Outlook on Current Global Economic ConditionsOutlookonCurrentGlobalEconomicConditions

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  Howard Nowell:

  Good afternoon and thank you very much for joining this lunchtime webinar with PGIM Wadhwani. My name is Howard Nowell and I'm part of the Institutional Relationship Group at PGIM, who work very closely with PGIM Wadhwani, and I'm based here in London. For the next 30 minutes or so, we're delighted to have Sushil Wadhwani, the CIO of PGIM Wadhwani, an ex-Bank of England Monetary Policy Committee member offer up his thoughts on a number of areas that have impacted all of us and the investment markets over the last few weeks. Thank you very much for joining us at short notice. What we're proposing is a session that lasts about 30 minutes, but we do have a little bit of time left for overrun for those of you able to stay beyond the top of the hour.

  Sushil is going to offer up his remarks in line with the agenda invitation around a number of areas, including central banks and their views on hiking, their timelines and hopefully some form of ultimate end point, inflation covering of the Fed and other central banks’ latest thinking, the recession: hard landing, soft landing, the US, Europe and the UK, and also towards the end, hopefully some grounds for optimism and opportunities and how this might affect people's thinking in respect of portfolio implications.

  And of course, all of this is against the backdrop of political challenges and uncertainties in many of the markets that we're all involved in. So, I'm going to hand over to Sushil. There is the opportunity for you to feed in questions through the chat facility. Unfortunately, due to the numbers involved today, we can't take personal questions or verbal questions, but please feed them through and we'll get through as many of them as we can in the second half of the session.

  So, for now, Sushil, I would like to hand over to you and look forward to hearing your observations. Sushil, sorry you're on mute.

  Sushil Wadhwani:

  Sorry. Schoolboy error. Thank you very much, Howard. Good afternoon or good morning to those in the US. And good evening to our friends from Asia. As Howard said, I want to talk today about the outlook for the global economy, the possibility of a soft landing, primarily in the US, and the implications for markets more broadly. And obviously, central banks are a central element of this story.

  Now, in terms of the importance of whether or not one gets a soft landing, I think one way of illustrating that is to think about our approximate projections for the S&P 500 under different scenarios. So, we believe in a basis the S&P being around 3800 today, we believe that if you don’t get a soft landing, which, after all, is the Federal Reserve's central forecast, then we think the S&P could rise up to somewhere 4700 to 5000 over the subsequent months.

  On the other hand, if you do end up in a recession, so a hard landing, we believe the S&P would probably go down to somewhere in the 3000, 3200 zone. So, a lot really does depend on whether or not you get the soft landing. Now, as I said, the Fed's last published projections are approximately consistent with the soft landing in the sense that they have core inflation gradually getting back to target and the unemployment rate really only goes up a little bit from a little under four to a little over four, and GDP by that, you know, grows at a below trend rate, it doesn't even get negative. And therefore, you clearly avoid a recession on their forecasts. So, what determines the probability of a soft landing and the degree to which the central banks will have to tighten? It seems to me the key factors are what's going on with inflation expectations. Have inflation expectations become de-anchored? Now, if you look at inflation expectations as measured in the markets, then they're only a little bit above target.

  So that doesn't look worrisome. But the markets might be wrong - it wouldn’t be the first time. So, the second thing you might look at is what a firm is saying. And it's really interesting, that if you look at a variety of surveys of firms they’re displaying remarkably high expectations both for wages and prices in the US and actually even in the UK.

  Some of you may have seen the BoE’s most recent numbers that came out today in the UK. And firms are looking for prices to rise at about 6% and wages to rise at about 5%. Neither of which are compatible with the inflation target here. And if you look at a variety of surveys in the US, the same is true.

  So, there's clear evidence of de-anchoring in terms of the expectations that firms have about prices and wages. And this is what worries me and worries the central bank. So, they have to see these expectations come down to feel confident. There's then a second issue, which is with COVID and lockdowns and such like, we've clearly created significant issues in the labor market, what economists like to call labor market mismatch, i.e. firms have a lot of job offers and we have unemployed people, but they don't match each other in terms of, the unemployed don't want to take those particular jobs so they don't have the skills, or they don't live in the right geography. So, there is what economists call a labor market mismatch, which appears to have increased measurably since March 2020.

  And obviously, you see that in the very high vacancies to unemployment rate we have in many countries. And there is this whole debate about how much the equilibrium unemployment rate has gone up. Clearly, if the equilibrium unemployment rate has gone up a lot, then the Fed has to work that much harder to get wage inflation to come down. Now, this is a live debate.

