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Should investors be scared of heights?

Equities are scaling new peaks, driven by what appears to be a market-friendly first-round result in the French presidential elections and Trump’s renewed talk of tax cuts, but Eoin Murray, Head of Investment at Hermes Investment Management, warns that investors should look through the near-universal positivity for signs of risk.

In the US, for instance, the tech-toned Nasdaq breached 6,000 for the first time, while the Dow Jones retook the lofty 21,000 barrier it originally claimed this March.

But can risk assets sustain a rapid ascent to greater heights? Is there solid upwards-sloping ground past the escarpment, or do investors face an unexpected tumble down a crevasse?

History suggests that investing at such altitudes typically requires some high-tensile risk management strategies. Looking ahead, our range of risk measures indicates that, at the very least, investors should check their carabiners are screwed tight before climbing further.

Why peak crisis is always in view
One of the fundamental aims of risk management is to avoid drawdowns during crises. Over time, the investment industry has developed an array of downside risk management strategies and tools to mitigate the worst outcomes.

Crises, though, are assumed to be rare events – black swans, if you like – yet the data suggest that they are far more common. For example, as figure 1 illustrates, from 1965 to 2010 the International Monetary Fund (IMF) responded to no fewer than 70 systemic banking crises while inking 455 special lending agreements with institutions on the brink of collapse. It is clear that a financial crisis of some sort is always closer than expected.

Figure 1: Crises – what crises?


Source: IMF, Hermes as at April 2017

However, the magnitude and epicentre of the next crisis is unknown to even the most highly skilled risk managers. But we can look through the current environment to forecast the most likely conditions ahead.

For now, markets have priced in good weather: the risk of harsh conditions – glimpsed briefly through the gloom in early 2016 – has dropped from view but the current calm may mask the underlying market fragility.

In fact, the glare of optimism may make it even more challenging for investors to navigate the markets: as always, we think it is as important to gauge forward-looking ex-ante risk from as many angles as possible.

Five points on the horizon: correlation surprise flashes a warning
We map the probability of future risk flare-ups based on statistical and qualitative research focused on five factors: volatility, correlation risk, liquidity risk, event risk and stretch risk – the degree to which assets are over- or under-priced compared to historical averages.

Our current quarterly warning signals come against a back-drop of continuing global political upheaval – albeit that the first-round French election may have soothed some nerves – and uncertainty about the how central banks may, or may not, wind back the unconventional monetary measures in place since the financial crisis. They are as follows:

Volatility: A likely uptick in volatility from a very low level, followed by spikes throughout the year

Correlation risk: A new correlation regime has not fully asserted itself yet, but changes are clearly afoot

Stretch risk: Different market variables get tighter and tighter – we can only hope that any unwind will be orderly

Liquidity risk: Liquidity concerns have returned to bond markets, with other asset classes representing a lower chance of illiquidity-induced contagion

Event risk: Expect policy uncertainty to dominate the headlines, along with market fragility

In short, these five indicators have yet to all flash red: but we do not, and should not, expect the future to reveal itself so easily. We need to look more closely at subtle changes in the data for clues.

For instance, our correlation surprise indicator – which measures the statistical unusualness of asset class relationships compared to historical averages – remained high throughout the quarter and rose steadily. This suggests that correlations are behaving unusually.

We feel that it is important to continue to watch the development of this signal. From time to time, we would expect false-positive signals, but we think it is wise to remain wary about any portfolio assumptions with respect to cross-asset relationships.

Based on our analysis, spikes in correlation surprise are more often than not followed by disappointing returns.

In the face of a bullish market mood, we remain modestly cautious – and have checked our safety gear is in good order.

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