• Early rout of Iranian military offset by Iranian shutdown of Strait of Hormuz
• Hormuz closure has halted oil, LNG and fertilizer exports from the Middle East
• Reordering of global energy supply
• Economic implications of Epic Fury

The most recent crisis in the Middle East involving Iran and the US-Israel joint strike has reminded the world once again that global energy supplies are still the lifeblood of the world economy; when they are threatened or restricted the economic impact is quickly felt. As was the case when conflict between Russia and Ukraine escalated in February 2022, energy prices and threats to fertilizer supplies became entrenched sources of economic angst. Once the US and Israel launched Operation Epic Fury, the military route of Iranian military capacity was quick. But Iran responded with a powerful example of asymmetric warfare. With its limited ability to match the US and Israel, it resorted to the use of low-cost, unconventional and very disruptive tactics using drones, mines and the closing of the Strait of Hormuz to inflict an economic cost.

In 2024, our first quarter newsletter looked at naval chokepoints that posed a risk to global trade and energy flows. Along with the Panama, Suez Canals, and other maritime chokepoints, the Strait of Hormuz was highlighted. Prior to Epic Fury, the Strait of Hormuz saw 20 million barrels of crude and refined oil products flow through it each day. This figure consisted of 15 million barrels of crude oil and nearly 5 million barrels per day of petroleum products, such as diesel, jet fuel, gasoline, and other refined products. In total, the Strait of Hormuz sees about 25% of all global flows of seaborne oil and 20% of total daily consumption flow through its narrow waterway. The UN Trade and Development organization (UNCTAD) estimated that in the week prior to military escalation, the month of February ended with a surge in exports from the region that saw the Strait of Hormuz’s share of crude oil exports surge to 38% of global seaborne oil movement.

In addition to crude oil, the Strait of Hormuz is an important transit corridor for liquefied natural gas (LNG) which is the second most valuable export after crude oil. About 20% of global LNG trade passes through it with nearly all of this belonging to Qatar and a small amount to the United Arab Emirates (UAE). It is the nations of Asia that are impacted by the LNG flows since over 80% of the LNG from the region goes to its energy thirsty nations. In particular, three nations – India, China, and South Korea – receive more than half of this supply.

If the energy exports were not significant enough – the world has come to also appreciate the fact that the Strait of Hormuz is also a significant conduit for the export of fertilizer inputs and outputs. About one-third of the world’s fertilizer ingredients move through the Strait.

Closing of the Strait of Hormuz

Knowing it could not match the military power of the US and Israel, Iran responded with missile attacks of its own. But as this capacity was diminished as the conflict went on – Iran closed the Strait of Hormuz. Shipping had fallen dramatically and the number of cargo ships moving through the Strait went from 103 vessels in the last week of February to a small handful within weeks. The net impact was to effectively close the strait and energy exports fell.

In addition to the closing of the Strait, military counterattacks from Iran have significant diminished the region’s LNG capacity. Qatar—the world’s largest LNG exporter—has been forced to halt production after direct strikes on its key LNG production facilities. Qatar has been forced to declare force majeure on its long-term contracts which allows it to suspend or delay its delivery owed under its LNG export contracts. Middle Eastern LNG exports have collapsed by roughly 70%, removing nearly 20% of global LNG supply overnight. This sudden loss of volume has tightened markets across Europe and Asia, driven benchmark prices sharply higher, and exposed the vulnerability of global gas supply chains to chokepoint disruptions. The scale and speed of this shock exceed even the post Ukraine gas crisis, underscoring how critical the Strait remains to global energy security.

As spot prices of LNG surged and export quantities evaporated from the region, countries across Asia have turned back to coal to maintain electricity supply, lifting coal plant output caps, boosting imports, and accelerating fuel switching to avoid blackouts. This rapid return to coal underscores the fragility of global gas supply chains and highlights how chokepoint disruptions can reverse years of progress toward cleaner energy.

Reordering of Global Energy Supply

The threat that Iran could close the Strait of Hormuz has weighed on energy markets for over three decades and today, that threat has become a reality. To help calm oil markets, the industrialized nations agreed to release 400 million barrels of oil from global strategic petroleum reserves. The markets greeted this policy with a yawn for two reasons – this is about 20 days of crude supply that goes through the Strait of Hormuz and given constraints – it would take about 200 days to get that amount of oil from reserves to the market.

Asia is the most dependent continent on oil from the Middle East. Japan receives 95% of its crude imports from the region; South Korea at about 75%; India at 55% and China at 50%. Taken together, this leaves Asia meeting about 60% of its crude oil needs from the Middle East. 

When it comes to natural gas (LNG), 90% of Middle Eastern LNG is exported to Asia. India is the most dependent on the Middle East as about two-thirds of its needs come from Qatar. Due to Iranian attacks that destroyed 17% of its LNG export capacity, Qatar has declared force majeure which is the exercising of a clause that allows a supplier to suspend or delay delivery obligations due to extraordinary events. The repairs on Qatar’s infrastructure for the export of LNG will take 3 to 5 years to complete.

According to Henning Gloystein, managing director for energy at political research firm Eurasia Group, there will be reduced LNG supplies for the balance of this decade. Gloystein further stated that “Anybody at the moment who is in a country or a company that has plans to do gas-fired power stations is going to have to review these. There is going to be no return to normal even if the war ends.”

At this point, it is expected that even with a permanent end to the conflict, the return of oil and LNG flows from the region to pre-war levels would take several months and move forward at an uneven pace. Clearing the current queue of ships in the Persian Gulf alone would require about two weeks if the strait were fully open – which is not yet the case. Tanker movements would also lag because of port damage, sunken vessels, elevated war-risk insurance, and the need for sustained security. Repairs to loading equipment and port infrastructure could take months rather than weeks. Production recovery could then take three to four months even under immediate peace, and very likely much longer, given that prolonged shut-ins of energy production sites materially increase the risk of restart complications.

Coal – The Other Energy Shock

For many years, climate treaty negotiators from many nations have tried to move the world away from coal – often referred to as the dirtiest fossil fuel. Rising energy demand in the developing world made this task difficult even under the best of circumstances but progress was being made. One outcome of this war is likely to be the fact that many nations will have to consider the trade-off between cleaner burning LNG against the security provided by domestic sources of coal. Already, the Iran War has triggered the largest rebound in coal demand in more than a decade.

Some nations in Asia have switched back to coal to replace the missing LNG supplies they are no longer receiving. South Korea has been one of the most aggressive nations in making the switch back to coal as it lifted the output caps on coal-fired power plants by allowing them to run at full capacity. According to consulting firm Wood MacKenzie, the switch to coal will allow South Korea to meet its summer needs for more energy while it awaits for LNG to begin flowing out of the Middle East.

Japan has also switched to the aggressive use of coal as it will offset up to 70% of its natural gas fired power generation capacity. For its part, India’s government has ordered all coal plants to operate at full capacity for the summer the second quarter of the year while China will make use of its newly built record coal-power capacity by utilizing its large domestic coal reserves. Even Europe is not able to withstand the pressures to maintain a steady supply of energy for its nations. Coal usage has risen in Europe. Germany – which led the fight against carbon emissions in Europe for years – is now considering the reactivation of mothballed coal plants to curb electricity prices.

Implications Beyond Energy

The consequences of the war – apart from the human and environmental impact – are being felt beyond energy prices. Oil and gas are also the inputs for thousands of products such as fertilizers, plastics, carpets, solvents and pharmaceuticals. Petroleum industry sources have often cited the importance of their industry by stating that over 2000 products are derived from hydrocarbons.

While the potential impact on any industry is sure to be sharp, policymakers and financial markets are keenly watching for the impact on the agricultural industry. Fertilizer production relies on natural gas because it is both the chemical feedstock and the energy source required to make ammonia—the foundation of all nitrogen fertilizers. Without natural gas, the modern fertilizer industry would not exist. It is worth noting that fertilizer production has undergone three shocks since 2020 – the COVID pandemic; and the invasion of Ukraine and the current conflict in Iran.

The rapid halt to the export of natural gas from the Middle East due to the closure of the Strait of Hormuz has put the global fertilizer industry on edge. Fertilizer is a significant cost for farmers and a sharp rise in input costs for farmers will eventually lead to higher food prices and broadening of inflation pressures. One mitigating factor for now is that demand for fertilizer at this time of year is uneven because the Northern Hemisphere is preparing fields for planting and the Southern Hemisphere is harvesting which means fertilizer demand in the Southern Hemisphere is currently low. Fortunately, the main destination for Middle East exports of fertilizer and related inputs such as LNG for fertilizer production is the developing nations of the Southern Hemisphere. Still, the impact is being felt in North America as a survey by the American Farm Bureau Federation showed 70% of 5700 famers surveyed said they cannot afford all of their fertilizer needs this year.

All nations have a vested interest in restraining food price inflation since it leads to instability in developing nations and angry voters in developed nations. It is one of the reasons that international sanctions against Russia largely exempt its fertilizer exports with Western nations being important markets despite the rivalries over Ukraine. Europe still continues to import over 20% of Russian natural gas exports for its energy and fertilizer needs. This highlights the structural importance of natural gas in global food supply and the complications that exist when sanctions are levied against a nation that is an important part of the global fertilizer and natural gas supply.

Markets Looking to War’s End

Global energy markets will remain structurally tighter, more volatile, and more politically fragmented long after the Iran War ends. The conflict has disrupted physical supply routes, damaged critical infrastructure, and accelerated a global rethink of energy security, all of which create lasting aftershocks. It will take years of rebuilding infrastructure in the Middle East before pre-war levels are once again reached. Export terminals, gas fields and equipment have been destroyed. The world’s spare capacity in energy infrastructure has been diminished at a time that global oil demand was already straining the ability of the energy producers to supply it.

History shows that wars end when one or both sides have exhausted themselves or the costs are too high to continue. For the Iranian side, the focus is going to eventually return to the need to rebuild and stabilize the government and for the US, it is a midterm election year and politicians know voters are feeling the pinch at the gas station and grocery store. For financial markets, thus far – they seem to be pricing in a scenario that negotiations will eventually succeed or if they do not – going forward, the war will transition to a slow but steady fade.

The post Eyes on Hormuz: Energy Markets at a Geopolitical Crossroads appeared first on Pacifica Partners.

• US undergoing productivity boom while economy begins to accelerate
• Labor markets stabilizing
• Canada’s productivity gap & population trap
• Productivity booms raise wages & hold back inflation

For most industrialized nations, their respective economies fared better than expected in 2025. The shock of the trade and tariff dispute of early 2025 did not cause the sharp economic slowdown that economists had feared. Much like in 2020—following the global shutdown caused by the COVID pandemic—and despite rising interest rates and inflationary pressures, the global economy once again demonstrated notable resilience.

As tariffs rose sharply in the early months of last year and investment flows fell sharply, stock markets sold off sharply with most major stock market indices falling 15-25% in a six-week wave of panic induced selling. As the US walked back some of its tariff threats and trade deals were reached with many nations, the focus of the financial markets shifted towards standard issues such as the expected level of economic growth, inflation and in particular – the labor market. The labor market has been of particular concern for over a year as investors try to look through the murkiness of economic data and forecasts for any signal that there is an economic slowdown brewing or even any indication of a potential recession.

The US economy added only 584,000 jobs in all of 2025, the weakest annual gain since 2020 and the second weakest since the Global Financial Crisis that began in 2008. Monthly job creation averaged only 49,000 jobs per month – a nearly 70% decline from the 168,000 jobs created per month in 2024. However, one significant factor behind weak total job growth in the US is the fact that the civilian federal employee headcount finished 2025 lower by 9.1% which is equivalent to approximately 275,000 jobs.

In contrast, Canada’s federal civilian workforce has grown by nearly 40% over the past decade, peaking in the 2023–2024 fiscal year. Notably, the expansion of the federal workforce has been roughly double the growth rate of the Canadian private sector.

A reduction in the Canadian government’s federal civilian payroll is coming as Canada – like most nations – faces a severe fiscal crunch that has brought about rising budget deficits. The deficits of the last decade have doubled Canada’s national debt to $1.2 trillion with not much capacity left to raise taxes so spending cuts are going to have to be significant. With federal government payroll spending up nearly 83% in a decade, the government has begun downsizing its payroll. Apart from helping Canada to lower its federal budget deficit, the reduction in government payroll numbers should help to expand the labor supply as many businesses had been complaining of a lack of skilled labor. Budget cuts are aiming to reduce $60 billion from current expenditures with reductions in management and front line staff announced.

