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.
Cross-sectional dispersion of stock returns
Source: Hermes, Bloomberg, FTSE as at November 2018.
Absolute measures of volatility stayed low over the September quarter with the February equity-market splutter seemingly consigned as a one-off aberration for 2018.
But lurking risk – which emerged in subsequent months – was already manifesting as stock-market dispersion tracking higher. From here, volatility looks set for re-launch.
Source: Hermes, Bloomberg as at November 2018.
During the September quarter, the correlation signal has picked up signs that asset-class relationships are under stress. The data shows that periods of correlation instability are becoming more frequent, indicating that investors should be cautious about asset-class assumptions based on the recent past.
The countdown to a correlation regime change has begun.
Stretch risk – 1937 reprise
Source: Reuters, Hermes as at November 2018.
Valuations appear stretched across many asset classes, while macro data shows global debt levels hit almost $250tn at the end of March – up $25tn over the 12-month period 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.
Fund managers answer the question:
where do you think the most crowded trades currently are?
Source: Hermes, Bank of America Merill Lynch as at November 2018.
Going long technology stocks remained the consensus crowded trade as investors bet the sector can defy gravity a little longer. But for now equity markets appear highly liquid.
If liquidity risk is to reassert itself, we expect it would appear first in the corporate-debt market rather than equities. Fixed-income markets in general tend to re-price risk quicker than equity investors: we note that the gap in the relative liquidity conditions of credit and equity markets remains wide.
Economic policy uncertainty
Source: Economic Policy Uncertainty, Hermes as at November 2018.
The political uncertainty index continued to rise during the September quarter as a raft of global issues competed for attention.
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.
The Paris Agreement Capital Transition Assessment (PACTA) tool
Source: 2o Investing Initiative, PRI as at November 2018.
The plastic threat flared as an environmental issue in 2018. As more countries seek to ban plastic bags and ‘single-use’ became a pejorative term, the backlash against the ubiquitous material will ultimately have investment consequences.
During the last quarter, the 2o Investing Initiative also released the Paris Agreement Capital Transition Assessment (PACTA) tool to help investors manage the change to a low-carbon world.