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Why relaxed investors could soon feel the heat

Markets are running hot in 2017 and markets are apparently cool with this. The complacent mood was recently jolted as the VIX spiked at its highest levels since the election of President Trump in November last year, but amidst geopolitical turmoil, calm has seemingly returned again to the markets. Here we check the temperature gauges for accuracy and identify potential risks that investors should consider as we progress through the third quarter.

Every week the St Louis Fed measures the degree of financial stress in US markets through an index that combines 18 different financial variables – seven relate to interest rates, six to yield spreads, and five others – into a single metric. For some time now, this gauge, called the St Louis Fed Financial Stress Index, has found that investors are relaxed.

Given the importance of the US to markets worldwide, the index also serves as a reasonable proxy for global conditions. Apart from the intensity of the immediate aftermath of the global financial crisis (GFC) and a brief rally in the opening months of 2016, the St Louis Fed index has been trending down or flat in sub-zero territory (see figure 1).

Figure 1. Chilled: Since the 2008 crisis, investors have been relaxed

MRI-chart-2

Source: Federal Reserve Bank of St Louis, Hermes as at 30 June 2017

But the big question for investors is how to reconcile these stress-free readings with the looming tightening of monetary conditions – or at least the phasing out of ‘unconventional’ central bank policies – and increasing global macroeconomic tensions.

For example, US politics have been distracted by international flashpoints, such as North Korea, or embroiled in the domestic dispute over the US President’s alleged Russian links. At the same time, the Trump administration has notably failed to progress key legislation through a theoretically compliant Senate and Congress.

Meanwhile, the world’s second-largest economy, China, has also disappointed somewhat in 2017: despite the unexpected resilience of the nation’s property market, nominal growth expectations remain conservative as policy-makers attempt to curb excessive credit and real-estate growth.

Against this disruptive global backdrop, financial market insouciance – as reflected in the sleepy St Louis Fed index – might seem a little misplaced, or complacent even.

Shattering news on complacency

While complacency might be, as author Vladmir Nabokov put it, “a state of mind that exists only in retrospective”, we think data can shed at least some light on the current condition.

Our Complacency Indicator, which is based on the premise that volatility has a history of long calm stretches punctuated by times of crisis, indicates that markets may be a little too relaxed (see figure 2).

It tracks two important components of volatility that we classify as ‘jumps’ and ‘long memory’: the former relates to the propensity of volatility to spike, while the latter suggests that deflation of the spikes is far slower than the initial jump.

We measure them by comparing volatility high points to the sum of the volatilities for the days constituting the jump. Using this technique, the higher the reading on the Complacency Indicator, the less complacent markets appear to be.

The indicator covers a period that includes three major market dislocations: the 1998 Long Term Capital Management/Russian default crisis, the so-called ‘dotcom’ collapse in 2001 and the three or four years from just before the GFC until 2011.

Figure 2 shows that all three events generated the classic long memory and jumps typical of market crises. Only the dotcom crash coincided with a high reading on the Complacency Indicator, showing that investors were anxious prior to the sell-off.

Figure 2. Complacency and crisis

MRI-chart-1

Source: Hermes, Bloomberg, CBOE as at 30 June 2017

Clearly, we are now in a period where risks threaten to make the market increasingly brittle but investors seem unfazed. Complacency, Nabokov concludes, “has to be shattered before being ascertained”. We hope that won’t be necessary.

Our latest analysis of the investment environment can be found in the current issue of Market Risk Insights. A summary of our expectations for the third quarter is as follows:

Volatility – A likely uptick from an environment characterised by very low volatility;

Correlation risk – A new correlation regime has not fully asserted itself, and investors should not rule out sharp movements in correlations;

Stretch risk – This is evident in both equity and credit markets, in terms of momentum and extreme valuations. In the face of greater leverage, as a result of lower volatility, we can only hope that any unwind will be orderly;

Liquidity risk – Liquidity concerns continue to be concentrated in bond markets, and investors should temper their appetite for yield with an awareness of how quickly the market could become paralysed by a wave of selling;

Event risk – The focus seems to have reverted from political and policy uncertainty to economic conditions, which for the time being convey modest growth. Look for market wobbles as quantitative tightening becomes more of a reality.

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