Speakers: Jeremy Lawson, Abigail Watt, Sree Kochugovindan, Luke Bartholomew, Paul Diggle, Rob Gilhooly, Michael Langham, Edward Glossop

Paul Diggle 00:06

Hello and welcome to Macro Bytes economics and politics podcast from abrdn. My name is Paul Diggle Deputy Chief Economist at abrdn, and this is our final episode for 2022 and quite the year it has been in the global economy and financial markets. We've spoken about many of the themes and drivers on the podcast over that time. Inflation, monetary policy, recession risks, energy markets, political turmoil, COVID policy, climate change, cryptocurrencies, we've covered a lot of ground because there has been a lot happening. And to do something slightly different in this final episode for the year I've asked some of our economists here at abrdn to give a snapshot outline of the key question or key driver, they'll be watching in 2023, which they think is really going to drive the macro and market outlook. So, I hope you enjoy the show.

Abigail Watt 01:13

My name is Abigail Watt. I'm an economist in abrdn, based out in Boston. And I think the biggest question for the US economy in 2023 is whether the US enters a recession. There's been a lot of debate for some time now around a hard landing versus a soft landing in the US economy and we're landing on the side of a hard landing being most likely. And there's a few reasons why we think a soft landing is unlikely. The first is soft landings tend to be the exception and not the norm. It's very difficult for policymakers to perfectly calibrate policy to slow the economy enough to quell inflation without inducing a recession. The second is the labour market has been very tight and continues to be very tight in the US. And we think it's unlikely that the labour market can loosen in a manner that doesn't cause higher unemployment. And then the final is that policy has been tightened very significantly through 2022. And we think that given the long and variable lags with which that actually feeds into the real economy, we won’t be seeing the kind of true tightening in the economy off the back of that tightening and policy until the middle of next year. That said, though, we have seen consumers, you know, holding up fairly well in the US economy. Consumption has been fairly resilient. And that's due to the kind of the strong buffer of excess savings that's been built up through the pandemic, both through kind of fiscal support, but also just through consumption being kind of curtailed by pandemic-related restrictions. The question that's kind of key in terms of the recession timing, then is how quickly those savings are depleted. We have seen savings rate rates decline to the kind of lowest on record of 2.3% in the latest data. And so we think those are being run down fairly quickly by US consumers. We're also seeing that other interest rate sensitive sectors such as housing are already weakening. And our recession model suggests that the risk of a recession in the US by September next year is around 60%. Therefore, we think the Fed will likely have to pause its rate hikes in February after delivering a further 100 basis points of hikes. And we think inflation and inflation dynamics will be key - in terms of whether the Fed can pause rates. In particular we are watching wage growth, given the kind of services sector inflation that's being driven in the US by that kind of high wage growth. And we did see an upside surprise in that. So that does risk a higher terminal rate from the Fed. Ultimately, though, we expect a recession next year. And we think that will help to wash some of the inflation pressures out of the system, allowing the Fed ease rates back to support the economy.

Rob Gilhooly 03:41

I'm Rob Gilhooly, Senior Emerging Markets Economist at abrdn. For me, the one thing that I'm definitely going to be watching is the COVID situation in China, and how the authorities manage the move towards endemic living. Living friendly recently, we've had a big flurry of news on various restrictions being eased the tone from the party has definitely shifted a lot in this. And while we've not had I guess, an official change in policy, I do think this adds up to a kind of de facto abandonment of the dynamic zero Covid policy? We've had rolling back of contact tracing, where possible the ending of mass testing and lockdown should now be very much more targeted. All of which means really, it's going to be near impossible to return to a strategy to eliminate outbreaks, given the high transmissibility of Omicron. I think the interesting part of this is the timing, in that it's occurring before the majority of most vulnerable section of the population, the over 80s, have had their booster shots and indeed about a third of the over 80s haven't even had two doses of the vaccines. So while I guess this implies authorities are now more willing to take a little bit more risk to get the economy moving, get it reopened, we've still got this risk of a disorderly exit from zero COVID given the high transmissibility, plus given I guess the need to differentiate China's approach to that taken by the West. I think this means that tough restrictions are still likely to be needed to slow the spread, and also just, you know, reduce the stress on the healthcare systems. So, I think there are a couple of clear implications here. Given what we've seen already, with COVID spreading in December, potentially more restrictions being needed to slow the spread in Q1, adding further disruption. This could potentially push China towards a technical recession. And then I guess there's just here a question of kind of lack of exposure and whether vaccines turn out to be sub-par or not within China, all of which could slow the exit, to make it longer and more protracted than we or the market expect. All of which I think could really test the market's ability to kind of appeal to light at the end of the tunnel.

