Q & A With Erik Weisman
Do you expect rising inflation throughout 2023?
Weisman: History suggests it takes a while for inflation to come down when it gets high. Some recent research looked at every episode when inflation has gone above 8% in the developed and the developing world. On average, in that scenario, it takes a couple of years to get back anywhere close to normal. It doesn’t mean it can’t happen quicker, but it would be historical if inflation is back in the low threes or upper twos [percent] within the timeframe the market is pricing in. I think the market is overly optimistic on that.
What does that mean for bond yields?
Weisman: All else equal, you would think bond yields would be a little bit higher – but if you’re waiting to buy duration, be patient if your expectation is that the Fed will pivot and it’s all going to be good. You probably will want to make a shift, but it’s open to debate whether it will be quite as dramatic of a turning point as the market expects.
Are we headed for recession in 2023 – and how bad might it be?
Weisman: Viewed in totality, it’s hard to come away with a view that isn’t recessionary. It seems to be the most obvious recession we will ever forecast – which makes me worry we might be missing something. Some banks and asset managers are pushing narratives about a soft landing, but I’m not buying it. I don’t understand how anyone can believe we can avoid recession after the Fed raises rates 500 basis points in a little over 12 months, allows its balance sheet to roll off – and every other central bank in the developed world except Japan is doing something that rhymes. Every episode is different, and it’s not as if we’re running thousands of experiments every year, decade, or century. We can only look at history, which suggests if you tighten that much that quickly and everybody else is doing the same thing; and, you’re tightening along two metrics – the policy rate and your balance sheet – there’s nothing to latch onto to tell us that won’t result in a recession.
Are central banks between a rock and a hard place?
Weisman: How low can you go? Is zero a lower bound? Not if you’re the ECB, Sweden, Switzerland, or the Bank of Japan. And how large can your balance sheet be as a percent of GDP? If you’re Japan, apparently it has no limits. The Bank of Japan can own more than a 100% of the 10-year part of the curve because it can sell in the repo market. In that sense, there is no limit in terms of trying to loosen – and who would’ve ever thought it would be so soon we’d be worrying about the opposite for most other central banks? Is getting inflation back in the box as simple as tightening – and how much do you need to tighten? And how quickly and how long? Central banks didn’t ask those questions and now they are facing them.
Do you see the recent midterm elections having much of an impact on what happens economically in 2023?
Weisman: Not if you look at it from a purely fiscal, macro policy mix. We are seeing central banks outside the U.S. deal with whether there’s more or less fiscal stimulus. The UK is the poster child of “Let’s throw fiscal at this, we’re not going to fund it.” To which the market responds, “Fine, but we damned well better see the Bank of England raise rates to 5.5 or 6%. You can’t have it both ways.”
We’ve seen Australia and Canada come out with more contained fiscal forecasts for next year, not wanting to be on the wrong side of the bond vigilantes. With Republicans in control of one of the legislative houses, the likelihood we’ll see a lot of fiscal is de minimis. That way the Fed will only have to fight the inflation battle.
That said, we’re seeing some states essentially adding fiscal into the mix. Massachusetts exceeded a ceiling and they’re returning 14% of all state income tax. That’s not really what the Fed wants to see. Same with states cutting gas taxes – you don’t want fiscal to be stimulative right now, at least at the Federal level.
When you look more broadly around the world, what do you anticipate in a geopolitical context in 2023?
Weisman: I think overall we too quicky and easily become inured to geopolitical dysfunction. What is the risk there will be some kind of nuclear event? We wouldn’t have been talking about that 12 months ago, or five or 10 years ago. You would think that markets will react very poorly to that. Over the course of time, as we worry about what goes on in Ukraine, Russia, China, Taiwan, North Korea, Iran – and those are just the obvious flash points – doesn’t it dictate a higher risk premium? I think it will work its way through the system gradually, but we’ll see demand to be paid a little bit higher because the world is that much more uncertain. The post-Cold War dividend, which you can define in a bunch of ways, should reverse and make it harder for asset valuations to rise the way they have over the last 20 or 30 years.
Do you see greater opportunity in any sector compared to others?
