Strategy & economics
What noise annoys an investor most?
The biologist Edward O Wilson noted in his book, Consilience, that given all the billions of dollars that have been invested in economics, there has been a remarkably poor return. Nonetheless, he observes, we should continue to invest, because the potential benefits are so great.
I think economics suffers from a fundamental problem: that many in the profession would prefer to see it as a quasi-natural science, rather than a social science. Thus, many academic economists are too focused on discovering universal truths, rather than trying to understand economics in a social or cultural setting. This is just one aspect of the myriad problems that economics faces. In the world of applied economics, there are, broadly speaking, two types of mistake that we make: first, we ignore the obvious and, second, we pay too much attention to noise.
In my view, the financial crisis was largely the result of ignoring the obvious: that excess demand in advanced economies supported by rising debt-to-income ratios could not continue indefinitely. The problem was that it took far longer for this debt mountain to come crashing down than might have been expected. As a result, although the moment was (by definition) forever getting closer, the longer the cracks did not appear, the more complacent policy makers and many others in the economics profession became. Indeed, rather than seeing the debt mountain as an increasing risk, economists began to invent reasons to explain why it was becoming more sustainable. In reality, we were standing in the middle of the road, while the big, red, double-decker bus continued to motor relentlessly towards us. Unfortunately, every time we focused on it, it seemed sufficiently far away not to worry.
The second trap for applied economists and commentators is noise. If you look at most short-term changes in economic and financial variables, the day-to-day, week-to-week or month-to-month changes are little more than random movements around whatever underlying trend there might be. For instance, even after ONS statisticians have adjusted the data for normal seasonal variations, the month-on-month changes in retail sales volumes are little more than noise, conveying almost no information about whether spending patterns are strong, weak or indifferent. Unfortunately, however, it is this noise that captures attention – often because it is so discordant. And when you see news reports of retail sales, it is the monthly noise that generates the headline – retail sales are either soaring or crashing. Writing about the monthly change conveys immediacy. It is also quick and easy: both of which attributes are particularly important in the highly competitive arena of instant news. And, of course, bad news always makes better reading than good news. The "£50 billion wiped off the value of shares" headline is clearly judged by editors to be a much more effective attention-grabber than "£50 billion added to the value of shares". Try searching the internet – you will find scores of headlines akin to the former, but virtually none of the latter ilk.
Associated with the problem of using the randomness in economic and financial variables to create a story is the tendency to extrapolate. The most-used instrument in the applied economist’s toolbox is the fifteen-inch ruler. The technique is beguilingly simple: take the last two data points, draw a line between them and extrapolate to the end of the measure. More often than not this will generate the possibility for another extreme headline.
In the first quarter of this year, we saw a number of weaker economic readings emanating from the US economy. Without going too far into the arcane world of seasonal adjustment, it is not unusual for the first three months of the year to ‘disappoint’, and there is reasonable evidence to suggest that this is more a statistical quirk than an accurate representation of changing economic momentum. Nonetheless, duller data releases during the first few months of this year have generated not a few warnings that we are on the brink of the next recession. To me, this is the perfect example of the danger in extrapolating the ‘trend’ from the latest two data points.
At some stage, we will have to contemplate the possibility of renewed weakness in advanced economies. For the moment, however, I would characterise the trend as being one of persistently-dull growth. There is a paradox here. Dull may be a growth rate of 2%, which is clearly less exciting than the near-3% that was achieved over the prolonged but unsustainable growth phase prior to the last recession. The paradox is that although duller equates to safer, it also leaves us feeling much more vulnerable. On the upside, the normal fluctuations around the lower average growth rates now being achieved do not generate the same feel-good sensation. And, on the downside, we are taken into growth territory that seems much more worrying.
So, as much as we might realise that we should be wary of paying too much attention economic noise, it will always remain difficult to ignore – until such time as our forecasting expertise has improved many-fold times on what it is today.
This article is issued by Cazenove Capital which is part of the Schroder Group and a trading name of Schroder & Co. Limited, 12 Moorgate, London, EC2R 6DA. Authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. Nothing in this document should be deemed to constitute the provision of financial, investment or other professional advice in any way. Past performance is not a guide to future performance. The value of an investment and the income from it may go down as well as up and investors may not get back the amount originally invested. This document may include forward-looking statements that are based upon our current opinions, expectations and projections. We undertake no obligation to update or revise any forward-looking statements. Actual results could differ materially from those anticipated in the forward-looking statements. All data contained within this document is sourced from Cazenove Capital unless otherwise stated.