  We'll see how things materialize. I thought it was really interesting earlier this week that the number of job offers in the JOLTS report in the US came down markedly and that is certainly unambiguously good news. Let's see how that evolves. It's something we're going to have to watch, but there are a number of experts who think that the equilibrium unemployment rate actually moved up to 5% in the US, which means that you wouldn't get wage inflation to fall until actual unemployment goes above five.

  For actual unemployment to go above five, you may well have to generate a recession. Then another element in how much the central banks are going to have to tighten is the extent to which inflation is high now because of transient factors. Now, you know, we've seen a number of these factors begin to fade. Commodity prices in many cases peaked in May or June this year.

  We've seen used car prices come down everywhere. We've seen supply chain pressures to some extent abate. So, some of the transient elements are falling out. The problem is they're being replaced by broader-based price pressures in services. And that's the problem that many of the central banks face. Now, what does this all add up to? And the answer is, we truthfully don't quite know.

  There is a legitimate debate. The Fed thinks unemployment only needs to get a little above four. People like Larry Summers think that unemployment needs to go above six and stay there for a while. Now, to get to six, you would need quite a deep recession. There are people in between who think maybe it needs to get between five and six. So clearly, as always, we have to recognize what we don't know, and there is significant uncertainty. But what I would say is that, obviously, the terminal rate in the US is around the 4.5% level. It's been volatile: it got to 4.7%, 4.8% came down to 4.4%. But the markets are at around the 4.5% level. That seems to me to be absent some financial stability shock.

  That seems to me to be almost the minimum the Fed will do. So, it seems to me that a combination of most likely 75 at the next meeting and either 50 or 75 at the following meeting, and then maybe another 25, you get to this sort of level that would be approximately consistent with current market expectations.

  And the data is then going to determine whether the Fed keeps going or it decides to have a temporary pause at that point. I would emphasize that even if they do pause, that it's likely to be a temporary one, just to give them a chance to evaluate what's happening to the economy in terms of the data and just to make sure that they haven't done too much.

  So, it would be unusual for them to take a sort of three- or four-month break, look around and then decide whether they have to go again. And whether or not they have to go again will depend a lot on outcomes for core and headline inflation. Now clearly, if wage inflation remains resilient, then the pause I'm talking about may well easily get postponed because the Fed will work out that they actually need to go further, in which case they might get to 5-5.25% before they pause.

  I guess what I'm saying is that the risks to current market forecasts largely reside on the upside in terms of the extent to which the Fed is going to have to tighten, absent the financial stability shock. So, to the extent that I am arguing that the risks reside to the upside in terms of rates and in terms of how much unemployment needs to go up, I am, as a corollary, arguing that we will eventually, more likely than not, see a hard landing.

  So, you know, a hard landing is very, very likely in the Eurozone because of what's been happening to gas prices. It's incredibly likely in the UK because the UK has the worst of all problems. You've got the gas prices here. We've got wage growth too high. And then to top it all, we've got, you know, it's a degree of political uncertainty and a degree of fiscal policy uncertainty.

  So, the UK is definitely at the top of my list now in terms of recession risks. In the US, the recession risks are lower than they are in the UK and Eurozone, but you know, still well above 50% now, I would say. Now people tell me that, you know, household balance sheets are in good shape and you know, the recession in the US may not be so deep.

  I worry about that complacency and the reason I worry about that complacency is that ultimately wage inflation needs to come down. And for wage inflation to come down, you're going to need unemployment to go up quite a lot. And, you know, the fact that household balance sheets are in good shape, you know, don't alter the notion that unemployment is going to have to go up to bring wage inflation down.

  All that resilient household balance sheets do is they may imply that the Fed has to work even harder than normal in order to bring wage inflation down. So, I wouldn't necessarily get too relaxed about the notion that the recession would be mild. And in the UK I would actually be very, very worried if market expectations about interest rates turned out to be correct.

  I'm hoping, and actually indeed expecting, that these market expectations would be wrong. But if short term interest rates in the UK do get to just under 6%, which is what the strip is pricing this morning, then I think that'll be too much for the housing market to bear. I think the downturn you would then see in the housing market would be so pronounced as to give us quite a deep recession.

  Howard, have I gone on too long?

