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Infographic: Market Risk Insights, Q2 2018

Home / Perspectives / Infographic: Market Risk Insights, Q2 2018

Eoin Murray, Head of Investment
18 July 2018
Macro EconomicsRisk
Dickensian conditions
Q2 2018

Risk is amorphous, creating investment opportunities and threats to capital at each stage of the cycle.

In response, investors must watch for familiar patterns and new disruptions amid streams of financial indicators.

Models based on statistical history can serve as useful, if inexact, guides. But we need to use all the tools at hand, going beyond number crunching to consider geopolitical tensions and sustainability concerns, to separate meaningful signals from the noise.

We recommend tracking the following six indicators to recognise risk in its current form – and identify where opportunities lie.

Volatility of volatility

Source: Hermes, Bloomberg, CBOE as at May 2018

Equity markets returned to their historical, volatile form as 2018 began. Our range of risk indicators suggest that this was no mere blip. While volatility in other asset classes remains subdued, we expect that to change in the year ahead.

Forward-looking risk gauges edged higher, with the Volatility of Volatility Index (VVIX) spiking in February to levels not seen for at least two years and the long-term trend rising. The worm has turned.


Source: Hermes, Bloomberg as at May 2018

Our multiple measures of correlation risk largely held steady during the first quarter of 2018 in spite of rising equity-market volatility. However, asset class relationships seemed to be shifting, with a slight lift in equity-bond correlations during the period.

Meanwhile, our correlation-stability signal reached a 12-month peak early in the year, suggesting that long-standing asset class relationships could be strained.

Correlation regime change, which we expect to occur in 2018, can happen at speed.

S&P 500

Source: Reuters, Hermes as at May 2018

Assets can hold historically unusual valuation levels for various reasons and for extended periods, but should eventually snap back. We have no difficulty in finding examples of such ‘stretched assets’ in today’s markets.

For example, European credit markets and US equities look tense relative to historical valuations. Passive investors in those assets may be walking a tightrope.

Which trades are the most crowded?

Source: Hermes, Bank of America Merrill Lynch as at May 2018

Money is plentiful for now, with global financing and liquidity conditions stable over the quarter. But a number of offshore US dollar funding risks loom on the horizon, including: ‘quantitative tightening’ by the Federal Reserve, tougher banking regulations and money-market reforms.

Financial trauma is usually transmitted by liquidity stress, which can pop up anywhere, however fund managers’ consensus views of crowded trades, shown in the chart above, can signal the most likely pressure points.

Absorption ratio across 17 asset classes

Source: Hermes, Bloomberg, MSCI as at May 2018

Global political tensions abound in 2018, with a populist Italian government and further US-instigated trade disputes making headlines at the time of publication.

Regardless of the simmering geopolitics, our main event risk gauges – the Turbulence Index and the Absorption Ratio – do not suggest a market boil-over. Both indicators are at a moderate level, with the Absorption Ratio – which measures the potential vulnerability of markets to external shocks – trending upwards.

Water stress on the Indian subcontinent

Source: WRI Aqueduct 2014

Emerging-market investors are no doubt wary of water stress in India, and should consider the impact of China and Pakistan’s agreement to build two new dams on the Indus River.

More than half of India already experiences high-to-severe water stress, exacerbated by contamination and a low volume of rain in 2017, but this could intensify further if the new dams are built upstream. The Indus is already considered to be one of the world’s most endangered water bodies, along with the Ganges.

In conclusion
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Eoin Murray Head of Investment Eoin is Head of Investment and a member of Hermes’ senior leadership team. Eoin also leads the Investment Office, which is responsible to clients for the investment teams’ consistent delivery of responsible, risk-adjusted performance and adherence to the processes which earned them their ‘kitemarks’. Eoin joined Hermes in January 2015 with over 20 years’ investment experience. Eoin joined from GSA Capital Partners, where he was a fund manager. Before this, he was Chief Investment Officer at Old Mutual from 2004 to 2008 and also held senior positions at Callanish Capital Partners LLP and Northern Trust Global Investments. He began his career as a graduate trainee at Manufacturers Hanover Trust (now JPMorgan Chase) and subsequently performed senior portfolio manager roles at Wells Fargo Nikko Investment Advisors (now BlackRock), PanAgora Asset Management and First Quadrant. Eoin earned an MA (Hons) in Economics and Law from the University of Edinburgh and an MBA from Warwick Business School. Eoin is a Freeman of the City of London, and a Liveryman of the Worshipful Company of Blacksmiths. He is a member of the Exmoor Search and Rescue team, a fully qualified Swift-water Rescue Technician and a Flood Water Incident Manager.
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