By David Lloyd
“Prediction is very difficult…especially if it is about the future,” Niels Bohr, the famed Danish physicist and Nobel Prize Winner, once said.
How true this statement is, particularly when it applies to economics and financial markets, which are governed by a bewildering complexity of factors that make forecasting appear to be a fool’s errand. No amount of crystal ball-gazing can generate consistently accurate assessments of what will come to pass 12 months from now, such as the yield of government bonds.
Let’s take the example of the US Treasury Yield forecasts. In December 2013 economists’ consensus forecast for U.S. 10-year notes yields at the end of 2014 was in the range of 2.3 percent-4.2 percent, with an average at 3.2 percent. For the following 12 months, it continuously dropped from 3 percent and dipped to 2.1 percent at the end of the year.
Nonetheless, people crave forecasts. There are several reasons for this. People believe forecasts improve clarity in planning and, as a result, we are conditioned to respond to them. Forecasts also are seen as providing key insights, particularly by those who claim they can forecast reliably while promising a commercial “edge” in investment decisions.
The public might believe that the central banks might be better at forecasting than private sector economists since it is seen as having “inside “ economic data denied to others. But a review of forecasts that the U.S. Federal Reserve, the European Central Bank and the Bank of England, have used to guide monetary policy reveal they have consistently failed to accurately predict growth and inflation.
This is particularly troubling since their monetary policies, such as adopting quantitative easing, might have been different had their forecasts been more accurate. Yet investors continue to place trust in the central banks when they price market risks despite the fact that European Central Bank, for example, is still targeting inflation in a deflationary world.
If forecasters add value, they need to be right a lot in the current “fully valued” market conditions when most assets are expensive and investors are only rewarded for taking on the hard work of complexity and illiquidity. In this environment, one of the few ways that investors can hope to achieve target returns is to correctly and consistently forecast future price movements.
If central banks, the most scrutinised forecasters in the world with access to the widest and deepest range of information, struggle to predict the future, than what is really important for investors to consider?
Instead of relying mainly on forecasts, investors should focus on value. The critical questions to search identify it are: Which risks are adequately rewarded and which are not? What do we know and what don’t we or can’t we know? What should be our approach to investing?
Instead of investors following a top-down approach in forecasting fixed-income markets, for example, they should follow a bottom-up approach in selecting good companies based on fundamental factors and be patient in their investments. That’s important for institutional pension and insurance funds that need stable returns with low volatility.
Taking this as a starting point, the bottom-up approach to investment in credit enables investors to buy and sell based solely on value opportunities in the market. It responds to events rather than trying to predict them and thereby focuses investment decisions on what is knowable (facts), rather than on the unknowable (the future).
This approach is certainly resource-intensive since it takes manpower and deep credit research capabilities to assess each opportunity and it requires patience since there are times when markets do not present many opportunities where risk is adequately compensated. But our experience shows that patience is rewarded, and the approach delivers repeatable, sustainable excess returns.
So, for credit investors, there are really two follies of forecasting: one, that it can be done, and two, that it is needed. Remember that forecasters not only need to get it right once, but they need to repeat their successful forecasts year after year.
David Lloyd is head of institutional public debt at M&G Investments.