INSIDE ECONOMICS

Mark Zandi:                     Welcome to Inside Economics. I'm Mark Zandi, the chief economist of Moody's Analytics, and I'm joined by a few of my colleagues. Of course, my two co-hosts, Chris deRitis and Marisa DiNatale. Good to see you guys.

Marisa DiNatale:             Mark.

Cris deRitis:                      Happy to be here.

Marisa DiNatale:            Good morning.

Mark Zandi:                     You look a little tired. I guess it's very early there in California.

Marisa DiNatale:            It is, yeah. It's just after 6:00 AM

Mark Zandi:                     Oh, that is early.

Marisa DiNatale:            And I got up at 4:30 for a meeting we had before this. So...

Mark Zandi:                     Okay. So you've conquered the world.

Marisa DiNatale:            Not going to lie, I'm a little tired.

Mark Zandi:                     Yeah. I don't blame you, I don't blame you.

Cris deRitis:                      It's like the Marines.

Mark Zandi:                     I'm a little tired... What's that, Chris?

Cris deRitis:                      She's like the Marines, right? They can do more by 6:00 AM than most people do all day long.

Marisa DiNatale:            Fire up Zoom.

Mark Zandi:                     Yeah, exactly. And we've got two other colleagues. Steve, Steve Cochrane. Good to see you, Steve.

Steve Cochrane:             Hey, Mark. Good to see you.

Mark Zandi:                     Steve. I'm embarrassed to say, but I think this might be your first time on? No?

Steve Cochrane:             It is the first time, yes. I'm very happy to be on.

Mark Zandi:                     Oh my gosh, which is a shocker to me 'cause you... Steve and I go back, how long? 30 years?

Steve Cochrane:             30 years.

Mark Zandi:                     Yeah, 30 years. And you're running our operations in Asia, APAC.

Steve Cochrane:             Right.

Mark Zandi:                     You've been doing that for how long now?

Steve Cochrane:             I've been here five years now, almost.

Mark Zandi:                     Yeah, very cool. You're in Singapore.

Steve Cochrane:             I'm in Singapore. Great place to be, I love it here.

Mark Zandi:                     So this is truly a global podcast because we've got Marisa sitting out in California, 6:30 in the morning, and you're sitting in Singapore, it's 9:00 PM Eastern Time.

Steve Cochrane:             That's right?

Mark Zandi:                     Yeah. Oh, what am I saying? 9:00 PM Singapore time.

Steve Cochrane:             It's 9:00 PM, that's correct.

Mark Zandi:                     9:00 AM Eastern Time, yeah. Good. Well good to have you, Steve, because we are going to be talking a lot about... Well exclusively about what's going on in APAC, China and Taiwan. And also we've got Tim, Tim Uy. Tim, good to have you.

Tim Uy:                             Good to be here, Mark. Thank you.

Mark Zandi:                     You. And you've been on before, chips I believe?

Tim Uy:                             I have, yeah. Called both the shortage and the turnaround. So if you go back to the first time I appeared on the podcast, you asked when it was going to turn around and I called it the exact right quarter that it did, the year later. So yeah, I guess I have that going for me.

Mark Zandi:                     The chip industry. So when you say it turned around, what turned around? The pricing?

Tim Uy:                             Oh, that's essentially when the lead time started to drop.

Mark Zandi:                     Oh, the lead time.

Tim Uy:                             That's the key indicator for chips, right? And that had been increasing all throughout the shortage. And so the question was, when is the inflection point?

Mark Zandi:                     Yeah. And I guess given the demand from all this AI craze, are lead times now starting to extend out again?

Tim Uy:                             They're still relatively stable. It has to be said that there's a lot of inventory that was built up, especially over 2022, because a lot of companies were double-ordering even as early as 2021, due to the pandemic, the chip shortage debt. So I think it's going to take a little bit of time to work through all that excess inventory, and also I think a bit of time for AI to really take hold. Right?

Mark Zandi:                     Got it. Got it.

Cris deRitis:                      I think last time you were on, Tim, you mentioned though that not all chips are created equal. There's a lot of heterogeneity, right?

Tim Uy:                             Oh, absolutely.

Cris deRitis:                      So it could be that the AI, the high-end chips start to see some pressure but the lower end auto chips are fine. Is that accurate?

Tim Uy:                             I think your point on the chips not being equal is absolutely right. And so certainly if you look at lead times... I have this report that I look at every quarter, and it's very, very heterogeneous. You have some lead times in excess of 52 weeks, you have some lead times well below 20 at this point. It really depends on the application. And even between advanced chips and these, what's called older nodes. So advanced versus older nodes, older nodes being the ones that are used for cars, right? There's still tensions because a lot of the technology that's being developed, a lot of the fabs that are being built are really for these newer chips. So you're right in that it's true that AI is obviously driving a lot of the demand for the newer chips, but there's also more supply for the newer chips.

                                           Versus for the older chips, it's true that maybe demand is not really going up, but the supply is also really constrained because the margins aren't quite there. And so I think the shortage there, and there was certainly a significant shortage particularly during the pandemic, that hasn't completely gone away. It's slowly getting resolved. But yeah, I think it's still very much a... I would say you would really have to look at each individual application. Is this a logic chip? Is this a memory chip? What is this being used for? In what end product is it going into? To really determine what the accurate lead time would be.

Mark Zandi:                     Well, judging by Nvidia stock, investors are expecting a lot of chip sales here pretty soon. So I think it's coming. But this is tangential to the conversation at hand. There are listeners thinking, "Well, why this motley crew of Moody's Analytics economists? What are we doing here?" Obviously the relationship between the United States, China and of course Taiwan has gone... I don't know if off the rails is the right way to describe it, but it's certainly not going in the right direction here. And we've been getting a lot of questions from listeners and clients about what might happen here with regard to Taiwan. Taiwan feels like the flashpoint that could create the most difficulty for the global economy. And to that end, we have run a couple of different scenarios to try to understand the impact that different types of interventions between US, China and Taiwan might have on the global economy here, and we're here to talk about that.

