Priceless… on predictions and four letter words

Ros Price, Investment Committee member.IPS Capital Staff. 2016. Jon Enoch

It’s that time of year again – no, not just the annual spending jamboree that is the modern day Christmas Season – the time when investment professionals are asked to dust down their crystal balls and make predictions about where markets will be at the close of 2017.

Occasionally some people get the figures right, but my almost 40 years of managing multi-asset portfolios has taught me that this is more by luck than judgement!

Markets are just not that simple to predict. Of course, in some years it has been easier than others to look ahead and position portfolios to take best advantage of different asset performances. Perhaps in the years after the tech bubble burst and the Iraq war ‘ended,’ investors were lulled into a false sense of security about economic development and consequent market returns.  The previous Governor of the Bank, Lord King, once spoke in rather biblical terms about the seven fat years for the UK economy being followed by some rather not-so-fat years. How right he has proved to be!

But the economic largesse seemed to be well spread around the world in the time of economic globalisation, raising many in poorer countries from poverty. This is something that is conveniently overlooked in western democracies nowadays since it has become fashionable to blame international trade for many ills in society, forgetting perhaps that trade is at the very foundation of prosperity.

Then, seemingly out of the blue the global economy was bedevilled by a huge build-up of financial risk that hit much of the world economy well and truly for six. ‘Risk’ – that little four letter word! As the Queen herself said, how was it that no-one could see it coming?

Looking back further in time and at a different sort of economic risk, the harsh recession in the early 1980s that wiped out so much heavy industry in the UK also seemed to arrive out of nowhere. But in this case, the dire effects and risk to companies survival in these early Thatcher years, actually led to an improved industrial and economic backdrop for the country, whereas we are still trying to repair our banks after the Credit Crunch.

Risk, then, is a little word with devastating impact on people and economies. It can be difficult to foresee and also to measure the effects of. We have developed models over the years to deal with the volatile nature of asset returns. We can separate out risk specific to a company and its operations compared to that of the general market and these models are quite effective in managing portfolio risks. Using these models we can see that risk is like a currency we have to spend to buy returns – the more we spend the better our returns might be, but conversely, if our bet is wrong, the more we lose.

Now, however, we have a new layer of risk to add to the models that City risk managers must construct. One that might be rather more difficult to build algorithmic models for – intense political risk built up from peoples’ dreams and emotions, which are not always rational. With current political trends seemingly taking us backwards in terms of global trade and being subject to more irrational human ideas and interventions, annual forecasting requires more than a good crystal ball!

We have been spoilt since the fall of the Berlin Wall and the end of the Cold War in that until this year, politics has taken something of a back seat for markets. People risk has been marginal. International trade agreements have spread with both China and Russia joining the WTO. The Chinese state has leapt to being the second largest global economy and has been seemingly benign. No longer – we have a leadership which is flexing its muscles economically and militarily in the region giving rise to all sorts of new risks. There is a new incumbent in the White House whose radical policies ‘to make America great again’ appear to be aggressive in terms of military build-up and towards free trade with other economies. There is BREXIT of course as well as a continuingly aggressive Russia. So what’s not to worry about? There might well be ‘something nasty in the woodshed’!

But we also know from years of investing that there is just as big a risk of taking our money out of markets and hiding it in a hole in the ground. While political commentators have been worrying about future trends since the US election, markets there have gone up, smelling increased profits and also dividends as a result of possible changes in the new administration. And for foreign investors in the US markets there has been the added bonus of a stronger US currency.

Investors who did not take fright on political grounds but looked at the company outlook, have done well since the US election. Meanwhile, with the US economy strengthening, bond yields have started what is probably their inevitable rise, so bond investors might feel less happy – the risk of interest rate rises has increased markedly.  Savers who deposit cash or buy bonds will be delighted, but those who rely on borrowing to grow their businesses will be less pleased.

So, where does this leave us as we approach the end of 2016?  Although we could spend this time of year waving our finger in the air to identify where the FTSE will finish in twelve months’ time, we would be better focusing on what might happen in 2017. Looking at these potential sets of risks, with rather differing impacts, aligned with a view on what to do if any of those risks materialise is probably a far better way of spending time at this time of year, which is exactly what we at IPS Capital intend to do.

Wishing you all a Merry Christmas and happy and prosperous New Year.