abrdn's Jeremy Lawson: Markets haven't fully priced in recession risk

So are any of the market's fears about to be realised? Joining us to discuss all that is Jeremy Lawson – he is chief economist and head of the abrdn research institute – normally based in the UK but with us today here in Sydney. Jeremy, good to see you...

Jeremy Lawson: Good to see you. Thanks for having me.

Hans Lee: With all these kinds of profiles, I always like to start at the beginning, so let's do that. You're born in Adelaide, then studied at the University of Adelaide, go on to LSC, then conquer the bright lights of New York as well. How did your upbringing contribute to your love of what you do now, all this macro research and economics?

Jeremy Lawson: That's a good question. I came from a family that was very political, not in the sense that they were actively involved in politics, but politics was always a subject of conversation around the dinner table. 

For example, I remember very strong memories of the 1987 and 1990 federal elections, even though I wasn't an adult at that point and I had very strong views on what the election outcome should be. 

And then as I got older and my interest in public policy in particular increased, politics, but public policy, the idea that it was an instrument for making changes in society that would make people better off.

Then in the 1990s, it was very clear that economics was the language of public policy. So if you wanted to have an influence on those issues, then economic training would be the way to do it. And so that's the path that I chose to go down. Although, if you had told my 18-year-old self that the things that I'd managed to be involved in over the subsequent actually very long 28 years would materialise, I don't think I would've expected it.

Hans Lee: We'll touch on the public policy stuff a little later. Of course, we've just had a federal election in Australia. So there's plenty to chat about on that. 

You've got a long line of experiences, but I want to start with one of your early major roles at the Reserve Bank. Look, as we know, central banks all around the world are tightening and having to wind back monetary stimulus. From where you are, I mean, you've seen the inside of it, do you really think that the RBA will end up being kind of an outlier to its global peers, kind of at the back almost of this tightening cycle we're seeing?

Jeremy Lawson: No, I don't think so. I think there was a period of time when the RBA thought that it might be, but the labour market in Australia is very tight. There are clear underlying inflation pressures that are more than transitory. I don't think these are as severe as in the United States. Certainly, wage growth isn't as strong in Australia as it is in the U.S. and even the United Kingdom. 

But I think the RBA has gone on a journey that's quite similar to other central banks in that it recognises that it misdiagnosed the problem in some ways, or at least how persistent inflation pressures would be. They're in the process of catching up and will initiate or are initiating a tightening cycle, and it'll have to be a fairly rapid one.

Hans Lee: In that sense then, do you think that they can nail this? I mean, the Fed talks about this soft landing, soft-ish landing, can the RBA achieve an equivalent in Australia?

Jeremy Lawson: If the last two and a half years should teach us anything, it's humility in forecasting. 

If you'd said at the end of 2019, so what is the probability that there would be a pandemic, that, that pandemic would usher in the strongest core inflation globally that we've seen in 45 years, and that there would be a war in Ukraine. People might have assigned a very low probability to all of those outcomes and you accumulate that, it would've been thought of as a one in a thousand chance or maybe even less than that. I think there's quite a narrow window for achieving a soft landing. 

If you look, for example, in the United States at the history of soft landings, there aren't really any good examples where inflation has been as high as it is today. 

In our view, you need a substantial increase in unemployment in order to bring about target consistent inflation. And I don't think I see Australia as fundamentally different from that. 

If the United States and many other Western economies go into recession because of their tightening and given that China's very unlikely to have a very strong economic backdrop over the next one, two, three years, I think it'd be difficult for Australia to avoid the same fate, not impossible. 

What you really would need to see though, both domestically and internationally is a very strong recovery in the supply side of the global economy. That means you get a lot of disinflation without that slowing growth so that central banks ultimately don't have to adjust as much as we currently think they're likely to.

Hans Lee: One thing about the pandemic, we were talking earlier about the structural versus transitory factors of inflation, to what extent do you think has the risk of higher inflation, it's kind of now permeated into the system as a result of the pandemic. How much do you think of that is going to stick around?

Jeremy Lawson: It only sticks around if central banks ultimately allow it to stick around. It has certainly become... I mean, you can sort of see it in the way that people are negotiating wages in the back of their minds, whether it be unions or anyone else sort of bargaining over wages. They're thinking about their real incomes, how much do I need to adjust wages to compensate for the fact that inflation is very high? A firm that is setting its prices is absolutely thinking about how much their costs are rising, what do they need to do to maintain margins. 