                                           But before we dive into those scenarios and talk about that a bit, maybe Steve, I can turn to you and you can provide a little context here. How did we get here? It feels like not too long ago, at least... I'm getting older, and not long ago might be very long for some people. But not long ago, going back to the Obama administration, it felt like the China-US relationship was going okay, you know? Moving in the right direction generally. But it's all gone off the rails. What happened and why are we here?

Steve Cochrane:             It has gone off the rails. And in a sense it's a shame because for many, many years, decades, the relationship has been quite good, in fact kind of symbiotic. If you go back, I don't know, you probably don't want to go all the way back to the day of Henry Kissinger and President Nixon, but certainly back to say 2001, when China entered the WTO and became a working partner in the manufacturing economy around the world. China and the US had a very symbiotic relationship as US manufacturers were looking for low cost place of doing business, places where they could offshore certain components of manufacturing and then bring it back to the US for final assembly. And it worked very well for many, many years. Our imports grew from China, it kept costs low, it kept inflation low. It was a very good relationship.

                                           I think when China then essentially at one point started to be considered more of a competitor than a partner, and an unfair competitor if you will, and this was, I think, highlighted during the Trump administration when the allegations of lack of protection of intellectual property, illegal government subsidies giving Chinese industries a leg up over other countries. These were some of the reasons why Trump then jumped in and started the trade war and slapped on 25% duties, tariffs on so many goods. And then that might not have been so bad, but then the rhetoric kept building up more and more and more, again, particularly during the Trump administration, that just made I think conditions even worse than they had to have been. And the dialogue then no longer became constructive, if you will.

                                           And so moving into the Biden administration, the feeling that there was this unfair trade that had to be managed with China continued, the rhetoric slowed down a little bit. But there hasn't really been any improvement in terms of building up communication between China and the US. So there are many, many avenues in which there are possibilities for misunderstanding, simply because the US and China don't seem to be speaking directly to one another. Or they do at one point and two weeks later something happens and it all falls apart. Then we begin to get a little better, and then something happens and the communication falls back again.

                                           And then this of course goes beyond pure trade issues, but then moves into areas of national security, both from the side of China and the side of the US. China, of course, trying to maintain its own security buffer around its country and the US doing the same. And then Taiwan kind of stuck in the middle. And the desire of course of China ultimately wanting to reabsorb Taiwan back into the People's Republic of China, and the US stating fairly directly that they would protect Taiwan as an independent country. So we have these intertwined economic and geopolitical issues that are complicating things and making things even worse today than they were in the past.

Mark Zandi:                     Yeah. I mean, it seems to me, even under the Obama administration there was growing concern about the relationship with China and what it meant for the US economy. And Obama's strategy was the Trans-Pacific Partnership, the free trade deal with the Pacific Rim nations, which excluded China, and China could not enter into the free trade deal TPP until they played fair, whatever that meant. So using a carrot to get them to be behave more like a responsible trading partner and partner in the global economy. President Trump blew that apart pretty... I don't know if it was his first executive order, but it was in the top five.

Steve Cochrane:             It was the day of his inauguration, right? I believe, if I remember right.

Mark Zandi:                     Was it? Okay, I don't... Yeah.

Steve Cochrane:             Was when he said, "We're exiting the TPP," right?

Mark Zandi:                     That and the Paris Accord, the climate Paris Accord. He said, "No, we're not doing that." And then not too long after he engaged in the trade wars. And then since then it's been kind of downhill on all kinds of levels. I mean, I was just reading this morning, here we are in June and a Chinese air fighter came within 400 feet of an American jet fighter, military jet fighter. Intentionally, obviously. I mean, that's not good. So that gives you a sense of where we are.

                                           So we've decided, given the direction things are headed and given how important this relationship is, and all the questions we're getting about particularly now Taiwan... Because that does, again, feel like if there's going to be a flashpoint here, at least militarily, it's going to be around Taiwan and Taiwan independence. We've run a couple of different scenarios trying to understand what that might look like, feel like and what it might mean for the global economy. Before we dive into those specific scenarios though, again, Steve, I'm going to turn back to you. In our baseline view of the world, our forecast, the most likely scenario, how are we thinking about how this is all going to play out between China, US and Taiwan?

Steve Cochrane:             So Mark, in the baseline scenario, we do assume that there will always be some potential conflict around China, Taiwan and the US, but that any potential conflict will be resolved in some amicable way. That there will be negotiations, there will be discussion and that there would not actually be a conflict. And that in the end, China, Taiwan, US all continue what really are rather rich trading relationships between all three, to the benefit of all three. And those will continue. We do assume that the economies will continue to grow. Right now Taiwan is in a recession, largely because we're at the bottom of this chip cycle. And we do expect that Taiwan, the economy will be rather slow, kind of hindered over the next six, nine months, but ultimately comes back next year as the semiconductor cycle turns around.

                                           We assume that China, which is struggling to recover from its zero COVID policy, will at least slowly, perhaps haltingly as we can see... Actually, we got a number today from the official Manufacturing Purchasing Managers Index, which was very weak, 48.8. Anything below 50 represents a contraction in the manufacturing side of the economy. This is the second month in a row where it's contracted, and the weakest number in four or five months. So China is clearly struggling to get its economy back on its feet post-COVID, and we could spend a whole nother podcast talking about this, but getting all the important components of the economy going.

                                           But our assumption is that it will. And then of course, the US economy is going to hopefully avoid recession this year and began working as towards faster growth next year and beyond as well. And so that's the baseline forecast, is a fairly benign forecast, no conflict, any issues between China, Taiwan and the US are managed amicably and we work through those issues and allowed the economies to continue on their way.

Mark Zandi:                     Chris, do you buy that baseline assumption? Does that make sense to you?

Cris deRitis:                      I think as a baseline it's reasonable. You don't want to go out too far on a limb here, but yeah, certainly the risks are weighted to the downside.

Mark Zandi:                     Okay. Okay. Well I guess the risks, you don't say it with a lot of conviction, so I guess it does make sense to consider other scenarios.

