Overview
Economic forecasting is a well-established practice among credit and financial analysts. Our view is that it is appropriate and helpful at the issuer level but more often than not, an exercise in futility at the macro level. Sophisticated risk and portfolio managers are best served by focusing on those areas where they can be successful and engage in scenario analysis for the other areas.
Issuer-Level Evaluations
Prior to taking on an exposure to a particular issuer, it is common to make some basic assumptions about the industry, the issuer’s position in that industry, the issuer’s management, its products, and other relevant factors.
(Note, in the words of Warren Buffett and other successful investors, it is better to invest in a strong industry with weak management than the reverse.) From such evaluation, one can typically reasonably assess revenues, margins, cashflow, in turn valuation metrics. Comparing relative appeal on a risk/ reward basis provides a reasonable basis for decision making.
Industry-Level Evaluations
At this level sound evaluations become more problematic. The reality is that more macro-level evaluations come into play such as overall consumer spending, interest rates, government policies and regulation, alternatives. Furthermore, with the economic turmoil stemming from COVID, high levels of government spending, and the rapid rise in FED funds rates, making predictions on the revenue levels and margins trends by industry is difficult at best; prior patterns are no longer applicable.
Hence, many managers set broad targets and provide some flexibility based on the relative appeal of various opportunities.
Macro-Level Evaluations
In our opinion, making accurate forecasts at this level is extremely difficult. Starting with the notion that a successful forecaster might be correct 65%. On the Ratings side of our firm we have a saying which is to check your politics, religion and sporting views at the door (a policy reminiscent of the rule in the Western saloons of yore of checking one’s firearms at the door). Nonetheless, since politics can have a critical impact on portfolio holdings, this issue addresses some of the dynamics likely at play in the upcoming presidential elections.
A Better Approach
Assuming we are correct in our premise that accurate macro level predictions are extremely difficult, then perhaps a more productive approach is recognizing such futility and focus on those areas which can actually add value.