper and quicker access to capital to invest more, innovate and compete. in that new innovation cycle. So that's what we're talking about, this market loop that will reinforce, accelerate the cycle in China and trigger these productivity gains that will make the Chinese growth in the years to come. Then you're not talking about next year, you're talking about the next cycle, five, maybe 10 years of economic cycle.
Speaker #0
Yeah, I think it's important. And as you mentioned about this next innovation cycle here, I mean, we... I think, you know, the assessment we make is clearly that China is well positioned to benefit and to be a strong actor, a strong player in that innovation cycle. So it's not only the U.S. here which are driving this cycle. We know that, you know, the Chinese authorities have been investing in AI and so on. And so they have the resources and the means to invest in that, to be a strong player in that innovation cycle. And also because China... as an initial conditions are strong strength in that in the in that race if i may say so we know that they have the resources now in terms of research you know okay we look at research papers published in china there are you know as much papers or even more chinese uh you know researchers working on ai than has been the case they have the investment capacity and they have the i would say the natural resources like rare earths and so on that you know the rest of the world doesn't have And I guess the U.S. will try to chase those rare earths, you know, globally to provide their model. And, you know, finally, but not the least, they have cheap energy. And we know that in that race, you would need to have an input as in your production cycle, a cheap energy. They have the capacity. They have already the capacity in place and it's cheap. And from that same point, you have a competitive advantage. So once again, we're coming back to the fact that the U.S. will not be sole driver of that cycle. And it's important in that puzzle, I think.
Speaker #1
Yes, and you're making, I think, an important point here. A state economy in this capex-intensive cycle is actually…
Speaker #0
You've turned communist.
Speaker #1
Yeah. It's actually an advantage. You know, when in the US you may argue that this high competition on AI investment may end up with some waste in the end as everybody is investing… for the same thing, to get the same AI engine. In China, more targeted investment may mean less investment and less waste in the end. So in that sense, the Chinese model and the Chinese approach to innovation may come as an advantage in this highly capex intensive innovation cycle. Now, maybe one last point, if we are to think of the whole region now, because Because it seems that, yeah, China is really on the verge of... a new economic cycle, but actually the whole region will benefit. And the whole region also already benefits from the AI cycle through these massive infrastructure investment. As we know, for instance, that when you are to build a data center, 70, 80% of the resources you need come from Asia. So Asia is already benefiting a lot as a provider from the theme. And beyond that, they will probably, all the countries around China will continue to benefit from the impulse of the new cycle of China that is very regional based. So that's the whole region is going to benefit. I think, you know, that would be my take on the Chinese impulse. I would add Japan. I mean, we should not forget Japan where also Japan is, you know, is a sort of a. booming phase by Japanese standards after 30 years of deflation, where at last you now have in Japan a very positive dynamics with huge potential because there as well, capital had been frozen for 30 years and is now being put at work. So you are in this unique situation where the two major economies of the region, China and Japan, are growing at the same time. for strong reasons and over the next cycle.
Speaker #0
Yeah, indeed. And once again, for strong reasons, and I would say mostly internal factors. You mentioned the fact that maybe domestic consumption is going to be growing back up in China. This is something that people have been waiting for years, but this is well ahead and you have this innovation cycle. So you're not that much dependent on the global cycle from that standpoint because you have your own strengths. Of course, you're not immune, but you have your own strength. And that's important. And, you know, just to get back very quickly about the Chinese. not the Chinese, the Asian economies around Korea, Taiwan. What is important to understand is that those economies are well ahead in the production cycle. Usually it's traditional. Korea has been used as an advanced indicator in terms of to assess the strengths or the weaknesses of, for example, the manufacturing cycle, which has been very low for the past 10 years. In a sense, it's been a sluggish manufacturing cycle. Here you see some strengths coming back in that cycle because... Those economies, because they have their producers of chips, and it's important in that cycle, they are well positioned to benefit from that cycle. And I would say that they own some kind of a new commodity, which are the chips. And we know that there is a race to access to those chips, and they are well positioned from that. So once again, you have the two engines and the rest of the region, which is well positioned to benefit from that. So once again, this is an encore. strong growth at par or even higher with few downside risks. So once again, this is a contrasting... Yeah,
Speaker #1
