Luke Bartholomew 0:06
Hello, and welcome to Macro Bytes, the economics and politics podcast series from abrdn. My name is Luke Bartholomew, and today I'm joined by Stephanie Kelly, Deputy Head of our Research Institute, and of course, co-host of the podcast. And James, McCann, Deputy Chief Economist. And in this, the last podcast for 2021, we will be looking forward to 2022 thinking about the important economic and political issues that we think will be shaping investment and market returns. And as we sit here today, in early December, I at least am sort of struck by this sense that the year is in some ways ending in ways that are quite similar to those in which it started, not least with emergence of a new variant of the virus that as we sit here today, we have no strong evidence for how it's going to perform, and therefore weighing quite heavily on the economic outlook. So Steph, maybe a good place to start is if you want to give us your understanding of where things lie at the moment with regards to Omicron.
Stephanie Kelly 1:15
I think Omicron is a really good example of why two weeks is a very long time in economic forecasting, because of course, we had just done our economic forecasts a week past or so and then we got announcements around this new variant Omicron. The big concerns from an from an epidemiological and an economic perspective, are that the mutations on this new variant are quite wide ranging. They may affect infectiousness. It looks as though early data's suggests, it looks like it's highly transmissible, there are concerns that might affect the ability for vaccines to target it, particularly because of mutations on the spike protein, which mRNA vaccines target. And then the third is around the risk of severity. And this is really where, honestly, at this point, when we're recording, it's the seventh of December, there's a lot of uncertainty left for investors around whether this is going to turn out to be a milder version of previous variants, in which case that might somewhat offset against the higher level of infectiousness that seems likely. I think that's a bit of an open question. But it's very early. So the early data is somewhat encouraging. But I think as anonymous, we just need to bear in mind and as investors, we need to bear in mind that we need to wait at least a few weeks to start to see if hospitalizations and deaths really start to accelerate. And that will tell us something about the extent to which we need to be concerned as investors looking into 2022 and the outlook for the recovery. But for now, it's very up in the air.
Luke Bartholomew 2:45
So James, turning to that outlook for the recovery, I suppose one of the biggest surprises for us in forecasters, more generally, through 2021 was the big run up inflation that we saw, sort of very strong demand growth in some parts of the world, not least the US and very strong demand growth in some sectors of the economy, in particular, around goods, meeting various supply shortages and bottlenecks causing much more price pressure than we and others had expected. So looking to next year, I mean, how do we see the inflation outlook shaping up? And what impact is the Omicron variant have on that outlook?
James 3:25
Absolutely. I think it's right there. The nature of that shock through different COVID variants, has been quite different to what economists might have expected to our to our prayers. So when we think about a shock from a pandemic, we might initially lean particularly on the demand aspect and think this is something that will weaken demand and be disinflationary over over some horizon. And I think the interesting dynamic that we saw, particularly over delta, but maybe of earlier variances that are actually these outbreaks generate simultaneous demand and supply shocks. And though the balance of those can prove quite inflationry. And I think that's what we saw over the course of this year. And certainly when we look forward and think about - I think, Steph is absolutely correct, it's very, very early to judge this will depend on how this variant spreads or does not spread across countries and the extent to which it is or is not vaccine resistant. But if we were to consider potential implications from Omicron, then you know, absolutely when we might think that this would be a disruption to demand to activity, but equally, you might think it could affect supply chains even more through Port closures, through different impact across the transportation and logistics pipeline. It could affect the supply and other aspects too. So we know that many US workers have been discouraged to go back to the workforce based on public health concerns based on their concerns around contracting COVID. If there's a new very contagious variant spreading rapidly through the US, maybe they won't go back and that just leads to further labour market tensions further wage pressures emerging. And then your point about the relative balance of spending, we know a lot of spending has been been tilted towards goods because people can't go out and experience services in the same way does Omicron extend that imbalance and that puts further pressure on global goods and supply chains. So I think that certainly when we think about Omicron, it leads leads us to fear that the risks remain tilted to the upside, I suppose the The better news is that we think some of the short term drivers of inflation, now absent, that dynamic, should start to ease as he moves through 2022. So certainly, through the energy price spike that we've seen recently, we think that those base effects turn quite convincingly over over 2022 will be at different times, depending on regulatory structures around how those are transmitted into consumer prices. We are seeing signs of supply chains, and some of the stresses around supply chain starting to ease. So we think that that will continue. And they will start to moderate as we move through next year as well, again, omicron given so we think there's some natural easing and inflation coming, but really, I think what this pandemic has taught us is we need to be open to the the dynamic by which shocks to the outlook and not just dampen demand, they can also dampen supply, and that can that can cause those inflationary pressures to persist for a little longer.
