Edward Lorenz, a meteorologist and mathematician, formulated a theory called the butterfly effect—based on a hypothetical scenario in which a butterfly, simply by flapping its wings, affects a tornado weeks later. The butterfly effect illustrates how small actions in complex systems can lead to big changes, underscoring the challenges in making forecasts. This is particularly relevant for investors. A complex global economy often takes unexpected turns, and macro disruptions and uncertainty present challenges for those navigating financial markets. But with this knowledge, investors could make better decisions by challenging conventional wisdom and taking a long-term view.

The Season 5 premiere of The Outthinking Investor explores how investors can steer through economic volatility and pursue sound portfolio construction for the long run. Philipp Carlsson-Szlezak, Boston Consulting Group’s Global Chief Economist, and Robert Tipp, PGIM Fixed Income’s Chief Investment Strategist, discuss the forces that may drive change in the economy, potential risks to the outlook, how market fears can distract from real long-term consequences, emerging opportunities in fixed-income markets, and structural changes resulting from a higher level of expected interest rates.

Do you have any comments, suggestions, or topics you would like us to cover? Email us at thought.leadership@pgim.com., or fill out our survey at PGIM.com/podcast/outthinking-investor.

>> According to the butterfly effect, small actions in complex systems can lead to big changes. Edward Lorenz, a meteorologist and mathematician, formulated the theory in the 1950s. He was running a computer model to predict the weather but there was a tiny imprecision in the data. To save time rerunning the model, Lorenz rounded just one of his variables from six decimal places to three decimal places. And that small change led to a very different set of results. So different, in fact, that he initially believed it must be due to something other than his tiny data imprecision. He compared that situation to a butterfly flapping its wings in Asia with cascading events that ultimately led to a tornado, weeks later in North America. A key principle of the butterfly effect is that predictive linear models can give us false confidence. Anything less than perfect knowledge of the starting conditions can lead to useless forecasts. Given that it's impossible to have perfect knowledge of any real world situation, why do we continue to rely so heavily on models and on definitive solutions, particularly when it comes to some of the most complex systems like the global economy? If even small individual events can lead to radically different results, how should investors frame decisions in light of macroeconomic disruptions? To understand today's investment landscape, it's important to know how we got here. This is The Outthinking Investor, a podcast from PGIM that examines the past, the present-day opportunities and the future possibilities across global capital markets. Philipp Carlsson-Szlezak is chief economist at Boston Consulting Group and co-author of the book, Shocks, Crises and False Alarms, How to Assess True Macroeconomic Risk. Robert Tipp is chief investment strategist and head of global bonds at PGM Fixed Income. Around the world, geopolitical tensions and shifting fiscal policies continue to reshape the landscape and make the global economy even more complex. That complexity makes it increasingly difficult to clearly identify disruptive forces. What are the kinds of macroeconomic risks investors need to understand, along with the potential impacts on their investment exposures? In his recent book on macroeconomic volatility, Philipp Carlsson-Szlezak and his co-author explain three categories.

>> Essentially, the risk landscape splits into three parts and in each part we have a list of five to six key risks that executives and investors should be aware of. First, there is a real economy type of risk having to do with cyclical growth but also structural growth over the longer term and what are the things that can either weigh on that or accelerate that? Remember, risk is both a downside story and missing the upside. So technology could be an upside risk that some might miss out if they're misreading it. Cyclical risks are typically to the downside. The second part of the landscape has to do with more financial risks. This comes down to how powerful will stimulus be in the future? Do we have the luxury of deploying large stimulus when we need it? What will interest rates do? What risk is there in longer-term inflation? What risk stems from bubbles? So these are more financial-system-based risks and narratives. And then the third part of the risk landscape is geopolitical or just global risk, having to do with certainly conflict and flux in the geopolitical space, but quite specifically also how do we organize the trade landscape? How do we organize global currency systems and the risks that emanate from that?

>> Understanding the types of macroeconomic risks may be the easy part. Interpreting these risks is where it gets complicated, especially for geopolitical risk.

