“The ‘New Normal’...turns out to be a world where scenarios move from impossible to inevitable without even pausing at improbable. Flocks of black swans go winging by with a frequency that is dulling our sensitivity to just how extraordinary these financial times are. Call it crisis fatigue.”– Mark Gilbert, Bloomberg, June 2010
July 2010 marks the third anniversary of the onset of the global financial crisis. No, I’m not celebrating and I don’t know anyone who is. But anniversaries – even those associated with disruptive events – serve the useful purpose of reminding us to ask ourselves what we know now, what we don’t yet know and what we can never know about major historical events. This is especially important today because, like generals plotting military victories, policymakers and regulators – as well as the legislators drafting laws that will govern their actions – have every incentive to “fight the last war” and fight it well. In fact – at least in the U.S. – the track record posted by policymakers in fighting the last war is impressive. But while some experts may be reassured that we have learned how to avoid another Lehman Brothers–style disaster, it should also give them pause to remember a few other moments:
- Twenty years ago we learned how to avoid another savings and loan crisis;
A dozen years ago we learned how to avoid another Long-Term Capital Management; and
Eight years ago we learned how to avoid another Enron. (So far, though I fear Enron accounting may be making a comeback in certain countries as they allow national champion banks increasing accounting forbearance in an effort to buy time as they repair tattered and mismarked balance sheets.)
I recall a
conversation six or seven years ago with a very senior policymaker in
which he said the number one problem facing the global financial system
today is hedge funds, because unlike tightly regulated banks, hedge
funds are unregulated. He invited me to react (I then advised a hedge
fund), to which I replied, “A hedge fund is a compensation scheme, not
an investment strategy. The prop desks at all the major banks you
regulate have the same trades that hedge funds have. Does this make you
more or less nervous?” There are a range of possible outcomes for the eurozone. At one
extreme is successful fiscal adjustment, the creation of a deeper fiscal
union and the creation of a European Monetary Fund – built on the
foundations of the special purpose vehicle (SPV) – to ensure that this
never happens again. At the other extreme it could involve exit from the
eurozone by one or more countries, and it may not be just the
eurozone’s weakest members that will have to leave. It is possible that
Germany may one day see the benefits of a return to the deutschemark
outweighing that of European solidarity. The unthinkable has become
Financial history suggests “never again” eventually becomes “this time it’s different” and, as Kenneth Rogoff and Carmen Reinhart remind us, throughout history “this time it’s different” eventually sets the stage for the next financial crisis. This is especially true when, as emphasized by Hyman Minsky, the “this time it’s different” wisdom supports and encourages greater and greater use of leverage.
In the case of the current crisis, the “this time it was different” embodied the logic that securitization and the expertise of the ratings agencies in assessing default risk in tranches of structured products could, in theory, diversify and distribute credit risk among a large global pool of sophisticated investors and away from an excessive concentration on the balance sheets of the too-big-to-fail institutions that were issuing these securities. It was supposed to be the brave new world of “originate and distribute” and for a while it was, until it wasn’t. An explicit assumption deployed by the rating agencies and the investment banks to price these complex structures was that default probabilities – and, crucially, their correlations – were drawn (to paraphrase Donald Rumsfeld) from an “old normal” distribution, in which realized cash flows from different tranches would cluster close to historic means. In reality, they didn’t, and hundreds of billions of dollars’ worth of AAA-rated CDO tranches were downgraded to junk. What should have been a Six Sigma event in an “old normal” world became an everyday occurrence in a New Normal reality.
The title of this essay distills what I have come to believe will be one of the significant and enduring consequences of the global financial crisis for investors: Now and for the foreseeable future, we are in a world in which average outcomes – for growth, inflation, corporate and sovereign defaults, and the investment returns driven by these outcomes – will matter less and less for investors and policymakers. This is because we are in a New Normal world in which the distribution of outcomes is flatter and the tails are fatter. As such, the mean of the distribution becomes an observation that is very rarely realized, creating at least three fundamental consequences for investment strategy.
Getting the Tails Right
First, since the price at which investors can buy an asset will tend to reflect the ex ante mean of the distribution of returns, realizing alpha in the New Normal world when selling the asset will require getting the tails right. Selling after a left tail event is realized (or after the market gets news that a left tail event is more likely – think Greece) will likely result in big losses. Selling after a right tail event is realized (or after the market gets news that it is more likely – think J.P. Morgan shares after the conference committee vote on the Dodd-Frank bill) will likely result in big gains. On average, the investor’s returns will likely be modest, but only rarely if ever does any investor realize those average returns.
