Where will the next shock come from?
ECONOMIC VIEW; Then, of course, just when the markets are convinced all is well, there will be some sort of disaster
Tuesday 20 February 1996
There are therefore two games which anyone interested in markets ought to play. One is fun. It is to keep asking themselves where the next potential surprise might come from: a figure, a change of policy, maybe just a change of fashion. The other is (usually) less fun. It is to look back at one's own views and see where one has got things completely wrong. More of the former in a moment, focus first on the latter.
Up to now there has been very little ordered analysis of the performance of economic forecasters. People do rankings of individual forecasts for the UK economy - who got things right and who got them wrong. Expect the results of an interesting little exercise of this nature to be published in this paper on Wednesday. But they do not look at the generality of forecasts and plot where the consensus has been optimistic and where it has been pessimistic. So a new indicator developed by the investment bankers Kleinwort Benson deserves a welcome: the surprise activity indicator.
The idea is very simple. You take the consensus forecasts each month for several indicators of the UK economy and then compare these with what actually happens. You can then see whether forecasters as a whole have been over-optimistic or over-pessimistic about the UK economy. Kleinwort has drawn up a composite indicator based mainly on gross domestic product, retail sales, industrial output, unemployment and money supply, the results of which over the last two years are shown in the surprise activity indicator graph.
You can see that for the whole of 1994 things turned out better than expected: the economy grew faster, inflation was lower, unemployment declined more quickly. If you think back, everyone started the year wondering whether the recovery would be sustained and how long it would be before unemployment stopped rising. We ended up with growth of nearly 4 per cent.
Last year proved the reverse. Everyone thought that the low-inflation boom would continue, whereas growth faltered and the inflation numbers rose. When the Treasury came out with a 3 per cent growth forecast in the November Budget, it was dismissed as unduly rosy.
Now, once again, things are beginning to turn out better than expected: the three-month moving average has just blipped positive. This raises the intriguing possibility that the year as a whole might turn out better than expected, for there does seem to be some sort of "fit" between surprises and out-turn. Indeed, better than that: changes in the surprise indicator seem to be a lead indicator for changes in economic growth.
The period from 1988 onwards is plotted on the other graph. Anyone who is interested in statistics will notice that quite a bit of pushing around of the figures has gone on to make the two series fit as well as they do. It seems that you have to take a 12-month moving average for the surprise indicator rather than a three-month one; you use non-oil GDP, which is fair enough; you have to fiddle with the scales and you have to put the zero on the surprise indicator at just under 2 per cent on the growth side. But once you have done all that, hey presto, there is a nice three or four-month lead indicator of the turn of the recession in 1991 and a slightly less clear indicator of the slowdown in growth that took place last year.
Most interestingly there is a hint now that the growth pause of last year may soon be over. We will have to see whether the surprises continue to be on the positive side, but the much-derided Treasury forecast appears a wee bit more credible now than it did in November. Kleinwort will carry on monitoring this series and I will update people in the next few months if anything interesting emerges.
What about the second game noted above, the "where will the next one come from?" Here there is not much to be done by feeding numbers through computers and trying to spot relationships - you just have round up the potential suspects and nab the ones that appear promising. Kleinwort suggests that higher growth will surprise us on the upside by the middle of the year, but that inflation expectations will rise too on the back of this, which would presumably be bad for gilts.
My own list of candidates would certainly include higher growth this year, but I would be more concerned about the balance of payments than inflation, as British consumers always tend to want to buy imported goods when they become a bit richer. My worries for the bond market would come from political uncertainty rather than current inflation.
But the most interesting surprises, surely, go beyond the range of the Kleinwort Benson exercise, for they will be external ones. In the broad scheme of things the British economy is not very important. What matters are the grand global changes of mood which occur from time to time.
Some examples. A year ago only the brave predicted that EMU might have to be postponed or even abandoned. Now the former is seen as odds-on, while the latter is something close to an even bet. Few people saw the French riots coming, and the consequences of that are still unclear.
There are potential surprises in the energy market (the oil price falling off a cliff?), and more generally in commodities (ditto?). Forecasts for the German and French economies have been revised down so dramatically that I suppose the most surprising thing there would be for a year of adequate growth. That would at least be more surprising than actual recession on the Continent, which at the moment looks all too possible.
Finally, there remains the future of the long, long bull market in US securities. As each month of higher Wall Street prices passes the quietly whispered possibility of a speculative blow-off in US share prices, followed by a crash, becomes more likely: the surge running on and on until the music suddenly stops. Maybe the potential surprise there would be for the bull market to continue intact through 1996 and well into 1997.
But all this goes far beyond the scope of the Kleinwort exercise. The most useful conclusion that flows from that is that if the pattern of the last few years continues, we should expect several more months, perhaps a year, of better performance from the British economy than the markets at present expect.
Then, of course, just at the moment when the markets are convinced that all is well, there will be some disaster.
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