Capital market assumptions - March 2022
Ninety One’s Capital Market Assumptions framework focuses on the key drivers of long-term performance. We do this to better understand possible future returns, enriching discussions with our clients.
Chapters
01
A painful adjustment02
Predictions, policy levers and lags03
The White House reaction04
Innovation shifts to fiscal levers05
Countering recession – the third lever01
A painful adjustment
The best reason to study economics was to avoid being deceived by economists, the economist Joan Robinson once said. Yet, for the greater part of the last four years, economists have had no difficulty in deceiving themselves.
There is no doubt that the rolling shocks delivered by the post-Covid-19 economic regime have made forecasting particularly challenging. At the same time, market economists have been continuously on the defensive. They have delivered at least five false alarms in recent years, as catalogued in a thoughtful recent book on forecasting by Philip Carlsson-Szlezak and Paul Swartz1:
- In early 2020, when the Covid-19 pandemic took hold, a narrative of a new Great Depression took hold. Yet by the first quarter of 2021, as a result of the willingness of policymakers to lean against it, economic output in the US had bounced back to its pre-Covid level.
- In 2021, the market narrative veered in the opposite direction as it became clear that the recovery was going to be robust. The narrative became one about a “Roaring Twenties.” Digital enablers of the lockdown economy, like Zoom and Teladoc were expected to deliver a tremendous boost to productivity. Yet little of that transpired, and investors in the so-called “pandemic winners” were left nursing losses.
- In 2021 and 2022, when post-pandemic inflation peaked higher and later than many expected, many economists entertained the notion of a structural break in the inflation regime, back to the 1970s, when inflation expectations were unmoored. Even if inflation over the next decade is higher than it was in the 2010s, the structural break narrative has not yet come to pass. Inflation did move lower, reflecting a cyclical and idiosyncratic mismatch of supply and demand rather than the structural break of the 1970s.
- In 2022, as the Fed raised rates at the fastest pace in decades, investors expected EM currencies and assets to be under pressure, triggering defaults and capital flight. Yet emerging markets have successfully weaned themselves from short-term dollar funding in recent years, and there was no systemic EM crisis.
- Starting in early 2022 and early 2023, a narrative of an imminent and inevitable recession took hold in rich countries. Forecaster models showed sharply higher recession odds. By end-2022, 85% of economists surveyed expected a recession over the next 12 months.2 The Economist’s World in 2023 publication, written by the newspaper’s editor, explained “Why a global recession is inevitable in 2023.”3 This went hand-in-hand with the view that inflation would not moderate without much higher unemployment, the key determinant of a recession in service-sector-dominant advanced economies. Yet by mid-2024, US unemployment remained near record lows despite a slowing labour market, and inflation showed continued signs of moderating.
The repeated failure to predict the course of the economy can be illustrated by the famous fan chart showing the failure of the Federal Funds Futures market to forecast the Federal Funds rate in both directions over the last few years.4
The least interesting conclusion to be drawn is that models can be ineffective or economists frequently exhibit a pigheaded form of hubris. They can, and economists do. But this is also a kind of analytical nihilism; it closes off an understanding of the world. The truth is market economists are a reasonably undogmatic and informed group of professionals. They are used to dealing with economic uncertainty. That they got it wrong so badly should be interesting.
It’s therefore worth focusing on the specific analytical errors involved, particularly in the last example of the narrative whiplash—the prediction of the “inevitable recession” of 2023.
That economists expected a recession in response to a rapid monetary policy tightening in 2023 is fairly understandable. Central banks had delivered the third fastest tightening cycle in at least fifty years. The only faster cycles occurred in 1980 and 1973 and both delivered a so-called hard landing, periods when employment and output declined considerably. When former vice-chair of the Federal Reserve Alan Blinder catalogued 11 Fed tightening cycles since 1965, he found that just three led to an unambiguously “soft landing,” i.e. stabilising or reducing inflation with no recession.5 Those episodes had involved Federal Funds increases of 175 basis points (1965-1966), 315 basis points (1983-1984), and 310 points (1993-1995).
Here, instead, was a rate increase trajectory worth 550 basis points, coming after rates had hit a 5000-year low6, a decade of easy money, a proliferation of new and untested financial business models (e.g. private credit, some of the less disciplined parts of private equity), a heap of “zombie companies” that were thought only to have been funded because of the zero interest rate environment. Surely, we would see a painful adjustment.
Figure 1: Historic Fed hiking cycles (% over months)
Source: Ninety One
