Jeff: Welcome to The Flip Side. My name is Jeff Meli, and I'm joined today by Ajay Rajadhyaksha, Barclays' Global Chairman of Research. Thanks for joining me today, Ajay, for our last episode of 2022, which certainly was a year with lots of topics to debate.
Ajay: Thanks for having me, Jeff. And yeah, it's been a heck of a year.
Jeff: Today we're going to talk about the outlook for the US economy in 2023. Now, many forecasters, including our own economics team here at Barclays, are expecting a recession next year driven by the rapid and ongoing hiking cycle that was initiated by the US Federal Reserve in 2022 as they try to get a grip on inflation. Now, the data so far doesn't really show any evidence of this so far pretty hypothetical recession that everybody is expecting. We and others keep pushing back the timing for when we think this weakness is actually going to show up in the economy.
Ajay: That is true, and you're right. Equity markets and other asset classes have rallied lately on the hope that the Fed may not need to or want to be so aggressive next year if inflation slows and/or the economic backdrop weakens just enough.
Jeff: Well, Ajay, hope springs eternal, particularly in equity markets.
Ajay: That is true too, Jeff, but in this case, I think investors are fooling themselves. In my opinion, the United States will experience a recession next year, and it will because by the fact they don't have a choice. This is not a policy mistake. It is a necessary implication of the need to get to their inflation target. This is the only certain path they have to getting to 2% inflation over the medium term. And I don't see the Fed as being ready to give up on that objective.
Jeff: Well, I'm a bit more hopeful, Ajay. I think there's a chance that inflation declines more rapidly from here. In fact, there's some decline in inflation that's almost mechanical based on how the data is likely to play out. But more importantly, I think there's a chance that the economy benefits from a reallocation of resources, from what I'll call some more dubious uses back into areas that are associated with real production. And this realignment or supply side realignment might actually provide a buffer from the shock of higher rates.
Ajay: Huh. Always the optimist, huh?
Jeff: I don't really think that's my reputation, Ajay Rajadhyaksha, but I guess I'll take it.
Ajay: All right. Well, I'll go to the other side. I'll start with the gloomier take and look. As we all know, the post-COVID surge in inflation has been very persistent. The US Central Bank belatedly realized that inflation isn't going away on its own, dropped the use of the word transitory and responded in force 475 basis point hikes already this
Jeff: Year. That's been a record setting pace of interest rate hikes, and we expect another 50-basis point hike in the upcoming December meeting.
Ajay: That's true, and I don't think they're done. I expect to see at least one more 50 bit move next year as well, bringing rates to 5% up from zero earlier this year.
Jeff: Yeah. Some commentators are critical of the notion that we actually need this additional tightening of monetary policy going forward.
Ajay: Well, I think the reason they're critical is because interest rates do usually hit the economy with long and variable lags. That is the phrase that you hear often. It means that higher interest rates don't immediately slow things down. It takes time, and we don't really know how much tightening is needed, not exactly when it kicks in.
Jeff: Now, remember, rates only started to rise just over six months ago, and so the critics believe that the Fed may already have done enough tightening. Now, you could argue that the Fed made a mistake by being too backwards looking during the initial surge in inflation. They presumed that inflation was going to go back to the low levels that we had experienced before COVID and that all of this was transitory, and it would fade pretty quickly. But if they hike too much now, they could be making the same mistake in reverse. They're too focused on spot inflation and not realizing that they've already done enough so that it's going to decline sufficiently in the future.
Ajay: Okay, so this is where I think the mistake in this criticism lies, Jeff, not that the Fed won't do what you describe. I think you're right. I think they absolutely will hike us into a recession. I think the mistake is in believing that in that inducing a recession is something that will not be by design. I think they are aiming for that.
Jeff: So, you actually agree that maybe rates are already or at least will soon be sufficiently high?
Ajay: I think I do. I think that is true, but I also think it's irrelevant. The Fed is now undertaking a risk management exercise driven by the very difficult position it finds itself in late in '22.
Jeff: So, risk management for what?
Ajay: All right. Take an example. Take housing because everyone focuses on that. Home sales are down 30% to 35% from the B. And when you buy a house, Jeff, you buy furniture. You have moving costs. You pay the realtor 5%. So, a number of industries feed off housing activity. And when that activity collapses, eventually all these areas are also hurt.
Jeff: So, I think housing's important to point out because it is actually the only exception to the statement I made earlier, which is that we don't see the effective rates in the economy. This is the one place that we actually see it. You cited some statistics around housing sales declining. House prices have declined somewhat as well. Aren't you just making my point that if we're already seeing it, the Fed's done enough?
