Navigating financial forecasting: Who to trust?

By Park Chong-hoon

In the world of finance, uncertainty is a constant companion. One issue that often vexes investors is which bank's forecasts they can rely on. It's a simple question, yet the answer can be anything but straightforward. Famous investor and Oaktree Capital co-founder Howard S. Marks has long questioned the value of economic forecasts. Moreover, the diversity of forecasts from various banks leaves investors in perpetual doubt about which of these predictions they can trust.

Our conversation with a client recently revealed an interesting and pragmatic approach: averaging forecasts from multiple banks, while acknowledging the inherent uncertainty of these predictions. Meanwhile, economists continue to issue forecasts, often with accuracy rates that leave much to be desired. It brings to mind a clever cartoon I once encountered, humorously portraying economists as experts in eloquently explaining why they were consistently wrong.

In foreign exchange forecasting, a research paper by Meese and Rogoff (1983) found that randomly chosen (or random walk) forecasts outperform model-based predictions. This finding underscores the formidable challenge of projecting consistently and accurately in the ever-shifting landscape of finance.

Circling back to the question of whose forecasts our clients should trust, we think that while some banks report a more accurate track record, finding a consistent winner is rare. Some banks occasionally hit the mark, though often due to unforeseen factors. Others present compelling reasoning for their forecasts, only to witness outcomes that defy their logic. In rare instances, a bank's forecast may align with reality, albeit for entirely different reasons than initially posited.

Perhaps the accurate measure of a bank's forecasting prowess lies not solely in the outcome, but in the assumptions and rationale that underpin their predictions. It's not just about being right, it's about articulating why you think you're right.

Now, let's delve into the prevailing narrative at our bank.

The U.S. market's performance has been fairly robust, exceeding investors' expectations for this year. However, this remarkable performance is unlikely to be sustainable. High interest rates and a reversed yield curve should eventually take a toll, putting pressure on economic growth and forcing the U.S. Federal Reserve to ease its tight monetary policy. The dollar has been strong due to high interest rates in the U.S., but the currency may have reached the peak of its high cycle. The U.S. labor market has also been robust, but the less favorable side to that story is that wage growth has been weak.

The rise in U.S. interest rates has profoundly impacted economic sentiment, though the transition to slower growth and reduced inflation has been delayed. Notably, since the first quarter of 2021, the U.S. ISM survey of manufacturing sentiment has recorded its most substantial decline in two decades. A drop of this magnitude is typically associated with widening credit spreads, a trend in the early stages of the FOMC rate-hiking cycle. Curiously, despite the U.S. rates complex reaching new yield highs, U.S. high-yield spreads have not only ceased deteriorating but have tightened for most of 2023. This divergence between economic sentiment and financial asset risk appetite is unsustainable, in our view. Tightening of financial conditions, coupled with expectations of prolonged high policy rates, will likely continue to constrain economic growth and corporate financing prospects.

Meanwhile, China's economy paints a different picture. The economy is currently weak and expected to face prolonged challenges from the real estate industry and negative export growth. Nonetheless, we continue to forecast approximately 5 percent annual GDP growth for 2023. During the first half of 2023, GDP growth averaged 5.4 percent year-on-year, and a favorable base effect is poised to bolster GDP growth in the fourth quarter. Since July, China's government has embarked on economic stimulus, including increased special deductions in individual income tax, reduced minimum down payments for first-home and second-home buyers, and lowered mortgage rates for new and existing borrowers. However, we think further policy easing is needed to sustain this recent recovery, as a combination of structural issues and waning consumer and business confidence has blunted the effectiveness of conventional stimulus measures.

Within the region, our outlook on Korea leans towards the negative, supported by recent macro data. Our less optimistic perspective is rooted in China's decelerating post-reopening rebound and global pressures hinting at an impending recession. Our global economic assumptions align with this perspective for 2024. We are also concerned about the Korean government's austere fiscal policy; the pursuit of fiscal balance may necessitate reductions in government spending given the considerable shortfall in tax income. As such, the government's announcement on utilizing foreign exchange stabilization funds to bridge the tax income gap was comforting. While the use of such funds may entail an increased burden for future generations, the current context of economic fragility underscores the need for a reasonable approach.

Financial forecasting is a labyrinth of complexities, and finding a reliable path through it is a formidable task. Instead of blindly following forecasts with a recent track record of accuracy, we think investors should scrutinize the assumptions and rationales behind every forecast.

Park Chong-hoon (ChongHoon.Park@sc.com) currently heads the Korea Research Team at Standard Chartered Korea. Before joining the bank, he worked as a senior research fellow and head of telecommunication policy at the Korea Information Society Development Institute (KISDI).