A closer look at the US labor market shows that while unemployment is still low as it ended at 4.4% in December 2025, the labor force barely expanded which is indicative of a soft jobs market and that means there is some slack in the labor market. Economists are wrestling with the data to discern if the US economy might be weaker than it appears. This comes about because as workers are discouraged from looking for work due to low expectations of finding a job, they often will decide to not look for work actively. Under such a scenario, the unemployment rate would mask economic weakness since workers who give up on looking for work are not counted as part of the labor force and therefore do not show up in headline unemployment numbers. But the labor market in the US is showing signals of bottoming out. Layoffs are easing and jobless claims are declining to levels consistent with a stable labor market.

US Economic Growth

While the final GDP growth figures for the fourth quarter of last year are yet to be published, estimates from the Atlanta Federal Reserve’s GDP Now forecast have been revised up to 5.4% from 2.7%. This is a stunning revision given the consensus amongst economists early last year was for a potential recession in 2025. A closer look at the factors behind the surge in U.S. economic activity shows that not only is growth strong, but the underlying quality of that growth is also high.

The data shows that one of the factors that fueled the sharp upturn in economic growth of the US was a sharp decline in the trade deficit. The trade deficit in October was down to $29.4 billion – down from $48.1 billion in the month before.  Furthermore, US government data shows the October deficit number was the lowest since June 2009. Often times, an economy with falling income or slowing economic growth will show a falling level of imports. But for the US, it was the best of all worlds as imports fell last October by $11 billion and exports rose by $7.8 billion. In short, last October’s trade data contributed to an $18.8 billion improvement in the trade deficit and therefore helped to contribute to the sharp rise in expectations for US economic growth.

There is, however, a risk that the trade deficit could widen again in subsequent months given the US economy is strongly consumption driven and is posting the strongest economic growth amongst the developed economies. Higher GDP tends to coincide with rising imports. Meanwhile, exports will be dependent upon the level of economic growth in Europe and Asia. Thus, it remains to be seen whether imports will surge again or exports weaken due to lower demand for US goods.

The Productivity Surprise 

Financial markets have been disappointed that the stronger than expected US economy has not been reflected in the labor market. As noted above, job growth has been lukewarm. Gone unnoticed is that the US economy has been undergoing a productivity momentum burst . As the figure at the  top of page 3 shows, the third quarter of last year saw US labor productivity growth move sharply higher by 4.9% – this was after second quarter productivity was revised higher to 4.1%. This data is pointing to a structural shift in the US economy’s ability to provide economic output with rising efficiency.

An economy’s productivity measures the amount of economic output produced per unit of input of labor and capital. A highly productive economy is able to produce more economic output (GDP) with less inflationary pressure. In other words, it is the best of all worlds when an economy can grow faster through efficiency.

Productivity Keeps Inflation Pinned

Ordinarily, rising wages are a concern for bond markets since it means there is a potential for wages to set off an inflationary spiral. Strong productivity keeps inflation fears in check since businesses will be able to produce more goods and services at lower unit costs (i.e. making more with less inputs). In addition, if productivity is rising, companies can afford to raise wages (household income) since the workforce is producing more for each hour worked. It also allows companies to hold off from raising prices since their cost per unit of output is falling. 

If rising wages are accompanied with rising productivity, firms can pay higher wages without passing costs to consumers. For the policy makers at the US Federal Reserve, a strong US economy with rising productivity is the dream scenario since it makes it easier for the Federal Reserve to satisfy its dual mandate of promoting stable prices and maximum employment.  Sometimes, the two goals are mutually exclusive.

Canada’s Productivity Challenge 

Canada’s productivity challenges stand in stark contrast to the United States. Unlike the Federal Reserve, which might be seeing its job made easier, the Bank of Canada has been sounding the alarm bells on Canada’s poor productivity growth. One of the main causes of this has been chronic under-investment in capital (machinery, equipment and technology). Canada has been investing far less per worker than other industrialized nations and this is seen in the amount of capital per worker; the oldest capital stock since data has been kept and slow investment in leading technologies. In the AI race, Canadian companies have been lagging significantly in deploying capital to harness potential benefits.

As noted above, Canada’s population had expanded far faster than peer industrialized nations. But without a productive way to employ that labor, those additional entrants to the labor force could not produce enough output to offset the rise in workers. As a result of poor productivity, Canada’s per capita income stagnated for over a decade – degrading Canadian living standards in a scene reminiscent of some of Europe’s slow-growth economies.

As noted in a previous edition of our newsletter, Canada is experiencing a population trap – something that has seldom been seen in a modern industrialized economy. A population trap occurs when the population of a nation rises faster than the economy’s ability to raise output, causing living standards to fall.

Limits & Debt Fears

In a perfect world, rising productivity in the US will help to make the economy grow faster, raise wages, keep inflation in check and help to lower interest rates.– an economist’s dream. Unfortunately, this perfect scenario is being offset by another issue that we have written about in previous issues of our newsletter – the rising tide of government debt which shows no signs of slowing down.

Across Europe, the combination of ageing societies, slow economic growth, high energy prices and rising defense spending commitments have combined to widen budget deficits. In Japan, newly elected Prime Minister,  Sanae Takaichi has called an early election based on her promise to raise government spending and cut taxes on food. In Canada, the federal government and provinces are rapidly accumulating debt while economic growth inches along slowly. Meanwhile, the US shows little focus on getting  its national debt down – despite rising tax revenue and select spending cuts lowering budget deficit estimates by $100 billion. While that is an extraordinary amount of money – the deficit will still add between $1.6 trillion and $1.8 trillion to the national debt in the current fiscal year.

Going somewhat unnoticed in recent months has been the trend of rising interest rates (yields) in the bond markets around the world. Japan’s 40-year government bond yield has reached a record high of 4.25%. US 30-year government bond yields are approaching very close to 5%. The benchmark 10-year US Treasury yield has been rising despite expectations for the US Federal Reserve to continue its policy of interest rate reductions. In France, the 30-year government bond yields have risen to 4.5% – the highest level since the 2011 sovereign debt crisis. Canadian government bond yields are lower than the nations noted above but are also trending upward toward 4%. .

Bond markets are signaling clear dissatisfaction with the lack of fiscal discipline. Investors are demanding a higher premium for two risks—one of which is relatively new for G7 economies. Bondholders require a “term premium” to compensate for lending over long periods, traditionally due to inflation risk eroding the value of future payments. Increasingly, however, investors are demanding an additional premium for lending to heavily indebted governments. Term premiums have been rising as investors confront debt‑to‑GDP ratios of nearly 240% in Japan, 136% in the U.S., and levels approaching or exceeding 100% across most major developed economies. The danger is that higher term premiums will push up borrowing costs for consumers and businesses, weighing on economic growth.

If the surge in U.S. productivity continues and helps power economic expansion, bond markets may stabilize and ease upward pressure on interest rates. A sustained productivity boom would help anchor inflation expectations and reduce the term premium. Even more helpful would be a meaningful slowdown in the growth of U.S. government spending.

It remains uncertain whether the U.S. productivity boom can be sustained, but there is reason for optimism. If U.S. policymakers want to support an economy that appears to be regaining momentum, they must demonstrate to bond markets that they recognize the fiscal challenge and are committed to reducing budget deficits. Doing so would lower the term premium on long‑term bonds, helping the economy further by reducing borrowing costs.

The post Productivity To the Rescue appeared first on Pacifica Partners.

• US legacy of technology leadership
• AI investment fueling US economy
• Tech sector spending on AI leads to bubble fears
• Today’s tech investment is funded mostly by cashflow—not debt

Since the end of World War II, the U.S. economy has consistently distinguished itself from the rest of the world. It has remained the economic engine of the global economy while being able to transition from an industrial powerhouse to the leader of the information age. This transformation began with the development of ENIAC in 1945, widely recognized as the world’s first programmable computer. The momentum continued into the 1960s with the creation of ARPANET, the precursor to the internet, which ultimately led to the emergence of the World Wide Web in the 1990s. From the early foundations of computing in the 1950s to the digital revolution of the late 20th century, a consistent thread has been U.S. innovation—driving technological progress and reshaping the global economic landscape.

The constant striving towards innovation from seemingly  humble beginnings has created the world’s largest corporations. Companies such as Microsoft, Google, Oracle, Intel, and Nvidia continue to propel technology forward. Other companies, such as Amazon, exist in large part because of what came out of the origins of ARPANET. It is important to note that many of today’s  technology giants are successful because they had the ability to reinvent themselves as technological change came. Those that could not adapt were left behind and either swallowed up by more nimble competitors or faded out of existence. This is an important distinction to make because this renewal has kept the US economy in the pole position amongst global economies.

Today, the rise of Artificial Intelligence (AI) is the latest technological revolution. While technology will undoubtedly evolve its definition, AI can be thought of as the ability of computer systems and software applications to perform complex tasks requiring reason, learning and decision making. In short, functions that once required human intelligence are increasingly being done by computer systems—and the US leads the global AI race.

Recently, the Managing Director of the International Monetary Fund (IMF), Kristalina Georgieva, stated that “The AI investment boom is bringing incredible optimism – mostly concentrated in the United States.” Data from Ernst & Young shows that in 2024, global private AI investment reached $252.3 billion – a 26% increase from 2023. Of this amount, the US accounted for nearly 45% of the global total and this was 12 times the level of AI investment in China and 24 times the level of the UK.

With respect to AI infrastructure such as data center construction, the so-called “hyperscalers”—Amazon, Microsoft, Google, Meta  and others—are driving an infrastructure supercycle as the chart below shows. Their aggregate capital expenditures (“capex”) on data centers, computational hardware (especially GPUs and AI accelerators), and power generation have neared or exceeded $350–400 billion in 2025 (a fourfold increase from just a few years prior).

Emergence of AI

The advent of technological progress has had an unmistakable impact upon people across the world. From cellular phones possessing levels of processing power that would have astonished the computer scientists of a generation ago to the incredible changes brought about by the internet to every industry and country across the world – the world has shown an ability to adapt and prosper from technology.

According to a survey conducted by global consulting firm McKinsey, 50% of the survey responding companies were using AI-enabled technology in at least one segment of their business and many are seeing efficiencies due to lower costs and some are able to translate their AI usage into higher revenue. A 2023 study by Statista found that the sectors that benefit the most from AI adoption include manufacturing, service operations and marketing and sales. Statista found that 4% of the companies it looked at were able to reduce costs by at least 20%. Importantly, these numbers match the numbers that McKinsey found. Fortune magazine has gone so far as to say AI is “the holy grail of cost reduction for CFOs”.

AI and Pharmaceuticals

The impact of AI is being seen in various industries with the promise of much more to come. In the healthcare sector, AI is being used to help researchers speed up research into new drugs by analyzing complex datasets in a fraction of the time a team of scientists would be able to do it. It is helping pharmaceutical companies with making drug trials more efficient and reducing the likelihood of drug failures. Historically, the development of a new drug has required a decade and billions of dollars. AI will change that as AI is able to identify illnesses with more precision, to help with drug development and optimize clinical trials and speed up manufacturing.

AI and the Mining Industry 

The global mining industry has also made large strides using AI. For a number of years, the global copper industry has warned that it will not be able to produce enough copper to meet the coming demand over the next 20 years given current discovery rates and the multi-year timeframes involved in getting a mine into production from the time an ore body is discovered.

AI has benefitted copper miners – and other mining sectors – by enhancing operational efficiency. AI’s predictive capabilities are being used to help mining companies extract millions of tonnes of ore from the earth in ways that are more efficient than using human experience or intuition.

Mining industry studies conducted by consultants have shown that up to 76% of copper mining projects are showing cost savings after AI has been adopted. AI-enabled predictive maintenance has extended the replacement cycle of equipment by 21% and reduced downtime by 18% and saved on fuel consumption by 12%. Not only are these financial tangibles but AI is helping the mining industry reduce its environmental impact. In addition, at a time where building new mines is becoming increasingly more difficult, AI in copper mining is increasing recovery from mined ore by 7%.

