Forecasting folly

Photo Credit: BBC

The columns ‘Darkest before the dawn?’ (21 April 2023) and ‘Tilting towards the storm’ (12 May 2023) suggest discounts are attractive and market sentiment is poor relative to outlook – this not being helped by erroneous yet influential economic forecasts from various financial institutions. In part because the reality is different and because much uncertainty has been baked into market prices, our portfolios have been gradually pivoting towards equities in recent months and away from a more defensive positioning – a positioning which has compensated somewhat for discounts having widened significantly during the last couple of years.

Given poor market sentiment and the fact humility is an essential component of good portfolio management, it is worth re-examining the case for equities at this juncture – particularly so given we are approaching the moment of peak interest rates. In doing so, investors are encouraged to focus on company fundamentals rather than economic or market forecasts – given the former is real and the latter are invariably wrong.

Astrology and forecasting

Regular readers will know of my dislike of forecasting. JK Galbrailth, the renowned Canadian American economist, once said: “The only function of economic forecasting is to make astrology look respectable.” Although well known, this prescient insight is usually ignored and undue importance is attributed to forecasts by various economic, financial and government organisations – even though a cursory glance at their track records usually leaves little doubt as to their worth. Yet, largely because of the ‘importance’ of those making and quoting these forecasts, this folly is accepted, quoted by media outlets, and therefore often casts a long shadow – as is presently the case with the markets.

The lesson of the last year or so should be sobering. The International Monetary Fund (IMF) led the way last year on behalf of the majority of its peer group in forecasting economic recession. As recently as the spring, their strategists were more bearish than since the financial crisis of 2008/9. Yet now the organisation has turned on a sixpence and raised its global growth forecast to 3% for next year. Talk of recession has vanished into thin year as though it never happened. Indeed, 25 of the IMF’s last 28 UK growth forecasts have been too low – until only recently it was forecasting the UK would be one of the few European countries to go into recession, and yet how events have transpired.

This folly is also evident at home. The Office for Budgetary Responsibility (OBR) is not having a good time. It has had to significantly reduce its forecast for public sector net borrowing on a number of occasions – recently, net borrowing turned out to be a huge £100bn below the OBR’s forecast as recently as in the spring of 2021. Meanwhile, inflation forecasts have been wide of the market, with recent year-end forecasts of 2.9%, especially as inflation is set to remain ‘stickier’ and more volatile for reasons covered in previous columns. Little wonder a recent annual assessment of 30 economic forecasts compiled by David Smith of The Sunday Times showed the OBR came third from bottom.

This brings us onto the woeful record of the Bank of England (BoE). In the autumn of last year, it predicted a harsh and protracted recession with a 3% fall in GDP. Meanwhile, it’s record on inflation is no better, having been long behind the curve. The defence that they cannot be expected to account for external shocks simply does not wash given the period before Russia’s invasion of Ukraine, the biggest ‘shock’ of all, saw inflation rising steeply and reaching 6.1% the month before – and yet interest rates were still at 0.5%, woefully below what was needed to achieve its objective of 2% inflation. A fundamental review has since been announced by the BoE.

The large institutions are not alone. In the summer of last year, CEOs of large international investment houses joined the chorus in predicting an ‘economic hurricane’, recession, and worse. And this folly continues. News that the UK has joined the CPTPP, which will eliminate tariffs with some of the world’s fastest-growing economies, drew yawns and predictions of only minimal benefit – but how can forecasters factor in the huge potential? Better not to make predictions at all. Instead, the lesson is to focus on company fundamentals relative to sentiment, and not the myriad of forecasts which shift with the sand, while recognising the occasional significant changes in the investment landscape – as covered in previous columns.

The reality is dawning

And whisper it gently amidst the noise, but reality is yet again proving the consensus forecasts wrong. Economies have not slipped into recession. Budget deficits and finances generally are better than expected. Company results have not plunged into the abyss. Corporate finances are in good shape and defaults remain low. Bond yields have not risen as far as confidently predicted. And stock markets have rallied and made steady progress. While inflation is high, and will remain stickier than hitherto, it will fall further in the short-term as one-off variables fall away. We may indeed soon be approaching the moment interest rates are higher than inflation. This is the economic reality.

And the market is certainly sensing it. It is climbing the wall of worry. Corporate earnings have been resilient because companies saw the problems ahead and tightened their belts by reducing their costs and borrowing. This protected margins and profits – as in part evidenced by the spread between corporate and government bond yields widening only fractionally. Little wonder the US market has been pleasantly surprised by strong earnings which have been helped by robust sales and lower energy prices. Concerns about the ‘narrowness’ of the market’s rise – being led by the big tech companies – should perhaps take comfort from the 2019-21 rally which saw it broaden out once it was evident the economy was improving.

And economies are moving along. In large part, the litmus test as to how well an economy is doing is the unemployment rate – the level being especially important given unemployment is a social evil. Levels both in the UK and US compare favourably – with UK employment being at a record high – and globally they are not out of kilter. Meanwhile, ironically, the forecasting folly has conditioned markets to bad news. And with money supply growth now negative and budget deficits retreating, the impact of higher interest rates (as evidenced by lead indicators such as the housing market faltering) suggest the peak is near – which will likely be a catalyst for markets.

In short, there will always be risks in investment. But now is a good time to be investing, as it becomes increasingly evident the risks are falling away. Do not wait for the forecasters to suggest it is, because by then it will probably be too late – and perhaps even time to sell. As ever, it will always be prudent to retain some firepower via more defensive assets given volatility will be the usual travelling companion on such a journey. However, while timing is important, it is usually better to be a little too early than too late – markets can move rapidly, when sentiment shifts.

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