The financial pages are filled with predictions for the month/quarter/year ahead – what can we expect from the economy, which of the major assets are expected to make the biggest returns, where are the greatest opportunities etc.
But these predictions, often formulated on past data and experience, can be derailed by various shocks and events, forging a very different path to that predicted.
2017 could be described as a “Goldilocks” year – a combination of healthy global growth, subdued inflation and cautious central bank policy were the ideal cocktail for a drama-light economic year. The consensus view is for this to continue, underpinned by both US fiscal stimulus and the benefits of a weak US dollar for emerging markets.
Over the next few years, however, we expect growth to moderate as economies encounter capacity constraints; central banks tighten monetary policy; the US fiscal boost fades; and China continues to rebalance its economy towards a lower, more sustainable path. With high levels of employment and spare capacity dwindling, inflation is expected to rise, as are interest rates, albeit at a cautious pace. Also generally accepted as we head into 2019, is that global asset purchase programmes, or overall quantitative easing (QE), will have reversed into gradual quantitative tightening (QT).
It is against this landscape on which most investment managers will base their strategies in allocating capital to (investing in) the various assets available to them.
But the path outlined is not guaranteed.
In an uncertain world, forecasting errors are inevitable. Predictions can be knocked off course by events that are familiar but that cannot necessarily be anticipated, such as changes in the weather impacting harvests, political surprises or the Organization of the Petroleum Exporting Countries (OPEC) altering the supply, and thus price, of oil. Projections can go awry due to technical errors, while forecasting models exclude variables that actually turn out to have a strong influence on economic behaviour.
Like weather forecasters, ever increasing amounts of data are expected to improve prediction accuracy as mistakes are made and lessons learned.
Other sources of forecast error are more challenging – the unknown unknowns are more difficult to assimilate. They include Nassim Nicholas Taleb’s ‘black swan’ events – events that occur without warning – and structural breaks in relationships previously viewed as constants, such as the relationship between unemployment and wage inflation currently, where wages are not rising despite full employment levels. Nassim is a Lebanese-American statistician, former trader and risk analyst whose work focuses on problems of randomness, probability and uncertainty. He criticised the risk management methods used by the finance industry and warned about financial crises, advocating a society that can withstand ‘difficult to predict’ events.
In the aftermath of the global financial crisis, economists improved efforts on focussing on the risks around well-anchored and articulated consensus views. Central banks, firms and investors can then explore how well policy, business and investment strategies perform across a range of potential situations. Indeed, the Bank of England’s forecasts for inflation and growth in GDP have fanned out into an immensely wide range to the point that they are much less useful as a baseline on which to base a company strategy or an investment asset allocation.
This current state of affairs leads investment managers away from the science of using charts, statistics and other historically based risk measures and puts more onus back on the art of investment – one that requires a human brain to assimilate a very large set of current information and data, backed by anecdotal evidences from real situations on the ground, to form a best opinion or ‘guesstimate’.
“Like weather forecasters, ever increasing amounts of data are expected to improve prediction accuracy as mistakes are made and lessons learned.”
So the art of active investment management remains alive and well and our investment teams continue to steer portfolios through the uncertainty via our own asset allocation judgements, supported by carefully selected asset managers who are close to their subject matter and have demonstrated good judgement overall through their past record in the navigation of economic and business turbulence.
The art of prediction is an iterative process; as we develop more insight, our predictions adjust to reflect the changing circumstances. So enjoy the predictions for next year. You can be certain some of it will be proved right and the rest will be tweaked to reflect the actualities of 2019. ■