Can economic analysis make you a better investor?
It would be a mistake to overstate its importance. A modern-day Rip Van Winkle could probably set up a globally diversified stock and bond portfolio, sleep for 20 years, and awake to be hailed as the greatest investor of his era.
But most of us live in the real world. We’re buffeted by headlines and vulnerable to emotion. We can benefit from an outlook that paints a picture of longer-term trends in the global economy and how those trends will influence the markets.
Consider three episodes from the first half of 2016, when a probabilistic perspective on the long term helped us put alarming headlines in context, maintain reasonable expectations, and remain focused on our goals.
The Chinese new year
In the first trading days of 2016, Chinese stocks fell sharply, prompting upheaval around the globe. The proximate causes were weakness in the Chinese currency, a decline in manufacturing activity, and a communication breakdown between policymakers and markets as regulators introduced new stock market “circuit breakers” (temporary trading halts). By mid-January, the MSCI AC World Index, a measure of global stock markets, had lost more than 8% of its value.
The bigger fear was that China might be headed for a “hard landing,” a recession that would smother global growth. Vanguard’s analysis suggested that a hard landing was less probable than a moderate slowdown. We noted that investors could expect periods of panic as China continued its transition from an investment- and export-oriented market to an economy driven by consumption and services. But the odds of a collapse that would alter the long-term outlook were slim.
By the end of June, the index had recovered its earlier losses to post a modest gain for the first half of 2016.
As panic about China receded, U.S. recession fears emerged. In addition to tumbling bond yields and stock market gyrations, the fears seemed to reflect the strength of the dollar and the oil price rout. Recession is always a possibility, but our analysis of financial and macroeconomic data indicated that, as of March, the probability was low—roughly 10% over the next six months.
Our model nevertheless indicated a higher probability of “growth scares”—a sharp slowdown in job growth—in the months ahead. The best strategy for investors, we noted, would be to brace for bad headlines while recognizing that they had limited relevance to the longer-term economic and markets outlook.
Since then, the growth scares have materialized. In May, the U.S. economy added just 24,000 jobs, the weakest report since September 2010. Headlines were dark. But the longer-term portfolio implications remained unchanged.
Low rates, high value
Since the end of the global financial crisis, bond yields have plumbed bewildering lows. Our instincts tell us that yields have to rise, simply because they’ve never been so low. In 1981, the 10-year U.S. Treasury note yielded more than 15%. In late August, it yielded about 1.5%. Nowhere to go but up, right?
Wrong. Interest rates reflect economic conditions, and low bond yields are consistent with slower global growth and low inflation. Low yields weigh on returns, of course, and as we noted in our 2015 outlook, global bonds will most likely return an annualized 2% to 2.5% in the next decade. But low yields are no reason to abandon bonds, which play an important role as a portfolio diversifier.
During the past year, bonds have played this role to perfection, most recently in the wake of the June 23 decision by United Kingdom voters to leave the European Union. The next day, as global investors reacted to the Brexit vote, global stock markets returned about –5%, as measured by the MSCI AC World Index. The Barclays Global Aggregate Bond Index, by contrast, returned about 0.50%.
At their historically low yields, bonds can’t provide the same magnitude of offsetting returns that they have in panics past, but they remain an effective diversifier.
Signal and noise
When an economic report or political development is different from expectations, markets react. The impulse to reposition a portfolio can be strong. What can be lost in a myopic focus on the moment is that these short-term surprises often wash out with time.
What matters most is longer-term trends. These trends reflect slow-moving forces such as globalization, technology adoption, and demographics. When changes occur—the fall of Communism, the rise of the Internet, and accelerating globalization in the 1990s—they unfold gradually, not in a single headline.
In the decade ahead, the dominant trends will be slower and more balanced economic growth, subdued inflation, and investment returns that fall short of historical averages. Even so, stocks are likely to reward investors with a risk premium; bonds can be expected to diversify stock market risk; and an asset allocation managed with discipline, diversification, and patience is likely to deliver inflation-adjusted returns that can help investors meet their goals.
All investing is subject to risk, including possible loss of principal.
Investments in bonds are subject to interest rate, credit, and inflation risk.
Investments in stocks or bonds issued by non-U.S. companies are subject to risks including country/regional risk and currency risk.