That's the sense in which it's getting into the cracks of decision making, whether that is a short-term thing or a long-lived thing, ultimately does depend on whether central banks correct the problem.

There's this phrase in economics which is "the central bank moves last" and it decides. So if they do the right thing and don't allow the inflation to take hold over the medium term, then we'll settle I think back into the type of environment that we were in before the pandemic, which is that inflation was something as genuine that's going on in the background. It's not distorting day-to-day decisions. 

If on the other hand, they don't do what's necessary, then it would become very pervasive and every conversation in some way will be about how high inflation is, where might it go next, what do I need to do with how that's going to influence the way I set prices or bargain for wages.

Hans Lee: I'm kind of keen to hear about what has been the single most important moment do you think for you in your time in the markets and as a result, with asset allocation calls?

Jeremy Lawson: I think for me, it's actually more of a realisation, almost like a light bulb moment, is that the way that markets historically had often thought, particularly Western focused investors have thought about geopolitics was that it was sort of largely noise. It was something that went on in the background. It might cause temporary short term disruptions to market pricing, but if you kept your eye on the fundamentals of economic growth, earnings growth, and that was really going to be the thing that you needed to understand. 

Then from about 2013/2014 onwards, we really developed this strong view that the grains of politics globally were shifting, that the Washington consensus that had driven a lot of policy-making over the previous three was falling apart, that the support for things like globalisation, deregulation, product markets, labour markets, so that was ebbing away. And that this was going to have really important consequences not just for economies, but for markets.

So we made a decision to actually have a full-time political economist in the team and infuse our research with that type of geopolitical analysis so that we can much more rigorously think about political risk and the effect. Now, I was just having on markets in the short term, but on markets in the long term, and then what I then see is that over that last eight years, it's not just that that's become valued, but that the demand for that type of work externally, internally has grown very substantially as others have realised that, yes, this is just not something that's in the background, this is a fundamental driver of markets.

Hans Lee: Let's go to politics then. What do you take away from the federal election campaign we've just had? Obviously, it's the first change at the federal level we've had for nearly a decade. How big will this moment be in terms of the shift in economic policy?

Jeremy Lawson: I don't think there's going to be a radical shift in economic policy, in part because if you look at the Labor Party's election platform, it's not a transformative policy platform. Many people called it a small target strategy, and I think in many ways it was - it was a reaction to the experience of the 2019 election. So Labor doesn't have a mandate and hasn't put forward proposals for radical changes in economic policy. So it's likely to be more around the margin.

Of course, governments are always reacting to new events. For example, if we are right, and that actually there is a severe global downturn induced by policy within the next two years, then that's going to create substantial new challenges for the Labor government and the way that it manages the budget. The way that it focuses its spending authority, whether it starts to consider deeper structural reforms that are very necessary to drive productivity growth higher. 

But it'd be hard for the Labor Party to launch that today, given that it didn't go to the election with a real sort of things that need to change very drastically when it comes to economic policy.

Hans Lee: You talk about the risk of policy error, which could create this massive global downturn. A lot of people have said that China's wish to maintain COVID zero, and the need after that to stimulate those cities which have been hardest hit by a lockdown, that is potentially going to be a major policy error. We are already seeing the effect of that in supply chains, in prices, and you talked about a slowing China as well earlier in terms of GDP growth. In what way does a slowing China concern you?

Jeremy Lawson: Well, it's important to remember that China has already slowed down. It struggled last year in part because of the Delta wave and the zero COVID strategy then, but also because of past policy tightening and the regulatory crackdown on important sectors in the economy. It had looked like it was recovering before the Omicron wave, and then the Omicron wave again because of the Zero COVID strategy, admits to much more transmissible variant of the virus has meant that they've had to put in place some very severe lockdowns.

We have a Chinese activity indicator that shows that activity has fallen about as third as much in the last couple of months as it did during the harshest lockdowns in February 2020. So it's a very severe near-term shock. 

From here though, I think that there's actually scope for Chinese growth to improve. It's just not going to improve as much as it has in previous cycles. 

We're probably through the worst of the lockdowns, the most severe. You are seeing more policy stimulus being put in place, both on the monetary side and importantly on the fiscal side, particularly around social spending and social infrastructure.

