Materials Risk

Its true that economists have an abysmally poor prediction record. Before explaining why lets have a quick look at how abysmal.

The Economist magazine have a database of projections by banks and consultancies for annual GDP growth. It stretches back 20 years and now contains 100,000 forecasts across 15 rich countries.

Unsurprisingly they found that forecasts tend to fare well over brief time periods, but got worse the further analysts peered into the future. If a recession lurks beyond 2019, economists are unlikely to foresee it this far in advance.

Projections made in early September for the year ending four months later missed the actual figure by an average of just 0.4 percentage points. Errors rose to 0.8 points when predicting one year out. But over longer horizons forecasts performed far worse. With 22 months of lead time, they misfired by 1.3 points on average—no better than repeating the previous year’s growth rate.

The most likely outcome is growth – economies usually expand slowly and steadily so its reasonable to forecast this. But sometimes unfortunately economies contract sharply…

…and this means the biggest forecasting errors occurred ahead of contractions. The average projection 22 months before the end of a downturn year missed by 3.7 points, four times more than in other years. In part, this is because growth figures are “skewed”: economies usually expand slowly and steadily, but sometimes contract sharply. As a result, forecasters seeking to predict the most likely outcome expect growth.

So why are they so abysmal?

Well, first the economy is a complex system full of positive and negative feedback loops. And so it doesn’t necessarily follow that a change in one part of the economy (say a cut in interest rates by X) would automatically lead to an improvement of Y elsewhere. Its non-linear.

“Nobody has a clue,” Jan Hatzius, Goldman Sachs’ chief economist, said to Nate Silver in the book “The Signal and the Noise”. “It’s hugely difficult to forecast the business cycle. Understanding an organism as complex as the economy is very hard.”

According to Hatzius, forecasters face three fundamental challenges: first, it is very hard to determine cause and effect; second, that the economy is always changing and, third, that the data that they have to work with is pretty bad.

Second, economic forecasters of all stripes are prone to the same biases. They are prone to recency bias (thinking the current trend will continue), availability bias (only considering salient data and insights) and confirmation bias only seeking out information that confirms their worldview).

Finally, they are all subject to different incentives. And the main one is whether to herd, or not to herd. If a forecaster strays too far from the consensus forecast and turns out to be wrong they may lose their job or be passed over for promotion.

As the great investor Warren Buffet said, “Forecasts usually tell us more of the forecaster than the future.” Forecasters are too busy looking in the rear view mirror and looking across at their competitors to provide an unbiased forecast of the future.

Related article: Financial market forecasts: How to avoid buying a lemon

Two headlines caught my eye recently that demonstrate the power of sentiment in commodity markets. If you read my post from June (What headlines are telling us about sentiment in commodity markets) you’ll recall that headlines in the media (and especially in the financial media) tend to confirm what we already know, once a trend has been firmly established and often extrapolate that trend into the future.

The two headlines are from the FT and the BBC and both relate to the market for palladium. To recap, from a low of $470 per oz in early 2016 the price of palladium has more than tripled over the past three and a half years to almost $1700 per oz.

The first article (“There’s no end in sight for soaring palladium prices” – 2nd Oct, FT) notes the fundamental factors in support of the palladium price but the headline suggests that there is no end to the palladium price boom. Just as with headlines that suggest it can only get worse this headline suggests that bullish sentiment is ripe for a reversal.

The second article (“Huge rise in catalytic converter thefts” – 20th Sep, BBC) brings it home to the average car owner that although they may feel safe driving round in their SUV, in fact they are showing off to potential thieves that they have something that has tripled in value. When the impact of high prices starts to register with the end consumer it can be a sign that demand will start to wane.

The long term palladium chart looks stretched with prices well above the 50 and 200 day moving average while there are signs of a negative divergence that could indicate a sharp correction is close.

Investment bank UBS sees further upside in the coming months but with an increased risk of sharp corrections:

“We see further price upside over the coming quarters, but performance will likely continue to be volatile with large price drops possible – as already experienced twice this year. Such corrections could be caused by renewed risk-off events and/or sales from Russia’s Nornickel Global Palladium Fund (GPF). It remains unclear how much metal the GPF still holds, however. Declining ETF holdings – which were used to cover the market deficits and are now at the lowest level since 2008 – suggest that above-ground inventories are quickly dwindling”

One of the oldest sayings in commodity markets is that the cure for high prices is high prices. It is exceedingly is rare for any commodity to remain this far above its long-term average for so long especially one where sentiment is so stretched.

Related article: Palladium prices: The top 10 most important drivers

Data covering the 45 years to 2005 from the largest global 85 economies shows a consistent pattern: people tend to consume capital (i.e. spend it) when they are young, build up capital from middle age through to retirement, and then gradually at first and then suddenly eat into that capital. This matters a lot for future investment returns. The demography of many developed and less developed countries is forecast to shift dramatically over the next few decades with the share of older people (consumers of capital) likely to increase significantly.

The chart below from Gavekal shows the global capital providers ratio (a weighted coefficient of the numbers of people in the capital providers relative to the total population) and plots it against the nominal yield on US 10 year Treasuries. Between 1960 and 1980 an increase in the share of capital consumers (both young and old) lowered the savings rate. In turn this meant that the real equilibrium interest rate increased since if capital is to be directed to where its needed and that capital is scarce its price must go up to. After 1980 this relationship reversed and resulted in the favourable tailwind of gradually declining interest rates that we’ve seen ever since.

Could the relationship just be a one-off resulting from the Baby-Boomers? It comes down to whether we are as inflationary in retirement as we are in our youth. Older people typically (but not always) spend their money on different things depending on their health; hopefully foreign holidays and a new sports car and not medical care. If pensioners are not in a position to contribute to inflation directly then another way older people can do this by passing some of their savings to their grandchildren.

In the future older people’s appetite for inflation will also depends on their investments and any income they receive. Traditionally they have reliant on fixed incomes and so have been wary of inflation eroding its value. That could change in the future if more pensioners have to manage their own investments, rather than relying on the state or final salary pension schemes.

Nevertheless, a look back at history suggests the the relationship will remain. The Bank of International Settlements (BIS) looked back over previous cycles going all the way back to 1870. It reveals the same stable relationship between age structure, the capital providers ratio and inflation. Although there are outlier’s, its also consistent across countries. 

So what to make of this? Well, inflation is very likely to make a strong return over the next 30 years. Aside from the demographic impact there are another two D’s. First deglobalisation is also likely to be inflationary as trade moves towards more regional systems and technology fails to deliver the same deflationary pressures that we’ve seen over the past two decades. Second, debt (government debt specifically) is likely to increase as central banks and governments are forced to move beyond quantitative easing to finally get their economies moving through fiscal policy.

From an investment perspective it says buy those assets that are cheap and that do well in inflationary environments. Right now, that’s commodities. We are entering a period very similar to 1890-1920 and 1950-1980. Both periods exhibited high inflation with rising commodity prices. Notwithstanding the bleak recessionary outlook in the short term, anyone with a 20-30 year time horizon could do worse than consider increasing their exposure to commodities.