Markets Rise as Forecasters Stumble

Investors have a lot to worry about, and they know it. Unfortunately, investors often worry about the wrong things, or they take the wrong actions in response to their worries.

Britain’s vote to leave the European Union (EU), which occurred after our last issue, is a great example. Markets for risky assets (stocks and commodities) rose before the vote because most investors believed forecasts that predicted a majority would vote for the United Kingdom to remain in the EU. After it was clear that a majority voted to leave the EU, investors initially believed new forecasts that economic disaster would follow. They sold risky assets and bought a lot of bonds. Central banks also were buying bonds to provide liquidity to the markets. All that bond buying caused interest rates to collapse. After a few days of selling and major declines, investors changed their outlooks again. The risky markets recovered. The bottom line: We had a month of worry and extremely volatile trading with little net change in market values.

That’s why I don’t spend much time on forecasts, short-term news and political events. If something is in the media, it also probably is reflected in market prices. When I consider the forecasts and news, I examine the economic fundamentals to see if the view is already reflected in market prices. I also look for signs the consensus is likely to be wrong.

That approach led us to buy long-term bonds and utility stocks in late 2015 just before their big rally. Instead of forecasts, we seek margins of safety. Our portfolios are diversified, so we don’t rely on one market outcome. Most importantly, we pay attention to the things that matter to the markets over more than the short term. We let others worry about predictions and the short-term noise.

Let’s look at the current status of factors that matter to the markets and determine which events might not be priced into the markets.

Central bank policies and interest rates are key factors to the markets. In the United States, monetary policy is tighter than a couple of years ago. But in a form of easing, the Fed shelved its plans to raise rates steadily in 2016. Also, central banks in Europe and Japan aggressively are easing monetary policy and looking for ways to make policy easier. The Brexit vote makes it likely global monetary policy will remain easy, though the Fed’s policy moves won’t be as easy as the other central banks.

The result is interest rates are very low, and are negative in much of Europe and in Japan.

The U.S. economy continues to grow, and recent data indicate growth increased after pausing early in the year. The manufacturing and resources sectors still are weak, but likely are forming bottoms. Housing continues to improve and is recovering from an early-in-the-year stumble. The service sector of the economy continues its solid growth rate.

Personal income continues to increase, and that has led to several months of rising spending and retail sales. Surveys of consumer and household sentiment are positive, which usually leads to higher spending. None of the reliable recession warning signs are indicating such a retreat is imminent.

In this recovery, wage and salary growth have been well below average, helping to keep inflation lower than it normally is at this stage of an economic recovery. That trend appears to be turning. The low unemployment rate finally is pushing wage growth above the 1% to 2% range. That will help increase economic growth but also is likely to lead to higher inflation.

We’ve likely seen the low points in commodity prices for this cycle. Falling commodity prices were offsetting rising prices for services. That kept net consumer price inflation low. As commodity prices stabilize or rise, reported inflation will increase. Rising household income also will put upward pressure on prices. Rising inflation in the United States will exert pressure on interest rates. The panic from the Brexit vote brought U.S. interest rates very low. Those abnormally low rates are going away.

Rising commodity prices are going to help many emerging economies, and that will improve growth around the globe. The central banks in Europe and Japan will continue to do whatever it takes to maintain economic growth. If other policymakers implement some growth-oriented fiscal policies, global growth really will improve.

A shock to the system always could come along and derail current trends. Italian banks are the biggest risk now, because they need a lot of capital. China remains in a precarious position, and it affects growth in many other countries. It should be a while before any negative effects of Brexit are felt, and Britain might not leave the EU despite the vote. Those are today’s major risks.

We’ll react to major negative events when and if they occur. We won’t invest assuming a worst-case scenario or based on a forecast. To protect us from sudden market turns, we stay diversified and balanced and invest with margins of safety.

For now, it looks like growth is improving in the United States and many emerging economies. Commodity prices aren’t likely to revisit their recent lows. Inflation and interest rates are rising a bit in the United States. This environment should be a relatively good one for our diversified, balanced portfolios.