Forecasting the economy: joining in the seasonal folly
No Monkey Business Limited, my financial planning and wealth management firm, starts any client relationship with an Initial Review: a highly detailed ‘money makeover’. In the spirit of the new year, our client reports at the end of 2005 included an account of one such review to make some points about the future path of the global economy.
Our subject is a powerful business leader on the international stage. For discretion’s sake, we shall call him Sam…
Sam’s family business interests are well established and widely spread around the world, to the extent many of his wider family now threaten to rival his own success. Sam is clearly asset rich, his assets predominantly entrepreneurial and their prices high as his business interests are generating healthy cash flows. But Sam’s household budget in almost every department can only be described as out of control, with debt levels high and rising because restraining expenditure has simply not been a priority.
Because of the strong performance of his businesses, Sam has been repatriating foreign profits and paying himself exceptional dividends instead of reinvesting, helping to keep domestic debt from rising further. He is also borrowing heavily from his niece, China. Her enterprise is evidently doing extremely well and throwing off huge surplus cash, in spite of strong capital investment in the business, and she has little choice but to keep lending much of her growing reserves to Uncle Sam.
You’ve guessed it: one of Sam’s burning questions was would China stop lending – or demand much higher interest rates? Sam saw this as forcing on him the kind of retrenchment in his household accounts he had put off making. His worry was that retrenchment might feed back into his business interests, damaging the price of his assets – including his sizable housing investment. Sam was experienced enough to know (without our advice) that markets could fall in spite of underlying profits performance being good if expectations were to change for the worse.
But why would they alter drastically? After all, it is nearly 15 years since the last conventional recession, as central banks (and businesses like Sam’s) seemed to have worked out how to tame the business cycle.
What Sam was worried about was that a relatively small change in sentiment would trigger a large market setback. For example, if his own stock prices were weak and bond yields did not fall equivalently, he knew that would trigger increases in the unfunded pension liabilities in his companies. Could he then get caught in a vicious cycle of having to sell more equities the more they fell?
We had to point out that this particular risk was highly correlated with another. Sam had been investing heavily in private equity deals in recent years. This typically involved taking businesses private (or buying non-core subsidiaries from public companies), gearing up against asset values and the promise to release early cash (both from asset sales and from putting in place tight financial controls), incentivising managers and then using the evidence of a turnaround to sell on at a handsome profit. Sam had done this sort of thing in the past – it used to be called asset stripping – but within his listed companies and with less hairy borrowing levels. This had proved a great idea in a bull market for stocks but a lousy one in a recession and bear market.
Seeing the possibility that individually modest changes in expectations for key economic variables could spark a chain reaction, Sam was desperate to know whether we thought the trigger could be avoided and, if not, whether it would necessarily lead to distressed economic and market conditions. Sam didn’t want us to say what could happen. He wanted us to predict what would.
We had to disappoint him. We could reassure him that the events he feared were at least within the range of probable outcomes for the diversified portfolio we proposed. In other words, the consumption and wealth effects of worst case outcomes that Sam says he can bear will not be breached. But we could not tell him ‘this is what is going to happen’ or even ‘this is what is most likely to happen’.
Why not? Because there’s a strong chance we will be wrong. Either our analysis of the economic risks might be wrong or, because nation states are not the same as individuals, they manage to avoid retrenchment – possibly only at a greater cost eventually.
Even if we were right about ‘what’, we could be very wrong about ‘when’. If markets continue to rise, then clients who follow our model-driven approach (and do not alter their risk aversion) will gradually reduce equity exposure anyway.
The opportunity cost of getting the timing wrong is essentially a function of market volatility. But with serial correlation (or momentum effects) in markets, it is possible to have lower than normal short-period volatility (as in 2005) yet face a higher opportunity cost because the eventual peak proves to be even higher. It is arguably a risk that has actually increased as a result of the modification of the business cycle Sam had observed.
What did happen to the business cycle?
It has not gone away (sorry, Gordon) but it has been stretched out – mainly by lower inflation.