Cris deRitis:                      Yeah.

Mark Zandi:                     Yeah. Okay. Let's consider them. And we ran two alternative scenarios. Before we dive into the meat of the matter, when we say we run a scenario what are we doing? What exactly does that mean? Because we know this, we do this every single day, but the folks out there that are listening to this, they have no concept of what we're doing. Exactly how does that work? Do you see what I'm saying? Marisa?

Marisa DiNatale:            You want me to answer that?

Mark Zandi:                     Yeah, because you run the ship here, you know? You run these scenarios on a daily basis. So maybe give us a sense of what that means.

Marisa DiNatale:            Right. So I guess the best way to put it is that it's an alternative forecast around our baseline. Some of those scenarios that we run, we actually attach a probability to them. But that's not really what we're talking about here, we're talking about a narrative scenario. So it's an alternative story around our baseline.

                                           So as Steve and Tim have just laid out with the baseline cases for the China-Taiwan relationship vis-a-vis the rest of the world and the US, we can come up with more optimistic or more pessimistic other stories in addition to that baseline. And so in terms of how we actually do it, we always start with our baseline and then we build in alternative assumptions that we overlay on the model. So we are being more heavy-handed in the forecast, we're saying, "Okay, we're going to make an assumption about a trade or military blockade," or, "We're going to make an assumption about a political regime and the fallout that might have on the economy." Or whatever the scenario is, interest rates or a war. So we are doing basically an overlay on top of the baseline to come up with an alternative story. Does that make sense?

Mark Zandi:                     Yeah, that helps. Yeah. But you said model, and of course we know what the model is 'cause it's our life blood, our baby, our... We're working with it every day. But the folks out there, what are you talking about model? What is that?

Marisa DiNatale:            Yeah. So we have an interlinked economic macro model that has 73 countries in it, including the US, China, Taiwan, and we run this every single month. We forecast baseline forecast out... Now we're going out, what, 80 years I guess? Every single month. It has tens of thousands of macroeconomic variables in it that include economic variables, demographic variables, financial variables. And so it is basically a stylized view of the world economy. And all of these countries are linked together in this model through historical relationships of financial markets, economic relationships, migration patterns. And so we're using this global model to run our baseline forecast every month, plus all of these alternative scenarios that we do.

                                           The US kind of sits atop the food chain in terms of this model. So Dr. Mark Zandi is the one who's point is sort of dominant in terms of the whole global outlook. Mark, you go first and you set the assumptions for the US economy and some broad global assumptions around financial markets and such. And then we have an economist that covers every single one of these countries. I should mention, we do more than 73, I think we're up to like... I don't know what the count is, 120 or so. There's some countries that we do every quarter. And so there's an expert on all of these economies, and Tim is our expert on Taiwan, for example. And then every month everybody goes in and checks their forecast and overlays any assumptions they have about their particular country.

Mark Zandi:                     Perfect. Okay, that's a great description. 'Cause I just think people can't... I get that question all the time like, in the context of the debt limit debate, when we were coming up with these estimates of, it's going to cost X million jobs if we'd breach the debt limit. How do you guys do that [inaudible 00:20:45]?

Marisa DiNatale:            How do you actually do that?

Mark Zandi:                     Yeah, how do you think about that? I can't even wrap my mind around how you go about doing that. And it is quite complex. Steve, any other color there? You don't need to add any color, just anything we missed?

Steve Cochrane:             Well actually, what I wanted to point out is that a couple of features of the model make this pretty uniquely suitable for the kind of-

Mark Zandi:                     And I don't want to turn this into an advertisement, so no advertisement. Almost on the verge of an advertisement. I don't want that, but I just want people to understand what we're doing. But go ahead.

Steve Cochrane:             Well our model is quite suited to doing this kind of a scenario because it handles prices very well and it handles trade very well. And these of course are two factors in the economy that would be hit very hard by some kind of a conflict, prices because of disruptions in supply chains and such, and then trade patterns themselves because we know very clearly which countries are quite open to trade, which are closed to trade, which trade heavily with China, Taiwan, the US. We specifically model our trade relationships for every country and its largest trading partners. So when we make assumptions about either the kinds of manufacturing and trade disruptions, or maybe even more importantly the kinds of sanctions that might be placed on companies or entities, we can quantify those assumptions and fit them into the model quite well because of the way the model's structured.

Mark Zandi:                     Great. Got it. Okay, so let's come back, Tim, to the scenarios around Taiwan. Tim, can you just describe the process? What are we doing here, exactly?

Tim Uy:                             Yeah. So thanks, Mark. Yeah, so what we did was we really tried to see how these existing tensions, which have been pretty elevated, how they escalate into conflict. And then we sort of constructed these scenarios in order to show two essentially somewhat different views of the world, a view of the world wherein the conflict is pretty severe but short in duration and then a view of the world wherein there's a lot of uncertainty over how the conflict is resolved but that that conflict does not cause as sharp of a recession.

                                           And the way that we've envisioned these scenarios, that sort of shorter, sharper conflict is what we call a military intervention scenario. We spoke with a lot of different people, we read a lot of reports in terms of trying to get data around how could this unfold. If there would be a military conflict, what would be the length of the duration? Who are some of the key players, how would they react? And really, how could the tensions escalate? We know that China right now is doing a lot of gray zone warfare tactics, right? Certainly unprecedented, nothing that has ever been seen before.

Mark Zandi:                     What'd you say? Rayzon war...

Tim Uy:                             Gray zone, gray zone.

Mark Zandi:                     Oh, gray zone. Gray zone war.

Tim Uy:                             Gray zone. Yeah, sorry.

Mark Zandi:                     Okay.

Tim Uy:                             I don't know if my voice is muffled.

Mark Zandi:                     No, no, no, that's just me. And gray zone, you got to explain that too, but...