Ajay: No, not this time. So, say you and I are right, and say the Fed agrees with us. Say the Fed believes with her 85%, 90% charms, but the economy is already on the process of slowing, that if they stop here, inflation will eventually go to 2%. But there has to be a 10, 15% chance in their mind that they haven't done enough. And this time, this cycle, the Fed cannot take that chance, partly because current inflation is still so high and partly because remember how wrong the Fed's already been on inflation in the last 18 months. I don't think they have a lot of confidence in forecasts. I think they have to be hawkish until the return to 2% inflation is a near certainty,
Jeff: But spot inflation is never going to reflect rates immediately, particularly when they have changed so rapidly. This is a record setting pace of hikes. Of course, it's not showing up in the numbers that we're seeing today.
Ajay: Totally agree, but that is the problem. By focusing on current data, current inflation, wages, the labor market, there is no way to avoid a recession. You said it. These are all lagging indicators, Jeff. By the time they turn around enough, that 2% inflation is in sight, it's going to be too late to avoid at a recession. And I want to keep stressing. This is not a mistake. It is a policy choice for them right now.
Jeff: Okay. Now, one point I think is worth making is that inflation may ease off pretty quickly from here. Some prices are almost hardwired to fall. So, here's an example. Owner's equivalent rent. In general, shelter costs are a huge part of the inflation basket. Obviously, a lot of our money is spent on either rent or housing costs. Rent spiked last year and early this year, but they're now declining. But the way shelter costs are computed, they reflect the leases that are being signed now. So those leases are higher than they would've been a year ago, like when those people signed the lease that they're on currently, and so they're adding to inflation. But the leases are lower than they would've been if those same renters had been unlucky enough to have to re-sign six months ago or nine months ago. So, in other words, we're overstating currently what's happened with lease costs because of the way the calculation works. If we track current leases, you would see there was an even bigger spike in inflation earlier, and it's actually turned. That's going to show up in the shelter cost data over the course of the next couple of quarters, and mechanically, we will see the inflation numbers fall from here.
Ajay: That is true. I completely agree. Shelter inflation is on a path to slowing down. In fact, I'll go further. In other cases, used car price, as a famous example, that decline has already started. All of this is true.
Jeff: Now, these mechanical improvements, Ajay might allow the Fed to ease up. Certainly, I think you could look at how equity markets have traded over the past several weeks and say that that belief is being incorporated into asset prices currently. Remember, equity prices have rallied substantially from their recent look.
Ajay: Yes, but I think investors are wrong because the Fed's focus has shifted to wages, spot wages but wages. Many speeches, including [inaudible] Pavel, indicate that they're worried most about the labor market, about the pace at which wages are growing. And look, this makes sense. Wages have memory. You got a 10% raise this year, an 8% raise last year. You expect another increase at the same pace next year. The Fed would say wages are rising too fast and will soon be a driver of inflation rather than just reflecting it.
Jeff: Now, it is true the labor market is still pretty strong. That's despite all the anecdotal evidence we heard about layoffs, including from some pretty high-profile tech firms. At the same time, it's hard for me to say that that's a bad thing. Don't people want raises?
Ajay: Of course, they do want raises, but you can have too much of a good thing at an aggregate level. And I don't think wages will ease off just because shelter costs and used car prices do not, unless jobs are lost. And if wages don't ease off, the Fed will stay aggressive, Jeff.
Jeff: Well, Ajay, that's a pretty bleak outlook that you're painting as we're heading here into your end. I'm not going to go so far as to call you a Grinch, but-
Ajay: But maybe you should. Look, I'm just being realistic, Jeff, and I realize it's not a very pleasant thing to say.
Jeff: All right. Well, I'm going to give an alternative and I hope somewhat more positive spin on how 2023 might play out.
Ajay: Yeah, please do. I could use some holiday cheer.
Jeff: All right, so here's my basic premise. I believe that one consequence of the ultra-low interest rate environment that we were all living in for many years is that investors put very high, maybe even inappropriately high, prices on very speculative, long dated cash flows.
Ajay: You're talking about reaching for yield, right, Jeff, where low rates force increased risk taking?
Jeff: Yes, but I'm talking about a supercharged version of that that has come to pass because of the duration at which we were stuck at zero for interest rates. So, here's an interesting example. The Republic of Austria issued a 100-year zero coupon bond in 2020. Now, at one point right after COVID, that bond traded at a premium. Just to be clear, that's a zero-coupon bond. Investors were willing to lock in zero return over a century. That is a seriously high price for a bond with no income until 2120.
Ajay: Yeah. I'm guessing that bond has not performed very well.
Jeff: That's right. At its lows, it was less than six euros.
Ajay: Wow. Well, that is painful. The Republic of Austria is AAA rated. It is doing just fine on the fiscal side. You're right, Jeff. It is very tough to lose nearly 95% on a AAA asset.