Skepticism and “Bubble” Worry

Increasingly, media headlines are starting to point to the AI technological revolution as being a “bubble”.  It is important to note that there is no accepted definition of what constitutes a “bubble” and that is largely because it is not always easy to differentiate between hype and reality. From our perspective, there are some broad similarities between the 1990s buildout of the internet and today’s spending on the datacenters that power Artificial Intelligence and importantly some significant differences.

In the 1990s, the telecom industry and other startups invested hundreds of billions of dollars into building internet infrastructure such as fiber-optic networks. This investment was largely funded by debt as the companies that were building the networks were often not generating anywhere near the cash that they needed.

The companies that built the internet were generating negative free cash flow compared to the nearly $250 billion being generated by the AI Hyperscalers. This difference provides some confidence that thus far, the AI build-out is sustainable. During the internet bubble, the builders of the telecom and networking infrastructure that built the foundations of the internet overstretched themselves and overbuilt capacity. Eventually, many of these companies collapsed under a burden of debt.

Today’s AI champions are generating rising free cashflows and nearly all of them have considerable borrowing capacity. In short, they have the balance sheets to support their forecast for AI related demand and the investment spending that it will require. Furthermore, the AI infrastructure providers are seeing a nearly insatiable demand for more and more computing power to be deployed. This means more data centers get built, more spending on semiconductors and more demands for electricity. This is a key difference from the “dotcom” era build out of the late 1990s and early 2000s. Then, there was little focus on where the cashflow was going to come from for companies to earn a significant return on the buildout of the internet. In fact, as history shows – there was little in the way of sufficient return on capital.

Hurdles for AI to Overcome

Up until recently, there was little question that the AI revolution was being funded in the right way which is from companies’ own cashflow and some borrowing but the borrowing is being done by some of the most cash rich companies in the world.

All signals from the technology industry continue to indicate that there is a continuation of a shortage of capacity to meet the coming demand for AI technology. OpenAI has been one of the pioneers in the AI space but is also considerably smaller than tech giants such as Alphabet (Google), Microsoft, Oracle, Amazon or Meta. But that has not stopped the optimism of OpenAI one bit. In recent weeks, OpenAI has announced an unparallelled scale of deals with Oracle, Nvidia and AMD to supply it with capacity and computer chips to meet the forecasted demand for its AI technology. OpenAI executives have described demand for its AI offering to be “voracious” and stated that OpenAI will have to spend “trillions” for AI to match its potential. As OpenAI CEO Sam Altman stated in the aftermath of its flurry of deals – “Our bet is, our demand is going to keep growing…and we will spend maybe more aggressively than any company who’s ever spent on anything ahead of progress.”

If OpenAI’s deals as announced come to fruition over the next several years, it will require new electricity capacity in the US that is staggering. It will require the US power grid to generate and deliver power equivalent to the output of 17 nuclear plants or about 9 Hoover Dams.  This is the amount of electricity needed to power about 13 million US homes. If power supply is inadequate it could temper the growth of AI.

AI Providing Tariff Shield 

In the first half of this year, economists were trying to update their models to forecast the potential impact the US tariff and trade policy would have on the global economy. It has been said for decades that when the US economy sneezes, the rest of the world catches a cold and that is still true since the US represents 26% of global GDP.

The concerns about the global economy have faded slightly as trade deals were announced between the US and most of the globe’s economy – with China remaining a glaring exception. For Canada and Mexico, trade talks are ongoing and there is a mixture of hope and angst that the upcoming USMCA free trade agreement will be reviewed without too much friction.

While the tariff agreements have calmed the economic waters somewhat, the US economy has also been shielded by enormous spending on AI related infrastructure and investment. As the fourth quarter has begun, the International Monetary Fund (IMF) has upgraded its forecast for the global economy to rise by 3.2 per cent this year – in line with the 3.3 per cent growth rate of last year. The IMF forecasts the US to lead the G7 leading economies with economic growth of 2.1% (by far the largest growth of the group) but it should be noted that the Atlanta Federal Reserve Board is forecasting that third quarter GDP will be closer to 3.9% and this follows second quarter’s revised numbers of 3.8% growth. It is safe to say that the IMF forecasts look a bit too low for the full year economic growth estimate. For comparison purposes, the IMF expects the United Kingdom to be on track for economic growth of only 1.3% this year – the second strongest growth rate in the G7.

Economists are recognizing the outsized impact that AI-related investment is having on the US economy. As we have noted above, this surge while welcome – is not indicative of being an all clear signal. The investment has to yield positive economic impact beyond the initial investment related “sugar high” or there is risk that this engine of economic growth will fade. Europe is certainly showing economic weakness once again as AI investment has not materialized there to anywhere near the scale it has in the US.

The risk for the US is that the AI boom turns into an AI bust. The optimism around AI has led to US tech giants funneling over $300 billion this year into AI investment spending and total AI investment now accounts for almost 40 percent of US GDP growth this year. In turn, AI related companies have accounted for 80 per cent of the rise in US equities so far this year. The AI boom has drawn in capital from all over the world and the talk earlier this year related to “the end of US exceptionalism” has faded. 

The ripple effect of the AI boom lifting US equities is that consumer spending by the wealthiest households is rising and fueling the US economy. Estimates from economists have consistently shown over the years that the wealthiest 10 percent of US households own 85 percent of US equities. Recent public and private sector data shows that this group of households accounts for half of consumer spending  – the highest share on record since this data point began being collected. Clearly, the AI boom has helped to shield the US economy from tariff fears and fuelled its continued resiliency.

Questions About AI and the Future

The optimism surrounding AI is clearly elevating it to the “next big thing” category. If AI is able to match up to the expectations of its proponents and the technology companies that are spending billions of dollars to build it out then it will increase worker productivity and make the global economy more efficient. It will create new industries and new jobs and enhance innovation and decision making. Furthermore, it will solve complex problems in sectors such as healthcare, space explorations and manufacturing. There is little doubt that the technological achievements of AI that are apparent today and are yet to come will bring enormous benefits over time.

From an investment perspective, the challenge is going to be for the hyperscalers and venture capitalists to continue to be able to generate a significant rate of return on their investment. As we noted, there is no agreed upon definition of what constitutes an investment bubble – we only know that the after effects of one are damaging to markets and the economy. In all likelihood, there are still significant returns to be earned by investments into AI by companies in the technology sector. At some point, investment in AI will begin to overbuild and profitable investments in AI begin to become less profitable. As long as the technology giants maintain discipline on their spending and invest in accordance with potential profitability, AI might be one of the few investment booms that avoids the bubble label.

The post Balancing AI’s Promise and Bubble Fear appeared first on Pacifica Partners.

• Artificial Intelligence’s rise is not without challenges
• AI showing great promise for the global economy
• Murky math of US tariff levies is puzzling
• China is the center of US tariff policy but there is some room for budding opti-

Since the 1980s, mainstream thinking had come to a consensus agreement amongst economists, business leaders, and policy makers that more trade amongst nations was a win-win policy. To facilitate this, free trade was seen as the way forward. Tariffs and trade barriers were to be chipped away to usher in more economic growth, higher employment, and lower prices.

At the time of its signing in 1987, the Canada – US Free Trade Agreement (CUSFTA) was the most significant free trade agreement in the world. However, in Canada, it was not a fait accompli as many Canadians saw free trade with the US as risky. Opponents believed that given the fact that Canada’s economy and population are one-tenth that of the US, it would lead to Canada losing its sovereignty, its public health care, and more.

In 1988, the ruling Conservative Party ran for re-election on the merits of free trade and won by convincing voters of the importance of signing the CUSFTA with the United States. The CUSFTA was followed up with the 1992 signing of the North American Free Trade Agreement (NAFTA) which brought about a free trade arrangement between Canada, the US, and Mexico. This time, it was the US that saw the most opposition to free trade – primarily due to fears that lower wages and environmental standards in Mexico would cost the US manufacturing jobs. One of the most memorable quotes opposing NAFTA belonged to former presidential candidate Ross Perot when he stated in a 1992 Presidential Debate, “We have got to stop sending jobs overseas. It’s pretty simple: If you’re paying $12, $13, $14 an hour for factory workers and you can … pay a dollar an hour for labor … there will be a giant sucking sound going south.”

President Trump has made similar arguments as Ross Perot and championed policies aimed at bringing more manufacturing jobs and more factories to the US. Long before entering politics, he has expressed his belief that the US has been getting taken advantage of by foreign nations and the trade deals that have been made by the US in the past have cost the US factory jobs. In the 2016 campaign, Trump stated “Bringing back our manufacturing jobs is the key to restoring the middle class” and in 2020, he stated “We want companies to build their factories in America, not overseas. We’re working on trade deals that put American workers first.”

Trump Trade Policies Wake Up Canada 

Canada has long enjoyed the benefits of being situated next to the United States. Sharing a border with a nation that has the largest economy and most powerful military has certainly been helpful to its development. At the same time, Canada has maintained a sense of both gratefulness and occasional unease since its founding. During his 1969 trip to meet President Nixon, Canadian Prime Minister Pierre Trudeau spoke to the National Press Club in Washington, DC. Trudeau told the audience “Living next to you is in some ways like sleeping with an elephant. No matter how friendly and even-tempered is the beast, if I can call it that, one is affected by every twitch and grunt.” The audience roared with laughter. Today, the calls by President Trump for Canada to become the 51^st state are rekindling Canadian emotions ranging from anxiety to anger.

The trade dispute with the US comes at a time that Canadians are realizing they have experienced a lost decade in terms of the economy. As we have highlighted in past commentaries, Canada’s per capita income growth has been about flat over the last decade and is amongst the worst in the G20 group of nations.

On paper, Canada has everything the world needs – energy, agricultural products, lumber, minerals, and manufacturing capability. Somehow, it has not translated into income growth. Seeing the writing on the electoral wall, Justin Trudeau resigned as prime minister as his poll numbers sank due to a population angered over the economy, taxes, cost of living, and crime. As the US – Canada relationship hit perhaps its roughest patch in over a hundred years, Trudeau was likely reminded of what his father told the National Press Club.

Canada, Mexico and China

Despite the signing and then re-negotiation of the USMCA by the Trump Administration in 2020, Trump has recently singled out Canada and Mexico as taking advantage of the US because both nations had a trade surplus with the US. He has stated that Canada is putting up non-tariff barriers to US exports and Mexico is being used by China to funnel into the US goods made in China made by using the cover of the USMCA.

Often missing in the headlines is that the North American tariff dispute began with the US making the case that narcotics, such as fentanyl, were being smuggled in through the open border with Mexico and Canada. The US government has stated that given the fentanyl epidemic in many parts of the US, there is a national emergency under the International Emergency Economic Powers Act (IEEPA) of 1977. Under the US Constitution, only Congress has the authority to impose taxes and tariffs, but Congress gave presidents the power to use the IEEPA to impose tariffs without Congressional approval if a foreign threat emerged.

About 2% of the fentanyl intercepted at the US border has been along the Canadian border and the rest has been at the US border with Mexico. US Customs and Border Protection (CBP) data shows that from 2019 to 2024, 80% of individuals caught with fentanyl at border crossings are American citizens. While the amount found by authorities at the US-Canada border might be small, it is enough to harm at least several hundred thousand people with some estimates ranging far higher.

Autos Are The Center of the Storm 

Canada and Mexico each have a nearly US $750 billion annual trading relationship with the US that reflects the deep economic integration amongst the nations. Canada is the largest export market for US goods and 34 states sell more goods to Canada than any other foreign economy. In addition, trade between the US and Canada is highly integrated with most Canadian exports to the US serving as inputs for US companies’ production processes. For this reason, tariffs on Canadian goods are likely to raise US industry’s production costs more than the cost increases arising from tariffs being applied to imports from other nations. 

This is likely going to be mostly felt in the auto sector which accounts for 22% of total trade between the three nations. For Canada, auto manufacturing accounts for 128,000 direct jobs. According to 2020 data cited by the Canadian Vehicle Manufacturers’ Association, for every one auto assembly job, approximately ten other jobs are created in Canada. The supply chain of the auto industry shows how complex applying a tariff really is since it become quite difficult to apply a tariff on a non-US car part. Depending on the model and the particular auto part, a single component or subcomponent can cross a border in North America six to eight times.

