Eric Lascelles - Managing Director, Chief Economist and Head of Investment Strategy Research

Hello and welcome to our latest video MacroMemo. We have plenty to cover. We'll talk about the latest with regard to the war with Iran. We'll talk about memory chips and how expensive they are and the effect that's happening on all sorts of different sectors and areas of the economy. We will talk about El Niño, the weather phenomenon, which looks increasingly likely or, dare I say, certain to happen over the year ahead.

We'll spend a moment on pandemic concerns. There are a few viruses that have broken out recently that have created some level of concern. We'll talk about China housing, which has been very weak. But it has shown one important green shoot recently that is worth addressing. And we'll spend a moment in the stock market just acknowledging some pretty amazing earnings numbers and earnings forecasts and those implications as well.

So that's the plan. Let's circle around and start with the war in Iran. And so it's foolish to try to be overly precise here about the state of this war. This is a video that has to sit on a website for a span of multiple weeks. And so I'll try to speak generally and at a fairly high level.

There have been seemingly quite serious talks between the U.S. and Iran as to a deal – and the potential seemingly exists for a deal to be struck before too long. And markets are feeling more optimistic about that than they felt in some time. So, there has been some genuine progress made and favorable comments have come from both sides.

When I look at betting markets and probability markets, the odds of a resolution have gone up. And the thinking is that it's more likely than not that the Strait of Hormuz will be significantly opened by the middle of the year. So, by the end of June, the negotiations seemingly revolve around, at least as key points, getting that Strait of Hormuz open, in exchange for significant sanctions relief for Iran.

I don't want to overstate this or suggest there's a certainty to it being achieved. The U.S., in fact as I’m recording this, attacked Iran overnight. So the ceasefire is not perfectly holding. Nuclear negotiations may be pushed to a later date, which could then create problems later. But again, betting markets do think it's more likely than not that there is a resolution by the end of June, which is, I suppose, good news.

In the meantime, let's acknowledge that, of course, this war and the effect on energy prices was meant to be quite problematic for the global economy. So far, the global economy is proving quite resilient both in the U.S. and elsewhere. We were optimists to start with, but we've been pleasantly surprised, even, given our optimism.

Inflation, though, is rising. So that side has not been dodged. The inflation data is showing clear, additional pressure here. And I can say it's not just energy prices, which of course we knew would show up. There's evidence that this is bleeding into food costs to some extent. And so broadening out, it does put central banks in a tricky situation.

And so there is a real macro cost to this war, certainly as much as some of that you would think should be able to unwind, if and when this war is resolved. If a deal is not struck in the near term, there is reason to think that the pain could increase substantially. So, I should flag that as a downside risk over the next few months.

In theory, continued Hormuz closure does not mean that oil stays at $100 a barrel in perpetuity. It should mean, in theory, that oil prices rise and rise and rise because inventory levels are falling and falling and falling, and shortages become more acute. And oil inventories are already at an eight year low. The IEA has estimated that even if a deal was postponed by a month, that could add $20 to the cost of a barrel of oil, which would be quite significant.

Distillate inventories, these are some of the processed products, such as jet fuel. Inventory levels are even worse. And so that's probably the real place to focus on. Though earlier claims that Europe would run out of jet fuel around the end of May, and I'm recording this around the end of May, have been pushing significantly backwards, but nevertheless, the next few months could prove painful.

If there isn't a resolution, we think there will be. But that is, I suppose, the risk.

The other thing to talk about in the context of this war and this energy shock are the regional implications. I think that's been well covered in the sense that the general acknowledgment correctly is that Europe and Asia are more adversely affected than North America.

That's where the Middle Eastern energy was broadly flowing and now, to a significant extent, is not flowing. Now, that analysis has been – and we've talked about this before – has been tempered a bit by government subsidies, some countries subsidizing their gas prices and so on in a way that reduces the consumer inflation hit. That reduces the short-term economic damage.

Of course, it increases the fiscal damage. Nevertheless, that's maybe tempered the North American advantage, you might say. There is another angle, though, which is that we also need to think about how much energy each economy actually needs. In terms of the intensity for every unit of GDP output, how much oil do they actually use? Some use more. Some use less.

The same for natural gases. It's widely understood that since the 1970s, the world economy uses about 62% less oil per unit of economic output. So there's much less vulnerability and exposure there. But how can we actually compare across countries? Let's say a few things about that. And so we've actually compared countries to the U.S. as the baseline.

