Every January comes with estimates of corporate profits and macroeconomic projections, which are essential to determine whether or not the stock market is cheap or if the economy is improving.

However, every year as well, especially in the past eight years, we witness a very entertaining pattern. Massive downward revision of corporate profit expectations. These have averaged 15% between January and December almost every year.

The mainstream consensus of analysts suffers from the same constant mistake of large international organizations, whose average accuracy in their short and medium-term predictions is less than 26%, as Ned Davis explains in “Being Right Or Making Money”. The error of the “double trap”: Long-term optimism and negation of short-term trends.

If we take Bloomberg’s earnings per share estimates for the Eurostoxx 50, for example, in January 2016 for that same year, these were + 1.5%, and + 12.4% for 2017.

If we then look at the same estimates for the same index on December 16, 2016, what do we find? Profits for 2016 -2.3% and + 11.1% for 2017.

This trend is very similar with S&P profits. Full Year 2016 from +2.7% in January to +0.1% in December and FY17 from +14% to+12.3%.

Note the brutal impact on the estimates in eleven months of profits for the very short term. From healthy profit to loss or no growth. But note, in turn, the gradual but inexorable erosion of estimates for the following year.

Graph: Consensus estimates of EPS (source: Citi)

Why is this happening? The “hockey stick” in future estimates is the best excuse to justify blunders.

Look at the examples in macroeconomic estimates, from the Federal Reserve to the ECB and the IMF . The Federal Reserve has been cutting one-year-forward estimates by up to half since 2009. What about inflation estimates? The same.

Ignore for a second the disaster in prediction track-record, and focus in the shape of estimates. Almost always a hockey stick.

Suppose, as with the aforementioned estimates, that we economists have screwed up in the current year. What is the answer? “Oh, but look, next year everything improves.” And, in turn, the next hockey stick is moved to the new, lower, base. But that hockey stick of fantasy future projections, remains. Don´t worry, “next year” will always be there.

There are various reasons:

Mainstream consensus tends to overestimate the positive impact of monetary policy over other risk factors. It is very evident in corporate profits and even more so, in capex estimates. According to Standard and Poor’s, capex predictions have been particularly erroneous.

Since 2012, consensus predicted increases in real net investment, and it fell, very severely in the last three years in particular. As one great US fund manager said: “Come to me with ceteris paribus and I give you zeros salarius”

Analysis houses often introduce large impacts on GDP, consumption, unemployment, and investment or inflation expectations due to changes in monetary policy, without addressing much more relevant trends such as overcapacity, ageing, technology or the real cost of capital. The results are invariably downward revisions, but gradually – little by little, month by month – in order not to look so bad.

Denying business cycles is another mistake. Cycles become shorter and more abrupt as debt rises and money velocity falls. Using estimates where the starting point is simply moved lower and then increased annually, as if there were no cyclical factors that cancel those correlations, is a more than common mistake.

Additionally, the confirmation bias is very evident in these errors in expectations. Assuming short-term mistakes are just anomalies, white noise, that do not change the medium-term prediction, because most of consensus supports the starting premise and it needs to be reaffirmed.

Of course, in order to justify these brutal deviations in short-term estimates, mainstream consensus will use sentences such as “it could have been worse”, “fundamentals have not changed”, and “in the long-term it will improve”.

In order to support the “eternal hockey stick”, there will be seemingly robust studies of regressions, endless Excel spreadsheets and complicated algorithms in which everything appears very scientific until you see that in two or three cells most of the key “inputs” are subjective.

I remember that three years ago I was surrounded by colleagues, former members of the Federal Reserve, when we entered into an endless discussion about business profits and growth in Japan. One of them sent his model of the country and Nikkei companies. It was very complex. Until we found the cell that changed everything. “Expected increase of real consumption from variations in money supply”. Depending on what one decided to input, the country and its companies were still stagnant or booming.

Another magnificent example of the “surprise cell” from those same colleagues came from estimates of US economic growth. “Expected net change in investment from non-financial sectors as a percentage increase in money supply”.

