In the latest Market Risk Insights, How to evolve in the new investment climate, Eoin Murray, Head of Investment at Hermes Investment Management, checks the temperature gauge and identifies risks investors should consider as we progress through the fourth quarter.
The year may be almost at an end, but 2017 still has the capacity to shock. The shift from one monetary regime to another is unlikely to progress without convulsions in the market. In our consistently-held view, the current calm – reflected in low volatility and generally benign conditions – may hide deeper market vulnerabilities that could catch complacent investors.
To remain ahead of the risk curve, we measure forward-looking ex-ante risk from as many angles as possible. Our models, built on the ever increasing piles of patterned data produced by the apparent chaos of daily market moves, help us discern likely hazards ahead. The following is a synopsis of the key findings.
Volatility risk: Why markets may get the UMP
Across the board, long-term implied volatility measures continued to drop for all asset classes over the quarter, with currency and commodity volatility dropping most rapidly. Equity and bond volatility eased off at a less precipitous rate. However, the tranquil surface could hide emerging disruptive forces – including economic, political and financial leverage risks – that may cause a splash before year end.
Most importantly, sustained low implied volatility can lull investors into gearing up portfolios – or via other techniques to ramp up exposures – in order to supercharge returns. Given that we anticipate further shocks with sharp surges in volatility, those same investors will be forced to cut their positions, leading to self-reinforcing position-shedding.
Eoin Murray, Head of Investment, Hermes Investment Management: “How the markets react to the unwinding of Unconventional Monetary Policy (UMP) is crucial. This, alongside rising global political unrest, means we can expect forward-looking gauges such as the VVIX to flicker upwards over the rest of 2017. We also anticipate markets will retain the effects of volatility shocks more deeply in their collective conscience (long memory will return).”
Stretch risk: Why investor can’t be sure of the floor
Stretch risk allows us to identify assets that trend in one direction for a considerable period of time. A ‘stretched’ asset typically features suppressed headline volatility that obscures true underlying risks.
Valuations can become stretched without the appearance of increased volatility. In this scenario, assets or markets become extremely cheap or expensive through continual small price movements. However, such valuations rarely persist.
Murray continues: “Overall, we can find examples of stretch risk in both equity and bond markets, either from a momentum or extreme valuation perspective. The injection of liquidity from unconventional monetary policy has led to an unstable floor for downside risk, which we see continuing to develop in unpredictable ways throughout the remainder of this year and well into next. In the face of greater leverage as a result of lower volatility, we can only hope that the inevitable unwind will be orderly.”
Correlation risk: Prepare to be surprised
Correlation assumptions underpin most asset allocation and investment strategies. Indeed, investors depend on the assumed relationship between asset classes to manage overall portfolio volatility risk.
Unfortunately, correlation is not a fixed quality, requiring us to closely monitor the subtly-shifting dynamics of asset class relationships over time. Over the last few decades, the range of investment options has multiplied across asset type and geography. In this process, portfolio construction and risk management techniques have become increasingly homogenous.
Because of this convergence investors tend to react in a similar fashion when faced with the same new information, increasing the gap risk in correlations. We anticipate sharp movements in correlation, which can be managed by combining different portfolio construction and risk management methods.
Liquidity risk: Contained but under pressure
“Liquidity is often the first casualty of any market dislocation. Dislocations can occur even in highly-liquid markets. By identifying ‘crowded’ trades, we are better able to identify potential trigger sources of liquidity risk. We believe concerns over liquidity risk in the corporate debt market remain highly relevant”, said Murray.
As in our previous Market Risk Insights we include the Hui and Heubel ratio for Bund futures: this measures intra-day price movement relative to traded volume scaled by either market capitalisation or open interest.
The ratio shows liquidity conditions remained relatively stable during the quarter, with the usual number of illiquidity spikes. However, it remains moot whether years of low rates and quantitative easing have eroded the ability of central banks to counter downturns. If so, should liquidity dry up, confidence could likewise evaporate abruptly. As we have maintained, liquidity will be the most likely transmission mechanism for contagion should any significant shocks upset the current market détente.
Event risk: Mood moderates despite the radicals
“Our global policy uncertainty indicator reached a 16-year peak around Brexit, only to be surpassed by a new high around the time of the US election. The metric has declined substantially since then, as the prevailing view appears to be that markets can remain immune to political uncertainty but not so to its economic cousin. Despite the sanguine market take on geo-politics, there are flashpoints aplenty – notably North Korea and Brexit, while populism is back on the agenda in Europe”, said Murray.
Regardless of the multi-jurisdictional pop-up political crises, investors remain buoyed by slowly improving macro statistics suggesting a global economy on the mend. However, event risk, incorporating political and policy uncertainty, is a constant feature of financial markets. Our principal metrics for capturing it, the Turbulence Index and the Absorption Ratio, are at moderate levels and broadly in agreement.
ESG risk: Are monetary incentives undermining carbon targets?
A study that grabbed our attention examines efforts by firms to meet ambitious carbon emissions targets. With a novel dataset compiled by the Carbon Disclosure Project (CDP), the authors found that while using stretch goals alone was effective, the addition of monetary incentives/bonuses seemed on the whole to undermine the achievement of those targets.
Studies like these give us strong clues about how to analyse the relative riskiness of company strategies to address climate change through corporate behaviour modification.
Another case of history repeating
History suggests that economic data surprises have far greater capacity to spook markets than geopolitical risks – central banks will need to tread carefully as they attempt to ‘normalise’. In this environment, we would encourage investors to shy away from any complacency implied by benign risk measures.
Murray concludes: “If we are indeed headed for a correction of some sort, then understanding your investment timeframe is paramount: depending on how your portfolio is adapted to your investment horizon may well represent the difference between calamity and opportunity if risk runs wild.”
Our full analysis of the investment environment can be found in the current issue of Market Risk Insights