Frontier Informal Thoughts - Understanding a Complex Economy 

“Simple” was rarely a word that could have been used to describe the last few years - from market worries after the Fed rate hikes in 2018, to 2019’s repo market squeeze, to the absolute disruptions of Covid, and then to war, inflation, and a global year of volatile politics, nothing seemed “normal”, let alone simple and certain. When major global events keep happening every year, notwithstanding countless other events at more regional and local scales, it might even be more prudent to consider this sort of rapid changes and complexity as what is actually normal!

 

Frontier has generally held this sort of view about how the economy works - that it’s a rather complex, volatile, and frankly, quite an unpredictable creature. The last few years have strengthened our belief in this view, and while our work has continued to evolve, it has tended to do alongside and, in many cases, because of this complexity.

 

This complexity in the economy is both quite obvious and not easy to work with at the same time. It’s obvious that there are so many things affecting the economy, that these things change all the time, and yes, that it’s not easy (or as we tend to claim, even possible) to quantifiably model these. At the same time, engaging in the economy requires one to somehow work with it despite all of these “realities”. Economic theory helps fill part of this gap, and forecasts and consultancies tend to fill at least part.

 

At Frontier, we have tended to fall in the second category - helping our clients understand how the economy works (or how it doesn’t) and what can happen moving forward. The only problem for us - how do we forecast the future if it is truly so complex and so uncertain? In our previous memo, we went into detail on Frontier’s approach to tackling uncertainty, but in this memo, we want to take a look at how we see the economy itself in more detail.

 

Why do we think the economy is complex?

 

“When I think of modelling an economy, my first reaction is to think about how complicated it is.” 

- Howard Marks

 

A 2022 memo by Howard Marks really helps us explain parts of how we think of the complexity in the economy. Here, in his own words, Marks “railed against macro forecasting” given what he calls the “Illusion of Knowledge” and the inability to consistently and realistically account for the highly complex nature of how economies work. Despite our own business being in that of macroeconomics, this memo really showcases some of our own thinking of how the economy is a highly complex environment that we can’t in good faith give simple answers to (in fact, we will very heavily quote Marks here since he has already explained it so well).

 

The inherent complexity of the economy is simply understood by just considering the number of potential factors that can affect it. Marks talks of how “a real simulation of the U.S. economy would have to deal with billions of interactions or nodes, including interactions with suppliers, customers, and other market participants around the globe”, but even beyond this, if we were to simplify it down to “the main participants that matter”, things don’t get any easier. In Sri Lanka’s case, for example, we’ve spoken of how the cashflows of the Treasury matter immensely to the pathway of interest rates, but that these depend on so many moving parts, which each depend on varied balance sheets, and varied individual decisions by taxpayers, investors, and even government administrators. The current moment, before both Sri Lanka’s AND the US’ presidential elections then add a whole other layer on top of this. All these factors affect each other, and even if we only take the “big factors” into account, this still results in a massively uncertain monster of an economy we’re dealing with. 

 

This is why Frontier has tended to resist giving single-number forecasts, though we do give “guesstimates” within our multiple scenarios of the economy. Compared to earlier, we also review our views on the economy more frequently - and this reflects the simple fact that the dynamic animal that is the economy, moves around dramatically and that can easily change how the future can look like. This means our views and forecasts are probably better understood not as reflecting how the future will be, but rather how we see the present affecting the future. The ability to move fast and course-correct when the economy shifts rapidly is what would form the base of our advisory.

 

What is the use of understanding the current context?

 

“I figure that I want to swim as well as I can against the tides. I'm not trying to predict the tides.”

 

- Charles Munger

 

A lot of the work we do with our clients has continued to evolve towards understanding the economy at a greater level, and then explaining these underlying complexities in as simple and an understandable a way as possible. Our explanations might be longer than they was a decade ago, but we do still spend a huge amount of time trying hard to simplify the complexities of the economy in great depth.

 

The fundamental idea we have here is that if you understand what has been happening in the economy, you’re more likely to be aware of ways you might both do well and do badly, and have a more realistic basis upon which you can make your decisions. Moving quickly to take advantage of a shiny opportunity as well as moving quickly to make sure your hand isn’t burnt are both more possible when you have a better idea of how things work (Of course, if we had a crystal ball things would be even better, but we have to make do with what we can).

 

What we do tries to meet this head-on. From our macro intelligence products that keep track of what’s happening (and what’s important enough to keep an eye out on!) to our quick updates after important events to the (by now very long) monthly reports that try to explain what’s going on and why, our work really is about engaging with this complexity as opposed to giving direct and specific answers to what it is going to be tomorrow, in one month or in one year. As time went on, it became increasingly clear that we couldn’t in good faith tell our clients that there were straightforward forecasts of the future, and our core aim since then has been to help our clients make better decisions despite this. In practice, our understanding of the economy is in many cases incomplete and in all likelihood, will always be so. However, giving some a framework to think through what happens and how it MAY evolve can still help tackle actual decisions. This is part of how we engage with one of Marks’ most famous quotes- “You can’t predict, but you can prepare”.

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