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Economic outlook with Jim Solloway

Jim Solloway, Chief Market Strategist and Senior Portfolio Manager for the IMU Advice Group, presents our economic outlook for the coming months.

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- Hi, I'm Kathy Oldfield, client portfolio Manager at SEI. Today I'm here with Chief Market Strategist and Senior Portfolio Manager Jim Solloway who will be presenting our economic outlook for the coming months. Jim, I think it's fair to call high inflation a global phenomenon but it seems to be affecting countries differently. Can you explain the factors driving this uneven landscape?

- Thanks Kathy. Let's start with a look at energy prices and employment costs. Europe will continue to be most at risk of an energy crisis owing to Russia's suspension of natural gas exports. Governments may be forced to impose restrictions on businesses and consumers to comply with energy saving measures. Heavy users of electricity from aluminum smelters to glass makers have already been shutting down but the landscape is uneven within Europe itself. Italy and the United Kingdom have endured the sharpest gains in consumer electricity costs over the past year. Canada and France by contrast have seen relatively mild increases. Canada has been held by its position as a fossil fuel rich country, while France gets the bulk of its electricity from nuclear plants and tends to be a net electricity exporter. Canada and France appear to be in the best position to weather the energy storm as winter approaches. A look at energy subsidies paints a vivid picture. The United Kingdom's new Prime Minister Liz Trust has rolled out a plan to temporarily cap residential electricity costs at $2,500 pounds per year. Along with other measures previously announced the cost now totals $180 billion pounds or six and a half percent of GDP. Other countries that have allocated funds for energy related relief in excess of 3% of GDP include Croatia, Greece, Italy, and Latvia. It would not be surprising to see more energy related fiscal relief come down the pike. Deficits could balloon in much the same way as they did during the early months of the Covid crisis.

- What about employment cost? Your latest outlook describes sort of a double edged sword where compensation is increasing at the same time that productivity has declined.

- That's right. The rise in US hourly compensation has been extensive with annualized gains exceeding 6% even when measured conservatively over a three year span. It's the sharpest increase in almost four decades. Similar to the 1970s, compensation gains have been accelerating even as productivity growth has slowed. In more recent cycles these measures have tended to rise and fall together. The recent divergence is concerning. The difference between the change in compensation and the change in productivity equals the change in unit labor costs, which we view as a key component of underlying inflationary pressures. You'll see where I'm headed with this. When we compare the change in US non-farm unit labor costs against the core personal consumption expenditures inflation rate, or core PCE, the Federal Reserve's primary inflation measure. Although unit labor costs are more volatile than inflation there is still a strong positive correlation. Unfortunately, history shows that it usually takes an outright recession to tame inflation especially when it gets this intense. Fed Chairman Powell's hope for a soft landing appears to be an exercise in wishful thinking. Unit labor costs have run far ahead of core PCE and we see no reason to expect a major reversal in the near term, even if the economy stumbles into a bonafide recession.

- How do you expect this to play out in the context of Fed action? Has the relationship between rate setting policy and inflation changed?

- We suspect that the Fed's projections of a 4.4% to 4.9% federal funds range next year may turn out to be low. The funds rate historically has traded above the core inflation rate. This relationship was turned upside down during the decade following the global financial crisis. But we believe that the post covid period has ushered in a new regime where labor and product markets remain tight and inflation stays stubbornly above target. Unless the Fed is truly ready to engineer a severe recession, we think inflation could settle in a 3% to 4% range instead of the sub 2% pace recorded over much of the past 25 years.

- Thanks Jim. We always appreciate your insights. Read our latest economic outlook for more of SEI's insights.

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This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events or a guarantee of future results. Positioning and holdings are subject to change. All information as of the date indicated. There are risks involved with investing, including possible loss of principal. This information should not be relied upon by the reader as research or investment advice, (unless you have otherwise separately entered into a written agreement with SEI for the provision of investment advice) nor should it be construed as a recommendation to purchase or sell a security. The reader should consult with their financial professional for more information.

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