Madagascar Math

One of the ways in which the Trump Administration has categorized nations for the kind of tariff treatment they will get is whether or not a particular nation runs a trade surplus or deficit with the US. Once again, the critics of this approach have a point when they see a nation such as Madagascar- which runs a USD $560 million trade surplus with the US – being given a 48 percent tariff on its exports to the US but Australia on account of its $18 billion trade deficit with the US receiving a 10 percent tariff on its exports to the US. It should be noted that Madagascar’s exports of $670 million are dominated by vanilla beans and apparel – two things the US cannot produce cheaply or easily. In turn, Madagascar does not have the earnings power to make meaningful purchases of US exports such as autos or military equipment. Looking at Madagascar provides an example of where the Trump Administration’s tariff math is seen as puzzling.
  

In another example of “murky math”, trade experts and policy makers in the US and Canada have expressed some puzzlement at President Trump’s claim that the US is subsidizing Canada in the amount of USD $200 billion. It seems nobody – including from the president’s own team – has clarified where that figure comes from exactly. If one were to hazard a guess, then perhaps the president is taking the roughly $63 billion trade deficit with Canada and adding Canada’s well-known shortfall in its defense spending commitments as a member of NATO. This figure then is added up over the last four years. To be fair, Canada is woefully short on defense spending and has also been called out by European allies and by the Biden Administration for not contributing what it is obligated to under NATO. Canada is seen by many nations as benefitting from the US and NATO umbrella without being a fair contributor.

Clearing The Air: Canada’s Trade “Surplus”

Canada ran a trade deficit with the US of about USD $45 billion if energy (oil, gas, and electricity) is excluded. Once Canadian energy exports to the US of about USD $108 billion are added back, the data shows that Canada had a trade surplus of about $63 billion in 2024. If the US was not in need of Canadian energy, the US would enjoy a substantial surplus. As things stand, Canada provides 4 million barrels of crude oil per day to the US – amounting to about 25 percent of the crude oil used daily in the US. Furthermore, due to factors related to its physical properties and transportation costs – Canadian oil is sold to the US at prices ranging from $13 to $18 per barrel below market prices. This helps the US because it can export its own oil at much higher world prices which boosts its economy.

Beyond energy, 85% of all of the potash used by US farmers as a fertilizer input is imported from Canada. Clearly, the president is wrong when he says that Canada does not have anything that the US needs. In recognition of this, the Trump Administration has backed off and exempted Canadian energy from tariffs. This was to be expected because a tariff on Canadian oil would have raised gasoline prices by $0.30 – $0.70 per gallon – something US consumers (voters) would have noticed quickly.

Often forgotten in the energy discussion are Canadian electricity exports to the US. Ontario supplies electricity to about 1.5 million US homes in Michigan, Minnesota and New York while Quebec supplies about 2 million households in the eastern US.

All Roads Lead to China

Behind some of the economic reasons for wanting to bring down the US trade deficit is the desire of the Trump Administration to become self-reliant for core goods such as steel, aluminum, semiconductors, and pharmaceuticals. With respect to pharmaceuticals, China controls the global supply of the precursor chemicals that give finished product pharmaceuticals their efficacy. Even most of the North American aspirin supply comes from China. It also dominates the US supply chain for its supply of vitamins, antibiotics, and other medicines. In his book “Fear: Trump in the White House”, author Bob Woodward quoted Gary Cohn, the chief economic advisor to President Trump in his first term, as advising the president against a trade war with China since it supplied 97 percent of all antibiotics in the US. Cohn counseled “If you’re the Chinese and you want to really just destroy us, just stop sending us antibiotics.” Cohn’s concerns were validated when some media sources quoted an economic advisor to China’s central bank suggesting that China should use its leverage over the vitamin and antibiotics supply chain to restrict the supply of those items in the US.

The Trump Administration will be announcing measures to repatriate pharmaceutical production back to the US. Apart from national security reasons, decentralizing production of pharmaceuticals, and antibiotics reduces the risk to the world since a centralization of the supply chain in China risks vulnerability to a nation – whether it is from accidental or intentional causes.

Glints of Optimism
 

While financial markets would prefer the tariff fights to never have begun, investors are largely trying to factor into asset prices what the impact of a disruption to trade will be on the global economy. Corporations have largely surrendered to the uncertainty and many are not giving any sort of guidance to what profits might look like over the next year.

We have been here before when the pandemic and shutdown of the global economy clouded the ability of corporations to provide guidance for future profitability. However, it did not stop stock markets from sending the US S&P 500 stock market index up by 63% (measured from the lows of March 2020 to the unveiling of the vaccines). What they are having some issue with is the dizzying array of announcements, reversals, and increases on tariffs coming from the White House.

With respect to China, it is likely that we have reached peak tariff as the US and China have announced tariffs of over 100 percent on certain goods—increasing them further will not have anymore impact on each nation.

Markets are looking for negotiations to yield trade agreements. The US has stated that currently, over 75 nations have asked for talks with the US. Japan and Italy (on behalf of the EU) have already begun talks and President Trump has shown some appreciation of this—which is helpful for financial markets. He has stated that his intention is to get a good deal for the United States but he is not interested in harming the economies of nations that want a deal. He has reiterated that he wants  a “fair deal”.  That is a helpful statement because it gives some potential visibility to the offramp from trade and tariff disputes.

US trade negotiations are being led by Treasury Secretary Scott Bessent. While Bessent has stated that he would like to reach trade deals with other nations to form an alliance to gain some leverage in talks with China, he has also stated that there is no reason for the economies of China and the US to decouple. He has stated that “There’s a big deal to be done at some point.” President Trump has stated “We’ll see what happens with China. We would love to be able to work a deal.”

These are all positive first steps. But as we noted, while the US is looking to do trade deals with dozens of nations—it is the China relationship that will take the most effort. China is digging in but has stated that if the US approaches it in a respectful manner, it is willing to talk. At this point, there are more reasons to be optimistic than a month ago but it is going to be a long and bumpy ride.

The post Tariffs, Trade & Turmoil 2.0 appeared first on Pacifica Partners.

• Taiwan is indispensable to the technology sector given its leadership in semiconductors
• China’s intentions towards independence of Taiwan raise economic risks
• US, Europe and Japan focused on rebuilding domestic semiconductor capacity

The key forces propelling the economy forward are innovation and advances in technology which compound upon one another. While the United States is without a doubt the economic engine of the world, it is the island nation of Taiwan that punches far above its weight and has become the centerpiece of the global technology sector. However, it has not fully escaped the forces that helped bring about its creation.

After World War II, a defeated Japan returned Taiwan to China. At that time, China was still embroiled in a periodic civil war that first began in 1927. The Communist forces led by Mao and the ruling Kuomintang party (KMT) battled for control of China’s future. By 1949, the communists defeated the KMT and the KMT’s leadership along with their supporters left China for the nearby island of Taiwan—only 90 miles off China’s coast. The KMT established one-party rule to govern the island from 1949 to 1987 – after which, other political parties were allowed to be established. The KMT finally lost power following the 2000 election.

Under the KMT, Taiwan saw its economy transform from an agricultural base to become an integral player in the modern technology and manufacturing sectors. Taiwan established itself as the world’s clear leader in the manufacturing of semiconductors (sometimes referred to as “computer chips”). This dominance is largely powered by its leading corporate titan – Taiwan Semiconductor Manufacturing Company (TSMC).

TSMC Is Indispensable

Much like oil powered the economies and war machines of the 20^th century, today’s modern economy is powered by semiconductors – making them a strategic asset for many nations.  Semiconductors power everything from cars, telecommunications, banking, energy transmission systems, satellites and military equipment. In May 2023, US director of National Intelligence, Avril Haines, told the Senate Armed Services Committee that TSMC’s chips are used in 90 percent of “almost every category of electronic device around the world.” More recently, the world is now seeing the role of TSMC in the advancement of Artificial Intelligence. While there are many companies in the semiconductor sector that are pivotal to powering the modern world, none is likely more indispensable than TSMC.

TSMC is the world’s largest semiconductor foundry (manufacturer of computer chips for other companies). While Intel and Samsung also provide foundry services to various companies, these companies also design computer chips. TSMC is solely a foundry only business and its advanced manufacturing capabilities have made it the foundry of choice. TSMC’s semiconductors are used by the world’s leading technology companies such as Apple, Nvidia and AMD. Nvidia’s founder, Jensen Huang, has stated that Nvidia would not exist without TSMC. These three companies account for 40% of TSMC’s revenues as of mid-2024. In turn, these companies are central to the US economy and to advances in Artificial Intelligence. Through TSMC, a clear nexus can be seen between Taiwan’s economy and that of the US and the modern global economy

TSMC has used this focus on manufacturing to establish a competitive superiority that has allowed it to dominate the global semiconductor industry. The majority of the most complex computer chips are produced by TSMC. The company’s ability to produce transistors at sizes too small to be seen by the naked eye means an every increasing number of transistors can be added onto a single computer chip, thus increasing computing power speed and energy efficiency. Intel has unsuccessfully attempted to compete with TSMC at being able to provide the smallest transistor scale but has come up short. Samsung is likely the next closest industry competitor to achieving this level of scale.  Chips that are increasingly smaller means they are more energy efficient and faster. The increasingly more powerful computer chips are a necessity for advancing technology to meet the needs of the future.

China’s Eyes Are On Taiwan

With the end of the Cold War, the consensus assumed that tensions amongst world powers were going to be a thing of the past. The Soviet Union had ceased to exist, Eastern Europe was free of Communism and China was transitioning towards a capitalist economy. Only things did not unfold as they were expected, to unfold and China and the US have emerged as fierce become competitors for the mantle of global leader.

For a number of years, various committees in the US Congress have sounded the alarm bells regarding the dependence of the US economy on Taiwan. There has been a push for the US to be able to become self-sufficient in the production of computer chips so that the US economy cannot be held hostage should China decide to take military action to bring Taiwan back under its formal authority.

China has long viewed Taiwan as a “breakaway province” while Taiwan sees itself as a unique nation with its own customs, constitution and democracy. Despite these sharp differences, China is Taiwan’s largest trading partner as China and Hong Kong accounted for almost 35% of its exports while exports to the US and Europe accounted for about 18 percent and 10 percent of exports respectively.

Unfortunately for US policymakers, the economic relationship between China and Taiwan is not enough to provide certainty that the two nations will avoid future potential for conflict. In fact, it is this trading relationship that worries them. TSMC sold over $54 billion of semiconductors to China and despite this – China has been ratcheting up military tactics aimed at destabilizing Taiwan.

China’s President, Xi Jinping, stated in his New Year’s address this year that “reunification” with Taiwan is inevitable. Xi stated that since Taiwan is its “sacred territory…the reunification of the motherland is a historic inevitability. China will surely be reunified.” To back up his words, China has been trying to keep Taiwan off balance with various military drills and incursions into Taiwanese airspace and waterways

This month, China conducted military drills around Taiwan code named “Joint Sword-2024B” – the largest   since similar drills in May of this year. While China has conducted numerous small sized incursions for years, it has tended to reserve the largest military exercises in response to major speeches by Taiwanese leaders that express a wish to remain free of China or when it feels other nations are not respecting its wishes on Taiwan.

While Taiwan could not win a military fight against China’s much larger forces, an invasion of Taiwan is not necessarily easy for China. In fact, China has stated a preference for unification with Taiwan through peaceful methods – but it has not renounced the use of force.

Assessing China’s Threat

Experts are undecided if China does make an advance on Taiwan, would it decide to invade militarily or put an economic blockade on Taiwan with its navy and air power – by which, it could wear down Taiwan into submission—or risk a military fight. Despite its overwhelming strength, there has been considerable debate about how easily China could win a military victory. Though China has the world’s second largest defence budget, its military is untested and invading Taiwan would not be an easy exercise. It would have to be able to synchronize air, land and naval forces while using electronic and cyber warfare. So far, only the US has successfully done so in actual combat.

In addition, a naval invasion would not be an easy feat due to the volatile weather and choppiness of the Taiwan Strait that lies between China and Taiwan. This leaves China a limited time window each year to mount an invasion. Taiwan is also assisted by its shallow water coastline which leaves few places for an invading naval force to land its forces. The shallow waters would require Chinese transport ships to anchor a mile away from shore – making them vulnerable to counterattack.

Military experts believe that a naval invasion would require over 1000 ships and several weeks to move the necessary military personnel across the Taiwan Strait – giving Taiwan ample time to mount a defense and perhaps call on the US, Europe and Japan for help.

