Investment experts – like everyone else – live in the present and have experiences based on the past. The task of predicting what will happen in the future is a demanding one.
There are no magic algorithms to predict next year’s interest rates or equity market levels with any degree of reliability. Markets can be boosted or hit by events that are difficult to predict, or they can move on the news we expect because people in markets did not know for sure what that news would encompass.
In the last couple of years, few would have predicted the arrival of an unknown virus that would disrupt economies worldwide, nor would many have thought Russia would launch a brutal invasion of Ukraine until the military reports of possible action filtered out into the media. In contrast, everyone knew there would be a Presidential election in the US – and many could predict that Joe Biden would win, but markets would still leave some of the adjustment to that reality until it had happened.
At Charles Stanley, our investment process includes creating scenarios of what might happen in economics and markets. We seek to research and create the strongest possible base case, our most likely judgement of what will happen. We then identify the biggest risks to that view, leading to worse cases and better cases than the central one. We ascribe probabilities to the scenarios to indicate how firm we are in our views – or how uncertain we think the world is.
Today there is considerable uncertainty, with governments and central banks tackling both inflation and possible recession at the same time. This is complicated by the continuing war in Ukraine, with an aggressive Russia considering making greater use of energy and food as weapons in a sanctions war. We, therefore, ascribe just a 55% probability to our base case that we get through with inflation subsiding next year and no deep recession to curb price rises.
There are worse cases where inflation proves stickier, requiring higher interest rates for longer, where Russia creates more scarcity in energy and food markets and where central banks make a new policy error by overdoing their new toughness and plunging more economies into recession. A better case would be earlier falls in inflation coupled with a faster shift in central bank thinking to a less hawkish stance.
It requires judgement to assess how accurate their forecasts may be.
To improve the reliability of these forecasts, we review a large amount of data covering markets and economies – and we examine various external economic forecasts based on complex models of the economies being studied. We pay particular attention to the published central bank and government models, data releases and forecasts as they are in a privileged position with access to good information from all parts of the economy.
It requires judgement to assess how accurate their forecasts may be. Last year, for example, we could not see how the leading central banks could be right in thinking inflation would stay low when there were evident inflationary pressures building in economies and when the banks were creating large amounts of new money to buy-up bonds to keep interest rates ultralow. As economies unlocked, so we saw shortages and excess demand lead to some sharp price rises. This trend was already pronounced before Russia’s war which gave another nasty upwards twist to energy and food prices.
Investing is a long-term business for those wanting higher returns from higher-risk investments such as shares. Nonetheless, there are times when it might be right to take action to reduce or increase holdings because something important has happened. Buying shares at the end of March 2020 when the Fed announced dramatically it would create $3 trillion and spend it on buying financial assets was such a possibility. You could respond as soon as the Fed announced and would have enjoyed a substantial uplift to values as the full force of what the Fed was doping sank in during the weeks that followed. Similarly, if you had decided to reduce your exposure to shares the day the Fed first announced an ending to its very loose policy you would have saved yourself some losses in the market falls which followed.
These events certainly affected our scenarios. The first greatly increased the chances of a happier outcome for investors, whilst the latter darkened the mood and led directly to discussions of when a slowdown might become a recession.
Investors need to have an eye for what matters most. When you read market commentaries of what happened yesterday in a stock market the analyst usually simplifies and seeks to capture the mood with one or two thoughts. You might read the market fell on inflation fears, or the market rose on news that companies are continuing to trade well. These are attempts to summarise the actions of hundreds of thousands of buyers and sellers and to assume the majority mood is either bullish or bearish depending on which way the overall index went.
In recent years, we have spent a lot of time on understanding central banks.
In a bull market, with rising prices for every buyer of shares taking an optimistic view, there is a seller who may think it has gone up enough or have some other reason to raise cash. Summaries are impressions, not scientific accounts of market movements. Good ones do, however, capture a market mood and tell us something interesting about why a market went up or down. Investors are trying to find the underlying drivers of share movements and attempting to select from all the noise the big changes that will have the most impact on prices.
In recent years, we have spent a lot of time on understanding central banks. They have dominated bond markets, buying up such large quantities of bonds and setting interest rates in managed ways that they enforce through their buying programmes. This has also had an influence on equity markets, where a low rate of interest favours higher valuations for shares.
Cheap government borrowing provides more demand boost from public programmes and allows more companies to invest on favourable terms. We have concentrated on understanding the changes in US and Chinese politics, as these big two have the most influence over trade and economic progress in the rest of the world. We supplement our scenarios on markets, interest rates and growth with the thematic study of sectors and trends, which also have a big impact on our societies and equities in general.
Nothing on this website should be construed as personal advice based on your circumstances. No news or research item is a personal recommendation to deal.