>> Geopolitical risk is commonly over-interpreted and seen as too much, too big, compared to how it usually pans out. So the feed-through mechanism from a geopolitical crisis to real economic impact is pretty challenging. The bar is pretty high for a geopolitical crisis to shape an economy like the US economy. Think about the war in Gaza. Think about the war in Ukraine. These are tragic geopolitical developments. They're extremely disruptive where they are and yet their ability to shape financial markets in the US or the real economy in the US, that bar is really much higher than we commonly assume. So this is one of those areas where the debate about risk often calls prey to false alarms.

[ Music ]

>> Gaza and Ukraine are just two of the many geopolitical risks that could disrupt the global economy. While the bar is high for these kinds of risks to disrupt the US, that's not necessarily the case for smaller and less stable economies. Robert Tipp looks at the potential impact for investors over the long term.

>> There definitely are a number of disruptors out there. The geopolitical situation is quite fraught. The policy range of items that are on the menu that could be aggressively pursued or not pursued in the US and as well, I would say, more so in emerging market countries where there's been stress, there are a lot of potential corners that could be turned here. I think the big ones are going to be the geopolitical shocks. And those are difficult to anticipate. I think the overarching thought though here is that this is, in all likelihood, going to turn out to be a really positive long-term investment market. I think the greater risk for investors and managers will be the risk of short-term movements in the market and a potentially challenging trading environment taking a toll on people's ability to add value and taking a toll on people's ability to stay with the long-term positive trades that are out there in the market. We're in a high-yielding environment. Returns are likely to be high. There will be trading opportunities, but investors are going to have to be very cautious in making sure they don't get knocked off of their long-term strategic allocations and taking advantage of what, with a higher conviction level, I would say is a good investment backdrop, particularly for long-term fixed income. There'll be more fear of disruptions than actual major disruptions. And therefore, we'll keep an open mind but we have already had a major disruption to the upside in interest rates. And I think staying with that theme is going to be important for investor success here.

>> This inflation shock felt worldwide has ushered in a structural change with deep macroeconomic ramifications.

>> I think the biggest structural change that we've seen in the market has been in the area of perceptions and anchoring. I think that investors and central bankers have changed their anchor of what's a normal level of rates, a normal range for rates to traverse through a business cycle, and regarding the levels of government debt that they expect to see and perceive as somewhat normal. That has really changed the range that investors expect to see. That's hit options pricing. And it's been something that, as an investor, we've been able to monitor. That up until the recovery coming out of COVID, it had been a one way street for 40 years of disinflation and a moving anchor, going from the mid single digits that when higher during the 70s and 80s, that took a very, very, very long time to come all the way down and back to the mid single digits, and then got anchored now in the low-to-mid single digits. The reason this is important is that central bankers could choose, I believe, to have a neutral rate in the US of maybe a nominal 4% Fed funds rate. I mean, we've had the Fed funds rate, frankly, in closer to 5 for a good time now, and the economy has been fairly resilient. The ECB had the deposit rate up in the 4% area for some time and growth was more abundant. Now they're cutting. They may find that growth remains more abundant. So that anchoring is really critical. That's something that we could position around on the way down over the decades of disinflation. But also in 2022, we could see that there was a break in that regime, that it was no longer a one-way shift all the way down. That there was a disruption that was going to take us into what could be a mid single digit interest rate environment without a recession. We've gone through that for some time. But still, the markets, they have this new anchor that includes that effective lower bound.

[ Music ]

>> A key variable related to interest rate levels is the amount of government debt. In the 1990s, Japan triggered concerns following decades of rising debt to GDP ratios. After that was the European sovereign debt crisis and the Greek government default. Today, debt levels for many developed and emerging markets have climbed further.