   

  Howard Nowell:

  No, no, that's fine. And it's actually quite an appropriate place to pause because we've had a clarification or question in respect to clarification. When you reference financial stability shocks, what kind of events are you thinking of?

   

  Sushil Wadhwani:

  So, it could be a variety of things. Obviously, we came close to a very big accident in the UK only a few days ago with the Bank of England having to intervene and stabilize the gilts market and postpone their quantitative tightening. Historically it's been also sorts. So, I guess you had Mexico blew up in 94 and that certainly changed the Fed's mind.

  And, you know, history is littered with these examples where what happens is, when you get one of these hiking cycles, is the central banks keep going in their desire to bring inflation down. But, you know, they're very conscious of these unknown unknowns which seem to pop up with alarming regularity, I must say. I mean, think about the central banks that were tightening in ‘07/’08 and how surprised they were then by what popped up.

  And the reality of our situation is that, you know, although it did get interrupted by COVID, we had a remarkably benign period where a lot of bubbles were inflated and we don't really know what financial stability risks may be lurking. And because they tend to pop up very suddenly, central banks then historically have had to pause. Yeah.

   

  Howard Nowell:

  And just on the inflation target, do you think it's a possibility that those targets could ever be redefined and if, let's say, if the US did that, it would that then be a trigger for Europe and the UK to do so as well?

   

  Sushil Wadhwani:

  So excellent question, Howard. There's clearly a debate going on among academics and policymakers in the US already. Obviously, current policymakers are staying entirely silent. But even at Jackson Hole, Jason Furman raised this notion that if the Fed gets underlying inflation back down to 3%, or looks like it's getting it back down to 3%, at some point, then is it worth the Fed generating quite a bit more unemployment to take core inflation down to 2%?

  Or should it declare victory at 3% and not create more unemployment? And Jason's argument is that the difference in terms of the welfare costs of inflation between 3% and 2%, in his opinion, are small. Obviously, there's a debate around that. I happen to disagree, but that's irrelevant for these purposes. There are lots of people who agree with Jason. You know, important people like Paul Krugman, [indecipherable] and so on.

  And so, one can easily see that becoming a live debate in the US, a much more live debate in the US next spring. And even if the Fed doesn't, sort of, accept the logic of that argument overtly, it might be tempted to go more slowly in terms of bringing core inflation down. The place where I have been most worried about this is the UK, although I think it may well be that the baptism of fire that Prime Minister and Chancellor had in the markets might now mean that they won't have the courage to go through with it.

  But I think, gossip has it, and I put it no higher than that, that they were very tempted by the notion that having announced a growth target of 2.5% real growth in GDP, that they should couple that by changing the Bank of England's marching orders and give them instead of an inflation target of 2%, a nominal GDP target of 4.5%.

  And the government would justify that by saying that real growth is going to be 2.5%, so we haven't changed the inflation target. But the bank, of course, thinks real growth is more likely to be 1.25%. And so, for the bank, the inflation target would have gone up from 2% to 3.25% and that would obviously have huge market impacts.

   

  Now, given the sort of febrile environment, I imagine, and certainly if I was advising the government, I'd be telling them to forget about this for a long time.

   

  Howard Nowell:

  I'd feel free to send through your questions and we'll get through as many of them as you can. And one broad question is in respect of what you think will happen to the dollar. And I think, you know, just to elaborate on that, is it US dollar strength or is it weakness elsewhere in the market?

   

  Sushil Wadhwani

  So excellent question. It's always a mixture, isn't it? So clearly, we've had us dollar strength coming from, in the first instance, the Fed tightening. Related to that, the dollar has always been a safe-haven play. With risk assets doing so poorly, people have been running to the US dollar. On the other hand, many of the countries against which it's been appreciating have had their problems.

  So, in the eurozone we've had the gas price issue, which has obviously weakened the euro meaningfully. In Japan, we've had the yield curve control policy, which has meant interest rate differentials have kept widening and the UK as always, has ensured that it's had multiple problems. It's had the gas price issue, it's had the political problems, the fears in the marketplace that the government doesn't have a credible plan to stabilize national debt.

  Now, obviously, I'm hoping that between them and the OBR they will achieve something before the end of October, which will look at least half credible. But hitherto they haven't presented any such plan. And that's obviously been highly problematic for Sterling. In terms of the outlook, if we take each of them in turn, it seems to me in Japan Kuroda-san shows no appetite to change policy in terms of [ICC?].