And so Canada is notably more energy intensive than the U.S. It consumes more oil and gas per unit of GDP. And I should say some of that is, of course, there’s a harsher climate. Much though, I believe is also actually the process of extracting other oil and gas for sale. Nevertheless, Canada, more intensive.

Conversely, if we look at developed Europe, developed Asia, Japan specifically, they are much less energy intensive.

Their economies don't use as much. In the UK, as the extreme example, it uses literally half as much oil per unit of economic output as the U.S. does. Not to say, therefore, that Europe's in the catbird seat, that North America has a problem, but it does significantly diminish that North American advantage. And I think it does help to explain why Europe and Japan have not immediately plunged into recession themselves when this energy shock began.

They're actually notably less exposed than you might have imagined.

Okay, on to the next subject. Let's talk about really memory chips, of course, in the context of artificial intelligence. Memory chips have been very much in focus in every regard, but certainly in a stock market context. And so the three main companies that make memory chips have absolutely soared.

The Korean stock market hosts two of them. It's up to an extraordinary extent. These companies have truly gigantic profit margins right now. And I should say there are concerns that this may not be sustainable. In fact, it doesn't look all that sustainable over any extended period of time. For those companies and for the memory chip industry historically, it's very cyclical.

There are boom and bust times. This is very much a boom. It’s not historically a high-margin business. Historically, in fact, it’s a commoditized business and at this point, there are incentives for hyperscalers to go make their own. So there is a clear downside risk for that sector over the coming years, sort of unknowable whether that risk manifests in in one month or two years.

Nevertheless, some very clear risks there. In the meantime, though, memory chips are extremely short in supply and very expensive. And between rising prices and more memory intensive chip designs, memory now represents – and this is truly extraordinary – memory is now more than 60% of the cost of an AI chip. And so that is driving hyperscalers CapEx bills a lot higher.

RBC Capital Markets has done some work here. They estimate that rising memory prices will account for one third of the year-over-year increase in hyperscaler CapEx this year. What that means essentially is that, yes, genuinely, hyperscalers are buying more memory chips and doing more. And there is a degree of acceleration here.

But it's a little bit less extraordinary if you're measuring it in inflation-adjusted terms, because a fair chunk of their spending increases are just paying more for the same thing as opposed to paying more for more or better things.

And from a gross domestic product (GDP) framework, that means that the real GDP boost isn't as big as you would think just looking at nominal CapEx growth. Similarly from the return on investment for these companies, it’s not quite as good if they're just spending a lot more money on the same old thing.

Okay, let's talk about El Niño. So El Niño is when the Pacific Ocean gets warmer, essentially, but it brings with it these cascading implications for the world's climate, often over the subsequent year.

And so it looks like El Niño is very likely in 2026. In fact, the markets have kind of leapt to a 98% probability of El Niño this year. So very likely it will happen. And there’s a 50% or slightly more than 50% chance of a super El Niño event. Those come along less than once a decade or so. The last one was 2015-2016.

The idea here is that climactic events may take place this fall and into the winter and lingering into next spring and summer, with implications. The last super El Niño, in 2015-2016 did global economic damage. The global economy is estimated to have been 0.7 percentage points smaller than it would have been over five years.

It was an almost $US4 trillion loss. Hardest hit countries tend to include India, Australia, Indonesia and Japan. In theory, you get a milder winter. In theory you get a hotter summer next year. But there is a lot of regional variation. As an example, the southern U.S. gets wetter, western Canada and northern U.S. getting warmer.

Critically, India and Southeast Asia get drier. It's a big problem for the agricultural sector. And so you tend to see food price pressures. Rice prices go up because of India. Palm oil prices go up because of Southeast Asia. Wheat prices often go up because of a drier Australia and Western Canada. Often sugar and cocoa prices are higher as well, sometimes copper and aluminum prices too, as some mines get adversely affected.

Not to say this is guaranteed to happen, but this is sort of the direction you tend to see during stronger El Niño events.

If you're looking for a silver lining, well beyond a warmer winter, perhaps, next year –historically you see less Atlantic hurricane activity. And so actually, insurers sometimes save money as opposed to spend money, even when you've factored in wildfires and floods and these sorts of things because of reduced hurricane, activity.