that's why we have a stronger confidence on the region than in the US. And I may try to extrapolate that to other emerging markets. It's not just about Asia. If we are to think of the cycle and of the strong initial conditions, strong fundamentals... of these economies, they have also improved in other emerging markets, namely cyclical emerging markets. You can find it in Latin America, for instance, where the commercial trade balance is now well at equilibrium, where you don't need foreign capital, in many cases actually at all. The capital balance is positive in many of these countries, a very traditional weakness of the region. It's no longer the case. Foreign exchange has been stabilized. The political framework has stabilized a lot. And in that sense, it seems to me that you have also very strong initial conditions out there. Of course, probably forced because they don't have that huge competitive advantage the U.S. has compared to other countries and the dominance advantage. So they were forced into some adjustments. But now they are in a strong situation where they are a lot less dependent what the Fed does on the weakness of the dollar that has been historically a precondition for these markets, these economies and these assets to perform. Not to mention foreign capital that, you know, you would need as a... as a flow of investment to keep the economy running. They don't need these anymore. You got also, as we said about Asia, it seems to me that we have some sort of organic growth out there. And you also have the ability. Now, the question is, how can these countries participate in this new big cycle? And we said, well,
Speaker #0
I would, you know, Put it slightly differently than you do is that I think they still need those conditions. Don't get me wrong, because they are somewhat a bit of price takers. But what we are trying to look at here, I think it's the momentum and the dynamics. And the dynamics and the momentum for those countries, the cyclical emerging, has been improving. Because it's been forced by a situation where they had to go through also some kind of cleansing of the balance sheet and the economy, because they had to reinforce it. institutional framework that policy mix independence of the monetary policy there's central banks we see that you know in many countries where inflation targeting has been well encored there is no very few question about the independence of the central bank which is in contrast with with what we kind of debate in the u.s at the moment so we see that we have this improving trend in emerging markets with lower debt level than it uh you know in their to their developed market counterparts, especially in the US during COVID. So you have those initial conditions and the momentum, which is better. And I would say that the momentum in the US is deteriorating slightly. So my background is in country risk. And I would say that, you know, the country risk of emerging market does exist, but it's improving while the country risk in the US which was very low historically, is deteriorating. Not to say that it's going to collapse to a level close to some emerging market, but clearly it's deteriorating and it's important to have this convergence. And I think what we're trying to express here is that this trend of convergence in terms of growth and framework favors the convergence of the risk premium between those two blocks. And that's the key here, I think. So, you know, clearly Emerging market used to be for riders. So as you mentioned, you need a weak dollar. Initial conditions, the Fed cutting rates aggressively so that capital flows are flinging out the US into emerging market. Community prices are very strong because Chinese growth is strong. You don't have the same situation as it's been the case where there were foolish price takers. Now you have some, I would say, some undeniable factors which are driving that. you know and we think i think that is
Speaker #1
you know a lot of values in those markets yeah yeah you're talking there yes about uh better balanced less dependent cyclical emerging markets while interestingly you have sort of the opposite dynamics developing out of the us where you start seeing some more emerging market-like characteristics and fragilities with now markets are playing a role in the macro macroeconomics of the US. That's interesting, two really opposite dynamics roughly. And maybe beyond that, you may expect probably investors to in weighing this dual situation where the US is okay, but with fragilities in the rest of the world, we have a lot more confidence in the scenario for the rest of the world, particularly emerging markets as a whole. with very significant potential, sort of a good alignment of planets from risk to potential to the potential also of investment. I mean, nobody is invested in emerging markets after these 15 years of cleansing you described on China. So you have also huge, very significant potential of investment out there. Odds are that investors that have started this year to invest in emerging markets essentially through equities may broaden that and invest in the asset class as a whole, including Latin America, more next year, both to better balance their U.S. assets that are getting riskier, probably to escape the depreciation of the dollar. Yeah, I think that's important. Early stage. And to get that potential, you have an emerging market that discount, these assets are discounted. They offer a very good premium, I mean, to invest in, as well as potential in the emerging market.
Speaker #0
Yeah, no, the dollar of course is important because I think when we describe the situation in the US, the consequence of that is that we are going to have a weak dollar because you know It's the consequence of the situation, but also it's part of the solution for the US in terms of reflating its economy going forward. With dollar, it's a way to make pay the rest of the world, you know, your own issues, as has been the case in the past. And it's probably going to happen. And it's very, you know, very positive environment for the EM.
Speaker #1
It's an expectation we've had for some time now, but it seems now that we're entering the very fundamental phase of that dollar depreciation. particularly on one angle, which is rates, as the Fed cuts and other countries cut less or even hike, the cost of hedging your dollar exposure, of course, is going to go down in most countries. For some countries, it's even now positive to hedge your dollar. And that completely changes the flow dynamics. So beyond the opportunity to invest in emerging markets, you will probably continue to have support from foreign exchange. in Latin America and cyclical EM, begin to have some support because so far they've not been strong, but to reverse the flow in Asia and probably next year, foreign exchange in Asia will prove stronger against the dollar and support any investment you may make in the region. So yeah, that's the opportunity. We'll conclude on that. Thank you very much and speak soon on the next year's podcast, Think Macro podcast together. Thank you, Thomas.
Speaker #0
Thanks, Vincent.
Speaker #1
And yeah, see you next year.
Speaker #0
See you.

