The Value of Predictions
I see a lot of forecasts and predictions, and many are wrong. Brexit – wouldn’t happen. Trump – would not win election in 2016. 2020 U.S. election – if undecided on election day, the markets would tank. Took a week to figure it out and markets were up every day that week. Russian invasion of Ukraine – Putin won’t proceed.
Given that most of these are so wrong, why do they get so much press? When we can actually track the success rate of most pundits, their success is somewhat less than 50% yet they still get called in to the TV studio to offer their prognostications and it seems that the more negative they are, the more coverage they get.
Let’s take a peek at the past two years of some massive unknowns:
The pandemic. Though one was inevitable at some point, nobody predicted that a hundred-year global infection crisis would strike as suddenly and catastrophically as it did in early 2020.
The lockdown. Given the immediate evidence that the virus’s lethality was overwhelmingly concentrated in the old and sick, nobody predicted that the response would be a total global lockdown and the almost instantaneous cessation of much of the world’s economic activity.
The recession. A 20% peak to trough contraction of the economies in North America would have been inconceivable if anyone were even contemplating it; no one did. That this contraction could start and end in two months would have been even further outside the realm of possibility.
The bear market and its evaporation. There is no precedent for a one-third decline in the TSX & S&P 500 in 33 days. Nobody predicted it, and even if anyone had, still no one could have predicted that such a decline could have been completely erased—peak to trough to peak—in six months.
The unending focus on the U.S. presidential election. A contested outcome of the November 2020 election was more than predictable; it was inevitable. Nobody predicted the chaos of January 6, nor that such an event might still be the focus of bitter partisan divisions in the U.S. almost two years after Election Day.
A 40-year spike in inflation, almost overnight. Anyone could have known, and some did, that the massive expansion of the M2 money supply, long after the pandemic had already done its economic worst, must lead to a perceptible increase in inflation. Nobody predicted the firestorm we actually got.
Surging recession risk/interest rate spike. Given that nobody could have predicted the severity of the aforementioned inflation surge, nobody can yet predict how hard the Fed may be forced to strike back, thus bringing the very real specter of recession to the fore.
China/Taiwan. If the preponderance of the talking heads was wedded to the belief that Putin wouldn’t invade right up to the day he did, then you know nobody was predicting that China might move against Taiwan anytime soon. Don’t look now, but “anytime soon” may have just gotten a hell of a lot sooner.
Nobody knows. By the time the next trading day is over, two dozen talking heads on BNN / CNBC will have opined with palpable confidence on what’s going to happen with GDP, earnings, inflation, Fed interest rate policy, oil prices, and what the stock market will do next. So many variables make a definitive conclusion difficult, if not impossible.
I used to appear regularly on BNN and other ‘news’ channels when I lived in Toronto and there is a push to be a bit extreme.
Inflation and the Markets
Global markets have been laser focused on inflation readings all year. And, while that was still a big preoccupation for investors over the past week, another issue has emerged that could soon overtake it as the predominant market concern: the risk of recession and its impact to corporate profits.
The U.S. Consumer Price Index (CPI) for August was released over the past week and it was up 8.3% year over year, below the reading for July but higher than expected. Food and energy price pressures remained elevated, although the latter declined as expected. More troubling may have been the core measure, which excludes food and energy. It was higher than expected and above the July reading. Moreover, it wasn’t driven by one particular category but showed relatively broad pricing pressures.
Nevertheless, our view on inflation remains largely unchanged. More specifically, it should recede in the months to come. One doesn’t have to look too far to understand why. Shelter is the largest component of inflation, accounting for nearly a third of U.S. CPI. It is made up of lodging away from home, rent, and housing-related costs. The latter two have shown no signs of slowing yet, and in fact increased in August. But these two categories have historically followed home prices with a meaningful lag. We know home prices are under pressure as a result of substantially higher mortgage costs. As a result, it is just a matter of time, in our view, before trends in the largest component within the CPI basket begin to subside.
Inflation may also be at risk of falling victim to recessionary-like forces that appear to be on the rise. In recent days, a few industrial conglomerates ranging from aluminum and steel makers to shipping and parcel delivery companies have warned of deteriorating conditions in their respective businesses that have led them to issue profit warnings. Part of this appears to be cost-driven and a meaningful shift in demand away from goods towards services. Weakness overseas was also cited as a notable driver by some management teams. But, it’s hard to imagine weaker demand avoiding its way into the North American economy. After all, the Bank of Canada and U.S. Federal Reserve have been aggressively tightening financial conditions with the hope that demand and activity would slow. We may finally be starting to see the impact of their actions.
A deteriorating economy is by no means something to look forward to. But it may have the potential to have a lasting impact on inflation. Ultimately, that may prove to be a very important and constructive development for the longer-term return prospects of most assets. In the interim, we expect equities to remain vulnerable as markets digest the risks to corporate earnings. This is why we focus on great businesses with growing cash flow, friendly shareholder dividend policies and ability to weather downturns better than peers.
Should you have any questions, please feel free to reach out.
J. Todd Kennedy, CIM, FCSI
Senior Portfolio Manager
613-566-4582
toddkennedy.ca