Jeff: It is. I would challenge you to find a AAA performing asset where you've had negative 95% return other than this one, but it shows how quickly prices can adjust when rates rise. Now, let me draw an analogy to economic activity that's happening in the private sector. Let's take crypto, tokens like Bitcoin. They have no cash flows at all, not even in 2120, right? But crypto prices rose very sharply in the aftermath of COVID, and I think that low interest rates were responsible for those prices rising just like they drove the Republic of Austria bond price.
Ajay: Sure, but look, crypto prices have already fallen. There's been very large wealth destruction on that front already. No?
Jeff: Yes. But there is an angle with the supply side of our economy that I want to talk about. A sector like crypto was absorbing all sorts of resources, energy, people, computer equipment. Those resources were being used to produce, by my estimate, and again, this reflects my own bias here, absolutely nothing of actual value. Now, all of those resources can be recycled back into the economy and put to uses that were undervalued when rates were low because they generated less speculative cash flows but more near dated but actually have some productivity associated with them that the economy can benefit from.
Ajay: Well, first, that is quite a negative view of crypto and DeFi. But look, I have sympathy with your argument on the resource utilization side. At one point, for example, to further argument you are making, the energy being used to mine Bitcoin was equal to the amount used by the entire country of Ireland. Bitcoin miners were buying all the graphic cards they could get their hands on, meaning that other uses of that computing power were going unmet. You are right.
Jeff: Yeah. And that's the physical resources you're talking about or the energy resource. What about the people, Ajay? The workers that are attracted to crypto are incredibly productive and very highly trained. They're computer engineers, coders, people operating on the absolute cutting edge of technology. These workers are now going to be recycled back into the regular, i.e., non-crypto, economy. We were wondering for a long time, why was productivity growth so slow in the United States? We had all these great new data tools and technologies that were being used, but it wasn't showing up with a productivity statistics. Maybe because some of the people who were the most productive, who knew how to use all these fancy new tools, we were basically paying them to waste their time.
Ajay: Okay. Even if I buy the basic tenet of this argument, and I think I might, I just don't think the magnitude of what you're talking about is sufficient to stop the recession. I get your point about quality versus quantity, but how many workers are we really talking about here?
Jeff: Well, look, crypto is just one example, and it's one where my own views are maybe the most strident. But there are other examples. You could argue that the performance of meta stock reflects investors revaluing the long erm prospects of the metaverse. That's a sort of vision for Mark Zuckerberg where he has been investing tens of billions of dollars a year in something that may or may not generate some future cash flows that people have a hard time pinpointing. Investment in self-driving cars was or even is absorbing billions of dollars. Some of the best and brightest tech workers focusing on that. Again, no realistic prospects of near-term productivity associated with that. These projects got funded because investors were willing to put a high price on these very long dated highly speculative cash flows when those prices made sense when rates were at zero, they don't make sense anymore. Now, as those investments slow or even cease, other companies will be able to utilize those same highly productive resources.
Ajay: All right, but look, hold on, this almost is as bad in the long run, no, because these moonshot investments should... Most of them might fail, but some will succeed with massive long-term benefits. Consider those electric vehicles. Plenty of auto experts thought Tesla was doomed, and now we can see a path to eventually retiring the internal combustion engine, going fully electric with large benefits through the environment, to the economy.
Jeff: Well, to quote Spinal Tap, Ajay, there's a fine line between clever and stupid. So sure, some of these moonshots, as you call them, might turn into something big. But the reliance on ultra-low rates to actually create the funding really tells me that the overall quantum of resources being used on these projects was too high. The rest of the economy suffered from that and will benefit from a reallocation.
Ajay: That is a fair point, and it might partly explain why the labor market remains strong, why job openings are still very high.
Jeff: And there's another issue, Ajay. In a normal, normal slowdown, firms get rid of their lower productivity, lower value-added workers first. That's the first thing that happens when we hit a slowdown. But in this cycle, those workers are already in short supply. Remember, so many workers left the labor force during COVID and have yet to return. People in service sectors, for example, can't get staffed. They're not going to lay anybody off. It's the tech firms where we're hearing about the layoffs. The more knowledge-based part of the economy is where the pressure's going to come, but it's in that more knowledge-based part of the economy where the job openings have been really strong because all the most productive people have been absorbed in these highly speculative parts of the tech spectrum. That's the jobs that are getting filled now. That is a slightly more hopeful story.
Ajay: Okay, well, first, I'm skeptical that this cohort is large enough, again, to have an economic wide impact, Jeff. But second, I go back to my original point. Without a large loss of jobs, I just struggle to see wages slowing down enough that the Fed can say, okay, we can rest easy. You might simply be making an argument for the Fed to have to go even further.
Jeff: Well, Ajay, I guess we're going to have to wait and see how things play out as we head into 2023. I'm a bit more hopeful that there's a path to 2% inflation without a recession, though. I hear your point on the labor market, and we're going to be watching that really carefully. In the meantime, investors can read our latest forecast for 2023 and our most recent global outlook available on Barclays Live.