Cyclical forecasting is futile and usually misses the most important trends

Eric Lonergan, Director of M&G Investments in London, and guest of Prudential Portfolio Managers in Johannesburg this week, made some controversial remarks about the capacity, or lack of such capacity, of asset managers and economists to gain insight into the causes of market failures in the past.

'Cyclical forecasting is futile when there are so many underlying dynamics and diversification across the globe that we do not understand,' he said.

In an amusing and hard hitting presentation, Lonergan took the audience through the comments and analysis of market changes immediately before and after other market failures, illustrating the point that in many cases the eventual outcome of these events had not been predicted by commentators at the time.

He said that leading commentators, including Harvard professors and leading International Monetary Fund personnel tended to focus on a limited range of causes in a crisis. 'There is generally a poor understanding of the structural characteristics of the global economy,' he said.

By way of example, he said that up to June this year, the concern of economists had focused almost exclusively on the energy crisis and the possibility of return to an era of high inflation, reminiscent of the 1970's. He observed that Allan Greenspan, former Chairman of the Federal Reserve, was currently being labeled a 'senile old fool' and yet post 2001, when he made the decision to lower interest rates, he enjoyed virtually unanimous support of his peers. The dominant fear at the time was that the reduction of interest rates was necessary in order to avoid a recession. Lonergan said that he had read the comments and analysis of leading commentators at the time, and no one voiced concerns that low interest rates would lead to a bubble in the housing market.  

He said that an analysis of the Asian crisis of 1997, (which he described as the Asian equivalent of the present banking crisis in the West) shared many of the same characteristics as the present crisis. It was accompanied by political change, and great economc pessimism in the 'Asian Tiger' countries.

'Conventional wisdom post the Asian crisis in 1997 anticipated that Asia would experience 'Japan-style' stagnation, that China would be the 'next accident waiting to happen' and that a global recession was likely. None of these thing happened,' he said.

'On the other hand, the three most important subsequent developments emerging after the Asian crisis were not even noted. These included the fact that Chinese share of global GDP would become a significant global influence and that the increased productivity due to the technology boom would contribute to global increases in GDP.

Thirdly, the policy response to the deflationary shock caused by the Asian crisis would dramatically increase financial intermediation and encourage the containment of price inflation in the developed world.

As a side comment, he observed that the increased Chinese demand for commodities (and the subsequent increase in prices of commodities, peaking in June this year) was one of the contributory factors masking the true level of the global economic slowing which contributed to the lack of preparedness of Western bankers in the current crisis.

He appealed to the audience to look beyond 'ceteris paribus forecasting' where there was excessive focus on a simple or singe cause for an event, to more complex and  demographic change for trends. To illustrate his point, he said that high economic growth required access to capital and human capacity. He said that those asset managers tors waiting for the revival of the Japanese economy would probably wait in vain as they had failed to take into account that the Japanese work force had been stable at 65 million since the early '90's. He said that there could be increase in output without either population growth or relaxed immigration policies.

Returning to the current crisis, he said that the financial contagion had been global, but that dependence on credit and structures of banking systems throughout the world were highly diversified.

'Throughout Europe, there are different banking ownership structures and models, different levels of exposure to over-valued property. In addition, there are different attitudes and policies with respect to non-performing loans,' he said. In the UK, non performing loans are dealt with severely, whereas this is not the case in Italy or Germany.

'So while the current display of common ideology across the globe is unique, there are a myriad of internal complexities and areas of potential economic recovery and boosted domestic demand which are unique.

'Investing in the current environment does present opportunities though,' he said. 'All we know is that the current opportunity set is extreme, and that by exploiting these extreme odds and changes in odds, unusual returns can be made.'