To be clear, El Niño is not the centerpiece of our economic forecast by any means. But I think it is relevant for the year ahead.

Something else maybe less relevant, I hope, for the year ahead, are pandemic concerns or at least disease outbreaks. And so, let the record show there are two notable outbreaks right now in the world capturing some attention.

One is the hantavirus, which spread in a cruise ship in South America. It usually comes from rats and mice and rodents. And Ebola, which is in sub-Saharan Africa, Congo and Uganda specifically. The concerning thing is both of these have high fatality rates. We're talking, you know, in the very approximate realm of 50% for each. The good news is, they have relatively low contagion.

They are in the 0 to 2.5 range. And, if you recall, COVID-19 got as high as about 10, which meant it was spreading much more easily. At this point in time, it's concerning, but these are very likely to remain contained, at least in a global context. Neither virus is new.

There are no mutations visible. Both have been successfully controlled. And, in prior outbreaks, they don't transmit via the air. They require close contact. Hantavirus spreads really quite slowly. It's a very long incubation period and so ultimately unlikely to become a global problem.

I think if you want to be fretful, you would maybe focus instead on H5n1 bird flu, which is not doing anything of note this week or this month. But it poses the greater theoretical risk. It's spreading more and more in birds.

It's spilled into mammals. If it were to be able to mutate and allow easier human transmission – and it is an influenza type virus, which means that that capability theoretically exists – that could become a bigger problem, though I should say an H5 vaccine does exist. So really the assessment here would be better markets are saying pretty low risk ultimately of a hantavirus or Ebola pandemic or indeed any kind of pandemic.

In 2026, vaccine maker stocks went up briefly. They've since settled back down, consistent with that. Let's not forget, mRNA technology does allow pretty rapid vaccine deployment these days compared to, say, before, COVDI-19. And so really, pandemic is not on our bingo card here. It's not central to our economic forecasts right now. But we’re keeping half an eye on it.

Chinese housing. So Chinese housing has been very weak for years. There was a prior bubble. Homebuilders failed in significant numbers. Resales are down by half. Home prices have been falling for years. It's a fairly challenging situation. All of this has been a real drag on Chinese economic growth. I do want to flag this, which is that a small, very tentative green shoot has appeared. Home prices in tier one cities in China are rising tentatively.

Tier one means the biggest metropolises. And, historically, this has been a leading indicator for the broader housing market. Of course, if true and if genuine, it would be an important boost to the broader economy. And maybe you talk about sustaining that near 5% growth rate for longer. Just to temper enthusiasm a little bit here, we have had a few false starts from tier one city home prices in recent years.

A couple times they went above zero and then drifted back down, so no guarantees. The good news is that affordability has improved a lot. So the Chinese home price, the median home price-to-income ratio, has dropped from 38 years of income needed to buy an apartment to 24. Big improvement in recent years. 24 is still a huge number that is still very unaffordable and compares unfavorably to other markets and so hardly automatic that the housing market is ready to start clicking.

Maybe there's a chance that it does. So we're going to watch very closely.

I will finish on stock market earnings acceleration, with a focus on the U.S., though not completely exclusive. Of course we've all enjoyed these very strong stock markets in recent years. It's interesting to observe it's not mainly due to valuations.

It is mainly due to very strong earnings growth, particularly in the U.S. I can say earnings forecasts continue to look extremely strong for the year and for the years ahead. Indeed, some acceleration is expected already. I think it's 19% earnings growth expected for this quarter and up into the 20s for later this year. And still double-digit earnings growth forecasts expected in 2027 and 2028.

So quite favorable. And you know, if anything upward revisions have been the norm. And I should say normally downward revisions are the norm. Normally forecasters start to feel optimistic and have to ratchet things lower. It's not been the case this year.

This is maybe not a shock, but historically strong earnings growth forecasts have been associated with strong stock market performances.

And so that bodes well for the stock market outlook. Now let's recognize that the challenge here is it's a narrow base. It is the Technology sector. It is AI that is the main driver. So a lot depends on whether that can continue to be a success story. I’ve expressed a bit of skepticism about memory chips in general.

I would say more broadly that we’re a bit more sympathetic and inclined to think that there is something real going on here. But that is the big question to get right going forward.

Okay, that's it for me. And so I'll say thanks very much for your time. I hope you found this interesting. I wish you well with your investing and please tune in again next time.