>> And so we've now adjusted. Debt levels are markedly higher. They're at levels never really seen on a sustained basis in peacetimes. In leading economies, levels of 100%, 120% are now quite typical. And investors have changed their anchor. In emerging markets, that hasn't necessarily been an adjustment that investors have made because of the differences in financing configurations and depth of local capital markets and so on. But for DM countries, there is attention to levels of debt and credit ratings but it's nowhere near the level of concerns and panic that got pushed into the market say, in the wake of the Greek crisis. Investors are very accepting of issuers with high debt levels as long as they see coherent policy. So that's having a big impact in the market. I think that it's creating opportunities in how bonds trade relative to riskless interest rate swaps. Treasuries are now a risk product. That's created an opportunity but also it may be impacting how corporate bonds trade. We're now seeing government credit weaken relative to corporate credit. There's been a lot of fear of downside risk with the pandemic, with the war, with the rapid rise in interest rates. Corporations are really trying to maintain credit quality. And so, relative to governments, many of which don't really have a fiscal anchor, are becoming increasingly indebted, having a very slow string of rating downgrades. Corporate credit, on the other hand, has been relatively solid. So that drives the amount of risk premium of credit spread that investors demand for corporate bonds. And whereas we have seen that widen during periods of time like the late 90s when the US was paying down its debt, we now may be entering a period where government yields push up towards corporate yields and drive a narrowing on the margin of corporate spread. So a lot of changes in the anchoring with a lot of impacts on markets and pricing.

>> Philipp and his co-author outline three habits they advise investors to follow to navigate macroeconomic volatility and make sound investment decisions for the long term.

>> The first one we refer to as master model mentality which we need to put to one side. Master model mentality refers to the idea that there's a belief the truth is out there. There is a sophisticated model that we can use to answer questions. And there's a scientific underpinning to all this that macroeconomics essentially behaves like a natural science. And we think all that is misguided. Essentially, the models will not give you the answer. They can't. Why? Because you build models on the past so you have an empirical basis in the models. But when you need models to give you an answer most in the times of crisis, almost by definition, the data points are outside that prior empirical base. And so what the models will do, they'll extrapolate outside that empirical history and they'll lead you astray. The second habit is to just tune out a lot of the doomsaying. Public discourse in the economy is essentially a business model. Financial press is monetized through your clicks and eyeballs. And that leads to a consistent doomsaying and a negative tendency in how we cover and talk about the macroeconomy. So there's a long string of false alarms that has piled up over the last few years. And we essentially advise executives, investors to take a hard look at which of the new cycles they want to follow down every single rabbit hole and where to take a pass and see through that. And then the third habit that we advocate for is economic eclecticism. And by that, we mean the master model is not going to give you the answer. You're going to need a broader lens, essentially a multidisciplinary approach. This means economics is part of the answer but only part of it. Economics is not a great soloist but it plays well as part of a band. So you need adjacent disciplines, finance, history, politics, international relations, to weave together a narrative of what you think risks are and how to navigate that.

>> The COVID pandemic was a case study in the importance of all three tenets, master model mentality, doomsaying and economic eclecticism.

>> At the time, the conventional wisdom was the recovery would be extremely long, many years, worse than 2008, maybe as bad as the 1930s Great Depression. And where did that come from? Where did that conviction come from? Mostly from models that were used to extrapolate and predict the recovery. What do they do? The economy recovery is typically modeled through the labor market. When unemployment is high, it takes time to bring that down. So after 2008, the global financial crisis unemployment went to 10% and it took many years to bring down the unemployment rate on a path to recovery. Now, if that was the empirical basis of the model in 2020, the unemployment rate didn't go to 10, it went to 14%. That was outside the empirical range. The models hadn't seen a 14% unemployment rate. So what did they do? They extrapolated this relationship between the unemployment rate and the recovery time. And because it was even higher unemployment, they predicted an even longer recovery time. I would think this is Exhibit A of master model thinking. It led a lot of analysts astray. Lots of smart people came out and said this will be a very, very long recovery. They were totally wrong. So I think this is one of the examples in recent history. You could also take the inflation crisis we've gone through. The Phillips curve on one hand or monetarism on the other hand, it did not help you understand what was going on with inflation in '21 and '22. These were not models that were useful and accretive to an investor trying to understand the risks and how this would unfold.

[ Music ]

>> There was also quite a lot of doomsaying at the time with expectations of a recession or even a depression and a very long recovery.