“Getting the tails right” will be easier said than done. Rules of thumb and historical correlations will likely prove to be irrelevant or, even worse, misleading guides to portfolio positioning. Examples abound: V-shaped recoveries may not inevitably follow deep recessions (as the incoming U.S. data are now confirming); tripling the monetary base may not inevitably lead to double-digit inflation (as the Treasury Inflation-Protected Securities [TIPS] market is telling us); and half-trillion-dollar official sector rescue packages may not inevitably be sufficient to address sovereign liquidity disruptions (as is reflected in Greek government bond prices). Regarding the euro, as my colleague Andrew Balls points out in a recent essay:
There are a range of possible outcomes for the eurozone. At one extreme is successful fiscal adjustment, the creation of a deeper fiscal union and the creation of a European Monetary Fund – built on the foundations of the special purpose vehicle (SPV) – to ensure that this never happens again. At the other extreme it could involve exit from the eurozone by one or more countries, and it may not be just the eurozone’s weakest members that will have to leave. It is possible that Germany may one day see the benefits of a return to the deutschemark outweighing that of European solidarity. The unthinkable has become thinkable.
Second, a New Normal world is likely to be one with frequent flips between “risk on” and “risk off” days. With so much profit and loss riding on tail events and so little profit and loss tied to the cluster of outcomes near ex ante means, repositioning will likely be more frequent. This is because many investors lack conviction in their understanding of the true distribution, so that each passing day provides an opportunity to learn or unlearn how likely the relevant tail events are. Positioning for mean reversion will be a less compelling investment theme in a world where realized returns cluster nearer the tails and away from the mean.
James Carville said twenty years ago that he wanted to be reincarnated as the bond market because the vigilantes had so much clout over policymakers. But in the New Normal world, he might wish to be reincarnated as the Asian equity markets because they are where traders in Europe and the U.S. look to see if it is a “risk on” or “risk off” day. With so much money chasing fewer assets with known return distributions, and with reliable investment rules of thumb scarce, frequent flips between “risk on” and “risk off” days will likely be a continuing symptom of the Knightian uncertainty that still, to some extent, hangs over global financial markets. Uncertainty is less chronic and its impact less systemic than in the first year or so of the global financial crisis, but it has not disappeared. Unlike October 2008, markets are now open and assets trade, but they trade at clearing prices that reflect daily news about the relevant, headline-grabbing tail events. For example, a Chinese growth slowdown suggested by a leading indicator report signals “risk off,” while the Dodd-Frank bill passing the conference committee with a watered-down Volcker rule signals “risk on.”
Third, because harvesting alpha in the New Normal will require getting the tails right, successful investment strategies in a New Normal world will generally be less levered than during the Great Moderation. Note that this is a consequence of the New Normal itself and not merely the outcome of tighter regulation, which itself is almost surely to discourage leverage. The contrast is instructive: In the Great Moderation years (roughly 1987–2007) of predictable policy, low inflation, and modest business cycles, generating alpha meant adding leverage to boost the returns realized by bunching close to the mean. As more leverage was piled on to the system, spreads shrank, which induced adding even more leverage to reach return targets. In a New Normal world, the cost of debt financing to fund speculative trades must go up. The lender does not benefit from the fatter right tail of borrower profits if that right tail is symmetrically matched by a fatter left tail of borrower losses. And the bias against leverage is only more pronounced if (as I suspect) left tails are not only fat but asymmetrically larger. As my colleague Paul McCulley likes to say, “Markets usually don’t melt up.”
Although it is now widely accepted we are in a New Normal with fatter tails, many investors don’t fully appreciate the key implications: First, rules of thumb and investment strategies based on mean reversion will likely be less effective or even unsuccessful in a world where realized returns rarely cluster near the mean, even though distributions with fat tails have means too! Second, with so much profit and loss riding on getting the tails right, fluctuations in risk appetite will be more frequent, a symptom of the Knightian uncertainty that still overhangs the markets and a fact illustrated by the uncertainty over policy in Europe now. Third, the cost of debt financing to fund speculative trades must go up. The lender does not benefit from the fatter right tail of borrower profits if that right tail is symmetrically matched by a fatter left tail of borrower losses – this will be true regardless of the inevitable regulatory response that will further discourage leverage.
Investors had 25 years to get comfortable with the Great Moderation. The sooner they recognize those days are over, the better.
Richard H. Clarida
Executive Vice President
Global Strategic Advisor