Can economic analysis make you a better investor?
It would be a mistake to overstate its importance. A modern-day Rip Van Winkle could probably set up a globally diversified share-and-bond portfolio, sleep for 20 years and awake to be hailed as the greatest investor of his era.
But most of us live in the real world. We’re buffeted by headlines and vulnerable to emotion. We can benefit from an outlook that paints a picture of longer-term trends in the global economy and how those trends will influence the markets.
Consider three episodes from the first half of 2016, when a probabilistic perspective on the long term helped us put alarming headlines in context, maintain reasonable expectations and remain focused on our goals.
The Chinese new year
In the first trading days of 2016, Chinese shares fell sharply, prompting upheaval around the globe. The proximate causes were weakness in the Chinese currency, a decline in manufacturing activity and a communication breakdown between policymakers and markets as regulators introduced new share market "circuit breakers", or temporary trading halts. By mid-January, the MSCI AC World Index, a measure of global share markets, had lost more than 8% of its value.
The bigger fear was that China might be headed for a "hard landing", a recession that would smother global growth.
Vanguard’s analysis suggested that a hard landing was less probable than a moderate slowdown. We noted that investors could expect periods of panic as China continued its transition from an investment and export-oriented market to an economy driven by consumption and services. But the odds of a collapse that would alter the long-term outlook were slim.
By the end of June, the index had recovered its earlier losses to post a modest gain for the first half of 2016.
Growth scares
As panic about China receded, recession fears emerged in the United States. In addition to tumbling bond yields and share market gyrations, the fears seemed to reflect the strength of the dollar and the oil price rout. Recession is always a possibility, but our analysis of financial and macroeconomic data indicated that, as of March, the probability was low – roughly 10% over the next six months.
Our model nevertheless indicated a higher probability of "growth scares" – a sharp slowdown in job growth – in the months ahead. The best strategy for investors, we noted, would be to brace for bad headlines while recognising that they had limited relevance to the longer-term economic and markets outlook.
Since then, the growth scares have materialised. In May, the US economy added just 24,000 jobs, the weakest report since September 2010. Headlines were dark. But the longer-term portfolio implications remained unchanged.
Low rates, high value
Since the end of the global financial crisis, bond yields have plumbed bewildering lows. Our instincts tell us that yields have to rise, simply because they’ve never been so low. In 1981, the 10-year US Treasury note yielded more than 15%. In late August, it yielded about 1.5%. Nowhere to go but up, right?
Wrong. Interest rates reflect economic conditions, and low bond yields are consistent with slower global growth and low inflation. Low yields weigh on returns, of course, and as we noted in our 2015 outlook, global bonds will most likely return an annualised 2% to 2.5% in the next decade. But we noted that low yields were no reason to abandon bonds, which play an important role as a portfolio diversifier.
During the past year, bonds have played this role to perfection, most recently in the wake of the June 23 decision by United Kingdom voters to leave the European Union. The next day, as global investors reacted to the "Brexit" vote, global share markets returned about –5%, as measured by the MSCI AC World Index. The Barclays Global Aggregate Bond Index, by contrast, returned about 0.50%.
At their historically low yields, bonds can’t provide the same magnitude of offsetting returns that they have in panics past, but they remain an effective diversifier.
Signal and noise
When an economic report or political development is different from expectations, markets react. The impulse to reposition a portfolio can be strong. What can be lost in a myopic focus on the moment is that these short-term surprises often wash out with time.
What matters most is longer-term trends. These trends reflect slow-moving forces such as globalisation, technology adoption and demographics. When changes occur – the fall of communism, the rise of the Internet and accelerating globalisation in the 1990s – they unfold gradually, not in a single headline.
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Robin Bowerman is Head of Market Strategy and Communication, Vanguard Australia. As a renowned market commentator and editor Robin has spent more than two decades writing about all things investment. |
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