“The only function of economic forecasting is to make astrology respectable”
JK Galbraith

This opening quotation might seem somewhat defeatist. Surely economic forecasting, given the importance of the economy’s performance on our investments, must be necessary. The problem is that in order to have a useful piece of information, that information must be both important and knowable. There is no doubting that the economy’s future performance is important information for us investors, but to what extent can we know it?

At the risk of using excessive quotations, there is a good story from Kenneth Arrow, who subsequently won a Nobel Prize in Economics in 1972, about his time analysing long-range weather forecasts in World War II. He came to the conclusion that there was no difference between the forecasts and pure chance, and communicated this finding to his superiors. The following is the memorable reply that he received: “The Commanding General is well aware that the forecasts are no good. However, he needs them for planning purposes.”

Which leads me on to inflation, without a doubt the economic piatto del giorno being served up in all current market analyses. Following a 2020 – 2021 in which it was decided, essentially on a global basis, to close down pretty much every non-essential activity and subsequently to apply massive amounts of government stimulus in the hopes of starting things back up again, we are finding a large number of anomalous economic effects. I imagine many people will have their own stories to tell, but my particular one is this: my son got to the point where he needed a new bicycle, having outgrown his previous one. A couple of years ago, this would have been as easy as going down to the local bike shop, choosing the model and swiping my credit card. This time, however, the bike shop told me that they hadn’t had a delivery of new bikes in two months due to logistics problems. They were, however, very happy to take my son’s old bike, a buyer for which was found in a matter of hours.

There have been plenty of variations on this theme in recent times, and it would appear that the process of economic restarting, with its attendant logistics issues, has fed into the current levels of inflation that are being reported. However, it seems unwise to extrapolate one observable trend and conclude that there is some inevitability about inflation remaining at its current high levels. This is the essential problem with economics: modelling extremely complicated systems such as economies is all but impossible: there are simply too many factors to take into consideration and the interactions between them all are unclear.

Of course, if we are investing, then it does seem like we have to take a view on macroeconomics and position ourselves accordingly. Financial newspapers exist to provide daily analysis of current trends and allow various experts to opine about their future path. There is little downside for those prepared to make forecasts: if they happen to be right about some particularly important phenomenon, they can trumpet for all time how they called the event. Their many incorrect calls, on the other hand, will be studiously forgotten about. If we extend this reasoning to well-known hedge fund managers, those who appear to have the Midas touch, we find ourselves subject to what is known as “survivorship bias”: for the few investors with truly long-term records, there are many others who have fallen by the wayside and whose investing results have been lost in the mists of time. This gives us the impression that there are gurus out there who know exactly what is going on in the economy, but it doesn’t correspond to the hard reality of investment: most truly successful investors don’t have a strong view on macroeconomic trends, because they understand that they are unknowable and that any market timing decisions based on forecasts are fraught with difficulty.

So if we can’t divine what is going to happen in the economy, can we know anything that is of use for protecting and growing our investments over the long-term? It turns out that the most important thing for investors is the mere fact of remaining invested. JPMorgan has shown that over the period from 1999 – 2018, the average return on the S&P500 index, the most important aggregate of US shares, was 5.6% p.a. However, your return would have been a paltry 2% p.a. if you had missed the 10 best days of that period, and you wouldn’t have made any money at all if you had missed the 20 best days. Keep in mind that those returns were produced notwithstanding several gut-wrenching market moves associated with the tech bubble bursting in 2000 (which led to three years of negative returns) and the financial crisis of 2008. If we zoom out even further, the annual returns for the US stock market in the post-war period have been positive in about 70% of the years. Those are odds that you want to take.

I should add as a proviso to the above that you need to have invested intelligently, and by that I mean choosing quality asset managers that are worthy, long-term stewards of your capital and who put your interests as clients before their own. It should, of course, be a given that financial professionals put their clients’ interests first, but the various scandals over the years have shown that one can never be complacent in this regard. My job as financial adviser is to help you to choose quality investments and to make sure that you understand the basic tenets of investment and stay with it for the long-term. If you’d like to discuss your own situation further, please don’t hesitate to get in touch for a free initial consultation.

With all of the above, I don’t mean to diminish the importance of inflation, but we need to keep it in its proper context: this isn’t a problem that has suddenly come out of the woodwork! It has been there all along, working quietly in the background to chisel away at your wealth. The graph below shows the effect of different levels of inflation over a number of time periods.

It should be clear that even modest levels of inflation can prove very pernicious – taking the example of a 2% inflation rate over a 20 year period, you will find that prices have risen almost 50%, and so if your capacity for generating income hasn’t risen commensurately, you will find yourself dedicating ever more of your resources to the bare necessities, leaving you less money available for discretionary expenditure. We are told that we have lived through a couple of decades of very low inflation, but I distinctly remember the prices of milk, fuel and train travel (between where I live and Milan) when I arrived in Italy in 2004, and the inflation rate based on these basic goods and services is in the region of 2 – 3% p.a. over the period 2004 – present day (the official value is about 1.3% p.a.). There is no need to get into a debate about how inflation is calculated – I fully recognise that some goods (like consumer electronics) have improved and become cheaper over this period, but I buy fuel for my car far more frequently than I buy a smartphone.

The effects of inflation on your economic well being often become clear only after a long period of time, so the best idea is to work out a plan right from the start to make sure that your expenses are going to be sustainable in the long-term. Doing this can be quite difficult however, as you need to factor in variable investment returns, withdrawal rates and inflation in order to see how your plan is likely to play out. Investing for a positive real return (a real return is adjusted for the effects of inflation) over time relies on taking a long-term view and, as with choosing the right investments, my role as financial adviser is to help you understand all the variables and to find a sustainable path for the future. If you worry about inflation, then you are right to do so, but I can help you in finding ways to protect yourself from its worst effects.

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