  I think it's highly likely his successor would change policy quite quickly, but that means we may have to wait till next May or June because he goes in April. In the UK, even if the UK government, you know, come up with some plan with the OBR, some mixture of cutting capital spending projects. So, I think HS2 is gone., Howard, if I'm running on too long...

  Howard Nowell:

  We've got four or five minutes left and we've got another couple of questions. So, if you could finish this point and then we'll move on to the question.

   

  Sushil Wadhwani:

  Okay. So, in the UK, all I was going to say is that even if they come up with a credible fiscal plan, I don't think the Bank of England will fulfill the market expectations on rates, and I think that in itself will put downward pressure on sterling. And I'll pause that. And I'm sorry I went on too long.

   

  Howard Nowell:

  No, no, no, that's fine.

   

  We’ve had a follow up question and you sort of touched on this a little bit. So, you might just want to elaborate a little bit. Often there’s a question around central banks actually quite like high inflation, it deflates debt or so we’re told. Is there truth in that discussion and that argument?

   

  Sushil Wadhwani:

  No, I mean, I really, really don't believe that. We never thought like that when I was with the Bank of England. And I see no signs of any of my colleagues thinking like that. I mean, my personal view is that high inflation in an economy where people don't have index-linked mortgages and index-linked corporate borrowing is actually very harmful in terms of growth and unemployment because of the cash flow effects of higher inflation and higher nominal interest rates.

  And you've also got to remember that at least in the UK, a lot of our debt is index-linked government debt. So, if central banks were supposedly colluding with the fiscal authorities doesn't do them, a lot of good here, because so much of the public debt is index linked and the private debt is it. And that's the problem, because it's the private sector that has huge problems with inflation.

   

  Howard Nowell:

  Yeah, I understand. So, given that a number of people on the call are either advising clients or running money themselves, given the backdrop that we're experiencing and your S&P number varying between as low as 3000 or as high as 5000. How would you think about investing in this chaotic landscape? And what are the things that people could take away from your thoughts in that space?

   

  Sushil Wadhwani:

  So, I think it depends on that time horizon. I think what you need in this environment is going to be agility. So, what you're going to need in this environment is agility and diversification. Agility and diversification. You always need diversification. And you can almost, in this sort of macro scenario, you probably need more diversification than normal. And you definitely need more agility than normal.

  I'm sorry, I didn't speak clearly. I mean, my best guess is that there's still more downside for risk assets. So, if you take those S&P numbers I threw out, I think you're much more likely in the next six months to have headed towards a 3000 level. You may have visited 4,000 first because you always get these bear market rallies.

  But I think over the next six months, the dominant move is going to be 2000 or 3000. And then maybe 18, 24 months from now, we can be thinking again of 5000. But probably 24 months from now. So, I think you're going to see both those numbers at some point in the next, I'm going to give myself 13 months rather than 24 months.

  You have to permit me that luxury. But to navigate that environment, I suspect that you need to be really agile and you need to respond to the data and you need to respond to central bank developments. We also don't know quite how deep this recession might turn out to be. And the key thing we don't know, by construction of the unknown unknown.

  So, if it turns out that the S&P gets to 3000, coupled with short term interest rates at 5.5% in the US, lead to a big financial accident, then the S&P may remain low for longer than I’m saying. Sorry.

   

  Howard Nowell:

  No, no, sorry. Carry on.

   

  Sushil Wadhwani:

  I was just going to say that I mean, this is very self-serving, but I obviously think agile strategies like systematic macro, discretionary macro, trend following are all good things to have in one's portfolio. But that's the end of my commercial spot.

   

  Howard Nowell:

  And that's what I think many of the people on this call are probably aware of your role in that and we can follow up with that with people separately. We’re on the formal close, I think we originally said 30 minutes, but I think you're happy to keep going for a little bit longer depending on other people's schedules.

  But for those people that do need to drop off exactly on time, we thank you very much for participating and we will send you a recording of this that you might want to pass on to your colleagues who were unable to join us. And if you're able to stay for a little bit longer, then please feel free to send through any more questions.

  We're probably going to have a little bit of focus on the UK for the next question, if that's okay with people. But feel free to send through other questions as well. So, I think in one of the conversations I heard you earlier on this week, might have been even in the public domain on the press, but I think you were referring to, I think the way you described it was, that the Bank of England taking action is a second-best solution. What you’d really like to see is some credibility behind a fiscal plan from the chancellor. Could you just elaborate on that a little bit?