Tim Uy:                             Right, right. So I think that's kind of the motivation behind the scenarios is that, we see that increasingly after former speaker Pelosi's visit and then subsequently Tsai Ing-wen's visit to the US, China's really accelerated what what's called gray zone warfare, meaning that it's not really direct military warfare. So under international law there's no grounds on which this could be punished. What it does is it just basically sends a lot of sand dredgers, it sends a lot of these sand transporting boats across the Strait, essentially in an effort to overwhelm the Taiwanese Coast Guard. It's also sent a lot of military planes across the median line. Again, far more than what we've seen in previous Taiwan Strait crises, there have been three. And then if you consider what happened shortly after Speaker Pelosi's visit, the fourth one, really the activity that we've seen along the Taiwan Strait was really unprecedented and is really pushing the boundaries of Taiwan's defensive capabilities.

                                           And in addition to that, China's also engaged in a lot of cyber warfare. Certainly there have been reports that there has been disruption to network and communication lines in Taiwan. And all of this really leading up to the potential for a screen to be created around Taiwan. And that's really the genesis of these scenarios, is that if that occurs, right, and it does seem like there is the possibility that that could occur based on what we've seen... Once again, I should reiterate what Steve said. Our baseline assumes that military conflict does not happen and there's also good reason why we assume that in the baseline. Reason being that even China's own Xi Jinping has mentioned in the most recent Party Congress that, in his words, "We will continue to strive for peaceful reunification, with the greatest sincerity and utmost effort. But also we will never promise to renounce the use of force."

                                           And so if you consider how this screen would be created, the natural extension to that is, what happens should that screen be created around Taiwan?

Mark Zandi:                     Great. Got it. Okay, so let's come back, Tim, to the scenarios around Taiwan. And you laid out a nice context. China does feel like it's tightening the noose around... Maybe that's too strong a word, but you used the word screen, I use the word noose around Taiwan. Not quite there yet, I mean, obviously. But you ended by saying they could, if they wanted to, put that noose around Taiwan and really make life very difficult and cut off Taiwan.

                                           And that now leads to the scenarios. One other question before we get there, though. What do the Taiwanese people think about all this? I mean, do they want independence from China generally? I mean, obviously I'm sure there's a lot of diversity of opinion there, but how are they viewing this relationship with China and how has that changed over time and where is it right now?

Tim Uy:                             So it's evolved a lot over time, I think, as you kind of anticipated, Mark. I think the Taiwanese people by and large are used to this at this point. I mentioned three previous Taiwan Strait crises that have already occurred, four if you include what happened after Speaker Pelosi's visit. So this is not something new. They're used to China essentially saying that Taiwan is a part of China, and certainly there are segments of the population and even a political party within Taiwan that has pretty, I would say, friendly relations with the Chinese Communist Party. That being said, if you look at the most recent elections, if you look at a lot of the most recent surveys, the Taiwanese do believe that... Or they would prefer to still be... They identify as being Taiwanese, and they would prefer to still be their own independent state, if you will, be a part of that. And so I think the identity has really coalesced around the island, as opposed to maybe in years past where there was more of a kinship due to the similarity in ethnicities.

Mark Zandi:                     Okay. Okay, very good. Okay, so let's turn to the scenarios, the alternative scenarios to the baseline. And let's begin with what we're calling the no military intervention scenario. In my mind, that scenario feels, tastes kind of sort of like the Russian War in Ukraine, right? It's this kind of ongoing conflict that doesn't feel like it's ever going to have an ending to it. I don't know in our scenario whether we have an outright invasion of Taiwan, I don't think we do, but it feels like this conflict is just ongoing. Is that a fair characterization?

Tim Uy:                             Yes, I think so, Mark. Yeah. So I think this scenario is really supposed to kind of, in some sense, mirror the Russian invasion of Ukraine, as you said. In the sense that there's a lot of uncertainty around how it's going to be resolved, it lasts several years and there isn't really a strong sharp recession. Precisely because, as you said, the US and its partners do not really get directly militarily. That being said, they do impose sanctions. Sanctions are imposed by both sides. The US does support Taiwan by providing defense intelligence. It also ensures that there's a corridor that's created in order to allow key goods like semiconductor chips safe passage. So there isn't a complete halt in supply chains that rely on key Taiwanese exports like electronic equipment, metals and machinery, semiconductor chips, things along those lines.

Mark Zandi:                     Why would China allow that? Is it 'cause they just don't want a military intervention? They know that if they actually cut off the chip supply from Taiwan the US would be in a pretty tough spot, the entire global economy would be in a pretty tough spot, and that would more than likely create a military conflict. Is that the logic?

Tim Uy:                             Yes. So it works both ways. China's also heavily reliant on Taiwan, and so both China and the US are in fact two of the largest consumers of semiconductor chips.

Mark Zandi:                     But presumably the Chinese could get the chips from Taiwan, they could create this screen around Taiwan, cut off all access to Taiwan except for Chinese companies, no?

Tim Uy:                             Right, but the US obviously, as you said, would react very strongly. [inaudible 00:31:30].

Mark Zandi:                     Okay. All right.

Tim Uy:                             And we've spoken with certain people who I won't name, who have full confidence that they would be able to break any screen that would be created around Taiwan. And so I think that gives us some measure of confidence that, even if there is an attempt to create a screen, that there would still be a corridor that's created in both scenarios that would allow, again, key goods. We're not saying that there's no supply chain disruption, we're just saying that any supply chain disruptions will be mitigated by this corridor that's created around Taiwan.

Mark Zandi:                     Okay. Okay, very good. And how us this ultimately resolved? Do we make an assumption about that as well? I mean, is it ever resolved?

Tim Uy:                             It's gradual, right? So basically the brunt of the recession happens within the first two years, but then there's gradually basically sort of this recovery and it kind of fades into the rearview mirror, right? Much like, I think, Russia-Ukraine. When it first started it was such a big deal, it had such a huge impact, particularly in commodity prices. In this case it has very much the same flavor, where I think a lot of the shock to the global financial system, the global economy is in those first two years. But there are still lingering effects.