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Transcription

Speaker #0
Hi everyone and welcome to our Think Macro where today we are going to discuss with Thomas, a macro expert and portfolio manager at H2O, we're going to discuss what 2025 told us for the world economy and what we can expect for 2026 with two very different situations. On the one hand, the US, where we see quite a lot of uncertainties, a lot of questions, and the rest of the world where On the contrary, you have a lot more certainty on what's going on and what's going to develop for next year. So let's start with the US. We were expecting a slowdown for 2025. That happened, at least in the first part of the year. We were expecting back a year ago also some market participants and households also being a bit skeptical. on the policy of the new government after two, three months of euphoria on the policy past the election. And we had that as well. And we had that as well, particularly on the bond market, where investors took a defensive tone on their participation there when the Fed said, I'm going to focus more on growth. Rather than inflation, the curve steepened. Participants took long rates higher, essentially saying, guys, I need a higher premium for my investment if inflation is not to be as much under control. And same for the fiscal policy. When the government moved from cutting costs to spending more, so a complete reversal of its policy. Bond investors reacted in taking long rates higher. And in that sense, they sort of suppressed the policy when the Fed cuts rates and it doesn't translate all across the curve. Of course, it weakens the policy when long rates go up, when the government spends more, what the government gives from a hand, the market takes from the other. So in that sense... Our monetary policy, fiscal policy in the U.S. have been weakened by market participants. You are now in this rare situation in the U.S., something we haven't seen for decades, where investors do participate in macro developments. They are the police here basically saying to the Fed and to the government, you can't go too far. and we can... weaken, if not neutralize, the impact of your policy. And in that sense, the U.S. economy is now more fragile compared to a year ago. And we are in this new situation where whatever happened in the U.S., you've got these safety nets are now a lot less efficient in the way they can accompany the cycle, or in case of a shock, in case of a weaker setup, counterbalance. the negative forces. Now, that's what bond markets are saying in 2025. Equity markets are saying the opposite. They're taking the opposite stance, saying basically, okay, inflation, creditworthiness of the US economy, independence from the Fed, all that is secondary to the profits we're going to make with our very strong companies and the potential the big productivity gains we're going to have from artificial intelligence. So you have a situation where you have the bond market players that are skeptical and equity investors that are a lot more optimistic on the take on the US economy. So who is right, basically, is the question. So Thomas, what's your take on that?
Speaker #1
Yes, hi Vincent, thanks for having me. I guess the way I would describe the US situation is a bit of the economy being on a thin line and where you can stay on that thin line but you have downside risk which is growing as we go further down the cycle. Why is that? You described very well and you mentioned the fact that the policy framework and the economic policy mix in the US is becoming more and more constrained, the fiscal risk. you know, is constrained. The monetary policy has loosened, but you know, the margin for further loosening is getting... harder. And at the same time, we are well ahead in the economic cycle in the US in the sense that as we have seen, the job market has normalized a lot, we have come down from a very high level of job creation. In the past four or five years, we are now to a level which is more, you know, on average to the breakeven point, I would say, and the unemployment has increased. So there is no broken level yet of the drop market but it has deteriorated quite significantly. It's not to say that it should be deteriorating much further, but clearly we're not in the position of strength that we have been experiencing so far. So clearly it matters for confidence for the consumer. It matters for the total income generated by the U.S. economy through the job market and the salaries, of course.
Speaker #0
Okay, but one may argue, yes, you have less hiring. on the US economy, but you don't have that many layoffs either. So you are in this unusual situation where both are actually down. One may argue that companies are just staying put in front of the uncertainty driven by tariffs and the policy in the US, and because immigration has been completely stopped. And in that sense, actually quite a few companies are just explaining that. They're just waiting for more certainty, more visibility on the outlook to potentially higher gain. And you can see that to some extent in productivity numbers when you can see that companies may just squeeze their labor force just as they wait for more visibility to potentially higher. So it's not necessarily negative, is it?
Speaker #1
Yeah, well, it's true what you're saying. The issue is... You know, I think the likelihood of having a strong upside in the market with strong job creation, as we've witnessed in the past, is quite low. You mentioned the uncertainty. It might be declining a bit, but we're still looking at what you described in your introduction. We are still in a world which is quite uncertain in terms of policy framework and the room to put further stimulus in the U.S. economy. from the economic policy mix is cross-constrained. So I think this uncertainty might be declining a bit, but it's unlikely to be fully lifted. And from that standpoint, I do agree that we may have a situation where some companies have been waiting to hire a bit, but net-net, it's unlikely to provide the stimulus to the market that we have seen in the past. And remember that thanks to tariffs this year, we've got an increase in inflation. which has eroded quite significantly the purchasing power in the U.S. for the consumer. So clearly here we have a situation where what has been driving a lot part of the U.S. economy over the past three, four years is eroding as well. You know, it's fading out. Yeah,
Speaker #0
but there again, Thomas, it's temporary, right? Inflation is taken higher by tariffs, but companies are already absorbing the tariffs, adapting to the tariffs. We may expect that inflation spike to, well, a few more months, maybe even one or two more quarters. But past that, purchasing power will just come back positive to the consumer.
Speaker #1
Well, yes and no, because it will a bit if salaries, you know, are getting back on a positive trend, which is if the market is not accelerating is unlikely. And I say I would say that I think the way we see inflation is in terms of regime. beyond the cyclicality of the next few quarters is that we are in a regime post-COVID where inflation is ticker than it was in the past. So we should be landing at a level of inflation, which is higher than, let's say, you know, in the pre-COVID period. So from that standpoint, it's constraining, once again, the policy mix for, you know, the Fed in terms of the way and the pass forward in terms of cutting rates, but also in terms of the actual level of real salaries, real wages for the U.S. consumer. So the consumption at best is going forward, is going at a similar pace. But it's hard to see a very strong uptick in the consumption going forward from the private consumption or the public consumption via the fiscal. They might do some fiscal, but it's very much constrained by what you mentioned before.
