JANUARY 9, 2012
Investing in a 'Fat Tail' World
By pushing interest rates to very low levels, central banks are pushing investors out the risk spectrum.
By MOHAMED A. EL-ERIAN
Every year has elements of unpredictability, but what's in play in 2012 goes far beyond the usual risk of policy slippages, unexpected election outcomes and geopolitical hotspots. This is also about the global economy losing important anchors.
The very construct of the euro zone, the largest economic area in the world, is uncertain as efforts to keep the 17-member currency union intact continue to falter. Persistent political dysfunction in the United States precludes the world's only superpower from properly controlling its economic destiny. And emerging economies, such as China and India, have gained influence but still lack the institutions to deliver on their new global responsibilities.
Such unpredictability speaks to an uncomfortable possibility of extreme events. "Fat tails"—the technical term for the extremes of an outcome distribution—are risks for any global system that loses its anchors. Economies and markets function differently, companies and households feel unsettled, and policy measures become less effective.
With European economic fragmentation no longer totally unthinkable, expect even more people around the world to opt for "self insurance," thereby sucking growth oxygen from the global economy. We already see this in companies' preference for holding record levels of cash on their balance sheets, not because they like earning virtually no interest income but because they want lots of assurances of safety and freedom of action.
We will also spend quite a bit of 2012 worrying about the stability of European banks and, with that, the smooth functioning of the international monetary system. And all this comes at a time when America, the traditional engine of global growth, is already in an unemployment crisis, has interest rates floored at zero, and faces mounting deficit and debt concerns.
Navigating such unpredictability requires investors to rely less on historical short cuts and, instead, spend more time decomposing asset classes into their constituent risk factors. Moreover, they need to internalize a much broader set of correlations, pursue a more global opportunity set, and mitigate risk not only by diversifying but also by using active tail hedging aimed at protecting against the bad extremes of possible outcomes.
Investors must also stay ahead of a whole range of "unconventional" policy interventions that alter the very functioning and liquidity of markets, including the large-scale use of public printing presses by central banks in Europe and the U.S. By driving interest rates to very low levels, central banks are pushing investors out on the risk spectrum. But there is a reason why being pushed into an activity by the actions of others feels (and is) very different than being pulled in by the inherent attractiveness of the activity. It is a fundamentally less stable situation.
In such a world, prudence is the name of the game, and patience will likely be rewarded. To paraphrase Will Rogers, investors are well-advised to worry first about the return of their capital and second about the return on their capital. In doing so, they should exploit the flexibility that comes with cash and make prudent allocations to instruments that pay positive real returns, including high-quality municipals, bonds issued by countries with solid balance sheets, and the debt and equity of global companies with iron-clad cash flows and debt dynamics.
Unpredictability yields both risks and opportunities, and the answer to it should never be paralysis. More than ever, investors in 2012 will be challenged to understand an unusual set of global dynamics and to position their portfolios accordingly. For many, this will translate into strategies that are generally defensive yet agile enough to also be offensive as opportunities emerge.
Mr. El-Erian, the author of "When Markets Collide: Investment Strategies for the Age of Global Economic Change" (McGraw-Hill, 2008), is CEO of Pimco.