Whether it’s the prospect of a trade war between the United States and China, between the United States and Europe (or both) or rising inflation in the United States – bringing with it the prospect of higher interest rates – macroeconomic concerns are again dominating the headlines.
And that’s before considering the political turmoil in the United Kingdom over Brexit, German Chancellor Angela Merkel’s perilous position, and continued hostility by the so-called “resistance” to the duly elected President of the United States.
Given the plethora of macroeconomic and political risks at the moment, should you consider them when investing in shares?
In a word, yes, but not in the way most investors consider them.
What do I mean by that?
Firstly, it is very difficult to predict changes in interest rates or foreign exchange rates, changes in economic growth or movements in other macroeconomic variables.
And political events are just as hard to predict: Exhibit A is the election of Donald Trump.
As Warren Buffett noted in his 1994 Berkshire Hathaway Chairman’s Letter: “Thirty years ago, no one could have foreseen the huge expansion of the Vietnam War, wage and price controls, two oil shocks, the resignation of a president, the dissolution of the Soviet Union, a one-day drop in the Dow of 508 points, or treasury bill yields fluctuating between 2.8% and 17.4%.”
And the same goes for the Asian crisis of the late 1990s, September 11 and the GFC.
Yet despite history overwhelmingly proving Buffett’s point, most investors still believe they can predict these variables, and adjust their portfolios to reflect their predictions.
This is where the opportunity arises for other investors.
Rather than trying to predict macroeconomic or political events, wait until a company, sector or market reflects a consensus on a particular macroeconomic or political risk.
Already priced in
As the stock market is forward looking, this risk will likely be priced in. That is, if the consensus turns out to be correct, prices have likely already adjusted to reflect it before it occurs.
But if the consensus is wrong, then those who think differently will profit as prices subsequently adjust to reflect the new consensus.
One current example is the recent underperformance of cyclical stocks versus defensive stocks in the United States. The main reason seems to be concerns over the abovementioned trade wars, which, along with a flattening yield curve, has led to falls in materials, industrials and financials.
These sectors could be prospective waters to fish for undervalued stocks, especially as the market’s concerns may already be priced in even if they do turn out to be correct.