Speaker #0
Yeah, yeah. I mean, that's fair. I mean, it's fair to say that if you are to trust the inflation numbers you see across... the world economies, the lending zone is definitely higher than it was before COVID. So indeed, there you have some permanent drag to purchasing power that is here to stay. Now, what about the other upside possibility, you know, which is the innovation cycle? We're just starting, and AI particularly. I mean, there's massive investments in the U.S. That supports growth. And we have some big productivity gains down the road there. Of course, we don't know exactly what they are going to be, and they're going to spread over an extended period of time, but they will be there. And that's really strong potential growth for the five, maybe 10 years to come. Is that not enough to say, okay, I've got these fragilities in my economy. Part of the economy is slowing down. Consumption is going to be... dragged down or pressured down to some extent. But I've got this productivity cycle that is just starting now that will support my growth for the years to come.
Speaker #1
Yeah, that's true, Vincent. I'm sorry to say that, but I think this is not the right way to ask the question, in a sense. It might be true that, you know, we are, you know, on the eve of a very strong and prolonged productivity cycle in the US. But first, if it's true, It's not going to be only in the U.S. It's going to be spread out in the world. So here, I think the question we are trying to answer here for us as an asset management company and for our listeners is whether the U.S. is able to pursue a growth path, which is much higher than the rest of the world, as it's been the case in the previous cycle. This is the key question here, and whether you have upside and downside risks. So if I would say that... If you have upside risk, you may have upside risk on that. We don't know, but it's likely and is very likely to benefit to the rest of the world. So the question of the outperformance of the U.S. then become secondary in a sense. We have strong growth globally. It's perfect. It's a good environment for assets and so on, but not only in the U.S., but for the rest of the world. The second thing, and I think it's important to remind that, is that AI in the U.S. and in the rest of the world, but in the U.S. is important. But it's not the key driver for growth in the US. By itself, AI can't be the sole driver of the US growth. You need to have consumptions. You need to have all the parts of the US economy growing in order to reach this potential growth level, whether it's 2%, 2.2% for the US. We don't really know. It doesn't matter either. The point is that we are growing close to potential or above potential. So that's, I think, a key point here where You need to have the other part of the U.S. economy growing as well, consumption, unemployment, confidence to be driving this U.S. growth. The second thing is that we are moving out of the phase of the initial phase of innovation in the U.S. with huge investment. This investment will be, you know, continued in the near future. We know that, you know, according to figures, we're going to be moving from 500 billion maybe to 700 million, 900 million. But... The growth of the investment going forward is less because we're not starting from zero. So the marginal impact on the U.S. growth will be, in a sense, lower than it's been in the past. So this impact of AI, it's probably going to be important, but it can't be by itself the sole driver. I think the link here might be through the equity market, which is driving, I would say, in a circular way, consumption in the U.S. And this is where we have uncertainty. whether it continues or not.
Speaker #0
Yeah, indeed. And you may add to this reasoning that it's anyway going to spread over time. And unlike the web or previous revolutions, it's going to take real time for AI really spread out through the economy and get these productivity gains we're talking about. There, there's probably a mismatch between, as you said, the impact itself relative to consumption. and the speed at which it develops. So it helps, but it helps over the next 10 years. It can't be enough to support in 2026, 2027, the U.S. economy if consumption is to come down. But that boils down to one last thing, one thread that today holds the U.S. economy, which is equity markets. If you are in this context of a mechanical slowdown of the U.S. economy and fragilities, with a less efficient monetary policy, fiscal policy, absence of savings buffer. the U.S. economy now holds on that little thread, which is equities. Now, that's a powerful one, and that's where maybe I would not entirely agree with you. Yes, productivity and AI infrastructure investment cannot explain or explain a small part of U.S. growth, but they take a confidence, and we know the role confidence plays in the U.S. economy and in the current cycle. So as long as you have trust in that theme, Equity markets hold, you get some positive wealth effect, as well as confidence that make people consume more. And you get that consumption we are talking about now derived from just that trust in this new theme. So is there not room for some upside for the U.S.? I mean, once again, I mean, as we had in 23, 24, that sort of surprised us to some extent. Can we have that again?
Speaker #1
Yeah, agreed. But the thing is that... This is where I'm getting back to the thin line. I think the issue here is that if you have, you know, buffers around that, and you're holding up on, you know, one single factor, it might be, you know, a bit stressed to summarize that one single factor. But, you know, it's true that the key thing, the key strength of the US economy and the rest of the world has been post-COVID, that there was a transfer of private leverage to public leverage. John Z. C. White. that public debt to GDP has increased so much and private debt to GDP has decreased so much. The thing is that then here, for me, you have a U.S. economy and a U.S. consumer, especially, you know, the wealthy people, which are highly leveraged on the equity market. So it's another form of leverage. So it can last, you know, it can last. The Fed is cutting rates. It's easing financial conditions. it can last. But I would say that at some point, you know that this game is going to break to me. And then, you know, it's very likely to break. We don't know. We don't really need to answer that question about the timing rightly, because when we are trying to, you know, look at all this piece of this puzzle of global growth, what's important for us, I think, in terms of the message we want to convey is the US can be okay, but the risks to the downside are increasing. So the anchor around this confidence interval are weakening as well. And I think that's the key.