These are anecdotes, but they show that the general mistake in medium-term estimates comes mainly from altering the result to justify the conclusion, albeit involuntary, due to individual prejudices, peer pressure and ideological preferences. There are many studies  that warn of the “pollution” in optimistic estimates, where many of these predictions simply seek to justify an existing policy or strategy, or, in the case of corporate profits, justify valuations that are hardly supported by fundamentals. Any analyst in the world knows that, on average, 80% of the valuation of a stockis explained by the years that exceed the “forecast period” (normally four, maximum five years).

Does this mean that analysis is useless? Not at all.

Analysis has an enormous value in what has to do with the detailed study of factors that affect companies, governments and families. But predictions, especially for more than three years, have to be taken not with caution, but with the certainty that they are contaminated by optimism. To be guided by long-term predictions of economists that deny cycles and are clearly unable to predict the most immediate future is, at the very least, dangerous.

Making estimates is essential for economic analysis. It helps us realize where we are wrong, and act accordingly by recognizing those impacts – positive or negative – we missed, for further analysis. Making mistakes is essential to improve. The problem is to confuse estimates with infallible magic predictions and, even worse, to cover these “hockey stick” estimates with a fake “scientific” layer, when they only serve as an excuse to perpetuate erroneous policies and recommendations.

Daniel Lacalle is PhD in Economics and author of “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

@dlacalle_IA

Pictures courtesy of Business Insider, Citi, David Stockman

Last week, the Central Bank of Mexico intervened twice attempting to defend its currency  with more than disappointing results. The Mexican peso has suffered one of the largest devaluations of any currency in the past twelve months, only comparable to that of the Turkish Lira, and weakened again shortly after the interventions.

Despite these measures, the local currency continues to be under pressure and the cause is mainly the United States rate hike.

On the one hand, Mexico suffers, along with the rest of emerging markets, from capital outflows due to the rise in interest rates in the US.

As US ten year bond yield rises, emerging market debt loses its appeal, especially at current levels. These countries had seen a record inflow of capital over the past eight years thanks to excess liquidity and lower rates in the US, and issuances yield fell to a 30-year low. Today, even at 7.6% these rates are less attractive compared to a US 10-year bond, close to 2.4%.

That is the main reason, not Donald Trump’s tweets, but of course the president-elect’s messages regarding NAFTA and his criticisms of automobile companies do not help.

Many analysts compare the current risk to that of 1994, shortly before the so-called “Tequila crisis,” which triggered a Mexican stock market crash and a domino effect on other emerging markets.

Why? The combination of capital outflows and rising current account deficit, which could lead to a huge liquidity crisis.

But, nevertheless, there are very important mitigating factors.

Although the outflow of capital is true, it is not at worrying levels. In addition, in 2016, Mexico was the third largest recipient of net capital , despite low oil prices and risks in emerging economies in an environment of low global growth and weaker international trade.

In addition, although foreign exchange reserves have declined since 2014, they remain at record highs and more than seven times above 1994 levels.

One of the distinguishing characteristics of this crisis compared to 1991 or 1994 is precisely that central banks of emerging economies have carried out a correct policy of preserving foreign currency reserves at the highest possible level, thus avoiding a liquidity crisis. Exactly the opposite of what these countires did in the 90s crises, where reserves were almost depleted trying to “defend” the currency.

In fact, the action of the central bank of Mexico in these days can be called more “technical” than the desperate ones of that time.

Another, and very important factor, is the exposure to leverage in the stock markets. Before the Tequila crisis, citizens and entities borrowed massively to buy a seemingly unstoppable bull stock market. The level of leverage in the stock market was such that there was a period when “margin debt” in terms of market size was higher than that of the US stock market in 2007.

If we analyze the perfect storm that happened in 2013-2015 in emerging countries, a dramatic crisis has been avoided despite the abrupt fall in commodities, net capital outflows and the global slowdown in trade (the “sudden stop” effect that we mentioned in 2013 here).

In this period, Mexico’s foreign currency revenue has been reduced by a third from the highs, and the fact that massive recession and crisis has been avoided proves that many things are very different today in Mexico.

These important differences must be taken into account when we read some alarmist messages, but we must also be cautious because the situation for emerging markets remains complex given the “hoover” effect of the US rate hike. A strong dollar, rising rates and inflation provoke a dollar-sucking effect out of riskier markets and back into the US domestic market. Especially after almost a decade of extraordinary capital flows into emerging markets.

