Investment prospects for 2018

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by Alasdair Macleod, GoldMoney:

Predicting the future is a mug’s game, and in financial markets we simply cannot know tomorrow’s prices. All we can do is make assessments of the factors that can be expected to influence them.

Economists’ forecasts today, with very few exceptions, are a waste of time and downright misleading. In 2016, we saw this spectacularly illustrated with Brexit, when the IMF, OECD, the Bank of England and the UK Treasury all forecast a slump in the British economy in the event the referendum voted to leave the EU. While there are reasonable suspicions there was an element of disinformation in the forecasts, the fact they were so wrong is the important point. Yet, we still persist in paying economists to fail us.

With the novation from the old year into the new, it is the time of year when highly paid, highly qualified investment analysts and strategists, many of them professing to be economists, come out with their forecasts. And here again, there’s another problem. Very few analysts have the confidence, or even the imagination, to make a forecast without regard to those of their peers. There is a feeling of safety in moderation, which, if you think about it, means adjusting forecasts without regard for true conclusions and inferences. 

So, forecasting is a mug’s game, which is why this researcher never does it. Even for the best experts, the fact remains the future is unknowable. And even if it were, for financial assets, such as equities, economic predictions are not the most relevant. On a time-scale of less than eighteen months or so (the period covered by new year forecasts), fundamentals such as the outlook for profits and dividends for equities matter less than the outlook for bond yields. And bond yields in turn are heavily dependent on capital flows. 

The subject is a large one, but for the purpose of focus and simplicity it should be condensed into its most important indicator. The chart below is probably the most important one to watch evolve in the coming months.

There are a number of reasons to select the 5-year US Treasury bond as the best indicator for capital flows. The best is it is the longest maturity that banks will normally hold on their balance sheets, as an alternative to lending bank credit to the non-financial sector. As such, it is the least directly influenced Treasury Bond by changes in variations in overnight lending rates you are likely to find in a bank’s portfolio.

In the last five years, the yield has risen from a low of 0.68% to a current rate of 2.25%. This means a bank has only avoided realising considerable losses by holding the bond to maturity, which was probably the bank’s intention when first bought. We can deduce this, because when banks buy low-risk government bonds, it is because they are averse to the risks of lending to the non-financial sector. Therefore, when they sell, the banks’ motivation is not investment-driven, but by the need to raise liquidity to be reapplied elsewhere. 

However, if a bank had bought this bond in July 2016, it would currently be sitting on a loss of about 8% on its invested capital, always made considerably worse in terms of the cost to a bank’s own capital by fractional reserve gearing.

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