Speaker #0
No, no. I mean, yes, it's a very, very fair point. Yes, households are less leveraged, but the portfolio mix of their savings is riskier than it has ever been with a lot of equities, private debt on equities skewed towards innovation, which is fantastic, of course. in good moments, but also makes it more vulnerable to reversals. So maybe to conclude on what we see on the U.S. economy, we are probably in this situation where either the equity market prices, these fragilities we are depicting here, these less efficient policies, and then you get back to that slowdown, regular slowdown that we see. started to see in the first half of the year. Or alternative scenario, you have an equity market that continues with its sort of overconfidence in the theme. Not that it's not there, but in that it's going to spread over a longer period than the market expects and cannot really carry by itself growth for the next two years. And then you have... That's sort of excess on equities. You push growth to higher levels for some time, but then the next phase would be a sharper slowdown. So you are in this sort of duality in the U.S. market. And I guess portfolio and investments will have to be managed along these two possible scenarios we have in the U.S. Now, if we are to move to the rest of the world, comes the question, does... Can this uncertainty have a strong impact, as has always been the case historically? Can this uncertainty and potentially a substantial slowdown of the U.S. economy, how far can it impact the rest of the world, you think?
Speaker #1
Well, you know, as always, you know, the U.S. has some leadership from that standpoint. So the rest of the world is not immune from a sharp slowdown in the U.S. but the reaction of the authorities in the US would be quick and sharp. So probably there is some room here to face that issue. But I would say that when we look at the framework we just described, and for example, if we look at Europe first, we have more certainty about the scenario and the risk around the scenario. So contrasting to the US, with the US, we have a situation where Europe is likely to grow at potential or slightly above because there are some autonomous factors that are driving this growth. And the first, of course, we've been describing for some time now is a fiscal German plan, which is something which is here to stay, to continue and to have some strong, I would say, a spillover effect on Europe, on Germany and the rest of Europe. And remember, you know, remember that the debt in Europe, except few exceptions like France and Italy, the level of the debt at the aggregate level in Europe is quite low. So there is some room to do that without questioning or jeopardizing the bond market as it is maybe in the US where questions are rising. So here we have certainty. We know that the excess savings that has been built after the COVID in Europe has not been spent fully. even more so in France because of the situation, but even in other countries. So you have those buffers. The question is whether those buffers will be used or spent in the coming years. I think, to me, it's still a question mark. But knowing that you have those buffers, that it helps a lot to anchor the scenario around some certainty, which is not the case for the US. I think it's important.
Speaker #0
Yeah, Europe is in a situation of basically strong buffers to absorb. An external shock. Actually, we've seen it with the Ukraine, the war in Ukraine, or more recently, volatility you had coming from the US or trouble, political trouble in France. And yet you had positive growth, not fantastic, but no recession. So you have that resilience here pertaining to a high saving buffer, monetary flexibility. absence, maybe a lot less inflationary pressure, endemic inflationary pressure in Europe.
Speaker #1
Even so, if inflation is sticky, it's going to be sticky in Europe as well. But it's at a lower level probably in the US. Yes,
Speaker #0
giving more flexibility to the central bank. The fiscal aspect, there's a lot more room there indeed. And there's one last aspect that maybe beyond that 2026 scenario where, yes, we can expect a growth in Europe with decent certainty there. to come above potential. So, of course, that's European standards. You're talking maybe 1.5% growth, so sort of half a point above potential for Europe and fairly organic growth. But now beyond that, maybe, potentially, and we can't know yet, but there's that option, there's some further upside, maybe first from a resolution of the situation in Ukraine, where Without knowing really how that will unfold, really something positive may be expected there. And maybe more medium term, the way capital is used in Europe, capital is essentially frozen in Europe, as we saw essentially money markets, short-term investments. And part of this German plan, I find interesting, goes along that route of putting the capital at work. Trying to find ways, they develop pension funds, they've got incentives to make people invest in equities and particularly in small and medium companies targeting the innovation sector. You have all these measures, regulation as well is getting looser to facilitate these investments, cheaper access to capital. So you've got that sort of mechanism that is being implemented in Europe coming from Germany. that maybe will make capital work better. And considering the low level you're starting with on productivity, these 25 years of much lower productivity gains than in the US, for instance, starting from a low base, we know that it doesn't take that much to have a substantial catch-up. So my take would be that, yeah, okay, we have just 2026, but maybe there's room for more potentially in the years after that.
