There’s lot’s of talk about the “new normal.” Equity managers, for example, might estimate that amid consumer deleveraging corporations should expect to find equilibrium at about 15% less in revenues than in their 2007-2008 boom years.
For investors, that has to turn up as a loss somewhere, whether in earnings that grow less than in the past, or in investable companies that simply fold in an increasingly crowded market.
It’s trickier on the fixed income side. After all, governments are still going to market day after day – and succeeding in selling new bond issues. This despite fears that the bond vigilantes will swoop in like hawks – making for meagre dinner portions all around.
How bad could the new normal get? Well, the old rules of thumb won’t work anymore. Risk appetites may face a diet of uncertainty. This from PIMCO – the world’s biggest bond manager – in an op-ed for the Financial Times.
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 write: “Federal Reserve chairman Ben Bernanke’s characterisation of the economic outlook as ‘unusually uncertain’ has attracted much attention, and rightly so.”
But it’s not just the Fed that is “unusually uncertain.” So apparently, are the advisors to the policy-makers, in their economic forecasts of growth and inflation. Those forecasts, Clarida and El-Erian point out, are highly dispersed.
“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).”
So if the forecasters are turning up fat tails, what about investors seeking to avoid fat-headed decisions? Here, Clarida and El-Erian are quite provocative. Goodbye to expected returns.
“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.”
So forget the past, where an all-thumbs approach may have succeeded despite itself.
“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.”
As for the future, the tails that wag the market are ominous:
“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.”
There’s more of course, but let’s get our thumbs around these fat tails first.