>> The opposite was true. We had a very swift, very successful recovery. So that was clearly one of those doomsaying narratives that were very, very persistent. Then in 2021, it continued. The inflation crisis was immediately spun into a 1970s style structural inflection which was, of course, not true at all. It was an idiosyncratic squeeze of inflation due to too much demand, too little supply. When those constraints unwound so did inflation. It was not a structural inflection point. Then in 2023, when interest rates rose, the doomsaying veered into a predicted cascade of emerging market defaults. It was widely believed that higher rates in the West would put emerging markets under pressure. That didn't happen and I would think the mother of all false alarms was the inevitable recession of 2023, which has graced many covers and headlines of very respected publications, a lot of groupthink there.

>> This was also a time when it would have benefited investors to take the approach of economic eclecticism.

>> If you looked at the challenge of the crisis and the recovery as a multidisciplinary set of themes, if you looked at it in terms of political economy, what kind of stimulus can be mobilized, how fast, how much innovation in that, if you looked at it in terms of other ways of backstopping the economy with new policy, new innovation angles, if you looked at it much more comprehensively than the unemployment rate, you were much more likely to predict a fast recovery which is what we did at the time in March 2020. We published a piece in the Harvard Business Review that said don't jump to conclusions. Don't assume that this has to be a long and terrible recovery. With the right things in place this can be pretty swift. And that's how it turned out.

[ Music ]

>> The COVID pandemic was an extreme situation but there will always be potential for macroeconomic disruption, even when we don't see it coming.

>> I think the keys for resilience in portfolios and results are balance and diversification. I think keeping a margin of error in mind for the range of scenarios that can play out, so you don't end up unduly exposed to drawdown risk if you have one of these disruptions. Another key is diversification. To the extent that you can have a really diversified set of fundamental drivers in the portfolio for capturing and adding value, that should really improve your odds of success. When you think about having one big position in a portfolio or an unduly large one, it's going to really draw the focus and can keep you from missing opportunities in other areas and the unduly taxing mentally. So I think there's psychological as well as the technical benefits of diversification and investing is very critically influenced by behavioral factors that you want to be aware of. I think in addition to just the typical diversification, there's also temporal diversification. And that you want to allow time for making your adjustments and allowing for slow thinking, in addition to the rapid thinking but also gathering information. And all these tactics I think are particularly important in an environment where the sectors for fixed income are not as heterogeneous in their pricing as they are at some points in time. We have more pockets of value within the corporate market, the high-yield market, the structured product market, the emerging market but it's much more of a bottom-up bond-picker market than a top-down single sector kind of environment.

[ Music ]

>> So far, markets have been patient and mostly optimistic. But there are many variables that could come into play and tip the balance one way or the other.

>> Tariffs, immigration, deregulation, all of these things are leading to a mindset of a wider interest rate differential between the US and other countries. And this is leading to dollar strength. I think that the markets are going to see the potential for disruption and they're not going to do what the central bankers are likely to do. Markets are going to run to the full-blown scenario of potential impacts when policies get floated. That's the risk. Not when they get implemented, not after the data comes in, but you'll see market reactions when serious consideration is given to possible courses of action. So in the short term, there's going to be a lot of volatility. But in the end, I think what we've seen is that economics, the underlying aspects of productivity, maybe in this case what's going on with technology and AI, what's going on with immigration dynamics and underlying momentum in economies may end up being the more profound driver than the fears of government impact from the fiscal or the monetary side for that matter.

>> Investors who embrace the uncertainty that goes with macroeconomic disruption and remain open to all the potential scenarios of a given situation may be better positioned to interpret the risks. That may ultimately lead to better decisions for the long term, particularly for investors who are able to adapt and pivot as conditions change. Thanks to our experts, Philipp Carlsson-Szlezak and Robert Tipp, for their insights on macroeconomic disruption. The Outthinking Investor is a podcast from PGIM. Follow, subscribe, and if you like what you hear, go ahead and give us a review. If you enjoyed this episode and want to hear more from PGIM, tune in to our Speaking of Alternatives podcast. See the link in the show notes for more information.