Luke Bartholomew 6:24
So one of the implications of the higher than we expected inflation has been the policy tightening on the monetary side has been brought forward, I think a little bit more than we were expecting. And I guess the nature of this shock, as you described it there James, sometimes referred to in central banking parlance is a trade off inducing shock in the sense that it sort of makes growth worse, but also makes inflation worse at the same time, and therefore sort of the objectives of central banks might be pushing in different directions, and it becomes quite a difficult environment to set policy for. So given that backdrop, how do you see monetary policy in the US shaping up next year?
James 7:04
Absolutely. I think that's what the Fed is staring at at the moment. So worse trade off between between growth and inflation, I think that's coming through quite clearly in their communication at the moment that as they see that trade off, they feel that the policy needs to be adjusted a little earlier and a little more, more aggressively, too. So when we track the Fed and think about how they're how they're currently signalling, I think it's pretty likely that we'll see an acceleration in their tapering programme in December. I mean, it's pretty extraordinary in some ways, just as November FOMC meeting we had chair Powell coming out and saying, This is the pace that we'll go at, and will only be shifted based on material and material shockers, eventually. And just a few weeks later, he has himself and his vice chair at their boat signalling that they will be discussing the pace of tapering, which I think is a clear signal that they are onboard with it with an acceleration in that pace. So that opens up for a completion in asset purchases, notably earlier than the June July that had been implied by the previous path, perhaps around April for an end date, we'll have to wait and see exactly what is announced. But clearly that gives the Fed room to tighten policy earlier given that they're concerned that they've had a lot of inflation, and they have an average inflation targets, they need to be mindful of that. And that some of the drivers inflation that we've spoken about, particularly through the labour market channel. might not dissipate entirely without some intervention. So we've, based on the earlier tapering schedule, based on some of those more, more difficult signals that the economy's giving around the growth inflation trade off now think that they'll start tightening earlier, we've pencilled in a June rate hike for the first we think that starts a quarterly process of, of tightening, so you get three adjustments next year and four in 2023. So that takes the Fed funds rate to a peak of just just over 1.75%. Obviously, they they target a range now. So 1.75 to 2%, which still relatively low terminal Fed funds rate from a historic perspective, but represents a fairly sizable adjustment in policy settings over the two years or so.
Luke Bartholomew 9:13
Now, we spend a lot of time round here and in markets more generally talking about monetary policy. But it seems to me that maybe fiscal policy was where a lot of the action was in 2021, we had the huge $1.9 trillion stimulus package passed in the US at the start of the year. And then ongoing conversation through the year in terms of how the buy administration might go about passing its various infrastructure bills. So Steph, maybe you can give us a sense of sort of how fiscal policy looks in the US for next year and what we're expecting from that.
Stephanie Kelly 9:47
Yeah, for sure. I mean, honestly, even now, on the seventh of December, there are a number of uncertainties and factors related to in the very broad fiscal policy question So incorporating issues like extension of the debt ceiling limit, for example, that Congress is still grappling with now. And you know, Christmas is coming soon. So I think where we landed, as you mentioned, we had that early stimulus, we've since had the bipartisan bill; infrastructure bill, which gives about 550 billion in new infrastructure spending. So that was an achievement for Biden, particularly because he's kind of sold himself as this unity president who can unite the parties. I think for what it's worth, that's about all the Unity you're going to get from from the two parties. When it comes to further fiscal, it's going to be the Democrats going alone. And as we've talked about in this podcast, we continue to see deep divisions in the Democratic Party, which is what's delaying the next the build back better bill. So the Biden sponsored, very kind of green spending and social care spending focus bill, which, depending on estimates, you look at comes in somewhere between 1.7 5 trillion and potentially something up to 2.4. Depends on how you quantify it as the accounting method you use. That's still very much up for debate. It's gone through the house. So now it's sitting with the Senate, it's always really confusing to keep track of the US fiscal, and politics and process. But where it is now is with the Senate. And it's facing downward pressure from Joe Manchin, who we've talked about a lot in this podcast, he's very concerned about too much spending. He's called for strategic pause. He's concerned about inflation. So you see more of a politicisation of inflation, which may mean that this bill gets pushed into 2022. Now, the midterms are in 2022. And that's what makes this all so crucial. Because if the Democrats can't get around the bill back better bill in some form, before the midterms, it's done, it won't happen after that, if the Democrats lose the majority in either the House or the Senate, it's widely expected that they will lose probably the house and maybe even the Senate, in which case, President Biden's agenda will be really, really limited. So it really is about the next kind of six to eight months are absolutely crucial for getting those reforms through before you basically have two years worth of what is likely to be a fairly lame duck, domestic policy presidency and a lot more focus on foreign policy.
Luke Bartholomew 12:16
So Jamie is bringing all of that together the uncertainty around the new variant uncertainty around different fiscal policy outlooks, what the election might mean, how are we seeing sort of the growth outlook for the US next year?