Let us not forget the risks, the macroeconomic, political and monetary threats. The end of excess liquidity and cheap money is here and countries like Mexico will have to adapt to a level of investment and capital flows that will likely be much lower than those of the last eight years.

Mexico will have to take advantage of a year in which oil prices have stabilized to match its investments to a new reality, closer to that of 2000-2006 than the three US monetary stimulus programs. But if we have to look at risks, we also have to look at opportunities, because Mexico has always been a better option compared to other countries with greater risk.

Daniel Lacalle is PhD in Economics and author of “Life In The Financial Markets” and “The Energy World Is Flat” (Wiley)

@dlacalle_IA

Article published in elespanol.com in Spanish

Picture courtesy of Google Images

By the title you might think that my article might be centered in Keynes’ economic policy ideals towards taxes, but no… I know and I’m conscious that that would be a really interesting debate, and that many of you will enjoy reading it, and sooner or later we’ll have time to talk about that, but today I want to write about a more actual theme that doesn’t come from 70 years ago, and that nowadays is essential in all the economy’s minister desks, I hope you know what I’m talking about.

Lately this last two months, in the news or even in the day to day and into economic conversations, nobody stopped talking about corporate tax or even its effects and causes in the economy, but why? It seems like economists are really excited about it, and have reasons for it.

Recently, the Hungarian Prime Minister; Viktor Orban has displayed his intentions on decreasing the corporate tax rate to 9.5%, having the lowest one in the EU, followed by Ireland, which actually maintains its rate in 12.5%.

Let me tell you that Spain is not an example to follow in this case, and that today talking about it might be really boring, I like action, and action is that the USA will provide to the labor market with Trump’s intentions of decreasing brutally the corporate tax rate by more than 20 percental points in just one year… from its actual 35% to nearly 15% over the companies’ income.

The American Dream

Let me say that by reducing the global tax rate on income and in contrast to what many people think, this would help to improve the American tax system and rise the revenues of itself.

We shouldn’t be negative when we are told by the new director of the FED, that the highest corporate tax of the major powers of the world (USA’s 35%) will be lowered down to the OECD average 25%, or even to its Canadian partner rate- which is 15%, leading to greater innovation in all the sectors of the economy and will help to shift profits generally upwards.

Should be kept in our minds, that by cutting corporate taxes, the USA will be much more competitive within international markets, generating higher aggregate demand and benefiting the larger part of Americans and their wages.

Internally, into the country, the new lower rates will reduce the costs of production capital in many firms, mainly manufacturers, which will rise the investment levels into that particular market, at the same time it will contract market share from economies as the Chinese.

With higher money being in circulation in the USA, productivity will increase due to more incentive for labor and higher salaries for the jobs in the secondary and tertiary sectors, producing consequently much better standards of living in the mean term.

Labour, wages, consumers & living standards … everytihng’s related

Secondly, we have seen able to see through experience how a lower tax rate on corporations will reduce prices of natural goods and materials, reducing business costs and freeing companies from their production expenses, allowing to increase supply in the market, as in the EU, where stock rates have risen by 6.5% over the last decade.

As we have previously mentioned, by lowering tax rates, investment and economic growth will be lifted in the economy, which will give place to greater wages for the human capital and improved working conditions for many, as we have observed that in the vast majority of developed countries, productivity is highly related to the final wages received by workers, and larger incentives lead to higher productivity of lab.

In case of decreasing the US corporate tax down from 35% to the 20% settled in the UK will rise over time full time employment by 2.8% in the mean term, generating 600,000 new jobs just in the first year, according to a study from the TAG.

But lowering corporate tax won’t be only beneficial for entrepreneurs and international investors, as it will also have many positive effects for the local population and low skilled workers.

Having a higher economic growth and an increased tax income will allow the government to descend tax rates also on income tax, which will provide workers with much more disposable income and purchasing capacity, rising living standards.

In conclusion, by reducing the tax rate to 15%-20% will make the economic growth of the USA to be boosted to a 3.3% extra added to the current growth rate over the next five years.

Workers will be one of the most benefited groups for this decrease in tax rates, and mainly in corporate, which will delegate on an increment in employment with 600,000 jobs being created just in the first and a half year of mandate, and wages of previously stablished employment will rise by 3.6% over two-three years.

Álvaro Martín is an international economy student. You can read his articles in Club de los Viernes´s website.