Speaker #1
I wish you were right. And I know that, you know, you would like and I would like that, you know, all this potential is going to be unleashed. I think from the macro scenario standpoint, it does matter for the medium run. But in the short run, we have enough uncertainty around the scenario that I would say those questions can be answered later. I mean, and then you describe a potential which is real, but it's not that important for us. To answer to that question, at that moment, it's important to, you know, set up the debate with the potential. But, you know, we've been disappointed a few times, but I think we have the initial condition for Europe to maybe unleash some potential. Yeah,
Speaker #0
to make the link with the US. In the US, still decent, but downside risks that are accumulating, weaknesses that are accumulating. When in Europe, there's upside risk, maybe, you know, it may not materialize, but risks. lie to the upside.
Speaker #1
Yeah, and once again, you know, in this AI innovation cycle, Europe might be benefiting less than the US, but it will benefit from that because we are going to the user face. And so even though Europe is not developing its own model, it will benefit to this user face. And that's important. That means that, well, this is, it's part of that game as well.
Speaker #0
Yeah, it's always, it's an important point indeed, yes. productivity gains are going to be made by the user of AI and not the engine maker. And we're all users of AI and we're all going to be users of AI, including Europeans, of course. So, yeah, so that's it for Europe, positive for 2026. Now, for the rest of the world, and let's move maybe east to China, where maybe there the planets are even more aligned than with Europe and with potentially... the beginning of a longer and more solid cycle, sort of a new phase of the Chinese growth. We have seen that the Chinese new plan in China is all about reorientating growth towards consumption and innovation. Now, we have seen China for a few years now really putting a lot of effort. in innovation sectors. We know that on the consumption side, there's a number of measures as well, as well as mechanical factors that will push consumption up. But there's still some risks. So I'd like to hear you on what you think on the remaining risks of China after 15 years of adjustment. You still have a big pile of debt. You still have some overcapacity in the manufacturing sector. housing market? Is it really, you know, balance? Will it not continue to be a drag? And last, but not least, demographics, which is a permanent drag to the Chinese economy. Are we in a situation where these risks are manageable enough to go to that next phase? Or are they still present? And will they continue to drag growth?
Speaker #1
I think that's the point. I mean, and to to To better understand, I think, the situation in China at the moment, we need to look back a bit of what happened in the past, you know, 15 years. Clearly, post-GFC, China has undertaken a very long phase of cleaning up, of deleveraging its economy, you know, zombie companies, zombie sectors. You know, I'm not saying that it doesn't exist anymore, but it's been purged and, I would say, cleaned up. in that long phase of deleveraging of the Chinese economy, of course. And it's also true for the real estate sector, which was one of the main drivers.
Speaker #0
of growth in the past and clearly you know there was a year-long adjustment which has been painful with other capacity in that sectors and we can see that thanks to prices and supplies that the sector is more balanced at the moment it's not going to be the key driver for growth in china over the next few years i think this is not the intention you know of the chinese authorities but clearly Here it's a drug which is much less that it has been the case because China has undertaken, and it was in this plan in 2010, this long phase of the leveraging of its economy and I would say to clean up its balance sheet. So now when we look at debt, debt has increased indeed, more at the state level than at the federal level. So there are room here. to have some buffer at the federal level if there are some issues. And I think what is important in China to understand is that this debt is owned locally. So that's, in a way, a domestic system where you have strong savings.
Speaker #1
Unlike the U.S., yeah.
Speaker #0
Unlike the U.S., which is very much depending on the rest of the world, which was not the case because the U.S. was able to offer the rest of the world, you know, outperformance of its assets and returns, which is at the end of the day, what we are kind of questioning now, you know, in that podcast. So here you have a situation in China where the debt is manageable because it's owned locally and you don't have the risk of capital flows or people fleeing out, not financing you anymore. So this is something which is manageable and under control, as you mentioned. I think on demographics, what is interesting is that indeed, the There is an aging population in China, as in many countries. But when you look at the demography in China, the issue is that you have still a lot of people in the countryside, which could be, you know, said as an internal immigration, as we've seen in the U.S., to, you know, accumulate new labor force, which are increasing your potential growth and so on. So here you have a huge potential for... that labor force to move from the countryside to the cities and to jobs which are more, you know, not productive, but in a sense more.
Speaker #1
Well, basically, yeah, they participate in the labor force and they offset sort of the demographic pressure you have on the Chinese economy. So basically, yeah, there's still risk, but clearly a lot's been cleansed. And it makes sense to move to the next phase of growth, right? Now, interestingly, it's not just about the state impulse for that new phase of growth. Of course, there's a plan, but there's also a mechanical aspect in this reshuffling of growth towards consumption and innovation where consumption will mechanically increase. I mean, savings have been very high, 35%, 40% of gross revenue. But a big part of that was precaution, precaution against housing, against the absence or lack of... education system, health system, all that now is a lot less risky. You need a lot less savings, precautionary savings against these risks. On top of that, you have this old generation that provided cheap labor to the world that is now retiring. That also is a factor that makes you consume more. Of course, retirement age is now time to... to spend these savings you've accumulated over your career. So you have, mechanically, you will have a saving rate that goes down. And that will increase the share of consumption in the economy a bit towards more, say, developed market standards. Now, beyond that, interestingly, what the state does is about not just having people consume their savings, but also reorientate their accumulated savings. towards more productive investments today. Like Europe, to some extent, savings are just in defensive assets, money markets, short-dated bonds. And the state is organizing a transfer of these savings, incentivizing investment in equities, particularly in targeted innovation sectors. It's developing the pension industry also that has. by construction along horizon and can invest in these sectors. So you are in regulation, of course, plays a role there. So China is creating that positive loop. The US developed in the 80s, 90s, where basically savers will have more, will get more rewards on their investments and targeted sectors, companies will have a cheaper and quicker access to capital to invest more, innovate and compete. in that new innovation cycle. So that's what we're talking about, this market loop that will reinforce, accelerate the cycle in China and trigger these productivity gains that will make the Chinese growth in the years to come. Then you're not talking about next year, you're talking about the next cycle, five, maybe 10 years of economic cycle.
