2012 — Year Of The Fat Tails

Source: Decline of the Empire

The Pimco boys Bill Gross and Mohamed el-Erian are warning about fat tails in 2012.

“The only predictable thing about 2012 is its unpredictability.”

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…

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.

I thought I should explain to my readers what fat tail risks are. Look at this graph.

In a normal probability distribution (the lighter blue curve), the odds of risky outcomes (bad stuff happening) are thin at the extremes. In fat-tailed distributions, such outcomes have a greater chance of occurring (the darker blue curve). Source

Non-normal distributions can be heavily skewed and unstable. Perhaps you think the chances of bad stuff happening looks more like this!

Source

Bill Gross talks about fat-tailed risks in Toward The Paranormal. Here’s the summary.

• The New Normal, previously believed to be bell-shaped and thin-tailed in its depiction of growth probability and financial market outcomes, appears to be morphing into a world of fat-tailed, almost bimodal outcomes.
• A new duality — credit and zero-bound interest rate risk — characterizes the financial markets of 2012, offering the fat left-tailed possibility of unforeseen policy delevering or the fat right-tailed possibility of central bank inflationary expansion.
• Until the outcome becomes clear, investors should consider ways to hedge their bets, including: maximizing durations, U.S. Treasury bonds that may potentially offer capital gains, long-term Treasury Inflation Protected Securities (TIPS), high quality corporates and senior bank debt, and select U.S. municipal bonds.

Bill also notes that the expected de-levering is not occurring if you include government debt.

What are the risks in 2012? We know the obvious ones—another recession, contagion from Europe, a crash in China. Those are the known unknowns. But as The Rumsfeld said—

Reports that say that something hasn’t happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns — the ones we don’t know we don’t know.

Yes, it’s those unknown unknowns which get you every time! But for ordinary Americans, working or not, there is a known known that never varies—if some really bad stuff happens, they will get the short end of the stick.

Bonus Video — From The Daily Ticker’s New Year, Really Big Threats: ‘Fat-Tail’ Risks Rise.

Read more at Decline of the Empire