changing risk environment
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 to the future. 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: the VIX is on the move
Source: Hermes, Bloomberg, CBOE, Deutsche Bank, Bank of America Merrill Lynch as at 31 July 2018
Despite gathering geopolitical clouds, investment markets experienced a mainly sunny, carefree quarter: volatility remained low across asset classes.
However, our gauges suggest equity markets will be more volatile in the months ahead, with other asset classes likely to follow suit.
Coming unstuck? Asset-class correlations
Source: Morgan Stanley, Bloomberg, Hermes as at 31 July 2018.
Cross-asset class correlations changed little during the quarter but long-term relationships are nonetheless under pressure. The Morgan Stanley index, which measures correlations across 17 different global asset types, is lodged at the bottom end of a multi-year range. Conditions are ripe for a decoupling – conscious or not.
Investors relying on historical asset-class correlations to diversify their portfolios must seriously question their underlying assumptions.
S&P500: 1930s reprise?
Source: Reuters, Hermes as at 31 July
Valuations appear to be stretched across many asset classes, while macroeconomic data shows that global debt levels hit almost $250tn at the end of March – up $25tn over the preceding 12 months alone.
Debt now exceeds GDP by about 320%, making the world extremely vulnerable to shocks. Meanwhile, an analysis of US stock markets reveals an eerie parallel with the 1930s.
Tale of two spreads: the TED and credit spreads
Source: Hermes, Bloomberg as at 31 July 2018
TED spreads – the difference between the three-month Treasury Bill and three-month LIBOR – narrowed over the June quarter, indicating that confidence in the global banking system remains high. Simultaneously, credit spreads tilted upwards (albeit from a low base), reflecting growing concerns about corporate debt.
Our gauges picked up some liquidity issues in the credit sector over the period. If shocks occur, they typically spread across markets through liquidity shocks.
Economic policy uncertainty
Source: Economic Policy Uncertainty, Hermes as at 31 July 2018
Global policy uncertainty intensified at the end of 2017 and into the June quarter, with geopolitics dominated by renewed talk of trade wars.
While political events can trigger broader economic and market crises, for now our principal measures of such risks – the Turbulence Index and the Absorption Ratio – remain at moderate levels.
CO2 emissions: Big meat and dairy versus big oil
Source: GRAIN & IATP, Hermes as at 31 July 2018
Fossil fuel firms tend to draw the most fire for their carbon emissions but, surprisingly, big dairy and meat companies also produce large CO2 emissions. Indeed, the top five meat and dairy producers combined emit more CO2 than any of the big oil firms.
ESG-conscious investors should broaden their focus when considering carbon risk.
A “Quantmare” on Wall Street 2: Apocalypse Tomorrow
360° - Fixed Income Report, Q3 2018