The new abnormal August 4, 2010 at 9:04 am
Naked Capitalism quote an article by Pimco’s global strategic adviser Richard Clarida and CEO Mohamed El-Erian in the FT. They point out that the expectations of future economic conditions are much wider than normal. From here they make two leaps, neither foolish but leaps nevertheless.
- They assume that not only are expectations more volatile, but they are fatter tailed. In other words, a normal distribution is a less good model. This may well be true, but Clarida and El-Erian don’t present any evidence for it.
- They also assume – and this is a bigger leap – that this means that actual returns will be fatter tailed. Now this seems intuitively plausible, given the degree of economic uncertainty at the moment, but it is an assumption. We could be on the edge of a low-volatility high-growth phase: this is unlikely, perhaps, but it is possible.
Let’s run with it, though, and assume the Pimco guys are right. They suggest five implications:
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.
This makes sense. The problem is there just aren’t enough safe assets, and attempts to manufacture them by the private sector have proved catastrophic. One very useful thing that governments could do is to increase the supply of very low risk bonds. World Bank issued twenty and thirty year linkers in GBP, EUR, USD, CHF and JPY anyone?
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.
Again, I think that this is right, but I don’t know. Andrew Haldane has produced some useful pictures of the actual return distributions during various periods before: I would love to see what distributions look like for the last year or so.
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.
The problem is tail hedging is really difficult, as counterparty risk is a big issue in the tail. Finding the right hedge is hard enough: finding a counterparty willing to sell it to you who is sure to be around in a tail event is even more difficult.
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.
That is very true: many investors are still comfortable with correlation-based models that simply don’t work very well. Diversification is getting harder to get, and conventional wisdom about balanced portfolios is increasingly out of date.
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.
I was chatting to someone from a major investment bank yesterday about prime brokerage. Our conclusion was that it is not clear that this business makes sense at the moment, because the returns from providing leverage are simply not high enough. If we are right, then leverage costs are going to rise for hedge funds. This is certainly part of the trend Clarida and El-Erian identify. Low leverage, long tail protection, and skeptical about diversification: this is the new normal in investment management.
Update. Matthew Lynn has a related (if whimsical) take here.
Corporate bonds are a better bet than most government bonds. Would you rather have your money in Vodafone Group Plc, with millions of customers paying their mobile-phone bills every month? Or in U.K. government bonds, with a weak economy, a massive welfare bill and a budget deficit equal to more than 10 percent of gross domestic product?
Small companies are safer than blue chips. Just think of the problems that BP Plc has run into in the past few months. Giant enterprises can run into giant trouble. The smaller businesses can flourish under the radar.
Private-equity and hedge funds beat bank deposits. It was the banks that ran into trouble in the credit crunch, not the alternative-investment industry.
We don’t know precisely what will emerge as “safe” once the dust has settled on both the credit crunch and the sovereign-debt crisis. But emerging markets are safer than developed ones, equities beat property, and corporate bonds are preferable to government notes.
Now, some of those examples are foolish. But the broader idea that what is safe is changing is reasonable. The conventional wisdom will have to be updated.
