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Healthy correction or darker times ahead?

Is the recent global market sell-off a healthy correction or a foreshadowing of darker times ahead for investors? In the latest Market Risk Insights, ‘Before the luck runs out’, Eoin Murray, Head of Investment at Hermes Investment Management, explores the six key risks investors face as they trudge out into largely unmapped territory featuring extreme financial conditions.

“Our ongoing concerns about the recovery’s tenure have been thrown into sharper focus by the steepest market sell-off since the credit crunch. In these exceptional times, as active investors, we need to probe beyond simple measures to gauge the underlying temperature of the broader financial system.

“We exist in a period where the market is acutely vulnerable to a change in circumstances. Indeed, our Complacency Indicator has been fixed at worrying lows – suggesting an explosive spike in market volatility could be expected. As we have noted before, complacency does not guarantee negative outcomes, but investors should continue to be cautious, embed flexibility into their investment strategies and be prepared for any eventuality.

“The coming year is likely to hold plenty of surprises. Central bank tightening, or at least the end of post-crisis monetary accommodation, will undoubtedly prove challenging. Long-dormant inflation looms as a tail risk, while the global political landscape remains unstable. Below, I set out the key risk gauges investors must consider when navigating markets that still reside at lofty elevations.

Volatility risk: The end of unnatural calm
“Recent benign conditions have encouraged investors to amp up portfolio exposure via leverage. Gearing is fine as long as implied volatility remains low, but given 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.

“Not only do we expect volatility to increase in 2018, and would urge investors to remain cautious of leveraging positions too far, but we also anticipate that markets will retain the effects of volatility shocks more deeply in their collective conscience (long memory will return). Recent low volatility has been a reflection of low macro volatility and central bank liquidity – as those conditions change, expect volatility to shift.

Stretch risk: Cape Fair
“We fear a significant part of the credit markets, particularly in the US, is intermediated by ‘shadow banks’ rather than regulated institutions. The shadow banking sector tends to be highly interconnected and hence subject to the same sort of liquidity demands as banks were in the past. This does not bode well for pre-stretched credit markets.

“US corporate debt shows a far higher beta to equities on the downside than on the upside. With the Federal Reserve beginning to unwind its balance sheet in the US and the European Central Bank leaning in the same direction, credit returns may begin to look less distorted relative to the same stage in previous cycles. Even under a very slow and measured version of quantitative tightening, we would anticipate spreads moving wider.

“On the eve of the recent sell off, on the cyclically-adjusted price/earnings ratio (CAPE) metric, the US market looked more expensive than before the Great Crash of 1929. In spite of the rationale for ongoing optimism we find excellent examples of stretch risk in both equity and bond markets, either from a momentum or extreme valuation perspective. UMP-enhanced liquidity has led to an unstable floor for downside risk, which we see continuing to develop in unpredictable ways throughout this year.

Correlation risk: Question conformity
“Analysing correlation surprise allows us to capture the degree of statistical unusualness in current correlation levels relative to history. The indicator hit a new high during the last quarter with a flurry of activity mid-November, suggesting highly unusual correlation behaviour. We think it’s wise to remain cautious about any portfolio assumptions with respect to cross-asset relationships.

“Traditional methods of portfolio diversification that rely principally upon historical measures of correlation have become less effective. Over the last few decades the range of investment options has multiplied across asset type and geography. While the expanding investment universe has brought the benefits of diversification, portfolio construction and risk management, techniques have become increasingly homogenous.

“As their strategies conform, 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 investors will need to handle by combining different portfolio construction and risk management methods.

Liquidity risk: Corporate credit looms as a danger
“Ultra-easy monetary policies have led to bloated central bank balance sheets in developed economies and suppressed both volatility and interest rates, causing a splurge in risky assets. Investors generally appear to be attempting to balance concerns about valuations and potential downside risks with the fear of missing out on more of the party.

“Global financing conditions and liquidity appear respectively stable and relatively plentiful for the time being. However, there is always the possibility that Fed quantitative tightening aligned with current banking regulations and money-market reforms could tighten offshore dollar funding further. As investors move into less liquid assets in search of higher yields, getting paid for illiquidity may seem attractive but it must be balanced against the need to absorb a tidal wave of selling should that recur.

“We believe that concerns over liquidity risk in the corporate debt market remain highly relevant. Alongside our credit portfolio managers, we continue to monitor this situation closely.

Event Risk: Accidents do happen
“Currently, the world features a few major political flashpoints – in particular North Korea and Brexit, while populism is back on the agenda in Europe (with notable outbreaks in Austria, Germany and Spain). While we expect policy uncertainty to remain at modest levels throughout 2018, under the worst-case scenario the rising threat of ‘geopolitical accidents’ could trigger more serious global conflict.

“Overall, as the disparity between policy uncertainty and implied volatility has fallen, the market seems happy to focus on what it sees as tangible, improving macro activity while discounting the more ephemeral potential political risk. 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: Investment risk of ignoring ESG becomes clearer
“A paper1 that recently caught our attention addresses the incorporation of ESG criteria into investment decisions, something that we would consider essential and standard practice. The authors argue that with the increasing provenance of social media it is more likely for an environmental crisis to rapidly incite regulatory change and consumer behaviour modifications – potentially leading to large swings in asset prices over a short timeframe.

“The authors considered two case studies: namely, the coal industry in the US post the election of President Trump; and the consumer goods industry with respect to palm oil products. The paper demonstrates that even the favourable winds of deregulation were insufficient to prevent poor performance in the face of the emergence of environmentally-friendly alternatives for the former. For the latter, those palm oil companies seen to be dealing most energetically with the problems of deforestation enjoyed the greatest success. The investment risk of ignoring ESG issues is becoming increasingly clear.”

 

Jagannathan, R, et al, ‘Environmental, Social and Governance Criteria: Why Investors Should Care’, working paper, September 2017

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