From a historical perspective, the largest amphibious invasion in history was the D-Day operation of WWII. To cross approximately 100 miles of the English Channel, the Allied nations landed 850,000 troops on the beaches of France. It is estimated that a successful  invasion of Taiwan would need to be larger than D-Day.

In May of this year, China reacted to the inauguration of Taiwan’s new president, Lai Ching-te, with another series of military exercises that lasted for two days.  The US Navy observed the exercises and shared its observations with Taiwan. Admiral Samuel Paparo, the commander of US Indo-Pacific Command stated that the exercises “looked like a rehearsal” for an invasion. “We watched it, We took note. We learned from it. And they helped us prepare for the future.”

Diversifying Taiwan Risks 

In 1990, the US accounted for 37% of global semiconductor manufacturing capacity. By 2022, the US only accounted for 12% according to the Semiconductor Industry Association, as Taiwan, South Korea and China have taken the market share away from the US. Asia controls 80% of global manufacturing capacity with TSMC alone controlling over 60% of the capacity.

One of the main factors for propelling Asian semiconductor manufacturing to surpass the US industry is the cost structure advantages of Asian companies. The Semiconductor Industry Association has stated that it costs about 30-50% more to build a semiconductor fabrication plant in the US than in Asia while also possessing an operating cost that is 25-50% higher.

In order to compete with Asia and to hedge against the risks of Taiwan’s semiconductor industry being impacted by a conflict with China, the US has taken steps to rebuild its domestic semiconductor manufacturing capacity (see figure above). In 2022, the US passed the CHIPS and Science Act. The legislation provided $52 billion in subsidies and incentives for semiconductor manufacturing and development in the US. The act will also aim to support quantum computing, artificial intelligence (AI) and advanced telecommunications such as 5G and 6G. All of these will require continued advancements in semiconductor technology.

Semiconductor Renaissance

The CHIPS Act has led to a surge in investment aimed at investing in not only new chip plants but also to the retooling and expansion of existing plants. Five of the leading semiconductor manufacturing companies have announced an investment for new plants. Earlier this summer, US Commerce Secretary, Gina Raimondo, told reporters that along with TSMC – Intel, Samsung, Micron and SK Hynix – have all committed to investing in new plants in the US. As the chart on shows above, the CHIPS Act has begun the revival of the US semiconductor industry. Raimondo highlighted the investment by SK Hynix was a “huge deal” because it would allow the US to “have the most secure and diverse supply chain in the world for the advanced semiconductors that power artificial intelligence.” The Semiconductor Industry Association has estimated that the new investments will help the United States triple its domestic chip manufacturing capacity by 2032.

Competitive Race With China Is On

China unveiled a comprehensive national security strategy in 2014. One of the principles of this strategy was for China to cement itself as the world’s leading science and technology superpower. For China, the road to achieving this is difficult because it is starting well behind the US.

For its part, the US has taken measures to maintain its technology lead in semiconductors and Artificial Intelligence (AI). The US has imposed rules on both US and international companies that will penalize them for selling advanced semiconductors and semiconductor manufacturing equipment to China. The rules restricting sales to China are administered by the US Commerce Department and it has stated earlier this year “it plans to continue updating its restrictions on technology shipments to China as it seeks to bolster and fine-tune the measures.” China has fired back through its Ministry of Foreign Affairs by stating that it wanted “the US to immediately corrects its wrongdoings and stop its illegal unilateral sanctions and long-arm jurisdiction against Chinese companies.”

Europe and Japan have also tightened export controls to China. Semiconductor manufacturing equipment exported by the Netherlands is a particular focus of US policy towards China. The US has worked with the Netherlands to ensure Dutch based ASML does not export  to China its most advanced machines —which sell for as much as $400 million each. While the Netherlands has agreed to restrict the export to China of the newest generation of ASML’s equipment, it is permitted to continue to sell its older generation of machines. The advanced equipment is used to produce semiconductors for Artificial Intelligence that have consumer, industrial and military applications.

Semiconductors are as pivotal a resource to economic  advancement today as oil was in the 20th century. The US, Europe and Japan recognize the risk to their economies of relying on Taiwan’s superior semiconductor industry since it lies less than 100 miles off the coast of China. They are now racing to reduce this risk while constraining China’s access to semiconductors. The potential threats to Taiwan have created an urgency for the West to  bring the semiconductor supply chain closer to home.

The post The Economic Risk of Taiwan appeared first on Pacifica Partners.

• Artificial Intelligence’s rise is not without challenges
• AI showing great promise for the global economy
• AI’s enormous energy appetite is going to challenge climate goals of policymakers
• AI’s future will depend on more energy

One of the hallmarks of the US economy for over a century has been its ability to renew itself through a dynamic process of creative destruction. New companies seemingly come out of nowhere and over time go on to become globally dominant. Whether it was Ford or IBM in the early part of the 20th century or Microsoft, Apple, Google, and Amazon in the 1980s and beyond – entrepreneurial ingenuity has allowed for the founding of entirely new industries. The innovations developed by many great companies helped to provide a continuous supply of fuel for economic growth. In recent years, it has been the arrival of Artificial Intelligence applications that are expected to provide the next great economic leap.

Though the concept of Artificial Intelligence (AI) has been in use since the 1950s, in today’s technologically advanced world it is a term that refers to the ability of machines, guided by computer programs, to simulate human intelligence by not only processing and analysing large amounts of data quickly but also to learn to use the information as a person would while applying a level of reasoning and logic. As AI developments continue, machines will be able to increasingly interact with human language, perform speech recognition, and have vision that would allow for self-driving vehicles, amongst other advancements.

The implications for the future of the global economy are difficult to foresee with certainty but on the positive side, forecasts would indicate that AI will allow for the automation of routine tasks that would allow workers to focus on more complex activities that in turn would enhance productivity. Another example of how AI is being used already is in call centers – where AI powered chatbots and virtual assistants are able to provide faster and more efficient customer service.

Companies such as Amazon are investing huge sums in AI in order detect fraud, improve inventory management and optimize supply chains. On the customer side of its business, it is using AI to enhance its relationship with its customers. Amazon uses AI to analyze the immense data its customer interactions generate each day. It uses this data to proactively reach out to customers with recommendations for products based on past purchases.

As the largest apparel retailer in the world, Amazon uses AI to learn millions of details on apparel items, such as style, size, and customer reviews. Amazon has been able to determine through AI that its customers are more likely to purchase and keep an item when a size or particular attribute is recommended to them. In this way, Amazon is able to reach hundred of millions of customers across the world quickly and cost effectively. From a bottom-line perspective, the impact on profits is positive since AI is able to induce customers to spend more on products that are a better match for their style and size preference. In turn, this minimizes the volume of merchandise that is returned back to Amazon – reducing costs for the company.

While it is too early to say what the future implications will be with any great precision, the potential for AI to be the “next big thing” is certainly possible. But AI is posing some challenges that could limit its growth, at least in the short to intermediate term. One of those challenges relates to generating enough energy to power the incredible growth of AI. Specifically, AI requires a tremendous amount of computational power that is done in data centers.

Data centers are large warehouse sized facilities that house computer systems and communication and storage systems. In turn, these facilities allow for the storing, processing and sharing of data and computer applications across wide areas. Many of the world’s largest institutions and corporations rely on data centers for their day-to-day operations.

Data centers are classified as “critical infrastructure.” If a data centre were to go offline due to a malfunction or due to a power shortage, it can cost companies millions of dollars per minute. Therefore, data centers must be running every minute of every day. To safeguard against this risk, data centers are intertwined with critical support systems (infrastructure).

These data centers require very high levels of power that must be consistent and able to increase in capacity. Not only do the computers require power but the cooling systems that keep the data center from overheating require a strong and consistent supply of power too.

Data Centers’ Risk to Net Zero

A long-standing goal of global policymakers has been to generate a continuous rise in power generation from renewable sources of energy such as wind, solar and hydroelectric. The global community of nations has pushed for “net zero” by 2050 which refers to achieving a balance between the amount of greenhouse gases emitted into the atmosphere and the amount removed from it through carbon capture, storage and reforestation. Some scientists have stated that achieving net zero emissions is essential to limit global temperature rises to levels that avoid the severest consequences of climate change.

The challenge, global electricity consumption has been rising steadily over the past 20 years; driven by population growth, industrialization, urbanization, and technological advances that have led to the proliferation of electronic devices, smart technologies and more recently – the rise of data centers.

Servers require extraordinary amounts of electrical power to perform the technological services that they are designed for, but must be kept at specific temperatures at all times. A site must have access to a power grid that can keep the servers running and the cooling systems working around the clock. Data centers alone are consuming over 3% of global electricity consumption. As the backbone of the digital economy, they play an indispensable role in storing, processing, and delivering the data that powers the economy and all aspects of society. However, this reliance comes with an immense energy cost, making the sustainability and scalability of our energy sources critical.

As the chart above shows, the US has more data centers than any other nation. It houses 5375 data centers – almost 50 percent of the global total. Data centers represent about 4 percent of all of the electricity consumed in the US. By the end of the current decade, data center power consumption in the US is expected to reach 35 gigawatts (GW). This is double the level of power consumption of the level of 2022.

The US data center capacity is centered in Virginia which has the largest concentration of data centers in the world. Earlier this year, Google announced a $1billion expansion of its three data centers in northern Virginia. Virginia’s leading power provider, Dominion Energy, states that 20 percent of its power sales in the state are to data centers and it expects that by 2040, power consumption by data centers will quadruple.

Environmental Constraints

The Virginia chapter of the Sierra Club, one of the largest environmental organizations in the US, is not pleased with this trend. It believes that at the current pace, 40 percent of Dominion Energy’s power generation will be directed to data centers. The Sierra Club believes that to meet demand, new power plants fueled by fossil fuels are going to have to be built with the costs borne by Virginia households. Virginia’s governor, Glenn Youngkin, states that critics of datacenters are not taking into account the over $2 billion in wages paid to Virginia based employees in the data center sector and the over $1 billion in tax revenue that has been generated to fund government services.

Energy Shortfall Hinderance to AI

It is not only in Virginia that the need for data centers and the environment are in conflict. Ireland is facing the same issues. Ireland has 82 data centers in service, with 14 more under construction and another 40 approved for planning. Ireland is a favoured destination of the technology industry because of its favourable taxes, educated workforce and its weather. Specifically, its rainy and often cool weather is helpful for a data center since it lowers the energy costs for cooling systems.

Ireland’s Central Statistics Office states that data centers account for almost 20 percent of its electricity consumption. This is equal to the power consumed by nearly all Irish urban households. The Irish government has stated that it will miss its 2032 greenhouse gas emissions targets by a wide margin. Furthermore, if all of the datacenters that are being proposed for Ireland are built, experts estimate that up to 70 percent of the entire country’s electricity supply will be consumed by datacenters.

Irish energy regulators have pushed back against data center owners such as Microsoft, Amazon and Meta by requiring data centers to have backup generators so that if they are asked to reduce their energy pull from the national grid, they can keep running during times of peak consumption. Without this measure, Ireland would be plunged into rolling blackouts.

Iceland: The Ideal Data Center Host

Iceland has also entered the competition for data centers. Iceland might be the perfect place for a data center given its cool temperatures and cheap and environmentally friendly power supply since all of its power is renewable. Iceland’s president, Guoni Johannesson was quoted in a data center industry publication earlier this year as saying “Data centers are here to stay. When I was studying in England in the late ’80s, there was no Internet. My mom sent me newspapers that arrived 14 days later…Last night, I attended a sporting event. I took loads of videos, listened to Spotify on the way back, downloaded necessary stuff, unnecessary stuff. But I didn’t pay any attention to the energy, because it’s just the cloud – I don’t see smoke billowing up out of my laptop or phone.”

Nuclear Powered Internet

While large economies cannot rely on renewable power the way Iceland does, technology companies and even some environmental groups have stated that nuclear power is the next best solution. It is able to provide a reliable source of power and it does not emit greenhouse gases. Some environmental groups have stated that if greenhouse gas emissions targets are going to be met, then nuclear power has to be part of the solution. The Biden Administration is broadly supportive of nuclear power to meet the energy needs of the US and views nuclear energy as the only proven clean and reliable source of power.

