Before the 1990s, the human condition was characterised by much more instability in the world, said Peston. Between 1992 and 2007, the world enjoyed relatively seamless growth and few political crises. There was an ongoing threat of terrorism, but in general, the world was a more stable, predictable place.
That period was an anomaly, argued Peston. In more recent years, the world has had to contend with the global financial crisis, Brexit, populism, the current rise of inflation, and the UK’s political instability, to name just a few challenges. Many of these events have taken economists, markets and leaders by surprise.
Take the UK’s revolving door of prime ministers in 2022. “I have lived through some extraordinary times, but I have never seen the kind of chaos we’ve had over the last few months,” said Peston. “I thought when 60 members of Boris Johnson’s government said they couldn’t bear to work for him any more, that would be the political soap opera event of my lifetime. But then we had Liz Truss! 44 extraordinary days in office followed.”
Short-lived prime minister Liz Truss and then-chancellor Kwasi Kwarteng tried to fix the fall in the UK’s growth rate with a debt-funded economic stimulus package. However, the move caused panic in the markets, ultimately forcing both to resign.
2022 was a period of very high inflation. It was caused by spending growth which considerably exceeded the supply of goods, services and labour, observed WTW’s global head of asset research, David Hoile. In 2022, many policymakers sought to control inflation by tightening monetary policy. “The speed and magnitude of the tightening of interest rates has been the most severe in the last 40 years,” he said.
Even before the Russia-Ukraine crisis, inflation was well above its two percent target. This was caused by a variety of factors: emerging from COVID, Brexit and its impact on availability of employees, and a growing pressure throughout the West to rely less on outsourcing to China, said Peston. Insourcing leads to cost pressures, which will persist until the West has built up a more reliable manufacturing infrastructure.
Inflation was heightened by the major commodity shock created by the Russia-Ukraine crisis, said Hoile. This also contributed to currency weakness in the euro and sterling, relative to the US dollar, which further added to inflationary pressures in Europe.
“European gas and global oil prices have already come down significantly, and we expect commodity-linked inflation and broader inflation to fall in 2023. But those price pressures may not fall as quickly as we or the central bank would like,” said Hoile. “The current energy supply situation in Europe is better than expected, due to both higher energy supply and weaker demand. For example, gas storage levels have held up well, with a high likelihood that gas storage tanks can be filled again for next winter. All else equal, gas prices over the summer would likely continue to fall below current prices. However, the combination of higher energy demand from China and Asia and the possible re-emergence of supply risks, could cause global and European energy prices to spike again, adding to sticky inflation and weak growth-related pressures in the UK.”
Indeed, if high and rising inflation and a sharp rise in interest rates were the story for 2022, 2023 is more likely to be characterised by weak economic growth, with inflation falling but possibly less quickly than expected, said Hoile.
For the US to sustainably reduce inflation, it will need to rebalance its overheated labour market in 2023. Hoile said: “If you have more employed people and a lot of job openings relative to available workers, that pushes up wage inflation. The jobs to workers gap is still very high and needs to fall a lot. How can policymakers achieve that? The Federal Reserve is already fighting that dynamic by pushing up interest rates rapidly. However, wage growth will still need to slow further.”
The UK also faces significant inflation-related challenges, such as the prospect of a sharp drop in house prices over the next couple of years. Rail workers, nurses, and other public sector employees are striking because of pay, with a lot of public sympathy. “This is unlikely to be a dispute where the government toughing it out will go very far,” warned Peston.
More broadly, the UK government could be limited in the interventions it can make to tackle inflation. The Conservative party is struggling with some ideological differences, from the UK’s relationship with the EU to how and when to impose controls on social media. It may struggle to take decisive action to curb inflation and address the myriad of other challenges it faces, such as the grievances of the public sector.
Despite the recent slowing of the UK economy, its labour market has been pretty robust, with unemployment at very low rates. From a labour market perspective, the UK has a similar dynamic to the US – a rebalancing is needed.
“Tracking labour markets is the best way to see if inflation will ultimately go back to normal levels,” said Hoile. “The normal dynamic is that higher wage inflation flows into higher spending on services, which benefits companies’ earnings and supports the incomes of employees, which supports spending, and round it goes in a circle.”
So, where do we go from here?
The Bank of England is forecasting a major recession in the UK in 2023, with other forecasters anticipating a shallower contraction. At WTW, considering many of the issues discussed above, we lean more towards the Bank of England’s pessimistic view, said Hoile.
We also think inflation will be slower and stickier to come down than the Bank of England anticipates. That means the Bank is going to have to keep interest rates in relatively restrictive territory. Looking at policy responses over the last 20 years, large monetary and fiscal easings to stimulate growth have been delivered by the Bank of England and government. Now, policymakers are much more constrained in what they can do to respond.
More positively, we could see a ‘peace dividend’ if the Russia-Ukraine crisis ends. In that scenario, we would expect a material increase in energy supplies back to Europe, and therefore, a material weakening of commodity-related inflationary pressures.
Another area of greater optimism is around China. China’s business cycle is completely divergent to developed economies, and we expect China’s economy to improve as it works through the easing of its zero COVID policies, stimulating improvements elsewhere in the world.
The fast-moving economy has changed the funding picture for many defined benefit (DB) pension schemes. That will bring challenges and opportunities.
Shelly Beard, WTW’s managing director of transactions says: “A number of schemes have been able to significantly accelerate their journey to buyout. Where it was five or six years away, they are now gearing up to do it next year. But there are challenges – they may be holding illiquid assets and they may not have their data in order.”
There is very attractive pricing on offer to schemes which are ready to transact, so 2023 may well be a busy year for buy-ins and buyouts.
DB schemes may have shed assets in the LDI crisis in the autumn of 2022. What should they bear in mind as they rebuild their investment portfolios? Dave Aleppo, WTW’s managing director of investments, advises: “Do not automatically buy back something that you had before. Think about how your scheme’s strategy and journey plan has changed. Use this as a stop-and-think moment. Don’t buy back carbon-intensive assets then manage down your exposure. This is an opportunity for a step change in carbon emissions.”
Both DB and defined contribution pension schemes may also be seeking ways to help people in the cost of living crisis. We’ll be publishing an article on this subject in early 2023.
“I cannot imagine a harder environment to be working in pay and reward,” said Peston. Companies must operate in a recession, whilst trying to attract and retain people in an extremely competitive jobs market, with a cost-of-living crisis fuelling people’s desire to maximise their salaries and benefits. All the while, significant numbers of people are choosing to leave the workforce, for reasons not fully understood.
In a cost-of-living crisis, people’s focus will be on salary and benefits more than ever. Companies must think carefully about what they can offer compared to their competitors and benchmark their packages regularly.
In addition, younger generations are motivated by purpose. Many see their work as an extension of their own beliefs. So, how can you help your people to see their work as meaningful, and connected to the bigger picture?
At WTW, we can work with you to ensure your company is in the strongest position possible to weather and thrive in these extraordinary times.
Company leaders, managers and employees will need to work as a united unit to thrive in these uncertain times. In this environment, a company’s people will be its strongest asset. Investing in those people will pay dividends.
