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Uncertainty changing investment landscape
By Richard Clarida and Mohamed El-Erian
Published: August 2 2010 18:06 | Last updated: August 2 2010 18:06
Federal Reserve chairman Ben Bernanke’s characterisation of the
economic outlook as “unusually uncertain” has attracted much
attention, and rightly so. It speaks to the immediate impact of a
series of ongoing national and global realignments whose effects are
consequential but not yet sufficiently appreciated.

At a fundamental level, the unusual uncertainty reflects the
disruptive combination of deleveraging, reregulation, structural
unemployment, and other ongoing structural changes.

EDITOR’S CHOICE
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Text of Bernanke’s speech - Aug-02

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US factory output slows in July- Aug-02

In depth: US states’ budget crises - Jul-27

The phenomenon is not limited to the US. It is also visible in other
industrial countries. Just look at the latest inflation report issued
by the Bank of England, which points to unusual dispersion in
policymakers’ expectations for such basic economic variables as growth
and inflation.

It is the shape of such dispersion that strikes us as particularly
important. It seems that, wherever we look, the snapshot for
“consensus expectations” has shifted: from traditional bell-shaped
curves – with a high likelihood mean and thin tails (indicating most
economists have similar expectations) – to a much flatter distribution
of outcomes with fatter tails (where opinion is divided and
expectations vary considerably).

We should all feel sorry for policymakers who face such distributions.
The probability of a policy mistake is materially higher, especially
as policy measures are subject to lags. What is less appreciated is
the extent to which this changing shape of distributions affects
conventional wisdom in the investment world, together with the rules
of thumb that many investors have come to rely on.

We can think of five implications, some of which are already evident
while others will only be obvious over time.

First, investing based on “mean reversion” will be less compelling.
Even though flatter distributions with fatter tails have means, the
constituency for mean reversion investing will shrink as those means
will be much less often realised in practice. A world where the
realised return rarely equals the expected valuation creates a bigger
demand for liquid, default-free assets; it also lowers the demand for
more volatile asset classes such as equities. These shifts are already
taking place.

Second, frequent “risk on/risk off” fluctuations in investors’
sentiment are here to stay. Investors, based on 25 years of rules of
thumb that “worked” during the great moderation, thought they knew
more about the distribution of risk than they in fact did. This led to
overconfidence during the bubble. The crisis reminded investors that
these rules of thumb are less useful, if not dangerous.

With declining confidence in a reliable set of investing rules,
markets have become more susceptible to overreactions to daily news
and, are, therefore, more volatile. Just think of the number of triple-
digit days in the Dow.

Moreover, because of the complex and broader involvement, real and
perceived, of governments in the economy, separating policy signal
from noise, and execution versus intent, has become as important as –
but harder than – forecasting the macro data.

Third, tail hedging will become more important. An understandable
consequence of the crisis is less trust in diversification as the sole
mitigator for portfolio risk. We are already seeing increased investor
interest in tail hedging, though the phenomenon is still limited to a
small set of investors.

Fourth, historical benchmarks and correlations will be challenged. In
this new “unusually uncertain” world, many investors will need to
fundamentally rethink the design of benchmarks and the role of asset
class correlations in implementing their investment strategies. The
investment industry is yet to give sufficient attention to this.

Finally, less credit will be available to sustain leverage and high
valuations. Even apart from the inevitable response to regulatory
actions aimed at derisking banks, a world of flatter and fatter
distributions will reduce available supply of leverage to finance
trades and balance sheet expansion.

This is not just because extreme bad scenarios “melt down” positions
but rarely “melt up”. Even with a balance among good and bad
scenarios, the provider of leverage does not benefit from the fatter
good tail, but faces greater likelihood of loss with the fatter bad
tail.

Investors had 25 years to get comfortable with the great moderation.
Its end poses challenges that extend well beyond policy circles as it
fundamentally undermines the rules of thumb that served so many
investors for so long. The sooner this is recognised, the better.

This article was co-authored by Richard Clarida, global strategic
adviser at Pimco and professor of economics at Columbia University,
and Mohamed El-Erian, chief executive and co-chief investment officer
of Pimco