In the short to intermediate term, even if the commitment is made to increase nuclear energy capacity, plants can take over a decade to move from permitting to production. Meanwhile, hundreds of billions of investment in new data centers is being planned and data centers can be up and running in under two years. Given the time gap between the immediate term demands of the AI industry and more reliable power supply coming on stream, it is likely that fossil fuel use will have to rise to fill the gap. This would mean in the US and other nations, natural gas demand  for power plants would rise. Currently, about 43 percent of US electricity demand is met by natural gas plants.

A further limitation on energy options comes from the fact that under-investment in nuclear plants has caused the US  and western nations to now lag China by 10 to 15 years in rolling out next generation nuclear reactors.

If the AI boom is to be sustained and enhanced and in turn provide the benefits being touted for commerce, science and the broader economy, then energy production will have to rise. The future growth of AI is going to have to require a strong contribution from old economy sectors such as uranium, natural gas and utilities. In many parts of the US and around the world, data centers are putting a strain on power grids. Even a relatively simple AI application such as ChatGPT requires about ten times the energy for a query that Google needs in a traditional non-AI search.

It is perhaps ironic that as world leaders finally came to a consensus on the need to reduce greenhouse gas emissions, they are being confronted with the potential for their economies to face severe energy shortages from advances in computing technology. Under that scenario, they would likely have to consider abandoning net-zero emissions goals. 

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• Canada’s economic malaise
• Caught in a population trap
• US economy sets the productivity bar
• Rising population and labor supply will not bail out Canada from its challenges

The story of major economies of the world undergoing a prolonged period of malaise is more frequent than it might appear. Japan’s economy was once regarded as the miracle economy as it went on a nearly 40-year charge upwards after WWII. For the last 35years, Japan’s economy has been tied to the phrase “The Lost Decades”. In the UK, the 1970s were a time of social and economic upheaval as the nation’s economy became inundated with labor strikes, unemployment, inflation and the inability of its products to compete on the world markets.   The UK was in such dire straits that even the Soviet Union viewed British goods as inferior. A declassified conversation between President Gerald Ford and Henry Kissinger quoted Kissinger as saying  “Britain is a tragedy – it has sunk to begging, borrowing, stealing…That Britain has become such a scrounger is a disgrace…”

Not longer after this conversation took place, Ford’s successor, Jimmy Carter told the US in a national address in the summer of 1979 that the American people had lost faith in the ability of the government to fix the problems the US faced. He stated “A majority of our people believe that the next 5 years will be worse than the past 5 years. Two-thirds of our people do not even vote. The productivity of American workers is actually dropping, and the willingness of Americans to save for the future has fallen below that of every western nation.” Initially, the speech was well received for its honest and frankness but as conditions continued to deteriorate and confidence sank further, the speech became known as the “malaise” speech.

Northern Malaise

Looking at the contents of Carter’s speech, it could be used to describe Canada’s current predicament. For the last several years, it has been our contention that a malaise has been setting in across Canada. A poll taken at the start of this year showed over half of Canadians want an election as soon as possible or later this year. Another poll taken in late 2023 by Pollara showed that only 31% of Canadians are optimistic about the future of the middle class and only 52% are confident their children will be part of the middle class or higher.

Polling data and economic trends show that Canadians’ confidence about the future can be tied to their inability to get ahead of rising household debt levels. At the end of 2023, Canadians’ household debt was 101.2% of the year’s nominal GDP. In the G-7 group of nations, only the UK comes close to Canada at 85% with the US down at 64% of household debt to nominal GDP.

To further underline the national mood of Canada, consulting firm Meredith and Boessenkool Policy Advisors found that over 60 percent of Canadians believe that “Canada is broken.” The factors behind this shocking number are related to the cost of living, housing, health care, immigration, public safety and lack of confidence in the government itself.

Rising Debt, Stagnant Income

High levels of debt can be overcome in time with the right set of macroeconomic policies that boost economic growth, raise employment and in turn boost household income. Unfortunately for Canadian households, rising debt and stagnant income growth has become a serious challenge. About 75 percent of household debt in Canada is tied to mortgages. The chronic shortage of housing relative to years of rapid population growth has left Canadians scrambling to pay ever higher prices for shelter.

The shortage of housing has reached record levels and current data shows Canada has only one housing start for every 4.2 people entering the working-age population.

Population Trap

Canada’s current population growth has been too fast relative to the ability of its economy to absorb it into the workforce. At the same time, social services such as health and education are becoming policy challenges for governments at all levels to resolve. Earlier this year, Stefane Marion, an economist for National Bank published a report on Canada’s economy in which he stated that Canada has been caught in a population trap. This is defined as a situation in which the population has risen too fast and too quickly and there is not enough capital creating opportunities for the rising population to be absorbed. A population trap has tended to happen in emerging economies—not developed economies.

The lack of productive capital for the Canadian economy and its workers is highlighted by the fact that the capital stock (roughly defined as plant, property and equipment) of the business sector has been declining for seven years and is down to the same level it was at in 2012. Given the Canadian economy has grown in nominal terms by 17% over that time, it means that Canadian businesses have not seen fit to invest in order to expand and update their productive capacity.

Ignoring Impact of Policy

For its part, the Canadian government is highlighting that the economy has recovered the lost ground from the pandemic and GDP has surpassed pre-pandemic levels. Its last budget stated that “Canada’s economy is now 103 per cent the size it was before the pandemic, marking the fastest recovery of the last four recessions, and the second strongest recovery in the G7.”

The government is saying that the size of the economic pie has never been larger – but neglected to mention that each person’s share of the economic pie (per capital income) has been falling for the better part of the last seven years. This is the same length of time as the stagnation of the capital stock. This is no coincidence since workers need updated equipment and productive capacity in order to produce more output per hour worked. This is what economists refer to as productivity.

Productivity Growth is Quality Growth

The shortage of housing has been a key contributor to economic growth. High real estate prices have increased construction activity that has translated into economic growth While housing investment is no doubt important for any economy, Canada has become dependent on it and this has fueled a low quality source of economic growth powered by debt. This is diverting capital away from finding its way into investments that will enhance future economic growth.

As things stand currently, both domestic and foreign investors are sending their cash to jurisdictions besides Canada. This reduction in the supply of capital means businesses are competing increasingly against the real estate sector for access to relatively scarce capital. No major economy relies on residential real estate investment for economic growth as much as Canada as real estate accounts for over 20 percent of GDP and over 40% of fixed capital formation. Economists estimate that Canada’s economy is 10% more dependent upon housing than the US was at the peak of its real estate bubble in 2006.

The reliance on real estate for fueling economic growth is a poor quality economic lever. It has actually further undermined future productive capacity as real estate has absorbed a relatively scarcer supply of capital – leaving less for the private sector to retool an ageing stock of productive capital (plant, property and equipment).

Canada needs its companies to invest more in their productive capacity. Such investment is the foundation for future economic well-being because it leads to innovation and the ability to compete on world markets. More investment in machinery leads to more output per worker which pushes up wages and raises the standard of living for a nation.  The productivity of labor is important for any nation because it is one of the purest drivers of economic growth since it is an economic lever that produces no significant negative consequences. It is the most desirable way to strengthen economic growth.

Unfortunately for Canada, its productivity track record is getting worse – not better – even with the spotlight being put on it for the last several years. Its productivity has fallen for 13 straight quarters and is back to 2016 levels and has never had a slower growth rate in labor productivity over any previous eight-year period.

As Chart 6 shows, since the 2008 Great Financial Crisis, the paths of Canada and the United States have diverged widely when it comes to investment in machinery. This is now showing up in the productivity data. The chart on below shows that the US has led the entire G7 group of nations by a wide margin in terms of annual output per hour of worker labor.

The US Sets the Productivity Bar

In 2018, the Canada’s Senate Committee on Banking, Trade and Commerce warned of Canada’s productivity challenge when it stated that Canada was rapidly falling behind the US. It stated that the US had gone from being the seventh most competitive economy in the world to second in only 5 years while Canada remained stuck at 14^th.The US economy continues to lead the G-7 group of nations in terms of economic output per worker. Its productive labor force has allowed it to absorb a rising pool of workers – keeping unemployment down – while boosting per capita income. Economists say that a nations per capital income is synonymous with the standard of living.

To provide some additional perspective, the Public Policy Forum – a Canadian public policy organization – stated that in the three decades after WWII, Canadian real weekly wages rose 2.5 percent per year. This allowed Canadian wages to double in under 28 years which set young workers on a path to double their income well before retirement. Such a rise in the standard of living likely provided a sense of optimism about the future – a stark contrast to the mood unveiled by the surveys outlined earlier. But in the last five decades, Canadian real wages have grown by less than a quarter of a percentage point per year. This pace means wages would take 288 years to double!

Canada’s productivity problems long pre-date the surge in its population. Its policymakers made a mistake thinking that a rising population would make up for the shortcomings of its economy arising from taxes, regulatory uncertainty and an inadequate supply of capital that finds more attractive returns in other nations. Canada has essentially gambled that this could be overcome by a surging labor supply through a more welcoming immigration policy. Unfortunately, the labor supply has not helped productivity and that has led to the stagnation of per capita incomes. The data shows that Canada’s long-standing productivity challenge will not be solved with  “quick fix” approaches. 

The post Canada’s Challenge: Closing the Productivity Gap appeared first on Pacifica Partners.

• Global shipping chokepoints expose risks
• Vulnerability of supply chains exposed again
• Inflation risks are put back on the table
• Houthi militias hold the cards if the Red Sea is going to cause wider economic risks

Over the last several decades, military and shipping industry experts have warned how vulnerable the global economy is to attacks on ocean shipping routes. Nearly 80 percent of all goods are transported by ships and the volume has been growing steadily over the last three decades. From 1990 to 2021, the volume of cargo transported by ships has nearly tripled. from four to 11 billion tons.

The vital importance of the global shipping industry was felt in the immediate aftermath of the COVID-19 pandemic. Shutdowns in Asian factories, shortages of workers and congestion at ports led to widespread shortages of goods that spurred inflation. The economy was able to put these challenges behind it by the Fall of 2022 and inflation, port congestion and global supply chain challenges all eased.

Global Shipping Challenges…. Again

When armed conflict broke out between Israel and Hamas following the attacks of October 7^th, the financial markets were briefly rattled from initial fears of the conflict escalating across the region. Some observers pointed to the possibility of an oil embargo by OPEC nations aimed at reducing oil supplies to North America and Europe. Those worries have thus far not materialized.

The surprise with respect to the conflict’s impact on the global economy has come from Yemeni based Houthi rebels who receive military training, weapons and technological support from Iran. The Houthis issued a warning to the global shipping industry that any ships passing through the Red Sea that they suspect of delivering cargo to Israel will be attacked. Yemen’s territory borders a narrow 20-mile-wide section of the Red Sea, the Bab-el-Mandeb straits; providing the Houthi militia with an easy reach to target passing cargo ships from their land positions. Perhaps it is no coincidence that Bab el-Mandeb loosely translates into “Gate of Tears” or “Gate of Grief”.

The Red Sea is crucial to the global economy as nearly 12% of global trade flows and 30% of global container traffic passes through it. It is also a key waterway for oil tanker traffic as ships enter the Red Sea to deliver crude oil to Europe and North America via the Suez Canal.

Each year, nearly 20,000 ships travelling in either direction between Asia and Europe or Asia and North America enter the Red Sea and will use the Egyptian controlled Suez Canal. Being the shortest shipping route between Europe and Asia, the route saves approximately 9 to11 days of shipping time and reduces costs that arise mainly from decreased fuel consumption and lower freight insurance costs. If ships are cutoff from this route, then these shipping costs rise and are passed onto consumers and businesses.

Recent comments from Shalanda Young, director of the US Office of Management and Budget, expressed worries about the potential for inflation to rise due to this conflict. Young stated “I worry about the geopolitical space we live in. The Red Sea attacks, shipping, all of these things in the geopolitical space certainty have the chance and opportunity to raise prices ….”

Young was referring to actions of the majority of the global shipping industry that are now avoiding the use of the Red Sea passage and instead electing to sail around the southern tip of Africa.  Despite the rise in fuel costs and time, it is seen by shippers as being cheaper than risking an attack through the quicker alternative route given that insurance costs for traveling through the Red Sea have also surged higher.  Adding to the complexity of the problem, is that the more ships stuck in travel time creates a shortage of available ships.  Whereas a ship might be able to make perhaps six or seven runs yearly, it will now be reduced to four or five runs which can create a global shipping bottleneck.