                                           And so here maybe I'll talk about some of the model mechanisms. I think Steve mentioned trade, trade is obviously one of the biggest mechanisms through which the shocks are transmitted. In particular, trade in and out of greater China really grinds to halt, declines very sharply, as does investment into the region. Obviously their currencies fall significantly. And furthermore, and here is where I'll contrast it with Russia-Ukraine. So in contrast to Russia-Ukraine, where you have a huge shock to supply, in this case you have a huge shock to demand, particularly for oil and other commodities, because China's the world's largest importer of these key commodities. And so as a result of that, in contrast to Russia-Ukraine, here you actually have prices falling pretty significantly. Price for Brent basically drops below $50 a barrel in this particular no military intervention scenario. And that [inaudible 00:33:56].

Mark Zandi:                     I thought you said the price of bread. Did he say the price of bread? I thought he said the price of bread.

Cris deRitis:                      He said Brent. Brent.

Tim Uy:                             It's Brent Crude, Brent Crude.

Mark Zandi:                     Brent Crude. Sorry, I'm having a hard time. Okay. I was going, "Price of bread, how does he know that?" Yeah.

Tim Uy:                             I Don't know whether it's the sound or just my [inaudible 00:34:13].

Cris deRitis:                      I think Mark is hungry.

Mark Zandi:                     Yeah, the price of Brent Oil.

Marisa DiNatale:            Yeah, that famous Taiwanese bread.

Mark Zandi:                     Okay. Okay. Fair enough. Okay. I'm going, "Boy," I go, "That is very detailed." So go ahead, sorry I stopped you.

Tim Uy:                             No worries, no worries. Yeah, so I was just saying I think, in contrast to Russia-Ukraine, you have these oil and commodity prices falling through the roof. And so then you have inflation actually coming down instead of what you would expect perhaps with some of the supply chain disruptions. So coming down in the short run, but then eventually the supply chain disruptions, and more importantly the decoupling and the de-globalization that happens as a result of all this uncertainty around greater China, basically leads to inflation going above baseline in the medium term before reverting back to baseline. So it creates a lot of these really interesting dynamics that, again, are very different from Russia-Ukraine, just because of the nature of the conflict here where-

Mark Zandi:                     So what you're saying, one of the perhaps surprising or feels like a surprising result ism the shock initially is disinflationary, deflationary because it's such a hit to global demand, particularly for commodities, 'cause China is a huge consumer of global commodities. So oil prices go down, metals prices go down, commodities more generally, and that overwhelms the inflationary impacts of any supply chain disruptions. But eventually, further down the road, the commodity price effects fade. And then you're left with the disrupted supply chains, just kind of a scrambled mess. And that ultimately results in shortages and in higher prices and inflationary pressures.

                                           And also you pointed out, longer run the inflationary impact of de-globalization. I mean, globalization lowered prices pretty consistently back after China entered into the WTO, but in this case de-globalization results in higher inflation. That's kind of the dynamic you're describing here that comes out in this scenario.

Tim Uy:                             That's absolutely right, Mark. And I think that reorganization of supply chains, this de-globalization, really is the strongest lasting impact in both scenarios.

Mark Zandi:                     I think Tim is speaking Canadian, I think that's the problem. Have you noticed?

Tim Uy:                             Could be more [inaudible 00:36:37]

Mark Zandi:                     Speaking Canadian. How do you say reorganization? How'd you say that again?

Tim Uy:                             A re-organization.

Mark Zandi:                     Re-organization.

Tim Uy:                             I mean, at least I'm good at finance. If I said finance that would [inaudible 00:36:45]-

Mark Zandi:                     Be, is that actually Canadian? That feels...

Tim Uy:                             I can tell you that finance versus finance, that I think a lot of my American friends always used to give me... I'm a CFA, right? So all of my CFA friends always said, "You're saying it wrong, man. You shouldn't be allowed. You shouldn't even be given the qualification."

Steve Cochrane:             Can't be in the club, man.

Tim Uy:                             That's right. That's right. That's right.

Mark Zandi:                     So in the no military intervention scenario, it's a kind of dark scenario that plays out over a long period of time, and it's darker than Russia-Ukraine just simply because, or in part because, China's a big economy with lots of links with the rest of the world, Russia's a small economy with very few links to the rest of the world. Is that kind of sort of right?

Tim Uy:                             That's right, that's right, Mark. And I think you've hit the nail on the head. China's just too big for the world to decouple from completely, and so I just want to emphasize, in these scenarios we do not assume that China's just completely isolated, right? On the contrary, what we actually do is we have very specific assumptions around sanctions. So sanctions only being applied to sectors that are critical to national security in this no military intervention scenario. So that those would be defense, advanced manufacturing, AI, chips to a certain degree or electronics. But they are not comprehensive and do not include other sectors, because yeah, as you said, Chinese demand is too important.

Mark Zandi:                     Okay, got it. Just [inaudible 00:38:18].

Cris deRitis:                      Can I ask a question?

Mark Zandi:                     Oh sorry, go ahead, Chris. Yeah.

Cris deRitis:                      Could you speak to the timing of the scenario? I think it [inaudible 00:38:22] matters, right? If this is pushed out into the future there's enough time for those supply chains to be moved around. There's already activity around that. But of course if it happens immediately the effects would be greater. So what does the scenario assume?

Tim Uy:                             Yeah, that's a great question, Chris. And so we had a lot of discussion around this. So let me preface by saying that... And here actually this will go back to Mark and Marisa's point about scenario construction. We assume that the conflict starts the end of this year. This does not mean that we think any military conflict is going to happen this year, right? On the contrary, we believe that, first of all, the probability of military conflict is very low, and even if it does happen the earliest possible date would be 2027.

                                           There's a couple reasons why we made this assumption, that the scenario of shock starts end of this year. One is that we want it to be far enough out in the future so that, by the time the scenarios come out, the forecast come out, this would not be history. Which does happen sometimes with some of the standard scenarios that we produce.

