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Market Risk Insights: remaining vigilant in the dry-tinder environment

This quarter we launch a new version of Market Risk Insights. We continue to analyse six different risk measures – volatility, correlation, stretch, liquidity, event and ESG – but now describe why we use them, what they are composed of and how to interpret them.

An unnatural calm

The world was on fire over the last quarter, both literally and metaphorically, as wildfires broke out across California, the Amazon rainforest and Australian bush, while protests erupted in South America, the Middle East and Hong Kong. Yet financial markets appeared to buck the trend, as indicators of risk stayed relatively muted.

But a closer look shows that investors seem to have banked on a revival of global growth – which is far from guaranteed – and that markets have been soothed by another injection of central-bank liquidity. The yield curve may have steepened, no longer indicating that a recession is imminent, but risks appear to be fomenting behind the relatively calm conditions.

The inverted US yield curve seen over most of 2019 may have been a harbinger of things to come, while debt and leverage levels are worryingly high. Given these trends, there is definitely cloud – or is it smoke – on the horizon

Credit-rating downgrades for US firms have reached their highest level in four years, while companies continue to increase their aggregate debt burden. Geopolitics are also a flashpoint, with tensions between the US and China about technological dominance likely to persist for years to come.

In this environment, investors would do well to consider risk from as many vantage points as possible – something we seek to do in Market Risk Insights through our six key risk metrics (see below).

Volatility is the most obvious indicator of sentiment and we look at it through a variety of measures.  While volatility is currently at low levels – dampened by central-bank liquidity – we worry that this could ultimately encourage riskier behaviour. The near-term outlook may be subdued, but investors should watch out for hotspots like the US-China trade war.  

Investors need to consider what drives asset classes closer together or further apart at any one time, as portfolio diversification is only effective if different assets behave independently. Our correlation metrics don’t indicate any danger in the near term, but it would be prudent to watch out for further convergence in asset-class relationships.

We use stretch risk to analyse assets that have apparently low levels of volatility or have trended one way for an extended period of time. This lets us assess how likely it is that stretched assets could snap back in the opposite direction, as they typically sustain price extremes without indicating any volatility. This quarter, we consider whether value, the out-of-favour equity factor, has turned a corner.

If liquidity dries up, markets can respond in turbulent and unpredictable ways. We consider a variety of metrics, including the relationship between market risk, funding and monetary liquidity. Monetary easing may mean that liquidity conditions have been broadly stable, but there is growing unease about the corporate-debt market.  

This year has seen an outburst of populist uprisings and a geopolitical outlook clouded by the US-China trade war and Brexit. We use measures of market uncertainty and non-financial information to capture this, considering risk through our turbulence, absorption and economic-policy uncertainty indices.

Climate change burst onto investors’ horizons in 2019. It seems that for the first time there is a general consensus that rising global temperatures will impact future economic growth. This quarter we consider connections between ‘tipping events’ and look at how they can affect other environmental processes.

Smouldering hotspots 

Volatility may be contained but it is unclear how long this calm will prevail for. While risk assets stabilised over the last quarter, the threat of volatility remains ever present and markets may be vulnerable to ructions if central banks fail to provide the easing that seems to be priced in. And in 2019 – dubbed the year the world woke up to climate change – it is prudent to consider the number-one financial risk currently facing investors. To find out more, read the full Market Risk Insights Q4 report.

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