Michael Langham 06:01

I’m Michael Langham EM Economists in the abrdn Research Institute. The topic that I'm most focused on is the paths of EM central banks and inflation next year. I think it is fair to say it's going to be a tough year for EM with a global recession, and the tight Fed and ECB policy stances. Broadly speaking, most EM central banks are at the stage where they're either slowing or pausing monetary tightening cycles, given the concern around the growth outlook, and inflation fears generally peaking. So looking ahead, we think most EM central banks are either positioned in one of three buckets, they’ve credibly pivoted, that is paused their hiking cycles credibly. There's also those that have less credibly pivoted, and then those that are slowing the pace of tightening, still tightening budgets, albeit at a slower pace. So, Brazil, we would class as a credible pivoter. It's fair to say that Czech and Chile as well probably fall into that bucket, those that hiked early, and then are now we're seeing inflation fall and the economy's also slowing. In contrast, we put Poland into the less credible bucket. Hungary is borderline as well into that camp. They're seeing their economies slow going into 2023. But we think inflation could prove to be on a more sticky path, labour markets still tight, some fiscal measures in Poland ahead of elections as well, keeping inflation a bit more sticky. So, pivoting may be putting too much faith in external drags and the lagged effect from their tightening, tackling current core inflationary pressures. Finally, we've got those that haven't yet got a handle on underlying inflation, the likes of India or a lot of EM Asia. They're going to continue hiking in line with the Fed that should be shielded from the worst of market pressures in six to nine months given that they're doing this tightening. The key takeaway is that divergences are going to continue to play out. Those that have credibly pivoted ahead of their own coming recession are going to be best placed to begin monetary easing when the Fed does. Those that haven't yet done enough tightening could face market pressures to re-start hiking cycles given already high inflation and their delays to monetary easing.

Edward Glossop 08:54

My name is Edward Glossop and I’m an Emerging Markets Economist in the Aberdeen Research Institute and my big thing to watch for next year is developments in Russia and Ukraine. So as the war has ebbed and flowed over the course of this year and we've heard murmurings of ceasefires, palace coups, détentes all of these rumours have come and gone. And so our view, long-held view the war will drag on for a prolonged period has gradually, slowly but surely, become the consensus. As we head into next year, I think there are three things in particular that I think are worth watching. So the first is a likely slowdown in the pace and intensity of the conflict. We've already seen this start to happen as the winter months have begun. But I think the key point is this shouldn't be interpreted as a sign that Ukraine's really impressive counter offensive over the past six months is over. I think this is most likely to be just the regrouping by both sides ahead of a renewed Ukrainian counter offensive push in the spring once weather conditions are better. The second thing I think to watch is what Putin's reaction to this might be. You know, we have seen rumours of mass mobilization of the deployment of tactical nuclear weapons. These are the two options that are most likely mooted. I think there are definitely strong arguments against both of these. But ultimately Putin needs a win.He needs a win from the war and that makes for very kind of fat tails in this distribution, if you like. And the final thing to watch is developments in the energy markets. So you know that the EU oil embargo and the G7 oil price cap are threatening to disrupt energy markets. But so long as Russia continues to ship oil to India and China and other third countries, none of this will make a significant dent in Putin's ability to finance this war. I think finally, the EU has really impressively this year filled up its gas storage, which will help this winter, but ultimately, the bloc faces a multi-year adjustment to wean itself off Russian gas.

Sree Kochugovindan 11:15

I'm Sree Kochugovindan, Research Economist at abrdn, and one of the biggest things that I'll be watching over the course of 2023 is really going to be about labour markets, the key indicators there, and that's critical for the outlook for inflation, for 2023. So we'veprobably seen the peak of inflation for many countries, that's probably behind us now. And we expect headline inflation to start easing off next year. But, there are some risks that inflation may not decelerate as quickly, as markets are expecting at the moment. So if we start with commodity outlook, the base effects there, even with supply constraints, if we have demand destruction and a recession, then the outlook is really for lower prices across commodities, and particularly in oil, in energy prices. So we expect the base effects to be quite negative for and drag down headline inflation for many countries next year. Moving on to supply chains, we expect some of the disruptions to persist, but they are definitely improving quite markedly. And we expect them to continue to repair. And they seem to be moving in the right direction. So freight costs are down, semiconductor production is improving and the intermediate inputs are now available across the supply chain. So that's all moving in the right direction. Core goods prices have already started to decelerate in response to that. But really where we see some of the issues is around core services, and that's already remaining, quite elevated, still quite persistent there. And really, it's the tight labour markets that are the issue. And those are the key factors to be watching going forward. So we do think there is a risk that inflation could be quite sticky. And that's a scenario we've been considering, where inflation slows more gradually. And the risk there is that inflation expectations start to become more backward looking. And at the moment, inflation expectations are quite stable. So there's a lot of faith in the ability of central banks to actually bring inflation down and meet targets. But the longer we have persistent and high inflation, the greater the risk that households and firms start to look backwards and start changing their behaviour. So there is a risk that inflation expectations can become unanchored. And the heart of that really is the core service prices and the labour market, what happens with wage pressures and what happens with key labour market indicators. And that's really the focus going forward. It's going to be quite important in terms of setting how much economic pain there might be, and how aggressive policy tightening may need to be in response in order to tame inflation.