                                           But the other thing also is that we want this to have an important impact in terms of measuring risks. As you mentioned, Chris, if this was too far out, if we started this out in 2027, then necessarily the impacts would be far more diminished than starting it out end of this year. And that's really for the benefit of our clients, because we do have clients that are interested in seeing and quantifying just how big of a shock this would be to the countries wherein they have significant exposure. We started at end of this year.

Steve Cochrane:             But Tim, to Chris's question, the no military scenario is about a two to three year length, right?

Tim Uy:                             That's right, that's right. So the conflict starts end of this year, the conflict proper is for two years and then there's a slow recovery that lasts about five years in total. And then all of those, we mentioned the reorganization of supply chains, that in total is about 10 years. So the reversion to baseline doesn't happen until about 2030 or so.

Mark Zandi:                     So very quickly, Tim, 'cause I want to move on to the next scenario, what is the peak to trough decline in global GDP in this no military intervention scenario?

Tim Uy:                             Yeah, that's a great question. So in this scenario we have 8% at the trough, relative to baseline. And then long run is 6% below base.

Marisa DiNatale:            And this is for the US?

Tim Uy:                             This is for the globe, this is for-

Marisa DiNatale:            Global GDP, okay.

Tim Uy:                             This is global GDP.

Marisa DiNatale:            Okay.

Mark Zandi:                     That's a lots.

Tim Uy:                             It's a lot.

Mark Zandi:                     Yeah. How much did a decline in the financial crisis, do you know? Probably like, 5%-ish.

Tim Uy:                             Yeah. I don't have off the top of my head, but I believe that's right. Yeah. 'Cause we calibrated this basically to be worse than anything that we'd seen before. So...

Mark Zandi:                     Okay. Okay. All right. The second alternative scenario is, okay, there's military intervention. So describe the mechanics, what happens there in that scenario and...

Tim Uy:                             Absolutely.

Mark Zandi:                     Okay.

Tim Uy:                             So this scenario really, I think... And then you played a big part of this, Mark, in constructing this scenario.

Mark Zandi:                     I did?

Tim Uy:                             At least that's how it felt, 'cause we [inaudible 00:41:53]-

Mark Zandi:                     Okay, very good.

Tim Uy:                             You were at the various iterations of it.

Mark Zandi:                     Then it must be good. Okay, fire away.

Tim Uy:                             Yeah. So it must be good, right? And I remember when we were discussing this, you specifically said you wanted a sharper scenario, as opposed to in the past we used to have these prolonged conflicts. And there's good reason for that. I think the scenario assumes that there's an immediate counter offensive by the US and its allies, and this catches China off guard. This is pretty important. And the counter offensive leads to direct conflict, and this direct conflict is certainly a lot more severe than the no military intervention scenario, given that it now involves the entire world. This is no longer just China-Taiwan, this now involves the US, Australia, the UK, Japan, Canada, what have you.

                                           So it only lasts a couple of quarters, and there's also much heavier sanctions. It's going to be sanctions on both sectors that are important for economic security, but also national security. So on top of your defense, your AI, your advanced manufacturing, now we're talking about banks, we're talking about professional services, we're talking about key sensitive sectors or even products that are very critical for the trading relationship. Things like soybeans, things like rare earths. Those would be covered under this scenario because there's going to be sanctions on both sides and pretty intense fighting for a short period of time. And certainly there's going to be more firms, especially Western firms, that move away from China as China is also barred from SWIFT. So this is really the scenario wherein you see kind of...

Mark Zandi:                     SWIFT, you got to explain that. SWIFT.

Tim Uy:                             Oh yeah. SWIFT is a payment system that's used all around the world to facilitate all kinds of international transfers. And so that's really something that...

Mark Zandi:                     You can't trade without SWIFT. You need SWIFT to...

Tim Uy:                             That's right, that's right.

Mark Zandi:                     You know, it's not exclusively the case but still it's pretty much the case, the SWIFT system, which is controlled, I think, by the US, right? Effectively. Okay.

Tim Uy:                             I believe so, yes. I believe so. And so I think this is really the darker scenario, if you will, from a short run perspective where we wanted to see just how bad could things get. That being said, because this scenario resolves relatively quickly, the recovery is far stronger as well because there is just less uncertainty. You know that when the conflict ends it ends, and we're in the clear. Because of that you see that, while the initial drop is more severe, so 10% below baseline at the trough for global GDP, the faster recovery leads to long-term GDP impacts that's closer to 4% below baseline, as opposed to 6% in the no military intervention scenario.

                                           So I think that presents this very nice contrast between short-term impacts and long-term impacts. But I must say though, that in the end the one overarching conclusion really is that nobody wins in either of these scenarios. Not a single country benefits on net, right? Certainly there are countervailing forces, certainly during this reorganization of supply chains you see a bunch of countries, especially in APAC, having more Western firms build factories and plants in those countries to replace what would otherwise be built in China. The negative effects from just negative sentiment, the productive capacity that's destroyed as a result of the conflict far outweigh any of these positive countervailing forces.

Mark Zandi:                     Great. Good. Could one... I'm just trying to think of what's the most realistic scenario. I mean, we have our baseline but could it be the case that the way this plays out is the US becomes much less dependent on Taiwan? I mean, we're very dependent on Taiwan because of the chips, and that's one key reason why the Biden administration passed the CHIPS act, the piece of legislation to try to incent more production here of chips in the United States. That's going to take time, obviously, building a chip plant is a pretty difficult endeavor, it takes years to do.

                                           But if you look out five, 10 years from now, presumably the US is much less dependent on Taiwan, and other US companies much less dependent on China. 'Cause as Chris pointed out, US companies are moving operations here pretty quickly. They're reshoring, they're pushing production into Southeast Asia. Vietnam is the poster child for that, Mexico. And we are decoupling, we're just quickly decoupling. And this doesn't feel like that's going to change anytime soon. And so you look out five, 10 years from now, the two economies, two countries are just much more disengaged. And in that point we just kind of... The conflict fades away. I mean, I don't know what happens, it feels like Taiwan is in a very tricky spot at that point, but it just feels like the US doesn't have the interest that it has now to protect Taiwan from China. Does that sound right to you as a scenario, or would you push back on that?