James 12:29
Absolutely. Well, I think there are a few headwinds, I think that's becoming clear, we know that, that monetary policy, as we've discussed, is tightening. We know that short term inflation in itself is a headwind that's eating into consumer incomes, even though they're growing relatively robustly in nominal terms, in real terms. In many cases, they're they're negative in the short term, at least. And you know, as Stephanie said, some some of the bigger expectations around fiscal policy have been have been disappointed, the size of that bill has come down from a 3.5 trillion draft, even if that always looked unrealistic. And the pressure seems to be to pretty much try and finance that entirely. You know, there might be some budget coming gimmicks in there, which means that it's not actually genuinely finance. But in terms of net spending, it looks like there'll be relatively little net spending in that. And so that means given the boost from this year, fiscal stimulus is fading, that the fiscal impulses is turning too, so even though the US is going through quite a nice short term reacceleration as it gets over itself to drag, we probably don't expect that reacceleration to last particularly long as we go into 2022. We think growth will will moderate and potentially there are some further downside risks from Omicron. That's not to say that we think the recovery is drawing to a close or is overall the end of the cycle is particularly near, I don't think we'd be giving those risks are recession probability. Modelling framework does not tell us that there are a lot of late cycle signals coming but but certainly there is evidence that you'll get slightly more advanced than you'd expect in your business cycles. I think it's natural that we'd be expecting US growth to slow from the really strong recovery rates we've had this year to something approaching sort of the new normal, or the post, the lower potential growth rate that the US economy has shown over now, a number of years. So a mixed picture, one in which I guess this recovery is is continuing, but one in which this recovery is moving down, down the gears and we're really getting out of that strong growth phase into more of a consolidation phase.
Luke Bartholomew 14:35
So turning away from the US I said at the start there that it seems to me that there are a number of ways in which this year is ending in ways that are somewhat similar to how it started. And perhaps another parallel is that we're having a new government and a very important economy. It was the US this time Germany in which the fiscal policy outlook might it'd be changing significantly or indeed, might not. So maybe Steph, do you want to tell us a little bit about what the German, new German government means for the outlook for next year, both Germany itself and more widely for the Eurozone?
Stephanie Kelly 15:12
Yeah, absolutely. I think to a degree, I'll caveat it with a three party coalition is always really tricky to try and govern. So I'm interested to see how they balance very different objectives. The three parties now in government in Germany are not obvious bedfellows, I would say, we've got the centre left SPD, we've got the liberal, kind of very market focused FTP. And we've got the Green Party, who, as the name suggests, are very focused on green spending and green infrastructure. And those aren't three easily reconciled parties, but they have managed to put together a coalition for government, we have some initial signals around the approach that's likely to be taken, it looks like the death rate will be extended, at least for this year, and then reinstated thereafter, it looks as though they'll use that as an opportunity to get some green spending in early, I expect, they'll also be a lot of focus on things like infrastructure, digitalization, those kinds of issues. And then outside of the pure fiscal space ,in Germany, we're also seeing, I think, a really interesting test coming off, which is around the policy that Germany takes and encourages in Europe, towards Russia. Because there we know that there's some tensions around Western Russian relations at the moment, as it pertains to intelligence reports that Russia might be, might have plans to have an incursion in Ukraine, which has been kind of debated quite heavily in the news in the last kind of week or so. So I think that's a really interesting task for the new coalition, and obviously important for investors for all kinds of reasons. But the reason why I say it's a test is because the Green Party hold the foreign policy ministry in this new government. And they are quite hawkish, when it comes to Russia and, and China, they want to align with the US and their foreign policy approach. And they have, you know, in their own individual approach, being relatively keen to have, you know, I sort of an arm's length relationship in Russia. Now, that's not translated into the actual coalition agreement that we got. So there was no mention of Nord Stream two in the coalition agreement that we found, when we we saw the new government in place, which I think is really interesting, it suggests that there's a bit of uncertainty in that coalition around how they'll move forward. So I think that's an important test that might happen early in the new year, depending on how things play out in the next couple of weeks. So it's really it's a really interesting time. But as I said, a lot of it is going to be determined analogue from be hammered out through just really difficult political process between the three parties trying to get an edge over one another. And, you know, this is why it's hard to rule in the three, it's hard to rule the two party coalition, let alone let alone a three party coalition.
Luke Bartholomew 17:57
And finally, one way in which 2022 might be different is that 2021, at least by European standards, didn't seem to be a year of particularly high political risk. Of course, we had the German election, as you described there. And of all the difficulties of forming a free Park coalition, there was never really a sense of profound political risks around that. Whereas of course, next year, we have the French presidential election where perhaps there are slightly more existential issues at stake, at least with regards to European Union policy. And then there's the question as ever, there seems to be of the UK, its relationship with the EU, and whether Article 16 is going to be triggered. So perhaps Steph, you could finish us off with thinking about where the risks might lie for European politics next year?