Then assuming that they can increase the vaccine coverage in China to levels that allow them to relax the zero COVID strategy, particularly after the Party Congress towards the end of the year. What you might see, funnily enough, is it's almost like the United States and China being ships passing in the night. So just as the U.S. is decelerating very rapidly, Chinese growth might be picking up. 

As I said, that pickup, will not like the booms that we saw after the GFC or in a couple of episodes after, something more moderate. And whilst that's positive for Australia at the margin, again, higher demand when inflation is too high poses a challenge.

Hans Lee: So with that in mind then, how does that inform your team's asset allocation views? 

Jeremy Lawson: Our house view has been very cautious in recent months. So the focus has been on de-risking and diversification. As you can imagine, your standard asset allocation is almost always going to be risk facing in most environments because that's what tends to be rewarded and risk assets tend to generate returns a period of cash in most periods and certainly on a strategic set of outlook basis. But when you have a combination of interest rates rising, which affects valuations and the expectation that earnings are going to deteriorate as the economy softens, then clearly you're going to go through a period. 

We've been seeing that already. On a 12-month view, we remain very, very cautious. You're going to get bear market rallies arguably. That's one of the things that we've been seeing in markets in the last couple of weeks, but if you extend your horizon, I think things are going to get worse before they get better. 

So holding very small amounts of equity and credit risk. We are not leaning too heavily into duration. One of the debates in markets at the moment is whether it's now the time to be long bonds. I mean, it might be if they're pricing in the full extent of the Fed tightening cycle, although I think it's quite possible they're going to have to do more than is currently priced into markets.

And so that would have an adverse reaction. Then we've tended to hold long dollar positions because again, in these circumstances and where risk sentiment is relatively low, where U.S. policy is moving more aggressively than many other economies, these tend to be environments in which the dollar outperforms and certainly where that diversification is beneficial. 

So for us to really then turn back towards being risk facing, I think we would need to become much less concerned about recession risk or feel like that was priced into markets. It's not priced into markets today.

We think that if a recession comes, it's most likely to be in the second half of 2023, but you could make an argument for it being in the first half of ‘23 or in early 2024. How far ahead of that will markets get? 

Historically, a little bit ahead, but not radically ahead. 

So it's very unlikely that with the economy still expanding and consumer indicators actually still remain healthy in many Western economies, markets are going to be pricing in recession just on the basis of a forecast.

I think you would need to see a much more substantial global deterioration in economic activity before that becomes priced into the market.

Hans Lee: We started this conversation talking about life when you were born in Adelaide. So I thought we might finish by looking to the future. What is your biggest hope or perhaps the biggest piece of advice that you could give to this next generation of economists that are no doubt up and coming now?

Jeremy Lawson: I think the best piece of advice that I could give is to widen the lens. And what I mean by that is I think to be a good economist, whether it's a macroeconomist or otherwise, you need to be able to bring all sorts of knowledge bases to bear on your decision-making and your analysis. And I don't just mean within the field of economics. For me, in my undergraduate degree, I did a lot of history and I did a lot of politics and philosophy. 

Even today, a lot of my reading is in those areas. You try to make connections. You can't think of an economic system as some sort of narrow closed thing where the theory that you learn and the techniques you learn are sufficient to understand the world that you're a part of and the things that are influencing markets.

And so I think if you want to be a good economist, particularly given the nature of the challenges that we're facing often, which are sociopolitical, policy, you need that wider lens. And so I would encourage up-and-coming economists to make sure that they are incorporating in their training that wider lens on the world, a humanities education to supplement the rigour that goes with economics training.

Hans Lee: Yeah, there's that maxim that all politics is local. Maybe there's a new maxim that all economics is local.

Jeremy Lawson: It's political economy. The origins of our field were in political economy. It was never sort of divorced as a... You know, it was never a separate discipline. The professionalisation of economics has been very important, but sometimes it's been narrowing. 

And I think it's time to re-widen it, not to forget a lot of the great stuff that goes in economic theory and analysis, but to make sure that it's not thought of, it's not excluding those other areas of endeavour, which I think are complementary to a deeper understanding of the world that we live in.

Hans Lee: Good way to finish up with a nod to history. Jeremy Lawson, thank you very much.

Jeremy Lawson: Thank you.