SustainAbility: Why forecasts can be sensible yet end up being completely wrong?

Sensible, logical, yet completely wrong!

The investment industry is one which creates grand theories of how the world will evolve. There is a good reason for this: 100% of the value of a company is in the future, and none is in the past. What happens next will be decisive in determining which investments will be successful and which won’t.

We live in a world of forecasts and predictions, but why are so many of them wrong?

Forecasting the future is both possible and impossible. It’s possible to see that, generation by generation, the world, overall, becomes cleaner, heathier, safer, and more inclusive. This belief and forecast are the fundamental underpinning of our approach to investing and based on history is highly likely to be correct.

Equally though, the future can feel impossible to predict. In the last five years we have lived through a pandemic, a land war in Europe, and a rapid rise in inflation. Few, if any, predicted these events. For an investor perhaps the most damaging forecast was in October 2022 when Bloomberg published an article stating, based on their model of the US economy, there was a 100% chance of a recession happening in 2023. Those who followed this advice, which was completely wrong, missed out on a year of strong returns for equities.

The forecasts which get investors in trouble are the ones that sound sensible and logical but are incorrect. Ridiculous forecasts, based in no fact or rationale, are not a problem as they are easy to dismiss. To be fair to forecasts of a recession in 2023, there had been no precedent of interest rates going up as rapidly as they did in 2022 and it not causing a recession. What forecasters missed was that the US economy had become much less sensitive to interest rates since the last time interest rates increased rapidly, and therefore proved to be more resilient. Significant government spending helped too.

What forecasts today are sensible, logical, but could be completely wrong? Two of our current favourites are as follows

The first is that equity markets are too narrow and this will end badly. This seems a sensible and logical observation. If we look at previous periods when markets have been this narrow, including the technology boom and bust of the late 1990s, these were predated by an increase in concentration around a small number of companies. In 1999 these companies included Cisco, Lucent, Nokia and Intel and all were poor investments in subsequent years. Today markets are concentrated around Amazon, Nvidia, Microsoft, Apple and Meta, to name a few.

Will this end badly? We are not so sure. Whilst the excitement about the internet in 1999 has similarities with artificial intelligence today, there are also differences. Today’s largest companies have established market positions and products of a size and quality that the technology companies of the late 1990s never had. They are also much more reasonably valued, despite their strong share prices. This is because they have all grown their profitability rapidly and in some cases as fast as their share prices have risen. This is primarily an earnings-led bull market, rather than a valuation-led one. It may also become the case that markets begin to broaden out as the benefits of AI to all corporates, such as increased productivity, become apparent.

Another difference is the speed in which AI can be rolled out as a general-purpose technology. Smart phones, cloud computing, and personal computers will be our interface and are all ubiquitous. It will still take time for AI to become pervasive, but in my view it will happen much faster than the internet.

Maybe the dominance of US technology companies will continue, and whilst sensible and logical analysis might suggest we are at the tail end of a bull market in these names, more granular and current analysis might suggest otherwise. To be clear we don’t have a clear answer to this, but we do challenge the consensus view.

The second sensible, logical consensus view is the demise of China. There does appear, at a high level, to be a degradation of decision making as power consolidated around President Xi Jinping. This was first seen in Covid policies that were viewed as being counterproductive. In more recent times it has been seen in an unwillingness to intervene in a substantial property bust. China’s decision to political build bridges with Russia, to exchange components for commodities, has increasingly alienated the country from those who support Ukraine. This has led to the view that China is ‘uninvestable’.

We have no Chinese investments in our sustainable strategies, primarily due to corporate governance reasons. China is however a large influence on the global economy and therefore directly on the companies we invest in. What is perhaps less talked about is the record trade surpluses being seen in China, whereby its exports exceed its imports. Far from being the manufacturer of low technology toys and gadgets, China is now the world’s largest producer of vehicles with brands like BYD. A strong educational system and investment in manufacturing capacity and skills has left certain parts of the Chinese economy, those not connected to the property market, in a much stronger position than many believe. It is unlikely the property bust continues forever, and when it does end China could be viewed to be in a better place than expected.

To summarise the general point we are making here, there is an often-used Mark Twain quote

‘It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.’

It is worth thinking about what we all ‘know for sure’ and considering if it could be wrong. This is where the real risk lies in investment portfolios.

Half time

We have now passed the half-way stage in 2024. It has been a good year so far for equity investors, following on from a good 2023. Most markets are at all-time highs, and the damage which was done in 2022, as markets reacted badly to rising interest rates and the war in Ukraine, has been repaired. It is a good reminder that more difficult times for society and for markets can be an opportunity to buy good long-term investments at cheaper prices.

The second half of the year will be election heavy, with the US presidential election at the forefront of everyone’s mind. History shows us the US economy and stock market do well despite politics, not because of it. The US stock market did well when Trump was president and has done well under Biden.

Some commentators also see slightly weaker economic data as a risk to markets. This could be temporary though, and if central banks cut interests rates in response, I think this would be positive for markets.

Alongside these concerns, we see many positives. The drive towards improving healthcare, digitising and decarbonising the economy, infrastructure investment, and record wealth for consumers in key economies such as the US and suggest a good environment for the companies we invest in to grow their profits. If this is the case, I believe this will support markets for the remainder of the year.

This is a financial promotion and is not investment advice. Past performance is not a guide to future performance. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.