Weisman: One obvious thing is that there’s not enough energy out there. We need the green kind, and we need the dirty kind to transition to the green kind. My sense is that returns on energy-oriented companies might be higher than many investors expect. To the extent that we’re still going to have democracies in much of the world, you cannot tell the electorate to spend 20% of their income on energy and not avail yourself of all available resources.
The U.S. has a many decades supply of coal. We won’t use it all, but we can export it to countries that will. We have plenty of natural gas and oil, too. In an ideal world we would shut down production of oil and natural gas, but we can’t. Any political party will be voted out of office if it tells the people, “We’re not going to use all the abundant resources we have. We want you to have high heating bills in the winter and high cooling bills in the summer. Don’t like that? Too bad, deal with it.” I don’t know if energy is underpriced per se, but it makes all the sense in the world that the energy market recently hit new highs.
What’s your view on emerging markets as we look ahead?
Weisman: A strong dollar, weak global economy, Fed raising rates – none of that spells success for emerging markets. Some have done fairly well, and those driven by commodities seem to be outperforming, which makes sense. We’re also waiting for China to get back online. If it does, that should certainly help commodity producers, although not those who are price takers.
A negative ramification of China coming back online is a spike in energy prices. That’s not good for central Europe and Southeast Asia, both home to emerging markets. It’s going to be good for those who produce energy-related commodities in emerging markets, as well as Canada, Norway, Australia, and New Zealand.
Broadly speaking, to get out in front of a recession, to get out in front of central banks that are not finished raising rates, it’s too early to be excited about emerging markets as an asset class.
What do you see as the best-case scenario for fixed income investors in 2023? And what do you see as the worst?
Weisman: The best is the Fed gets to where it thinks it needs to be relatively early in the year, and we wind up with a relatively soft landing and a mild recession because yields would come down a lot and spreads wouldn’t gap out to historically wide levels. In that scenario, you have a nice cushion in corporates. Yields will still come in, and in that case you probably would prefer to be in corporates than Treasuries.
In a bad recession, Treasuries will perform well, but spreads will probably widen a lot more. Corporates would not be the best place to be in that scenario, so allocation mix matters. The deeper and longer recession, the more challenging it’s going to be for high yield.
If you’re in the camp that thinks we’ll have a nasty recession, at some point the Fed will probably cut down towards the zero bound and the curve will enormously steepen. The front end of the curve and Treasuries are where you’ll want to be, but corporates are going to widen out and you would prefer to be in sovereigns. My guess is munis would widen out a lot, too.
Since we’re on the topic of recession, what do you anticipate in terms of the depth and the breadth should one come?
Weisman: A nasty recession is typically a balance sheet recession like the 2008–2009 global financial crisis, or there’s a lot of excess – a long business cycle, companies have too much inventory, too much labor, too much capital. And then there are skeletons in various closets, whether on the banking or corporate side. You never know about the skeletons until the closet door is opened. The UK opened one for us a few months ago, so maybe there are more skeletons than we think. In general, however, it doesn’t seem like we have the mass of excess normally required to trigger a really nasty recession.
But we could get a bad one anyway if the Fed gets it wrong. We’ll only know from hindsight if they have over-tightened. To crush inflation no matter what does seem to be the mindset at the moment. It’s very easy for the Fed and other central banks to say, “The labor market is too strong, inflation is too strong. We must continue to hike.” Yesterday’s Fed would stop at some point and say, “We know we’re going to get weakness in the economy and labor market, and the thing that lags the most is inflation. We know we’re going to get it.” Today, the central banks have jettisoned the notion of being anticipatory.
What will the Fed do if and when inflation is sticky – if inflation does come down, but not as quickly and as durably as they think? Then you’re shedding 100,000, 200,000, 300,000 jobs a month. That’s when we’ll know whether central bankers are reprising the ghost of Volcker or they choose to capitulate – and whether they’ll be right to do so. Until it happens, we just don’t know.
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Assessing 2023
Assessing all the variables to paint a potential picture of what might happen – and how investors should perhaps position themselves – is no easy thing. But it’s what the expert II spoke to for this report does every day, and it’s why investors listen to him.
This report is a sit-down with Erik Weisman, Chief Economist and Portfolio Manager, at MFS. Weisman is one of the most astute observers of the global economy in the investment world, and never at a loss for insights and the proper context.