Speaker #0
Yeah, I think it's important. And as you mentioned about this next innovation cycle here, I mean, we... I think, you know, the assessment we make is clearly that China is well positioned to benefit and to be a strong actor, a strong player in that innovation cycle. So it's not only the U.S. here which are driving this cycle. We know that, you know, the Chinese authorities have been investing in AI and so on. And so they have the resources and the means to invest in that, to be a strong player in that innovation cycle. And also because China... as an initial conditions are strong strength in that in the in that race if i may say so we know that they have the resources now in terms of research you know okay we look at research papers published in china there are you know as much papers or even more chinese uh you know researchers working on ai than has been the case they have the investment capacity and they have the i would say the natural resources like rare earths and so on that you know the rest of the world doesn't have And I guess the U.S. will try to chase those rare earths, you know, globally to provide their model. And, you know, finally, but not the least, they have cheap energy. And we know that in that race, you would need to have an input as in your production cycle, a cheap energy. They have the capacity. They have already the capacity in place and it's cheap. And from that same point, you have a competitive advantage. So once again, we're coming back to the fact that the U.S. will not be sole driver of that cycle. And it's important in that puzzle, I think.
Speaker #1
Yes, and you're making, I think, an important point here. A state economy in this capex-intensive cycle is actually…
Speaker #0
You've turned communist.
Speaker #1
Yeah. It's actually an advantage. You know, when in the US you may argue that this high competition on AI investment may end up with some waste in the end as everybody is investing… for the same thing, to get the same AI engine. In China, more targeted investment may mean less investment and less waste in the end. So in that sense, the Chinese model and the Chinese approach to innovation may come as an advantage in this highly capex intensive innovation cycle. Now, maybe one last point, if we are to think of the whole region now, because Because it seems that, yeah, China is really on the verge of... a new economic cycle, but actually the whole region will benefit. And the whole region also already benefits from the AI cycle through these massive infrastructure investment. As we know, for instance, that when you are to build a data center, 70, 80% of the resources you need come from Asia. So Asia is already benefiting a lot as a provider from the theme. And beyond that, they will probably, all the countries around China will continue to benefit from the impulse of the new cycle of China that is very regional based. So that's the whole region is going to benefit. I think, you know, that would be my take on the Chinese impulse. I would add Japan. I mean, we should not forget Japan where also Japan is, you know, is a sort of a. booming phase by Japanese standards after 30 years of deflation, where at last you now have in Japan a very positive dynamics with huge potential because there as well, capital had been frozen for 30 years and is now being put at work. So you are in this unique situation where the two major economies of the region, China and Japan, are growing at the same time. for strong reasons and over the next cycle.
Speaker #0
Yeah, indeed. And once again, for strong reasons, and I would say mostly internal factors. You mentioned the fact that maybe domestic consumption is going to be growing back up in China. This is something that people have been waiting for years, but this is well ahead and you have this innovation cycle. So you're not that much dependent on the global cycle from that standpoint because you have your own strengths. Of course, you're not immune, but you have your own strength. And that's important. And, you know, just to get back very quickly about the Chinese. not the Chinese, the Asian economies around Korea, Taiwan. What is important to understand is that those economies are well ahead in the production cycle. Usually it's traditional. Korea has been used as an advanced indicator in terms of to assess the strengths or the weaknesses of, for example, the manufacturing cycle, which has been very low for the past 10 years. In a sense, it's been a sluggish manufacturing cycle. Here you see some strengths coming back in that cycle because... Those economies, because they have their producers of chips, and it's important in that cycle, they are well positioned to benefit from that cycle. And I would say that they own some kind of a new commodity, which are the chips. And we know that there is a race to access to those chips, and they are well positioned from that. So once again, you have the two engines and the rest of the region, which is well positioned to benefit from that. So once again, this is an encore. strong growth at par or even higher with few downside risks. So once again, this is a contrasting... Yeah,
Speaker #1
that's why we have a stronger confidence on the region than in the US. And I may try to extrapolate that to other emerging markets. It's not just about Asia. If we are to think of the cycle and of the strong initial conditions, strong fundamentals... of these economies, they have also improved in other emerging markets, namely cyclical emerging markets. You can find it in Latin America, for instance, where the commercial trade balance is now well at equilibrium, where you don't need foreign capital, in many cases actually at all. The capital balance is positive in many of these countries, a very traditional weakness of the region. It's no longer the case. Foreign exchange has been stabilized. The political framework has stabilized a lot. And in that sense, it seems to me that you have also very strong initial conditions out there. Of course, probably forced because they don't have that huge competitive advantage the U.S. has compared to other countries and the dominance advantage. So they were forced into some adjustments. But now they are in a strong situation where they are a lot less dependent what the Fed does on the weakness of the dollar that has been historically a precondition for these markets, these economies and these assets to perform. Not to mention foreign capital that, you know, you would need as a... as a flow of investment to keep the economy running. They don't need these anymore. You got also, as we said about Asia, it seems to me that we have some sort of organic growth out there. And you also have the ability. Now, the question is, how can these countries participate in this new big cycle? And we said, well,
