Uncertainty changing investment landscape

By Richard Clarida and Mohamed El-Erian

Published: August 2 2010
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

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