Stephanie Kelly 18:51
So I think it's a really good question. I think we can separate it out into important policy decisions that get made and risk events for investors to keep an eye on. In terms of the important policy decisions, obviously, we're going to be watching really closely, the EU fiscal negotiations. EU leaders are going to renegotiate EU fiscal rules, insofar as they can. We know in Europe, it can be very difficult to renegotiate these rules. But they're an important one to watch just from a signalling mechanism around the extent to which our expectation is that fiscal policy is kind of permanently a bit looser, long term. It kind of globally, particularly in developed markets as a result of the COVID crisis. The question is how European rules translate this and how exactly that works. So that's a really important one to watch from a process perspective. I think in terms of risk events, gosh, it feels a little bit like 2017, but I'm saying this, but we've got a French election, which clearly in 2017 caused a huge amount of concern for investors because of the success of the far right candidate and Le Pen getting through to the second round of the presidential elections and it looks like we're set off for potentially that happening again. So there are four Key candidates to watch. There's the centre left President McCargo people are pretty well aware of there's a centre right candidate, we've just gotten confirmation that it's the centre right candidate for La Republicains is a candidate called Pecresse and she's not well known outside of France, but has she's held fairly senior posts in the past. She's pretty moderate. I think she's similar to my Macron, but you can tell that the centre right party is being pulled a bit to the far right when it comes to issues of immigration. And this brings us to the second, the third and the fourth candidate. So we've got Macron, the centre left kind of running his presidential reelection. We've got Pecresse on the centre, right. And then we've got Le Pen. As I mentioned, she's running again. And we've got this new candidate, who's called Zemmour. And the idea with these candidates is their sort of direct competition, Le Pen and Zemmour, are running on similar, slightly different, but similar kind of candidacies the far right. Now, my expectation is that, again, we'll have to see Pecresse just got certified as the candidate for the centre right party. So we'll see how that her polling evolves, it had been at like 10, or 11%. But I expect that that will change now that she's formally the candidate, I think it's very conceivable, you end up with my call versus one of the far right candidates in the second round again, but investors need to bear in mind that unless they're polling really far ahead, in the first round, the chances of the far right candidate picking up enough votes in the second round are very low. And that's just reflective of the process. So I think it's an important election to watch, but structurally, the advantages towards more centre parties, which for investors is always a good thing, because it tends to imply less extreme outcomes. And then finally, on Brexit, unfortunately, again, it does feel a bit like 2017, we're waiting to find out if the UK will trigger Article 16. Because of the Northern Ireland protocol, they're not happy with the state of play as it is they want to make significant changes. Negotiations are ongoing right now. And we'll watch those very carefully. It's a real push pull one week, you get very positive headlines, and signs of constructive debate and discussion. And other weeks, you know, you get threats from the UK side saying that they're going to trigger Article 16, that in and of itself, would create a month, there's a month kind of notice before the UK would start to put in any changes. So that would potentially create a very focus period for investors around what might happen with Northern Ireland protocol. More importantly, the question becomes, what is the risk that the Northern Ireland protocol falling apart, triggers a wider disruption to the EU UK trade deal. And again, that's where there would be a 12 month notice period, if either side was to choose to pull out of that trade deal, you'd have a 12 month period, which would create again, what we've had in the past very intense negotiation period. So nothing is kind of done and dusted within, you know, you can just get an announcement and that's the end of it. But it could create a lot of uncertainty for investors in the coming year. And I think it's an important one as well to watch.
Luke Bartholomew 22:59
I think that's a brilliant note on which to end. So thank you, James. Thank you, Steph, for your excellent insights. Now, as I said at the start there, this is our last podcast of 2021. We will be back in early January. So please do look out for us then. In the meantime, please do like review and subscribe on your favourite podcast platform. And the meantime, I hope you have a very happy new year and we look forward to speaking to you soon. Thanks again for listening.
Unknown Speaker 23:36
This podcast is provided for general information only and assumes a certain level of knowledge of financial markets. It is provided for informational purposes only and should not be considered as an offer, investment, recommendation or solicitation to deal in any of the investments or products mentioned herein and does not to constitute investment research. The views in this podcast are those of the contributors at the time of publication and do not necessarily reflect those of abrdn. The companies discussed in this podcast have been selected for illustrative purposes only, or to demonstrate our investment management style and not as an investment recommendation or indication of their future performance. The value of investments and the income from them can go down as well as up and investors may get back less than the amount invested. Past performance is not a guide to future returns, return projections or estimates and provide no guarantee of future results.
Transcribed by https://otter.ai