[private] There is plenty of evidence of the general futility of trying to base investment strategy decisions on the basis of economic forecasts. Nothing better illustrates the problem than this simple chart, based on data originally produced by the Federal Reserve Bank of Philadelphia. It contrasts the consensus forecast of economists with changes in the real (inflation-adjusted) rate of GDP growth in the United States over the past 40 years.
What this clearly shows is that economists in aggregate have signally failed to foresee any of the big cyclical movements in GDP over the last four decades. Of course there will be individual economists who can and do come close to being right some of the time – the consensus by definition will be the mean of what is potentially a wide range of views – but there is absolutely no evidence that economists have any usable forecasting ability. Quite often, as in the late 1990s, they cannot even get the direction of the change in an economy right.
To paraphrase one of my favourite lines from the economist J.K.Galbraith, one reason that economists forecast is “not because they know, but because they are asked”. Forced to do so, and more concerned not to be wrong rather to be right, many simply extrapolate from the recent past. An excellent article by the economist Tim Harford in the FT last weekend explained why the failure of economists should come as no surprise. It is part of a broader phenomenon, namely that professional experts in most professions have poor forecasting ability.
A second and probably more important reason why economists cannot help investors much is that the markets predict what is going to happen to economies much better than economists have ever been able to do. If a correlation exists at all, it is that the market anticipates what the economy does subsequently, not the other way round. Not for nothing is the stock market itself an important component of the leading indicators that many official forecasters such as the Bank of England use.
That is not to say that the markets themselves are all that good at forecasting either. In retrospect they often display surprisingly good antennae for anticipating future changes, but the evidence at the time they move is far from clear-cut – and quite often the trends reverse themselves quite quickly, neutralising what seemed like an important prediction of change at the time. Hence the famous crack that the markets have forecast seven of the last three recessions.
A similar point was well made a few days ago by another member of the M&G bond team which I quoted last week. Analyst Michael Riddell points out that back in January the expectations of the markets, as measured by forward swap rates, was that there would be a whole series of interest rate rises between now and the middle of 2012. Now just five months later, the implicit assumption in swap rates is that there will be one interest rate rise at most between now and next summer.
This comprehensive change in expectations is not without its logic. It reflects, among other things, the clear evidence of a slowdown in the world economy, and the disclosure that the balance of opinion at the last meeting of the Monetary Policy Committee of the Bank of England, whose job is to set interest rates, remains decisively against immediate interest rate rises. As a result sentiment – which was overly rosy at the start of the year – has taken a turn for the worse in recent weeks. Risk aversion is rising. A colleague pointed out to me this week that a supremely wealthy client of one of the big investment banks has taken out a $50m put option on the S&P 500 index.
But does the change in market interest rate forecasts mean that this is what will happen? It is not logical to note the wrong-headedness of the expectations back in January and not to expect that the latest implied interest rate forecasts will also be wrong. What you tend to see is that those with strong views on where the markets are going jump to justify their stance on the basis of data that supports their view, and ignore that which does not. (This tendency is called confirmation bias by the behavioural finance experts).
The reality is that the factors driving economic activity – and by extension also those which influence markets – are much too complex and dynamic to be captured by simple forecasts. The range of outcomes, as Gus Sauter pointed out, can be very wide at times. What the investor needs, to use a phrase of John Maynard Keynes, is “a liquid mind”, a temperament and intellect that can live with the ever present reality of changing expectations. There are foundations on which investment decisions can sensibly be made – broadly speaking, valuation measures for the long term, technical analysis for the short term – but they cannot change the fundamental state of flux in which markets operate, more or less permanently.
The Eurozone crisis provides a powerful example of the way that markets can be swung from one extreme to another by unfolding events. The debate about how best to refinance Greek sovereign debt (and the issue is definitely how, not whether) is a highly politicised argument between multiple institutional participants whose outcome after weeks of negotiations still cannot be predicted with certainty. The outlines of the eventual solution are slowly emerging, but it is not yet a done deal. The longer it drags on, the more nervous the markets have become.
It will be a great surprise if a deal that avoids the necessity of an immediate Greek default is not patched up shortly. Whether it is the best solution for the longer term is another matter. There is no doubt that a Greek default today would be a traumatic event, chiefly because of the risk of the new banking and credit crisis that could follow. That risk, it appears, is one that few political leaders (not to mention the European Central Bank, whose own financial health would be immediately called into question) are willing to take. Postponing the evil day when banks and bondholders have to take their losses however – and nobody is under any illusion that Greece will eventually default on its debt – also carries hefty costs with it.
On a positive note, assuming that a deal is agreed by Europe’s squabbling political leaders in the near future, the short term impact on financial markets is likely to be positive. While the Eurozone crisis provides a useful narrative to explain why markets have been so weak in the last few weeks, it would be wrong to attribute the weakness of equities and other risk assets solely to that factor alone. The kind of correction we have seen since April is nothing out of the ordinary in terms of either the size or speed of the move and comes at a time of the year when markets are often relatively weak.
Just as importantly, given the clear evidence of slowing growth around the world, it can be explained just as readily by that factor as by the Eurozone drama. The latest Global Financial Stability Report from the IMF summarised these developments as well as anyone. It highlighted three reasons why financial risks have risen since the end of the first quarter.
“First, while a multi-speed global recovery remains the base case, downside risks to this baseline have increased. Second, concern about debt sustainability and support for adjustment efforts in Europe’s periphery is leading to market pressures and worries about potential contagion. Political risks are also raising questions about medium term fiscal adjustment in a few advanced countries, notably, the United States and Japan. Third, notwithstanding some recent pullback in risk appetite, the prolonged period of low interest rates may push investors into riskier assets in a “search for yield.” This trend has the potential to build financial imbalances for the future, particularly in some emerging markets.
Here are four of the charts that the IMF used to support its argument.
From a technical perspective, however, the equity markets appear to be oversold and the bond markets, after the sharp decline in yields, equally overbought. It would be very surprising, therefore, from a trading perspective, if there was not a rally in the former very soon. As yet there is no reason either to believe that the markets cannot rally further in the second half of the year, as Ken Fisher, among others, predicted at the start of the year. However, given that the bull market is now over two years old, and clearly vulnerable to further unexpected bad news, the need for vigilance remains. If the markets do break down over the next few weeks, whether prompted by a failure of the Eurozone, or some other cause, then the need for corrective action will become urgent. [/private]