Uncertainty Changing Investment Landscape (PIMCO)

This article is a guest contribution by Richard Clarida, EVP, and Mohamed El Erian, CEO and Co-CIO, PIMCO.

Federal Reserve chairman Ben Bernanke’s characterization 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 U.S. 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 realized in practice. A world where the realized 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.