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"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."
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:
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?" 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 RightFirst, 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.
This material contains the current opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660, 800-387-4626. ©2010, PIMCO.
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