I think I have one of the best jobs in the world: essentially, to predict the future – the future course of, for example, inflation and thus of, say, bond yields, or the success of individual companies. Making good predictions is about first identifying patterns – there is no pattern in a series of coin tosses, only randomness. Thus, only a fool – or a cricket captain – would seek to predict how a coin may land.
"Only a fool – or a cricket captain – would seek to predict how a coin may land"
Perhaps counterintuitively, it is often easier to make predictions about the longer term than the shorter term. Take bond or equity markets. Over periods of a few months, say, it is hard if not impossible to predict the movement of gilt prices or the FTSE All Share index. Their motion ostensibly follows a random walk.
Over longer periods however, bonds and equities are driven by factors that may themselves be predictable. For example, the percentage of workers who are employed fluctuates in a recognisable cycle over time. This cycle is known as the business cycle, and it defines how economies recover from recessions, subsequently overheat, then fall into recession before recovering again.
Employment patterns will mirror this cycle, with unemployment rates peaking during a recession and falling to their lowest point when an economy is at its hottest.
The unemployment rate in the UK is currently 4.1%. This is close to being as low as it has been in nearly half a century so there is a very good chance that it will be higher, perhaps considerably so, in the years ahead. (Note that there is nothing particularly scientific about this observation; it is simply common sense.)
The reason an analysis of employment patterns is important is that the tightness of the labour market at a particular point in time has a major bearing on wage growth. Wage growth in turn influences inflation – a major determinant of monetary policy. Ultimately, it is monetary policy and the level of interest rates that have the most impact on bond and equity prices.
This mechanism works in two ways. First, interest rates either stimulate or restrain consumer spending. If my mortgage payment goes up because of higher mortgage rates, I have less to spend on other things.
Lower consumer spending ripples through the corporate sector, causing profits to fall which in turn lowers the value of companies. Lower corporate profits also force companies to cut their workforces, leading to falling wage growth and lower inflation. Such trends, while negative for equities, are positive for gilts.
In other words, high interest rates alter the cashflows of equities and bonds. In the case of equities, profits fall; in the case of bonds, falling inflation increases the real value of bonds’ coupons and principal.
The other way in which the mechanism works relates not to the underlying cashflows but to the demand for said financial assets. Equities and bonds compete for investors’ attention with cash. Rising interest rates means that cash becomes more attractive in relation to bonds and equities.
What complicates matters is that the two mechanisms will at times be out of sync. For equities, falling profits at first tend to outweigh the benefits of lower interest rates and their enhanced attractiveness in relation to cash. Bonds, on the other hand, will tend to respond immediately and positively to falling inflation.
Advice for the amateur asset allocator? Focus on the tightness of the labour market, making use of either anecdotes or the data that is publicly available on the Bank of England’s website. Then make a judgment as to whether monetary policy is likely to be at its tightest or loosest at some point in the next two-to-three years. If you deem that it is, you may have an edge in relation to predicting where equities and bonds are heading in the medium term.
As I look ahead, I do not see a recession looming – monetary policy is still very loose and thus supportive of demand. However, I know I could be wrong, which is why we at Seneca Investment Managers have been gradually cutting our funds’ equity weights in recent months and will continue to do so.
Published in What Investment
The views expressed in this communication are those of Peter Elston at the time of writing and are subject to change without notice. They do not constitute investment advice and whilst all reasonable efforts have been used to ensure the accuracy of the information contained in this communication, the reliability, completeness or accuracy of the content cannot be guaranteed. This communication provides information for professional use only and should not be relied upon by retail investors as the sole basis for investment.
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