Tim Uy:                             I would say qualitatively I share your sentiment, Mark. I think there is certainly a desire to be more diversified. But we were also joking at the top of the call that you wanted statistics, right? And I'm not even going to make you guys guess, I'll just throw them out there.

Mark Zandi:                     Go ahead, make us guess. Go ahead.

Tim Uy:                             I'll make you guess. So...

Mark Zandi:                     I like to see... Marisa always gets all these anyway, so go ahead.

Tim Uy:                             All right. So what is over 90%? Something related to Taiwan

Mark Zandi:                     In chips?

Tim Uy:                             Related to chips, yes. But what specifically?

Mark Zandi:                     We get 90% of certain DRAMs from Taiwan.

Tim Uy:                             Oh wow, that's so specific. No, not really. [inaudible 00:48:10] DRAM, I can pretty much tell you that, absolutely, that very likely is wrong. I'm sorry to tell you that part.

Mark Zandi:                     Yeah, yeah, yeah. 'Cause [inaudible 00:48:18].

Tim Uy:                             Korea has very strong DRAM production.

Mark Zandi:                     What do you say, Marisa?

Marisa DiNatale:            Korea. Oh, I have no idea. I have no idea.

Mark Zandi:                     No idea?

Marisa DiNatale:            No, I don't know. Is it a particular type of chip or application?

Tim Uy:                             It is a particular type of chip, or a certain size of chip.

Marisa DiNatale:            Oh, so Mark's on the right track.

Mark Zandi:                     [inaudible 00:48:35] I deserve credit for that, come on.

Tim Uy:                             But...

Marisa DiNatale:            Being wildly wrong.

Tim Uy:                             But DRAMs, Mark, all my South Korean friends will write me hate mail and they're like, "You know better than this, right? You read all these detailed semiconductor reports."

Mark Zandi:                     Okay. What is it? Fire away.

Steve Cochrane:             Is it chips related to AI, 90% or...

Tim Uy:                             Very close. Very close.

Steve Cochrane:             TSMC produces them.

Mark Zandi:                     There's some wacko name for a chip that, you know, A X350-slash-801.

Tim Uy:                             Mark is just rattling off all these random chip types.

Mark Zandi:                     That has nothing do with [inaudible 00:49:10]

Marisa DiNatale:            I think those were made-up numbers and letters strung together.

Mark Zandi:                     Those were made-up numbers. I'm looking at the serial number for this PC, is what I'm doing. Yeah, go ahead.

Tim Uy:                             So Steve was very close. So it's literally chips that are five nanometers and smaller. So these are the advanced chips.

Mark Zandi:                     Ah, of course. [inaudible 00:49:25].

Tim Uy:                             And certainly.... I'm guessing Chris probably would've guessed that since he was talking about them.

Marisa DiNatale:            It was on the tip of his tongue.

Cris deRitis:                      I didn't want to say 'cause it was so obvious, but yeah.

Tim Uy:                             Yeah. But that was my easy number, right? Here's another number.

Marisa DiNatale:            Yikes.

Tim Uy:                             And they're both related to both to Mark's point, right? Over 60%, what is that? Just over 60%.

Mark Zandi:                     Another type of chip that we buy [inaudible 00:49:48]

Tim Uy:                             Still chips, but this is actually more general.

Mark Zandi:                     Okay. We give, go ahead.

Cris deRitis:                      Over five nanometers.

Mark Zandi:                     Yeah, right.

Tim Uy:                             So it's actually over 60% of the world's semiconductors are produced [inaudible 00:50:04]

Mark Zandi:                     In total?

Cris deRitis:                      In Taiwan, yeah.

Mark Zandi:                     Okay.

Marisa DiNatale:            Wow.

Tim Uy:                             In total. In total.

Mark Zandi:                     That's a lot, yeah.

Tim Uy:                             Right? So I think, while I share your sentiment, Mark, I think there's a desire to diversify. The reality is given just the preponderance of Taiwan, [inaudible 00:50:17]

Mark Zandi:                     Oh, you're saying we can't do it.

Tim Uy:                             All chips, it's very hard to do.

Mark Zandi:                     Interesting. Okay.

Tim Uy:                             It's very hard to do.

Mark Zandi:                     Very good. Okay, I want to end this way, handicapping these things 'cause people are saying, "Okay, well how big a deal is this?" So we've got the baseline. The baseline is sanguine. Lots of different ways you can get there. And let's say everything else, all other alternatives that involve some form of sanction-slash-conflict, military or not, what's the probability of that alternative world? Much darker than the baseline. Steve, what do you think?

Steve Cochrane:             I would say 5%.

Mark Zandi:                     Oh, geez. Really?

Steve Cochrane:             I think it's out there on the tail, yeah.

Mark Zandi:                     That's way out on the tail. Okay.

Steve Cochrane:             Yeah. And I think it is because, and we could see with the work we've done, what high economic costs there would be with the kinds of conflict that we've laid out. So I'd put it out there, yeah.

Mark Zandi:                     So you think that's basically an accident. You know, so there's an accident.

Steve Cochrane:             Well I mean, you talked about that the fighter jets...

Mark Zandi:                     Two airplanes crash together, yeah.

Steve Cochrane:             That's right, your example of today's fighter jets coming within, what, 400 feet you said?

Mark Zandi:                     Yeah.

Steve Cochrane:             That's so close to an accident and it only takes one of those to happen. And the lack of communication between China and the US for something like this to blow up, I mean, look at the brouhaha that occurred when we shot down the balloon over the Atlantic Ocean, and that was pretty benign. So yeah.

Mark Zandi:                     Okay. So 5%, and that's basically in some kind of accident that results in more involved conflict, okay.

Steve Cochrane:             That gets more involved, that's exactly right.

Mark Zandi:                     Okay. I'm going to go to Tim last, but Chris, do you have a view on this?

