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August 2010

This article was originally published on on August 2, 2010.

Uncertainty Changing Investment Landscape

By Richard Clarida and Mohamed El-Erian

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

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.

August 2010

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.

Moreover, because of the complex and broader involvement, real and perceived, of
governments in the economy, separating policy signal from noise, and execution vs.
intent, has become as important as – but harder than – forecasting the macro data.

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.

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.

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.

This is not just because extreme bad scenarios “melt down” positions but rarely “melt
up.” Even with a balance among good and bad scenarios, the provider of leverage
does not benefit from the fatter good tail, but faces greater likelihood of loss with the
fatter bad tail.

Investors had 25 years to get comfortable with the Great Moderation. Its end poses
challenges that extend well beyond policy circles as it fundamentally undermines the
rules of thumb that served so many investors for so long. The sooner this is
recognized, the better.

August 2010

About the authors:

Dr. Clarida is an executive vice president in the New York office and PIMCO’s global strategic
advisor. Since 2008, Dr. Clarida has also been co-head of PIMCO’s official institutions channel,
which oversees coverage of the firm’s central bank and sovereign wealth fund clients. Prior to
joining PIMCO in 2006, he gained extensive experience in Washington as assistant Treasury
secretary, in academia as chairman of the economics department at Columbia University, and in
the financial markets at Credit Suisse and Grossman Asset Management. He has 12 years of
investment experience and holds a Ph.D. in economics from Harvard University. He received his
undergraduate degree from the University of Illinois.

Dr. El-Erian is CEO and co-CIO of PIMCO and is based in the Newport Beach office. He re-
joined PIMCO at the end of 2007 after serving for two years as president and CEO of Harvard
Management Company, the entity that manages Harvard’s endowment and related accounts. Dr.
El-Erian also served as a member of the faculty of Harvard Business School. He first joined
PIMCO in 1999 and was a senior member of PIMCO’s portfolio management and investment
strategy group. Before coming to PIMCO, Dr. El-Erian was a managing director at Salomon
Smith Barney/Citigroup in London and before that, he spent 15 years at the International
Monetary Fund in Washington, D.C. Dr. El-Erian has published widely on international economic
and finance topics. His book, When Markets Collide, was a New York Times and Wall Street
Journal bestseller, won the Financial Times/Goldman Sachs 2008 Business Book of the Year
and was named a book of the year by The Economist. Dr. El-Erian has served on several boards
and committees, including the U.S. Treasury Borrowing Advisory Committee, the International
Center for Research on Women, and the IMF’s Committee of Eminent Persons. He is currently a
board member of the NBER and the Peterson Institute for International Economics. He holds a
master’s degree and doctorate in economics from Oxford University and received his
undergraduate degree from Cambridge University.

This material contains the 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. Information contained herein has been obtained from sources believed to be reliable, but
not guaranteed. This material was reprinted with permission of the Financial Times. Date of original
publication August 2, 2010.