Inflation Risk Rising

The shipping industry is also warning that possibly global supply chains will once again tighten and under a prolonged scenario, it could result in a shortage of goods available to customers.  Scarcity in turn, is a driver of inflation. Memories are still fresh of the supply chain disruptions that caused shortages of cars, electronics and consumer goods in the aftermath of the pandemic. Those challenges took nearly two years to resolve. At this point, we do not believe that the challenges in the Red Sea will exert the same pressure that the pandemic related disruptions did but the more prolonged this threat to shipping becomes, the greater the potential for inflationary pressures from supply chain issues to become an economic hurdle.

In a recent CNBC interview, Alan Baer, CEO of shipping company OL-USA, stated “Given the sudden upward movement of ocean freight pricing, we should expect to see these higher costs trickle down the supply chain and impact consumers as we move through the first quarter.”

In a scene reminiscent of the supply chain challenges after the pandemic, some port congestion issues could make a more muted replay of their performance in 2021 and 2022. Goods from Asia that normally would be destined for the East Coast of the US are being shipped to the West Coast since the cost of shipping to the West Coast is about $2,700 per container while East Coast shipping is $3,900 per container. It is important that trucking and rail capacity be available to move goods from North America’s western ports to their final destinations in the Midwest or east coast. Some retail analysts are worried that clothing fashions for Spring will be delayed – along with furniture, toys and electronics.

Europe in particular has an even more pronounced  problem as 40 percent of the trade flows between Europe and Asia flow through the Red Sea. Shipping rates for containers of goods being shipped from Asia to Northern Europe are up 173 percent in less than two months and exceed $4,000 per container.

Weary governments have already felt the anger of voters who are experiencing the pressures of inflation through higher food, fuel and shelter costs. In the US, it is an election year and the last thing any incumbent would want is to face an angry electorate facing rising prices or shortages.

Operation Prosperity Guardian

In recognition of the threat that the Houthi militants pose to the global economy, US Defense Secretary Lloyd Austin launched “Operation Prosperity Guardian” last month which united the naval resources of the US, United Kingdom, Bahrain, Canada, France, Italy, Netherlands, Norway, Seychelles and Spain to push back against the Houthi militants and provide protection for ships. Austin stated that, “The Red Sea is a critical waterway that has been essential to freedom of navigation and a major commercial corridor that facilitates international trade.”

So far, the US military has chosen to adopt a largely defensive posture. While it has successfully shot down numerous Houthi missiles and drones, it has not launched a massive attack on Houthi forces. This is mainly because the US is attempting to avoid an escalation that provokes Iran or other militant groups further involving themselves in the conflict between Israel and Hamas. In late December, the US issued a statement described as a “final warning” to the Houthis but in early January the Houthis responded by attacking another ship. This was a signal that things may get worse before they get better.

Eight Global Choke Points

Throughout history, trade ships were seen as legitimate targets of war. Whether it was in the ancient world of Egypt or Greece, during WWI and WWII or even in modern times – ships moving cargo have been seen as valuable strategic targets. Recent events in the Red Sea have reminded the world what some experts have been warning of for the last thirty years, the modern world continues to depend on eight global choke points for maritime trade (see figure above). These narrow chokepoints are all vulnerable to military blockades or attacks by rogue militant groups. As such, any of these corridors would have a ripple effect on the global economy. Choke points are defined as strategic and narrow waterways uniquely located that serve as linkages to other much larger bodies of water. As the figure above shows, the choke points are clearly vulnerable to attacks from armed groups or nations that wish to exert control over a region or a particular nation.

Various geopolitical analysts have noted that China and India – the two most populous nations – import over half of their energy needs from the Middle East. Tankers carrying oil from Saudi Arabia and other Middle East nations have to pass through the Strait of Hormuz which is less than 30 miles wide at its narrowest point. Concerns in the energy market have ebbed and flowed over the last forty years that Iran could shut down the Strait of Hormuz. Under such a scenario, analysts have surmised that oil prices could rapidly double. However, it should be noted that such an act from Iran would invite a strong international response and would most likely involve a military response.

For China, it faces a second choke point for its oil imports as ships must pass through the Strait of Malacca – a chokepoint through which a third of all oil shipped by tanker flows. China worries that it is vulnerable to an energy blockade and is trying to diversify its supplier base of oil by relying on Russia and Central Asia. But for China, even Central Asia carries risks.  It is a region that Russia exercises influence upon and it is reluctant to see another nation become too involved in its sphere of influence.

Not Only the Red Sea

An additional challenge to the global shipping industry is coming from the Panama Canal—the second busiest man made shipping lane as it carries about 5 percent of global trade. While the Red Sea and Suez Canal challenges are due to geopolitical issues, the Panama Canal’s challenges are due to low water levels.

Though Panama has one of the wettest climates in the world, the last year has seen rainfall nearing 30% below typical levels. This has caused a reduction in the water levels in the lakes that feed into the canal. The lower water levels in the canal have forced the canal authorities to reduce the number and size of the ships that pass through.

To overcome the reduced capacity, some shipping companies are paying up to $2 million to jump the queue to get through the canal while others are choosing to sail around Africa or South America. Once again, these costs have the potential to raise inflation.

Limited Options

With memories of the last global shipping and supply chain crisis still fresh in the minds of policymakers and consumers, the escalation of the Israel-Hamas conflict to the Red Sea has the potential to once again fuel shortages of goods and higher prices. While the shipping attacks have entered their third month, the global shipping industry has responded quickly to cut its risks. The choice to avoid the Red Sea and instead sail ships around Africa and then onto Europe or elsewhere has resulted in significant costs to shippers who in turn are passing their rising insurance and fuel costs onto their customers. Ultimately, these costs are going to show up in higher prices for consumers.

It is not  likely that the events in the Red Sea and Middle East are going to be significant enough to create a 2021-2022 type inflationary wave if the crisis ends in the near future. But the longer this challenge to global shipping remains, the greater will be its economic impact. For their part, policymakers will remain vigilant but they also recognize that when it comes to geopolitical issues that are impacting the supply chains, high interest rates are of limited impact in the inflation battle.

The post The Red Sea’s Inflation Risk appeared first on Pacifica Partners.

• 2001 consensus was for the US to be debt free by 2010
• Rising spending and the pandemic spiked debt
• Facing hard choices at a challenging time
• Canada showed debt can be solved

For over a generation, fears about the US national debt have ebbed and flowed. A lucky combination of events helped to keep pushing the potential for a debt crisis off into the future—allowing the US to kick the can down the road. This allowed politicians to avoid having to present to voters some tough choices about the affordability of the various programs and services provided by the US government. It was politically easier to borrow on the national credit card rather than raise tax revenues or cut spending. For clarification, the national credit card refers to the US Treasury – like all governments – being able to go to the bond market borrow what it needs from investors.

False Hopes

One of the few times that the national debt was a major issue for voters was in the 1992 presidential election when the deficit exploded to 4.5 percent of GDP. Eventually, a booming economy that generated strong growth in tax revenues and fortuitous circumstances that allowed defense spending to be reduced helped to arrest the budding debt problem. By 2001, the Clinton Administration left a $240 billion budget surplus for the Bush Jr. Administration. The worries about the national debt were replaced by fantastical thinking that the US was set for continuous budget surpluses that would eliminate the national debt by 2010. At the same time, investors became worried that the bond market would not function smoothly because the supply of US Treasury bonds in circulation was to largely disappear by 2010 based on the idea that if there is no debt, there would not be any Treasury bonds in circulation. This was seen as a problem because the interest rates on Treasury bonds act as benchmarks for other parts of the bond market.

As Congress contemplated what it should do in the face of the expected budget surpluses and the elimination of the national debt, it called on then Chairman of the Federal Reserve Allan Greenspan for his thoughts on future tax policy. At the time, Greenspan was celebrated as “The Maestro” based on his stewardship of the US economy. Greenspan told Congress that he would endorse the policy of the Bush Administration to cut taxes because tax revenue would be far in excess of what the US government needed to meet its expenditures.  If tax cuts were not enacted, Greenspan argued, it would leave the federal government in a position where it would be accumulating cash with nowhere to spend it. 

Deficits Roared Back

It did not take long for the mirage of endless budget surpluses to be replaced with the returning fears of a debt problem. The budget deficits returned as the US economy underwent a recession by 2001 that coincided with the end of the technology sector boom. US tax revenues began to decline and spending commitments went up. The result was the return of budget deficits that ended up being piled onto the national debt. The dream of paying down the debt was a one-year fantasy.

The recession also coincided with the events of 9/11 and military spending began to rise quickly. The wars in Afghanistan, Iraq and combat operations in Syria and Africa are estimated to have cost over $4 trillion over twenty years. Some estimates are considerably higher as the definition of what costs can be attributed to these events varies widely. US expenditures for the war in Afghanistan alone amounted to spending of about $275 -$300 million per day over a 20-year span.

Pandemic Spending Spikes Debt

With US combat presence in Iraq long over and operations in the Afghanistan conflict entering their final years, the hope for a return to more sustainable spending were shattered with the onset of the pandemic. The impact on the economy exploded the national debt yet again. Beginning in early 2020, the US government – like so many others – responded to the deep downturn in the economy with unprecedented levels of spending and other fiscal incentives to help the US economy steady itself. In a little over 2 years, the US government provided nearly $5 trillion in additional spending and other fiscal measures. This further ballooned the national debt. It should be noted that nearly all politicians and economists forged a rare moment of agreement in their support of these stimulus programs. Given the magnitude of the downturn that the global economy faced, stimulus at the time was an easy policy to support and one that would be hard to argue against given the challenges that arose.  Unfortunately, the spending has continued even as the economy made a faster than expected recovery and was long past needing government support programs to continue its recovery.

Path to Fiscal Crisis

Given the various shocks to the economy since the turn of the century – along with overseas military commitments and commitments to mandatory spending programs for healthcare and social security – the US national debt sits at $33.5 trillion.  For comparison, the national debt stood at $5.7 trillion in 2001 with the goal of being debt free by 2010. 

Since the 2008 recession and the Great Financial Crisis, the US has been able to largely avoid having to deal with the national debt challenge because low interest rates  made it easier to carry the debt. In addition, the US Federal Reserve had bought up about $7 trillion of the debt issued by the US Treasury by making purchases in the bond market. These purchases also helped to keep interest rates low on the US debt since the Treasury had a ready and willing buyer on hand. 

It is important to note that the Federal Reserve is required by law to return to the US Treasury any interest it earns from Treasury bonds. This is what the laws governing the Federal Reserve require. In 2021 the Federal Reserve paid back $109 billion of interest income earned from the Treasury and returned another $76 billion in interest in 2022. The US can no longer count on this as the Federal Reserve is no longer trying to keep interest rates low as it battled inflationary pressures.

Rising Rates and Reality

A combination of luck, low interest rates and a steady demand for US debt (bonds) made those who worried about the steady rise in the US national debt seem like they were crying “The sky is falling” and were quite often swept aside in the national discourse.

Unfortunately, the times are changing. The luxury that US policymakers once had of not having to deal with the debt problem has been all but taken away by rising interest rates, rising spending and a reduced demand by both foreign and domestic investors for US debt. The US finds itself in the unfamiliar place of having to think about where the buyers of its debt will come from so that it can finance its spending obligations. The challenges are breathtaking. When interest rates were at historic lows in 2020 and 2021, the US had the chance to lock in those very low interest rates on its debt by issuing long-term bonds. Instead, it chose to focus on locking in short-term interest rates that were less than 1 percent rather than locking in borrowing rates of 2% for 30 years. Today, borrowing for 30 years would cost the US Treasury more than 5 percent annually.

The return of inflation has forced the US Federal Reserve to halt its purchases of US Treasury bonds as it raises interest rates to cool inflationary pressures. At the same time, it has been aggressively raising interest rates to unwind the stimulus it had put into place during the pandemic. Against this backdrop, the US now faces a breathtaking hurdle where almost one-third of all outstanding US debt will mature over the next year and a little over half will mature over the next 3 years. The interest rate on this maturing debt will be significantly higher.