   

  Sushil Wadhwani:

  Yeah. So, for the bank, it's critically important that they see a plan that plausibly stabilizes the national debt because the bank has, for now, temporarily suspended QT and they've been supporting the gilts market. Now I know the support supposedly runs out on the 14th of October, but the bank won't take financial stability risks. If they return, the bank would be back in some shape or form.

  It may not be the direct intervention we saw, it might be a loan scheme, but they will be around because they don't want financial instability. But for them to be able to continue doing that, they need some confidence that debt to GDP ratios on the horizon will be falling. And these have to be, they have to have plausible reasons for believing that and markets need plausible reasons for believing that.

  So, I think the UK Government's going to have to work very hard with the OBR. And remember, the OBR cares about their credibility. So, you know, I'm assuming in the next week or two the UK government agrees with the OBR that they're going to cut public spending in a variety of ways. And I thought capital spending would be high up that list because it's usually easier to say I'm suspending HS2 or something.

  There's a possibility, you know, at the moment we pay interest on reserves which were created through QE, bank reserves. It's quite possible that they renege on that and they stop paying banks those reserves. It's many, many billions of pounds a year and that will make some [indecipherable] more easily for them. Then there's obviously talk about what they might do to benefits, but that, I mean, you've seen the political risks associated with that within the Conservative Party.

  So that might not get through. But clearly there's going to be a combination of things that they're going to have to do to allow the OBR to sign off and then we'll have to await the market reaction. Assuming that they do enough to satisfy the Bank of England, it then allows the Bank of England to continue its financial stability operations in the gilts market, and it also gives them comfort when they make their monetary policy decisions.

  And it may well be that a greater burden is placed on the bank in terms of stabilizing matters. But for the bank to be able to credibly stabilize matters, you can't have a current situation where the bank is pressing on the brake and the Treasury is pressing on the accelerator.

   

  Howard Nowell:

  Yeah. Just pivoting slightly. And this is probably a broader European question and apologies if you perhaps don't feel that this is totally your area of expertise. But I'll ask it anyway. So, the question from the Q&A: Some experts suggest that energy will be the next free asset class replacing government bonds.

  Do you have a view on this?

   

  Sushil Wadhwani:

  Sorry, which asset class?

   

  Howard Nowell:

  Some experts suggest that energy will be the next free asset class replacing government bonds. Do you have a view?

   

  Sushil Wadhwani:

  I don't know enough about energy, so I'm going to pass.

   

  Howard Nowell:

  I thought that may be an unfair question. So, in summary, Sushil, we're probably just pushing up against the boundaries of time, are there any closing remarks that you'd like us to think about and to contemplate going forward?

   

  Sushil Wadhwani:

  I just think these are very, very difficult macro conditions over the next two or three years. And I strongly suspect that this is going to elicit significant political ructions. And significant problems in the stability of our financial system. So, there are, you know, I don't know what they're going to be, but it seems to me this is an environment where you're likely to see important unknown unknowns turn up. And our portfolios therefore have to be both defensive and diversified.

   

  Howard Nowell:

  Yeah. And just on that, if we were lucky enough and let's all hope that, you know, that we're all praying for this, if there is a swifter end to the conflict in the Ukraine, do you think that that would give the markets a, you know, a positive implication?

   

  Sushil Wadhwani:

  Oh, huge, huge. I mean, it would be transformative on many, many levels.

   

  Howard Nowell:

  So even globally.

   

  Sushil Wadhwani:

  Yes, yeah, yeah, yeah.

  Very much so. I mean, think about, you know, just simple things. I mean, if you think about global welfare, the impact on poor people of lower food prices would be immense. Absolutely immense.

   

  Howard Nowell:

  Yeah. Okay. Well, I think we're all praying and hoping for that to end as soon as possible. So, thank you very much for stepping into the chair at short notice. We know you’ve got a very busy week, but we thought it was a valuable use of your time. And clearly by the number of people that joined the call, everybody was very keen to hear your thoughts over the last 35, 40 minutes or so.

  So, we very much look forward to having the opportunity to expand upon the comments that Sushil made. Please feel free to contact your usual person that you work with at PGIM Wadhwani or the broader PGIM organization. Sushil will be back on stage, as it were, on November the eighth and he'll be one of the keynote speakers at the PGIM EMEA Investor Forum in London on November the eighth.

  And if you haven't yet signed for to that, we’d very much like you to consider joining us in a couple weeks’ time. So, thank you once again and enjoy the rest of your day.