How to treat predictions on everything from bubbles to rate cuts

Predicting how an economy will behave in time to come is tough business, given that there are so many factors at play. Hence, it is hardly surprising that when the covid pandemic started to spread around 18 months ago, most economists thought that the world would face a deflationary shock, with prices of goods and services falling, as most people stayed at home.

But 18 months later, it is fair to say that the economists who predicted deflation got it wrong. Like always, there are exceptions to this as well. In a column in the Financial Times in May last year, Stephen Roach, who teaches at Yale University, had said that consumer spending will remain low only until a covid vaccine arrives. And once a vaccine hits the market, “pent-up demand will build as never before".

Roach explained that this would primarily happen because governments of the rich world would continue to support worker incomes until a vaccine became available. The pent up demand thus released would lead to inflation or a rise in prices.

Central banks are now getting ready to fight inflation. The major tool in their armoury to do so are interest rates. When inflationary expectations are high, monetary policy committees of central banks raise interest rates, the idea being that at higher interest rates people will borrow and spend less. This will bring down demand and in the process inflation as well.

Since the beginning of 2020, central banks of the world, rich and poor, have printed a lot of money to drive down interest rates in the hope of getting consumers and corporates to spend more. Thanks to very low interest rates, money has found its way into stock markets and other financial markets in search of higher returns. This has led to bubbles all around.

As Ruchir Sharma, the chief global strategist at Morgan Stanley, pointed out in a column in the Financial Times: “My research on the 10 biggest bubbles of the past century… shows that prices typically rise 100 per cent in the year before the peak." On the basis of this definition, it is easy to conclude that everything from stocks to cryptocurrencies have been in bubbly territory in the recent past.

But all this is the benefit of hindsight. The bigger question is: What does the future hold. As usual, there are arguments on both sides. One school of thought is that central banks will have to raise rates to fight inflation. On the flip side, the argument is that if central banks raise interest rates, they will derail the economic recovery process that is currently on through much of the Western world.

Dylan Grice, in the latest edition of the Popular Delusions newsletter, writes: “Central banks would accommodate the inflation, lacking the will or stomach to tame what they had unleashed." Hence, central banks of the rich world will be ready to ignore inflation, and try and maintain interest rates at low levels, in the hope of creating some growth.

Nevertheless, higher inflation will drive down the real rate of interest on bank deposits, the safest form of investing, even further. The real rate of interest is obtained by subtracting the rate of inflation from the interest offered on deposits. In this scenario, money should keep coming into stocks in search of higher returns, or as Grice puts it: “This would ultimately be supportive/bullish for equities." Of course, only time will tell which side turns out to be right.

So where does that leave investors? Should they continue to be invested in stocks? Should they buy gold? Should they move their investments to bank deposits?

It is important to understand that the ability of experts to make predictions is limited. As Daniel Kahneman, Olivier Sibony and Cass Sunstein write in Noise: A Flaw in Human Judgement: “Detailed long-term predictions about specific events are simply impossible… Unforeseeable events are bound to occur, and the consequences of these unforeseeable events are also unforeseeable."

Nevertheless, saying that the future is unpredictable is hardly an insight. As the authors write: “The obviousness of this fact is matched only by the regularity with which it is ignored." The future being largely unknowable doesn’t stop experts from making forecasts, and that too, confident ones.

The sense of confidence that experts have can make them believe their forecasts even more. Kahneman, Sibony and Sunstein call this the illusion of validity. As they write: “We have noted that people often mistake their subjective sense of confidence for an indication of predictive validity."

Investors need to ensure that they don’t fall for this illusion. For that, they need to go back to the oldest cliché in investing: Don’t put all eggs in one basket. Now is the time to diversify and diversify well across and between investment asset classes.

Of course, investing is an individual thing and the details need to be figured out depending on risk preferences.

Vivek Kaul is the author of ‘Bad Money’.