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An endless summer could make investors sweat

Last year was surprisingly hot – the second warmest on record – but it wasn’t just mercury that surprised on the upside. The bull market in risk assets gathered force, and as it continues we provide a five-factor risk outlook that could distract investors from the heat.

This month, NASA reported that 2017 was the second-warmest year since 1880, when reliable records began, confounding some predictions that the atmospheric coolant of a fading El Niño would take the edge off temperatures.

Global markets continued to run against the odds amid warnings about valuations. For example, last year the S&P500 gained in every month on a total-return basis, as did the MSCI All Country World Index, for the first time in 100 years. Similarly, the S&P500 completed its longest continual rise without a 5% or greater drawdown.

So far in 2018, the golden spell of weather in the markets has held, and many investors retain a sunny disposition. Consensus expectations for 2018 are for an ongoing Goldilocks-like scenario for the global economy, featuring solid growth, low inflation and accommodative monetary policies.

Turn in the weather?
Even the staunchest bears give a nod to the market’s current cheer. But their recognition is often swiftly followed by melt-up warnings, cannily leaving open the possibility of a knowing “I told you so” after any future correction.

However, the bond markets are stubbornly telling us their own version of the story – the US curve continues to flatten, and with a ‘seven-from-seven’ record, its inversion has a proud historical record as a harbinger of recession (with an appropriate lead-lag relationship).

Perhaps bond investors have every reason to be concerned that the combination of fewer asset purchases by central banks and greater overall issuance will likely lead to higher yields as supply swamps demand. A significant global mismatch seems inevitable, to the order of $1-1.5tn, and we must hope that demand from yield-hungry investors absorbs additional supply.

Even with a rosy global economic picture – against a backdrop of rising interest rates and ‘quantitative tightening’ (QT) in the US, not to mention heightened political uncertainty – ‘more of the same’ feels like hope triumphing over probability. The market’s current optimism might be supported by short-term data, but extrapolating recent trends too far into the future is risky.

Heat gauges are steady in simmering markets
Despite indices steaming ahead in most asset classes, our objective risk indicators have yet to flash strong warnings of a market boil-over. Nonetheless, some early signals, including a sustained increase in our correlation surprise metric, are flickering enough to warrant attention.

Bubbles, if not already fully inflated, could be forming across a number of assets including bonds, equities (with US shares at the third-highest level in history, for instance), and residential housing in several countries.

However, asset classes may not react immediately. Tail risks could emerge after a significant delay, triggered by an unrelated catalyst. They could manifest as forced deleveraging of systematic strategies, disruptions to market liquidity, or the failure of bonds to offset equity risk.

Of course, markets continue to offer opportunities for risk-aware active managers. But with a close eye on the indicators, investors should take the time now to consider how well-prepared they are for a sudden drop in temperature in 2018.

Download the full Market Risk Insights for Q1 2018: Before the luck runs out

Five-factor risk outlook
Overall, our views of market risk for the coming quarter are:

Volatility: we anticipate both a steady rise in volatility as well as more frequent spikes in 2018

Correlation risk: in the past two decades, most risk models correctly nominated bonds as the most attractive hedge towards equity risk. But this assumption could fail in the future, given the rising correlation between the two asset classes

Stretch risk: as credit spreads get tighter and tighter in the face of greater leverage (as a result of lower volatility), we can only hope that the inevitable unwind will be orderly

Liquidity risk: investors seem to be universally upbeat, and even though liquidity may not threaten solvency conditions we do not discount the chance of liquidity-sourced contagion

Event risk: the global political backdrop continues to evolve rapidly, and as a result, the room for error shrinks further

ESG risk: ESG risks manifest over the long term, but necessitate action today.

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