Luke Bartholomew 14:10

My name is Luke Bartholomew. And I'm a senior economist at abrdn. And one of the biggest things that I'll be looking at by 2023 is the evolution of the monetary policy path. And the reason I say evolution is because I think there will be three distinct phases of policy next year. At the start of the year, most major central banks are likely to still be in that tightening cycle we've seen over the last year, with further rate increases from the Fed in the US, the Bank of England and the European Central Bank. And if anything, the risks are skewed there to rates going slightly higher than we forecast. And that will partly be because the economy proves to be a bit more resilient in the near term and falls into recession a bit later, and that gives the central banks time to push through some further rate increases. But once the recession does start we then see rates peaking and staying at terminal level for some time. Now normally once a recession starts, central banks start cutting rates quite promptly. But we don't see this this time, because the sticky inflation is likely to mean that it takes some time before central banks feel that they have credibly got on top of the inflation problem and can start cutting. So even as we're in recession, we see rates sort of sticking at this elevated level for some time. But then finally, once the cutting cycle does begin in the back end of 2023 as inflation comes down, we see quite an aggressive cutting cycle, we see rates getting back towards the effective lower bound in a number of countries. And that seems like an extremely long way from where we are right now. But we think that is the most likely path if we're right about what unemployment and inflation is likely to do. Fundamentally, central banks do have to ease interest rates quite significantly in a recession. There was a lot of literature after the global financial crisis suggesting that zero lower bound episodes, were going to be a recurring feature of the macro economy, partly because the natural rate of interest is much lower, and therefore, sort of it takes more interest rate cuts to stimulate the economy in a way that's necessary. Now, if inflation were to prove a bit stickier than we're forecasting, then it's entirely plausible that rates don't get quite back to that zero lower bound. But nonetheless, either way, it's hard to see how a significant cutting cycle that is beyond what the market is pricing at the moment doesn't happen if we are right about this recession.

Jeremy Lawson 16:48

So I'm Jeremy Lawson, and I'm the Chief Economist and Head of the abrdn Research Institute. What you've heard so far is that 2023 is likely to be a very challenging year from a macroeconomic and policy perspective. So what I'm really focused on is then how this plays out in markets. 2022 is a year in which almost all asset classes underperformed cash, in some cases by much larger amounts than normal. Certainly, that was the case in bonds. And so in many outlooks 2023 is being set up as a year, well, it's not common that you have both asset classes underperform cash two years in a year in a row, so might 2023 be a positive year for returns? So I think our fundamental view is that that's actually pretty unlikely. So for a start, the monetary policy cycle that my colleague Luke talked about, is not in the price of assets and the price of bonds today. So we think that policy rates will fall quite substantially, eventually, after a recession, but if you look at bond yields they’re effectively pricing that policy rates will just sort of fall back to long term neutral levels so there really isn't a need for a very aggressive monetary policy cycle. So we think that's pretty unlikely in a recession. This is one of the reasons why bonds have the potential to be one of the best performing assets in 2023. On the other hand, we very clearly see that the corporate profit recession that would accompany a global recession is also not priced in, and sometimes this might seem odd. Aren't equities down a lot? Doesn't that mean that they're pricing in a very bad outlook? Well know most of that is just re-rating and de-rating associated with the oscillation of government bond yields. When you look through that the market is still expecting modest positive corporate profit growth in 2023. And so what's likely to occur we think if we're right in our recession forecast is that equity prices and credit spreads will both deteriorate next year, as the recession we're forecasting has to be properly reflected in prices.

Paul 19:18

Fascinating the set of quick-fire views of 2023 there. I'm sure we have quite a year in store for us. Thank you to you for listening to Macro Bytes over the course of this year. If you've been enjoying the show, please like and subscribe on your podcast platform of choice. We will see you in 2023. Goodbye and good luck out there.

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