Cris deRitis:                      I'd tend to agree with Steve. I think it's a fairly low probably and I think both sides recognize the consequences here. So it would have to be some type of mistake or accident. I think there's certainly the provocations that Tim talked about, I think they continue. But I don't know, at least I want to believe we don't cross the line so easily or cavalierly.

Mark Zandi:                     And just to be clear, I'm including the no military intervention scenario here too, not just the military intervention scenario. Something that...

Cris deRitis:                      Yep.

Mark Zandi:                     Okay. Put it this way, something that's meaningfully different than the baseline on the dark side.

Cris deRitis:                      Yeah.

Mark Zandi:                     Okay. Okay. And you're saying 5%?

Cris deRitis:                      Yeah, I think so.

Mark Zandi:                     Ooh, okay. Marisa, do you have a view?

Marisa DiNatale:            No, I mean, I trust Steve.

Mark Zandi:                     Okay.

Marisa DiNatale:            I'll defer to the expert here.

Mark Zandi:                     I have faith. I have faith.

Marisa DiNatale:            Yeah, I have faith in Steve and Tim.

Mark Zandi:                     Faith. Tim?

Tim Uy:                             Yeah, no, I'm with Steve. Yeah, I think definitely less than 10%. Yeah. I quoted Xi Jinping earlier, but that is a sentiment that even goes back to Deng Xiaoping days. And same thing in terms of if you listen to what's come out of the White House, I don't think anyone wants military conflict around Taiwan. So hopefully we can keep our jets away from each other and leave peaceably. And I think everyone would love to have that outcome.

Mark Zandi:                     And that probability is also including, again, just to make sure that I understand, no military intervention. Just strict sanctions, a corridor for the chips, that kind of conflict, you would include that in your less than 10%?

Tim Uy:                             Mm-hmm.

Mark Zandi:                     Okay. I think you guys are being too Pollyannish, actually, on this one.

Tim Uy:                             Okay. What's your percentage, Mark?

Mark Zandi:                     25%.

Marisa DiNatale:            Wow.

Mark Zandi:                     Oh yeah.

Marisa DiNatale:            For the no military conflict or for cumulative?

Mark Zandi:                     No, anything that's not the baseline.

Marisa DiNatale:            Okay.

Mark Zandi:                     Anything that's not the baseline. Take the distribution, put the baseline in the middle. Look to the right hand side of the distribution, I might say it's 25% something palpably darker is going to happen here than what we think. Yeah. We're moving apart at lightning speed on every level, economic, political, social, we're disengaging. And I think it's just a lot harder to hit each other over the head when you're disengaged like that. When you're embracing each other it's hard to pull your hand up and hit the other guy on the head 'cause you've got your arms around them. When you're apart you can take a swing, and I think accidents happen.

                                           So I don't know, I don't have a warm fuzzy feeling here. And when I say 25% I'm thinking not next month, next year, but over the expanse of this conflict that could play out over a decade or two. This is not something that's going to go away quickly, this is something that's going to play out over a long period of time.

Steve Cochrane:             Well you make a point there, Mark, I think that is worth noting, is if we're looking for that point where an accident might happen that would generate a conflict, if you've got a 10, 15 year period where one accident could happen, well that raises the probability just from the timeframe that you're looking at.

Mark Zandi:                     Simply cyber, a cyber war. It feels like maybe it's not jets fighting each other or ships fighting each other, it's we're fighting each other on the web. We're shutting down each other's, I don't know, making it up, electric grid. But you know what I'm saying? Yeah, right. Okay.

Cris deRitis:                      But how likely is it, that no military conflict scenario. I think sanctions would be interpreted as an act of war, if the US were to unilaterally impose [inaudible 00:55:51]-

Mark Zandi:                     Well, we're probably some sanctions now though, aren't we? In some form.

Cris deRitis:                      Well we're not at... I think we're talking a different level.

Mark Zandi:                     Okay. Okay, fair enough.

Cris deRitis:                      Right? We're putting some tariffs, certainly, but not to the point of cutting off trade as we've done with Russia to a very large degree. I think if that step is taken then the next step towards war become... I mean, the reaction would be quite negative, I would [inaudible 00:56:14].

Mark Zandi:                     Well, isn't that what I'm saying? I mean, you say 5%, but isn't...

Cris deRitis:                      Yeah, but that's why I don't [inaudible 00:56:19]-

Mark Zandi:                     Oh, I see, I see.

Cris deRitis:                      That's why you said 25% is anything.

Mark Zandi:                     I see, you're saying-

Cris deRitis:                      I don't see that that no military action scenario actually has a...

Mark Zandi:                     Is that viable.

Cris deRitis:                      Because it could either jump from this current détente to war.

Mark Zandi:                     I got it.

Cris deRitis:                      I don't see them... You can ratchet it up but not cross the line.

Mark Zandi:                     Right, right.

Cris deRitis:                      Maybe.

Mark Zandi:                     Yeah.

Tim Uy:                             I think to Mark's point I will say that, and this is something that is really the rationale for that 2027 date that I had said earlier, is that that is the date for the next Party Congress for the Chinese Communist Party. And certainly Xi Jinping has mentioned that he would like to leave a legacy, and reintegrating Taiwan could potentially be part of that legacy. And so I think your point, Mark, about a longer time horizon certainly changes the calculations in terms of how likely there is to be a conflict over time.

Mark Zandi:                     Yep. Okay, very good. That was a great discussion. And of course we're going to be, I'm sure, back at this in the not-too-distant future, because this is evolving very rapidly. Any last words, guys? I know it was a bit of a bear to do this. Lot of conversations with lots of different people in all walks of life, and here in Asia. And the whole team was involved and a lot of moving parts here, but you got to cross the finish line, and congratulations on that. And there is a paper out there, a white paper, so if folks are interested let us know. We'll get that to you as well. And the scenarios are in the databases for folks to use if you're interested. Any other words of wisdom? Okay, hearing none. I'm always open for words of wisdom. Okay, still hear none. Okay. Okay. Going, going, gone.

                                           Thank you dear listener, we'll talk to you next week.