On this interpretation, the key is still unsustainable imbalances, whether in sector flows of funds, relative rewards to labour and capital, capacity slack and relative prices. But with much lower inflation these imbalances arise more gradually than when nominal flows are changing more rapidly (even if in real terms they are not). Though not a fundamental change in economic laws, it is a modification that has had important impacts on both economic management and investment management. Once the imbalances emerge, however, the lessons of past cycles should be as relevant as ever.
The financial flows and balances between the different sectors of a national economy, which collectively must balance, are an approachable and fairly accurate way for non-economists to check for unsustainable relative positions. These arise at peaks and troughs of the business cycle and are causes of the restorative corrections towards a more normal balance. The sectors that are these equivalents of ‘essential elements’ are – households and businesses (together the private sector) – central and local government (the public sector) – the foreign sector (as measured by trade flows between the countries but not by the payments flows on capital account that automatically balance any surplus or deficit from trading).
Sector balances in the UK
Britain’s deteriorating sector balances arise from the persistence of growth, hence strong corporate cash flows here, as in the USA. Profits reflect strong final sales but also (as in the USA) relatively weak capital expenditure. Taken together with disappointing productivity growth over the whole of the cycle, both English-speaking business sectors are consuming the seedcorn (or at least returning cash to shareholders who are). But the quality of profits is not itself an indicator of the sustainability of the cycle.
The adverse side of the growth coin is a worsening trade deficit, something no longer masked by a large energy surplus. The Treasury still argues there is slack in the economy but the trade account and anecdotal evidence in different sectors suggest otherwise.
That the UK public finances are worsening in spite of continuing growth in the business sector and in household incomes might suggest taxes are not rising automatically with the growth in activity. But it is probably the high growth in public spending in health and education that has upset our balance. This cash injection has a finite life so we certainly cannot assume that public finances are spiralling out of control.
Sector balances in the US
Deteriorating US public finances at a time of record net imports have revived talk of the ‘twin deficits’ that dominated economic debate for several years ahead of the arrival of recession in the early 1990s.
Ironically, today’s sector imbalances owe something to a revival of Reagan-like simplicity and absolutism in politics. Abroad, it runs, America must send no-nonsense signals to its enemies and put hard cash behind the active promotion of democracy wherever in the world it is threatened by new tyrannies as noxious as communism. At home, it must prevent the tax system and regulation acting as supply-side disincentives. For many Americans of both parties, these messages resonate powerfully. And they are apparently not unwelcome politics for many foreigners, whether Asian central bankers, oil-powered states or global business decision-makers, who have a vested interest in America’s continued strength.
‘The twins’ relate in large measure to the public sector family, because they reflect how the economy is being managed by government and the Federal Reserve. Within the private sector, US households and businesses show unusual but offsetting balances, as corporate America has benefited from binge spending by consumers. Because the binge has required increased borrowings and erosion of savings (partly supported by a housing boom) and because spending power has also come under pressure from higher energy costs, forecasters are generally united in predicting that the party is over.
It is an easy step from this conclusion, coupled with the same effect of energy costs for companies as for households, to predict that business profits must also be at a peak.
To underscore the notion of a tipping point, some early vulnerability to credit tightening has already emerged in both the consumer and business sector. This has led to conventional bad debts for banks but also both bank and investor losses on credit risks transferred through derivatives in ways and on a scale new to this cycle. So in America too, the old-fashioned focus on the business and credit cycles is making a comeback.
Though we seem in many respects to be returning to familiar economic themes of the past, what this implies for inflation is not at all clear.
Fortunately a view of inflation is not necessary for portfolio investors. If future return probabilities are measured in real terms and based on real return histories, what can happen to inflation, and what can happen to markets as a result of changes in inflation, are both ‘in the model’ and in the predicted real return probabilities. In this inflation-agnostic approach, assets that represent pure bets on inflation, such as conventional bonds, are simply excluded from the opportunity set. You need to be a supremely confident economic forecaster to bet on bonds.