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Panic stations - five risk factors that show markets remain unstable

Home / Press centre / Panic stations – five risk factors that show markets remain unstable

Following the turbulence of the first quarter, Eoin Murray, Head of the Hermes Investment Office, believes that markets continue to be at risk of price spikes and falls, with volatility and liquidity risk being particularly concerning.

Alarm bells: After a volatile first quarter, investors appear to have calmed during the last two months. However, the problems that caused the turmoil at the start of the year have, if anything, become more acute. China’s growth continues to slow, the political risks presented by the US election and the Brexit referendum have become critical and the Federal Reserve’s guidance on interest rates is increasingly unreliable. Since the global financial crisis, markets have become more susceptible to nervousness, with the average time between peaks of anxiety, as shown by market sentiment, shortening from nine to three months. This ‘new normal’, aggravated by the macroeconomic concerns discussed, means that markets remain at a precarious point.

Five key measures of risk: Within the Hermes Investment Office, we continually consider five prominent forms of risk, with several indices contributing to our understanding of each. Our current views are as follows:

  1. Volatility is likely to remain heightened during the second quarter. Although some volatilities rose dramatically during the quarter, they subsequently dropped well below the average for 2015 and are much calmer than the surrounding uncertainty suggests. The increasing speed of market transactions, crowding, herding and short-term liquidity evaporation are likely to lead to sudden drops and spikes in the markets during this quarter, a pattern that forward-looking indices have also pointed to.
  2. Correlation risk can be an imperfect measure, as it is problematic during periods of market stress such as now, in which correlation levels can change rapidly before reverting at a later date. One way to address this is to use the standard deviation of the correlations between asset classes, which shows the stability and historical reliability of correlations. This indicates that correlation risk is currently subdued, as asset classes decoupled during the tumultuous first quarter. However, a deterioration of market conditions would return correlation risk to the fore.
  3. Stretch risk reflects the likelihood of a ‘snapback’ for an asset class, where medium-term trends have masked longer term risks and volatility levels. Many of these trends were broken during the first quarter, causing stretch risk to subside.
  4. Liquidity risk is particularly high in the credit markets, but low trading activity has been a feature in almost all markets and has clearly contributed to the number of violent dislocations in asset prices. This also means that the illiquidity of corporate bond markets could spread to other asset classes in the event of further shocks. As liquidity can come and go, dislocations can occur even among assets that are currently very liquid. 
  5. Event risk measures continue to present a mixed picture. While the turbulence index suggests that event risk is subdued, the absorption ratio, which captures the market’s systemic risk by measuring its ability to absorb shocks, rose during the first quarter, pointing to heightened fragility in the markets. We emphasise the latter measure and suggest that investors should remain vigilant of event risk during this quarter.

Cushioning the fall: Systematic strategies helped spur the equity rally during the first quarter and suppressed realised volatility, as many had bought call options. However, due to costs, this may not be repeated amid further market wobbles and if risk remains skewed to the downside. This is troubling as we are in a fragile risk environment where markets are capable of experiencing severe dislocations. Although we have seen some divergence between equity and bond markets this year, we believe that the benefits of diversification remain overstated given current market risks, and that portfolios that rely on correlation analysis may be more risky than they initially appear.

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