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Economic predictions tend to be more inaccurate when they involve short-term events or cycles, says Joseph Davis, chief economist and head of the Vanguard Investment Strategy Group in Philadelphia, Pa.

“Short-term cycles can be more erratic than long-term trends, and there’s a lot of noise in the data,” he says. “You tend not to have strong predictability for variables that bounce up and down a lot, such as the stock market over the next six months.”

Read: Economic data: What to watch and what to do with it

To illustrate why shorter-term calls need to be updated, Davis revisits one of his predictions for 2016. He also shares tips on how to use market predictions when managing portfolios.

Prediction: No 2016 cyclical rebound for emerging markets

In a December 2015 webcast and outlook report, Davis and his team called for weakness in emerging market economic growth, even though markets were calling for a strong rebound.

In the 2015 webcast, he said,There’s weakness at times in the emerging markets, and China, Japan, and Europe have yet to really accelerate meaningfully” in ways that support developing economies.

Read: China and India to lift developing Asia, says report

Yet he expected EM stocks to do well, mainly because there’s poor correlation between economic growth and stock performance, as Davis had written in a 2012 paper on forecasting returns.

Read: 7 economic trends to watch

Actual outcome

  • There has been an emerging markets rally this year, with the MSCI Emerging Markets Index rising from 794.14 on December 31, 2015 to 902.58 as of November 3, 2016.
  • But, the short-term performance of the MSCI Emerging Markets Index shows this year’s rally plateaued in August, outside of one spike of 927.29 in early September. The index is currently at levels last seen around July 2015, but isn’t near highs of prior years (see chart here).
  • As Bloomberg reports, the rally has stalled due to concerns over global growth—and, in particular, the Chinese slowdown—as well as worries over the U.S. election.

So, was the prediction correct?  

Yes. Emerging market economic growth has been uneven, despite a rally for EM stocks.

At the end of 2015, says Davis, “we looked at the drivers of EMs in the past and [concluded] that in the next five to 10 years, emerging markets were likely to disappoint.”

At that point, the primary growth drivers of emerging markets were shifting. Those drivers were “strong demand from the American consumer, which was fueled in part by American consumer debt, [and] the rise of the Chinese and world economy. Both of those engines of growth [will be] lower going forward.”

Read: Good news for China: growth is on target

All those things are still true. But what Davis didn’t foresee was how long it would take the Fed to raise rates. This is important to emerging markets because of their high debt levels. Interest rate moves can also affect the value of the U.S. dollar, which is tied to commodities.

In an August 2016 global outlook update, Davis and his team conceded, “The Federal Reserve not raising the federal funds rate has probably been supportive of emerging markets this year—as have more stable commodity prices.”

But, the update counters, “These economies still need to re-calibrate to a new business model and this will likely be a long and difficult process.” And, says Davis, “Emerging markets aren’t going to collapse. Still, they’re not going to return to the heady old ways of higher growth rates.”

So, even though emerging markets have rallied as money managers seek out higher growth, recent volatility and economic weakness suggests the rally is only short-term. A full-blown cyclical rebound based on improving fundamentals is still unlikely, says Davis.

Read:  

Lessons learned

Economic predictions shouldn’t drive portfolio decisions, says Davis, adding that he’s not against investing in EMs. “You would think with our analysis that we would be recommending investors avoid emerging markets. But that isn’t the case: when we compare our growth expectations to [expectations for] future equity performance, a bigger driver for [EM equities] is indicators such as P/E ratios.”

Read: The value of company valuations

He adds, “Emerging market equities could still have a decent year this year and in 2017, even though their growth will likely disappoint.”

It’s also important to update forecasts regularly, especially if they’re based on short-term periods, Davis says. “If something happens that’s worse [or better] than expected, that can have implications for three or five years out. An example would be when we see more details about China’s five-year plan. This is one marker we’re looking for and tracking that may increase or lower the odds” of emerging markets seeing growth.

Data from October suggests China may be stabilizing. But, Davis concludes, “Our view is that the EM economic slowdown should be gradual and it will be secular, meaning long-running. China’s consistent but lower growth, versus previous years, is consistent with this.”

Read: Where to find investment prospects in China

Katie Keir is Content Editor of Advisor Group. Email her at Katie.Keir@tc.tc.
Originally published on Advisor.ca
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