Speaker #0
I would, you know, Put it slightly differently than you do is that I think they still need those conditions. Don't get me wrong, because they are somewhat a bit of price takers. But what we are trying to look at here, I think it's the momentum and the dynamics. And the dynamics and the momentum for those countries, the cyclical emerging, has been improving. Because it's been forced by a situation where they had to go through also some kind of cleansing of the balance sheet and the economy, because they had to reinforce it. institutional framework that policy mix independence of the monetary policy there's central banks we see that you know in many countries where inflation targeting has been well encored there is no very few question about the independence of the central bank which is in contrast with with what we kind of debate in the u.s at the moment so we see that we have this improving trend in emerging markets with lower debt level than it uh you know in their to their developed market counterparts, especially in the US during COVID. So you have those initial conditions and the momentum, which is better. And I would say that the momentum in the US is deteriorating slightly. So my background is in country risk. And I would say that, you know, the country risk of emerging market does exist, but it's improving while the country risk in the US which was very low historically, is deteriorating. Not to say that it's going to collapse to a level close to some emerging market, but clearly it's deteriorating and it's important to have this convergence. And I think what we're trying to express here is that this trend of convergence in terms of growth and framework favors the convergence of the risk premium between those two blocks. And that's the key here, I think. So, you know, clearly Emerging market used to be for riders. So as you mentioned, you need a weak dollar. Initial conditions, the Fed cutting rates aggressively so that capital flows are flinging out the US into emerging market. Community prices are very strong because Chinese growth is strong. You don't have the same situation as it's been the case where there were foolish price takers. Now you have some, I would say, some undeniable factors which are driving that. you know and we think i think that is
Speaker #1
you know a lot of values in those markets yeah yeah you're talking there yes about uh better balanced less dependent cyclical emerging markets while interestingly you have sort of the opposite dynamics developing out of the us where you start seeing some more emerging market-like characteristics and fragilities with now markets are playing a role in the macro macroeconomics of the US. That's interesting, two really opposite dynamics roughly. And maybe beyond that, you may expect probably investors to in weighing this dual situation where the US is okay, but with fragilities in the rest of the world, we have a lot more confidence in the scenario for the rest of the world, particularly emerging markets as a whole. with very significant potential, sort of a good alignment of planets from risk to potential to the potential also of investment. I mean, nobody is invested in emerging markets after these 15 years of cleansing you described on China. So you have also huge, very significant potential of investment out there. Odds are that investors that have started this year to invest in emerging markets essentially through equities may broaden that and invest in the asset class as a whole, including Latin America, more next year, both to better balance their U.S. assets that are getting riskier, probably to escape the depreciation of the dollar. Yeah, I think that's important. Early stage. And to get that potential, you have an emerging market that discount, these assets are discounted. They offer a very good premium, I mean, to invest in, as well as potential in the emerging market.
Speaker #0
Yeah, no, the dollar of course is important because I think when we describe the situation in the US, the consequence of that is that we are going to have a weak dollar because you know It's the consequence of the situation, but also it's part of the solution for the US in terms of reflating its economy going forward. With dollar, it's a way to make pay the rest of the world, you know, your own issues, as has been the case in the past. And it's probably going to happen. And it's very, you know, very positive environment for the EM.
Speaker #1
It's an expectation we've had for some time now, but it seems now that we're entering the very fundamental phase of that dollar depreciation. particularly on one angle, which is rates, as the Fed cuts and other countries cut less or even hike, the cost of hedging your dollar exposure, of course, is going to go down in most countries. For some countries, it's even now positive to hedge your dollar. And that completely changes the flow dynamics. So beyond the opportunity to invest in emerging markets, you will probably continue to have support from foreign exchange. in Latin America and cyclical EM, begin to have some support because so far they've not been strong, but to reverse the flow in Asia and probably next year, foreign exchange in Asia will prove stronger against the dollar and support any investment you may make in the region. So yeah, that's the opportunity. We'll conclude on that. Thank you very much and speak soon on the next year's podcast, Think Macro podcast together. Thank you, Thomas.
Speaker #0
Thanks, Vincent.
Speaker #1
And yeah, see you next year.
Speaker #0
See you.

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