Deficit Rises While Economy Grows

History shows that budget deficits fall as economies grow. But since the pandemic, the US budget deficit has been slow to fall. The current fiscal year shows the US budget deficit will be about $2 trillion—fueled by a drop in some sources of tax revenue and rising spending. One area that has the attention of deficit watchers is the rising tide of interest costs on the debt due to the escalation of debt while interest rates have risen. Current year projections show interest costs in the current year will cost the US government about $600 billion – up 50% from 2019 levels. This figure is significant for another reason – it is on track to exceed defense spending within a decade.

Current global conflicts already require a significant resource commitment from the US with more likely as current defense experts – and some US allies – believe that the US must raise its ability to meet these threats. This is where the national debt challenge is going to become quite apparent. Interest costs on the national debt are going to approach $900 billion per year within a decade. Given the geopolitical challenges facing the US and its allies in Europe, Asia and the Middle East – there is going to be a challenge for policymakers to meet all of the commitments of today and any future escalations that might arise. This now brings added prescience to the 2010 warning from then Chairman of the Joint Chiefs of Staff, Admiral Mike Mullen, when he told Congress “The most significant threat to our national security is our debt.” The US is being pushed into a corner where it must make hard fiscal choices about how much it can continue to do to meet threats from abroad while meeting the needs of its citizens.

Bond Buyers Needed

Given the supply of new bonds issued by the US Treasury to fund even greater spending, the US is facing a problem rarely seen before. It needs buyers for its debt so it can fund its budget. At home, the US Federal Reserve is no longer a buyer as it wants to keep taking stimulus out of the economy.

Internationally, nations such as China, Japan and the oil producing nations of the Middle East are no longer eager buyers of US bonds. So much debt has been issued by the US in the last several years that international buyers have a reduced appetite to keep buying. China and Japan are the two largest holders of US Treasury bonds. China’s reluctance to continue buying US debt issues at the same pace as in past years is due to a combination of factors. One reason is that China’s economy is weak and its currency has been falling. If it were to sell its own currency to buy US dollar denominated Treasury bonds, its currency would fall further in value. In addition, China’s relations with the US have been quite cool in the last several years and China likely wants to risk having so much of its currency reserves invested in the US. Over the last decade, its efforts at trying to diversify away from the US has led China to increase its gold holdings from 1000 tons to 2200 tons.

Seeking a Path Forward

The rapid spiral of the US national debt is going to force the  US to make some hard choices of what spending it can cut and how much it can raise taxes. This is easier said than done as passing a budget in the current political environment seems like a distant prospect. For this reason, two of the three major credit rating agencies have downgraded their ratings on US debt.

There is some hope for the US. Nearly 30 years ago, a heavily indebted Canada went to the bond market to issue bonds for yet more borrowing and the bond issue received no bids from buyers. The market was shutting off the credit tap. Alarmed, the Canadian government took the scissors to the budget and implemented large spending cuts. Canada went from debt pariah to running consecutive budget surpluses and by 2008, Canada’s debt to GDP fell to 29 percent from nearly 100 percent in only 15 years. Since then however, Canada like the US has been accumulating debt again at a rapid pace. 

In 2003, Treasury Secretary Paul O’Neill told Vice-President Dick Cheney he was worried about the pending tax cuts and the potential for a large increase in the budget deficit. Cheney replied “Reagan proved deficits don’t matter.” Perhaps they did not matter then but today, the markets and foreign buyers of US debt are saying “Deficits do matter.”

The post The US National Debt Challenge appeared first on Pacifica Partners.

• China’s economic challenges
• China real estate sector causing significant disruption
• China’s population expected to fall 50 percent by the end of this century
• Implications for the global economy

Over a decade ago, many scholars and commentators had concluded that China’s economic rise would mark this century as China’s to achieve a level of global dominance. Observing China’s economic growth rates, the expansion of its military capabilities and its increasing reach across the world—it was a plausible, and for some, a foregone conclusion.

In 2009, British journalist Martin Jacques wrote a widely acclaimed book titled “When China Rules the World: The End of the Western World and the Birth of a New Global Order”.  His premise, geopolitical power was shifting towards China given its rapid economic growth powered by a huge population, a government able to steer the nation’s resources to its aims and a western world that had “peaked” by standard measures. Jacques was not alone in his thoughts and the bet on China’s unstoppable rise seemed to be a wise one – at least on paper.

Maturing Economy

There is no doubt that China’s economic rise and corresponding clout around the world has been rapid and significant.  Few nations in history have risen as quickly and to the heights that China has advanced.  Data from the World Bank shows that over the last 40 years, China’s economic growth has lifted nearly 800 million people out of poverty.  For clarification, the World Bank defines poverty as $1.90 USD of income per day.

Decades of very strong economic growth have allowed China to become the second largest economy in the world.  Expectations were that before long, the Chinese economy would surpass that of the United States.  However, recent economic data has put that assumption largely to rest. Where China was regularly growing its economy by 7 to 9 percent annually (a rate that allowed its economy to double in size every 8 to 10 years) more recent data has shown that the Chinese economy is officially growing in the range of 4 to 5 percent.

While this rate of economic growth is still substantially higher than what the developed world is able to achieve, it is worth noting that China’s official economic data has been questioned for its quality (accuracy).  A small minority of economists have long said that China’s economic data overstates its economic growth rate by 40 to 60%.  A 2017 study by the St. Louis Federal Reserve found that China’s economic data had gotten better but its“ economic statistics remain unreliable.” The St. Louis Federal Reserve’s study found economic data “falsification at the provincial and individual levels as the biggest source of unreliable GDP statistics.”  Data falsification is thought to occur in rural areas where leaders are evaluated by the economic performance of their local jurisdiction.  In turn, GDP measurements and other economic statistics get inflated at the provincial level.

Another method to evaluate the quality of China’s economic data has looked for growth consistency in China’s energy consumption.  A growing economy should see energy consumption rise with economic output.  University of Pittsburgh Economist, Thomas Rawski, found China’s energy consumption to be out-of-step with its economic growth rates.

Admitting to Challenges

Official economic projections from the Chinese government point to economic growth of about 5 percent this year.  When the government released this estimate, it caught many by surprise as it was seen as a rare admission by China that its economy is troubled and the post-pandemic restart will be labored.

Several factors are hobbling China’s economy; First and foremost, is the decline of China’s real estate sector. For many years, contrarians who looked at China’s economy worried that its real estate market played a dangerously significant role in its economy. Since economic reforms first began in the 1970s, China’s real estate market has been a central force in pushing economic growth higher. The estimates for how much of China’s economy is tied to real estate vary widely but they range from 17 percent to a high of 29 percent as cited in a research paper by Harvard economist Kenneth Rogoff. Rogoff also determined that the real estate and construction sector accounted for 15 percent of urban employment in recent years.

Herein lies a big problem for China’s economy; China’s real estate developers, which are some of the largest companies in China, are carrying hundreds of billions of dollars of debt.  Meanwhile, its government is trying to implement policies aimed at downsizing real estate’s influence on the economy.  A formidable challenge for China’s government that is analogous to walking a tightrope.

Thus far, the government’s policies are having a chilling effect on the economy and the real estate sector. Last year, Evergrande – China’s largest developer – defaulted on nearly $130 billion of its $300 billion debt load.  Less than two years ago, Evergrande had owned over 1300 real estate projects in 280 cities in China.  Evergrande is not alone.  Other developers who were thought to be safe have rattled the Chinese economy by missing debt payments.

If Rogoff’s estimate of the real estate sector are correct, China’s economic path is likely to be a turbulent one.  The problem for China’s real estate sector began even prior to the onset of the COVID pandemic.  Property developers had become used to making enormous profits from the multi decade real-estate boom that swept across Chinese cities.  In the decade prior to the pandemic, Chinese real estate sales were growing at an annual rate of nearly 22 percent!  Fueling this boom was easy credit—leaving developers owing over $5.5 trillion USD to lenders.

Reining in Real Estate

Alarmed at this enormous build up of debt, the Chinese government introduced some tough measures and began to restrict the flow of credit to developers.  The government has stated that the nation must “embrace a new normal” that relies less on fixed investment (construction fueled by speculation) and instead rely more on consumer spending and technological innovation.

China’s central bank, the People’s Bank of China (PBOC) went so far as to label the escalation of debt in the real estate sector as “reckless”.  To its credit, China’s government understands it has a problem and is facing it. But the task of trying to fix it is not going to be easy.

Lacking Resiliency

If one were taking bets in the spring of 2020 as to which nations would lead the economic rebound from the COVID recession, a safe bet would have been China. That bet would have been very wrong.

Whereas western nations decided to employ enormous stimulus through government spending and ultra-low interest rates, China chose to stimulate less for fear of firing up its real estate sector which it was trying to slow down.  In addition, China was reluctant to admit its zero-COVID policy was an error and change course.  It was not until massive protests erupted to challenge the enforced draconian lockdowns that the government relented and relaxed its measures.

Post lockdowns, the thought amongst investors and economists was that the Chinese economy would come roaring back.  This theory was based, in part, on the memory of economic growth after the 2008 recession. In reality, the post pandemic global recovery has been  US led with some assistance from Europe and Japan.

Normally, when an economy slows down, the policy fix involves increased government spending and lower interest rates to stimulate the economic rebound.  But China’s policymakers have resisted this urge.  The government has so-far adhered to their long-term plan to shift the economy towards one that is powered by consumer spending and technological innovation.

Technological innovation is an extremely urgent national priority for China.  The government sees its reliance on superior western technology as a strategic vulnerability that leaves it at the mercy of North American and European governments.  One of the few things that unites politicians in the US over the last decade has been a desire to be tougher on China and restrict access to US technology.  The US sees its technological superiority as a strength that will limit China’s future power and keep its military from being able to mount a credible threat to its interests.  The European nations are also largely united behind this goal. In recent weeks, Germany has announced policies aimed at limiting China’s access to German research and development conducted by its academic institutions and corporations. The UK and EU have stated that relations with China have become “imbalanced” – which is diplomatic code for “overreliance on a China that might not be an ally.”

Aging Society

If real estate is a challenge for China, its other problem might be insurmountable. Earlier this year, China’s population was surpassed by that of India (four years earlier than earlier UN projections) as China’s population has begun to age rapidly. By 2035, it is estimated by demographic experts that China will have about 402 million citizens who are 60 years of age or older. Currently, this age group is estimated to number at about 255 million.

As the chart shows, China’s population is projected to be much older than India’s with a greater tilt towards males outnumbering females.  Other data from China shows that men outnumber women by 32 million.  The figure also shows how a large elderly population in China will have to be supported by a relatively smaller working age population.

China’s population decline has its roots in the one-child policy introduced in the early 1980s and kept in force until 2016.  The Chinese government is now incentivizing families to have more children but it has had little impact.  Other nations such as South Korea, Japan and Russia have also tried financial incentives to help stem the population decline of their respective nations but it has had very limited success.  The base case projections envision China’s population dropping to drop to about half of its current level by the end of this century.

Shrinking Workforce

As China’s population ages, its workforce has begun to shrink. In the last 3 years alone, China has lost 41 million workers who are no longer in the workforce.  For comparison, this is roughly the size of the entire workforce of Germany.  Not all of this is due to demographic challenges. Some workforce shrinkage is due to a slowing economy and many workers unwilling or unable to return to work following the pandemic.

An economy can only grow if it has a rising supply of workers who are increasingly productive through technology and improved production processes. But current data shows that many foreign firms are finding it challenging to operate in China as skilled labor is hard to come by.  In addition, the current scarcity of skilled labor has increased labor costs—causing Western firms to find other countries to relocate their once China-based production.

China’s Challenges

The financial markets have been expecting China’s government to buckle and abandon its tough measures aimed at slowing down its economy and letting its real estate sector go through a tough restructuring.  So far, the government has not flinched. But it has made friendly comments aimed at Western corporations that state China can pursue its national aims while working with western companies that invest in China.

For the rest of the world, when the world’s second largest economy enters a sustained low growth mode there will be long-term negative implications for global growth.

Though China backtracked on zero-COVID policies after its citizens erupted in anger, it is showing no signs that it is willing to relent on its real estate sector. It sees the sector as a potentially destabilizing force and the one thing the Chinese government will not tolerate is instability. The problem is that the road ahead is going to be a long one. An ageing society, a real estate sector that needs a tough restructuring and a government sending mixed messages about its commitment to the path of capitalism are showing that China’s road ahead will be a challenging one.

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