INVESTORS ARE FLOUNDERING IN POST-TRAUMATIC SYNDROME

By Gillian Tett
Jim O'Neill, chief economist at Goldman Sachs, has recently been sounding out the US bank's clients over their inflation fears.
The results are striking. Nine-tenths of the companies questioned report feeling worried. But the number fretting about inflation is similar to those concerned about deflation - with almost no one sitting on the fence.
Welcome to the disorientating investor landscape of 2009. Just three years ago, when the world's big investment banks made inflation forecasts, economists got excited if they varied by a half a percentage point.
For back then, in the era known (infelicitously) as the "Great Moderation", most investors assumed that the financial world was a pretty stable, predictable place.
No longer. If you look at current inflation forecasts, the headline numbers do not look too shocking. JPMorgan, for example, has just surveyed 1,800 investors (see right), in which median expectations for inflation in the US, eurozone and UK are 1-1.5 per cent by late 2010. But behind the seemingly reassuring "median" number, there lies seething insecurity and intellectual dispute. At several large investment banks, the macro-economic teams are clashing with their fixed-income departments because each has strikingly different price expectations. And in the investment and corporate world, opinions are often equally polarised. "There is real uncertainty," observes Mr O'Neill. "People seem more unsure than I have ever seen."
On one level, that is no surprise. Goldman Sachs has an internal index that it uses to track liquidity conditions in the financial markets. This shows that in the past two years, investors have suffered a more violent rollercoaster ride than they have ever seen before in their careers. That has left investors disorientated and - crucially - newly aware of what is sometimes called "fat tail risk" (the statistical jargon for extreme events.) In a sense, investors are gripped by a phenomenon akin to the type of post-traumatic syndrome seen after a war: whenever they hear a "bang!", they jump in panic, since they no longer dare assume that the world is benign - in relation to inflation, deflation or much else.
Worse, investors lack the intellectual framework to make sense of what is currently going on, let alone predict the future with confidence. Recent research from Pimco illustrates the problem*. Until the 1980s, it points out, the expansion of nominal gross domestic product tracked the volume of outstanding private credit closely. But since then credit dramatically has outstripped economic growth, as securitisation took hold.
Before the bubble burst, few investors properly understood the impact of securitisation. But now the securitisation market has frozen, they do not really understand the implications of this new shift.
The old models that appeared to link credit growth, economic expansion and monetary policy with reassuringly neat precision no longer look reliable. Thus investors are faced with numerous uncertainties: is the world facing a bout of extended deleveraging that will drag prices down? Can the securitisation - and credit creation - machine start again? And if the government keeps pouring money into the markets, what impact might that have?
If the JPMorgan survey is correct, investors - on average - do not expect serious deflation to emerge from this unknowable mix.
Instead, on average, they predict low inflation in the UK, UK and eurozone this year, followed by inflation in the US and UK from late 2010 on.
But I rather suspect that one reason why so few investors predicted deflation in this survey is that very few have ever seen it. Similarly, the inflation projection for the UK and US probably reflects a generalised concern about quantitative easing - not because investors understand what this might do to prices, but because they are uncertain how it does (or does not) work.
Incentives may also have had an impact. The JPMorgan survey suggests hedge funds have more polarised inflation/deflation views than mainstream asset managers. Those working in the government bond markets and asset-liability sphere are more confident that governments will deliver low, stable inflation than, say, macro-economists.
Such variations do not mean that surveys are useless: on the contrary, the question of how inflation expectations could affect outcomes needs even more research. But as Mr O'Neill says: "It is very hard to forecast beyond six months now, with real confidence."
"Our analysis suggests that there will be a strong [economic] rebound for the next six months or so. But after that - who knows?" he adds, with a flash of humility rarely seen on Wall Street. It is a mantra that should perhaps be pinned on the desk of every investor right now - in relation to inflation, and much else.
* The Dog that Didn't Bark, Pimco July 2009
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