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OPINION

Uncertainties

Uncertainties
January 12, 2016
Uncertainties

Some of these come from China.

Everybody knows that the country's trend growth rate is slowing: prime minister Li Keqiang recently announced a target of 6.5 per cent annual GDP growth, whereas growth between 2000 and 2012 was never less than 8 per cent.

Beyond this, however, things are unclear. One uncertainty isn't about the future but the present. Few investors believe the official figures, which showed annual real GDP growth of 6.9 per cent in the third quarter. Economists at Fathom Consulting estimate that growth could be as low as 2.6 per cent. Martin Taylor of hedge fund Nevsky Capital recently closed his fund, complaining that the "obfuscation and distortion of data" made investment decisions difficult.

A second uncertainty is whether China's slowdown represents an orderly transition from export-led to consumer-led growth, as the government intends, or is instead - as Fathom's Erik Britton says - a more chaotic reaction to years of over-investment and bad loans.

A third uncertainty concerns cyclical moves around the shift to lower average growth. Simon Ward at Hendersons points out that monetary growth has in the past been a good leading indicator of economic activity and that it is now pointing to faster growth. But does this link still hold? If so, when will we see good evidence of a recovery? If this comes, might we see a disproportionately strong rise in equities as short-sellers close their positions or as investors interpret a cyclical upturn as evidence of stronger long-term growth?

However, it's not just China that's shifting to slower long-run growth. So too might be western economies. OECD secretary general Angel Gurria has pointed out that, since the 2008-09 crisis, "forecasts for global GDP have been high at the start of a year only to be cut later". This is consistent with economists being surprised by the transition to slower average growth. Whether this transition is a legacy of the financial crisis as Laurence Ball of Johns Hopkins University argues, or a longer-standing result of slower technical change and fewer investment opportunities as secular stagnationists claim, is unclear. But it poses the question: could 2016 see yet more downward revisions to growth expectations?

It's not just trend growth that's uncertain, though. So too is nearer-term growth. No mainstream economic forecaster is predicting a recession this year. But this is little comfort because they have consistently failed to forecast recessions. This might be because they are inherently unpredictable. New York University's Xavier Gabaix has shown that they can arise from failures of important big companies, while MIT's Daron Acemoglu has shown how network effects can amplify or dampen such shocks. Michael Roos at Ruhr University says the economy is a complex adaptive system in which small changes can sometimes have big effects - which, he says, means we are "subject to radical uncertainty".

This is especially the case when interest rates are close to zero.

One reason why equities did so well for much of the 1990s and 2000s was that investors believed in the Greenspan and then "Bernanke put" - that looser monetary policy would put a floor under share prices. However, at near-zero rates the ability of monetary policy to support equities if necessary is in question. Yes, quantitative easing (QE) could resume, but its precise effects are uncertain. Eric Swanson at the University of California at Irvine has shown that although QE had a statistically significant positive effect on share prices its effect can't be precisely quantified.

If you think all this shows that macroeconomists don't know much, you'd be right. But the uncertainty doesn't stop there. There's also uncertainty about the fate of individual companies simply because the winners and losers from creative destruction are hard to spot in advance. Bridget Rosewell and Paul Ormerod at Volterra Consulting have shown that corporate death rates are statistically similar to species' extinction rates - and, of course, species cannot foresee their own demise. This, they say, suggests that "firms have very limited capacities to acquire knowledge about the likely impact of their strategies".

Uncertainty, however, isn't merely a feature of the macroeconomic and corporate environment. As Stanford University's Mordecai Kurz has shown, it also emerges from investors' behaviour themselves.

One way in which it does so is that, at any point in time, investors might reasonably believe there is a small probability of disaster - say a deep recession in China or war in the Middle East. As investors revise these probabilities share prices can change a lot despite apparently little change in the real world. In this way, rational investors can generate share price volatility which is even greater than the volatility of the underlying fundamentals.

A second way in which traders produce uncertainty lies in the interaction between them. Imagine most traders had a strong idea of the true value of a stock. If others sold it, they would buy and so prices wouldn't move much. But what if they had no such strong opinion? They might then regard the selling as a sign that others know something they don't, in which case, they would amplify rather than dampen the price fall by selling themselves. As Harvard University's Andrei Shleifer and Brock Mendel have shown, bubbles and slumps can result from reasonable investors "chasing noise".

In these ways, equity investors face not just quantifiable risk but genuine uncertainties in the sense of dangers which cannot be quantified. And this is just to mention the obvious uncertainties: there's also the problem of what former US defense secretary Donald Rumsfeld called "unknown unknowns" - dangers that we don't yet know about.

We should respond to this by being humble - recognising that there is so much we just don't know. We should not try to chase every penny but rather try to satisfice, to choose an asset allocation that we are comfortable with even if this means we might miss out on some big returns. One strong argument for holding cash, despite its low returns, is that it helps protect us from uncertainty. The worst thing that could happen to cash - negative real returns arising from either higher inflation or the imposition of negative interest rates - is less bad than the worst thing that could happen to other assets.

But how bad is uncertainty? In one sense it is. The cliché that investors hate uncertainty is a cliché because it's true: people would much rather bet on known probabilities than unknown ones. However, this very hatred of uncertainty is what is causing investors to steer clear of equities now, which means the market could rise a lot if the perceived uncertainty diminishes. It is often said that high returns are a reward for taking on risk. It might be more accurate to say they are instead a reward for taking on uncertainty.