Let’s say one year ago I told you that over the next 12 months real economic growth in the U.S. would exceed 3%, unemployment would fall below 4%, wage growth would continue but inflation would remain modest, and lower federal corporate tax rates would lead to double-digit earnings growth for the S&P 500 Index. You might conclude that such a robust economic environment would produce attractive stock returns. Yet despite all of those hypothetical predictions actually occurring in 2018, the S&P 500 experienced its first calendar year loss in a decade. Many investors may find this puzzling, but it reminds us that investors need to differentiate between macroeconomic factors and expectations for those factors.
An interesting example of an insightful macroeconomic forecast failing as an investment strategy comes from a very well-regarded bond management firm. In the aftermath of the 2008-2009 financial crisis, the firm believed the developed world would enter a long period of deleveraging (paying down debt) and reregulation which would ultimately reduce access to capital, resulting in below-average economic growth. This view was well thought out and backed by solid research. The company called this extended period of low, fragile economic growth the “New Normal.” This view became popular as a number of the firm’s fund managers and representatives expressed their views as frequent guests of the financial media. Eventually, the company was asked about the investment implications of its forecast. In response, its best-known fund manager confidently predicted that stocks would return about half of what investors had previously enjoyed: New Normal stock returns would be 5-6% annually.
Sensing the commercial opportunity of the New Normal, the firm launched a fund designed to outperform more traditional investment approaches, which it viewed as poorly positioned for the coming economic environment. Advertised as seeking equity-like returns with lower volatility, the fund underperformed nearly every global stock index and most bond funds from its inception through 2013. During this period, the fund returned just 5.2% annually while the MSCI index of global stocks averaged 14% returns and Barclay’s Aggregate Bond Index averaged 5.8% returns. In late 2013, the company changed the fund’s benchmark, removing stocks entirely in favor a mix of short-term lending rates, a move that a Morningstar fund analyst described as “moving the goal posts” in the middle of the game.
How did such an accurate macroeconomic forecast deliver such poor investment results? When investors translate economic forecasts into investment forecasts, they often overlook the implications of current asset prices. In the aftermath of the financial crisis, stock prices didn’t simply anticipate a slow recovery. Instead, they priced in the possibility of a depression-like scenario. When that scenario failed to develop, extremely low stock prices were poised to deliver above-average returns, even with low economic growth. Determining what future events are likely reflected in current stock prices is challenging, but doing so is more likely to yield valuable investment insights than even the best economic forecast.