Excuse Me, But Your Tails Are Getting Fatter

I talk quite a bit about tail risk.

One of the biggest mistakes an investor can make is to assume that financial markets follow a Gaussian (i.e. normal) distribution. Put simply, the data does not support that contention. Indeed, the idea that there is something called “normal” when it comes to markets is to assume that when the waters are relatively calm, we’re all operating in some kind of magical equilibrium.

But that’s an illusion. Low volatility is just market participants fooling themselves into believing that uncertainty has, for the moment anyway, dissipated. But the investor who perceives such a comfortable stasis is deluding himself and indeed, we’re all better off when the illusion of equilibrium is disrupted, for that’s when risk suddenly reprices to reflect the fact that we never know what’s coming. That’s why, earlier on Thursday, I said the following:

…when we assess whether a given piece of research is “actionable,” what we should be asking is whether, upon reviewing it, we have expanded our list of possible outlier events. If we have, then we can say the following with more confidence than ever: “I know that I don’t know.” We have, in effect, gained a better understanding of where the limits are in terms of making predictions about a given security or about an index or about the economy or about… etc., etc. Those limits tell us something about how to hedge our bets.

It’s in this context that I return to PIMCO’s list of critical transitions that will shape markets going forward. For those who missed it, here they are:

• The transition from monetary to fiscal policy, which has gained speed with the European Central Bank (ECB) tapering the monthly run-rate of its asset purchases to €60 billion, the Bank of Japan (BOJ) abandoning its money supply target in favor of a yield target, and the next U.S. administration likely to embark on a more expansionary fiscal policy.
• The transition from globalization to de-globalization, which has been underway for some time but now looks set to accelerate as governments in the U.S. and elsewhere are likely to become more inward-looking.
• China’s currency regime transition from what was a U.S. dollar peg until August 2015 to the current quasi basket peg to what may become a managed or even free float of the yuan.

In addition to that list, PIMCO also looked at the left-tail, baseline, and right-tail outcomes that could prevail in 2017. Their analysis reinforces the notion that while Trump’s election has raised the chances of a boom, his victory has also raised the chances of a bust. In other words, the tails are fatter.

With all of that in mind, consider the following graphic which illustrates the distribution of possible outcomes for the new year:

(Graphic: PIMCO)