‘Hard truths’ about predictions heading into outlook season

KEY TAKEAWAYS

• Investment managers must question the correlation between variables more than they used to
• The labour shortage and mass immigration are complicating economic models
• Government debt and inflation are other factors with new nuances

The end of the year is a time for eggnog, tax-loss selling and market outlooks, when economists and asset managers publish their predictions for the year ahead. Before the season begins in earnest, Manulife’s chief economist, Frances Donald, has a warning.

“Here’s the hard truth about my forecast,” Donald said Tuesday at the Portfolio Management Association of Canada’s annual conference in Toronto, which this year was called “Hard truths and soft landings.”

“I have very little faith in it,” she said.

While some maintain the four most dangerous words in investing are “This time it’s different,” Donald is worried about relying on economic models based on what happened in the past.

“There’s a range of things happening right now that are completely different and not incorporated in most standard economic models,” she said at the conference.

Investment managers must question the relationship or correlation between variables more than they used to, she said, because something may be disturbing relationships that existed in the past.

One of those developments is a labour shortage, which complicates forecasts about the impact of a looming recession. Companies that took so long to find workers will be more reluctant to let them go, she said.

One way the government is addressing the labour shortage is by increasing immigration to unprecedented levels. But while those new workers provide supply, they also create more demand, and economists are struggling to incorporate mass immigration into economic data.

“We’ve not incorporated this before because we have never seen this extended population growth and labour shortages in our economies in the past,” Donald said.

Economists are also trying to figure out how to capture the relationship between labour, productivity and artificial intelligence. The conversation is already shifting, she said, from concerns about machines stealing jobs to solving the labour shortage, which could potentially lead to stronger GDP growth over time.

Another X factor in the economy since the pandemic lockdowns and stimulus cheques of 2020-21 is the amount of excess savings. Consumer spending has been resilient in the face of inflation and higher interest rates, making forecasting a slowdown more difficult.

“Here’s a dirty little secret: we actually have no idea how much excess savings are in the system,” Donald said. “I’ve got six measures in the office of excess savings. Do you know what they range from? Zero dollars left to $1.5 trillion dollars left.”

Excess savings relate to another complicating variable: government debt. Governments overspent in good times, Donald said. U.S. government debt now totals US$33 trillion, with potential consequences for its credit rating.

Donald said that for the first time in her career, she has to think about government debt and supply — and whether there will be buyers — when forecasting the 10-year Treasury yield. And a theme for 2024 is “the rise of fiscal dominance,” she said, where large governments face limits on the amount of debt they can issue.

“This is a game-changer in the way that we think about the fixed-income space,” Donald said.

Another theme she’s examining is the breakdown of the relationship between inflation and interest rates. The main drivers of inflation today — geopolitical conflict and drought, to name a couple — are different than in the past 30 years, Donald said, limiting the effectiveness of monetary policy.

“We can raise interest rates all we want — it’s not going to make it rain in Brazil,” she said.

Central banks will probably have to cut before inflation returns to 2%, she said, which is “hugely important for long-term asset allocation.”

Her forecast — with all its caveats — has the Bank of Canada cutting rates in the first or second quarter of 2024, and the U.S. Federal Reserve also cutting by mid-year.

Donald said the amount of uncertainty is uncomfortable for everyone in investment management, especially as year-end meetings with clients approach. But it’s important to address.

“You have a fiduciary duty. The first thing you should say is: ‘We acknowledge that there is less certainty than there has been historically,'” she said.

Where her team used to rely on a base case, they’re now operating with three to five scenarios, with a plan for each across different types of portfolios.

And she reminded managers to consider clients’ investment horizons and think beyond the short term. While she expects a volatile six months, she’s more bullish on the next five years.