20 July 2023
A paradox of the financial services industry is that few buy-side investors would admit to investing based on consensus macro forecasts. And yet brokers and investment banks employ teams of economists, strategists, and analysts who put out reams of such forecasts every quarter. Why does Wall Street spill so much ink and pay so many dollars to produce an output that no one seems to think has any value?
Famed value investor Howard Marks expressed his disdain for forecasts in a memo titled The Illusion of Knowledge, where he also questions how often the performance of these predictions is tested. “I ask because I’ve never seen or heard of any research along these lines. The world seems incredibly short on information regarding the value added by macro forecasts, especially given the large number of people involved in this pursuit.”
You may have seen a chart similar to the one below, showing the point-in-time forecasts of the US 10-Year Treasury Yield for the next six quarters against the actual trajectory of the yield. While this type of chart is often cited to show the persistent error and bias in some macro forecasts, we think that the question warrants some more analysis.
Source: U.S. Fed: Survey of Professional Forecasters
We assess consensus forecasts for 14 macro-economic variables across commodities, currencies, bond yields, inflation, and short rates, 11 of which are investable. We look at two different measures over the period from 2007 to 2023. First, we consider directional accuracy by measuring the correlation between the forecast change in a variable over the next year and the actual change that happened. An accurate forecast should be positively correlated with subsequent changes in the variable that it is trying to forecast.
Source: Bloomberg, Mergence
Of the 14 metrics we look at, 10 have a positive correlation between forecast and outcome, and the average correlation across all 14 indicators is positive, indicating some level of forecasting skill. These results also illustrate a few interesting points. Consensus has the ability to forecast the directional change of inflation and short rates, the largest determinants of US bond yields; yet they have not been able to forecast the direction of yields themselves, which have already discounted the inflation and rate forecasts. It is also interesting that consensus has had some success in forecasting commodity prices, except for gold.
Below, we plot the distribution of the errors in these forecasts. How far off was the actual price compared to the forecast made a year ago? What is striking is how far off some commodity price forecasts can be over just a year and how fat the tails are in these distributions.
Source: Bloomberg, Mergence
From this short analysis, we propose a few potential conclusions:
- Macro forecasts could be useful; in aggregate, they seem to produce some signal, but it is small and inconsistent.
- It is likely easier to predict non-investable economic variables than market prices.
- It is likely easier to predict variables or prices that have strong fundamental price drivers and a large real-world demand as opposed to a purely speculative or financial demand, e.g., industrial commodities vs. gold.
- Macro forecasts tend to work in stable, mean-reverting markets and regimes; large dislocations, volatility spikes, and regime change are the enemies of the forecaster.
- Some macro forecasts can be wrong by very large margins. Don’t underestimate the range of potential outcomes when using consensus forecasts in your models.
- The real opportunity lies in understanding when both consensus and the market may be ignoring and underpricing plausible future scenarios.
2For Commodities and currencies we calculate error as the forecast error as a percentage of the market price at forecast date. For yields, CPI and rates we calculate as difference between forecast and the actual.
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