Investors shrugged off the political shocks of 2016 with stunning nonchalance: the immediate effects of Brexit lasted less than a week, the election of Donald Trump was dealt with in a matter of days and the Italian constitutional referendum was forgotten in less than three hours.
Risk assets, it seems, are all the rage (again).
The FTSE and Dow Jones Industrial Average indices reached record highs this month, as the latter passed 20,000 points, an allegedly significant amount, despite the Federal Reserve hiking rates in December.
But where is risk as we begin 2017? A brief glance at commonly used indicators suggests that danger has disappeared from the radar screens. Across the board, long-term implied volatility measures – including the often-referenced Volatility Index (VIX) – fell throughout 2016 for all asset classes excluding bonds.
Indeed, even volatility itself relaxed during the year, according to at least one measurement of expected market jitteriness. Forward-looking volatility expectations – as tracked by the VIX of VIX (VVIX) – fell during the December quarter with a blip at the time of the US election, in a pattern that sums up 2016.
Of course, this apparent lack of investor concern could be a warning signal itself. While one metric – the variance risk premium – suggests that investors are neither overly pessimistic nor too upbeat, our bespoke measure of bearish versus bullish advisors in US markets shows that optimists are in the ascendant.
Given that sentiment often provides an early warning of major market turns, we are concerned that – for the sixth month in a row – the proportion of bullish advisors has remained at a level that would normally suggest that defensive measures should be taken. So much of the future direction of the US market now seems to rest on the ability of the incoming Trump administration to deliver on campaign pledges.
Looking back over 2016, we see that the rapid reversion of heightened risk to calm conditions indicates how torn the market is between the opposing influences of unconventional monetary policies – given their positive impact on the prices of risk assets – and the increasing economic and political uncertainty that we face. We believe that risk is best likened to a hydra, one that is highly time-variant and can simultaneously appear in different, unexpected areas.
For that reason, we track five fundamental aspects of risk, all of which are supported by a range of sophisticated statistical and qualitative metrics. Our current quarterly outlook is below:
Volatility: The majority of our volatility measures continue to point to a low risk environment – but we believe that they could be masking some fragility, and for that reason anticipate some turbulence in 2017. While much of the uncertainty stems from political developments, we see enough worrying signs regarding volatility’s influence on leverage to feel that this risk will likely spill beyond the world’s corridors of power. Conversely, greater volatility is likely to be accompanied by an increased dispersion of stock returns, potentially creating opportunities for active investors.
Correlation risk: The debate about whether we are in a new regime of rising correlations across asset classes, or experiencing a temporary shift, should be settled soon. We believe that traditional methods of portfolio diversification that rely principally upon historical measures of correlation will be less effective in 2017 and beyond. This is because the potential for regime change in cross-asset correlations remains as great as it has been in recent times.
Stretch risk: A turning point has been reached, with stretch risk diminishing in some asset classes. There is some evidence of mean reversion in the commodity markets, while share buybacks, which have boosted equity valuations over the last few years, could be waning. This suggests that companies could be undertaking capital expenditure. Bond valuations have declined from extremely expensive to slightly less so, but they would have to fall much further to normalise.
Liquidity risk: Liquidity concerns returned to the bond markets, with other asset classes representing a lower likelihood of liquidity-sourced contagion. However, focusing on liquid and global bond issues could mitigate any losses. Liquidity remains the most likely transmission mechanism for contagion risk should any significant shocks upset the current stability.
Event risk: Policy uncertainty and investor sentiment are set to dominate market news headlines (see figure 1). Our principal metrics for capturing event risk, the Turbulence Index and the Absorption Ratio, both indicate that markets are less fragile than in recent quarters. However, with increasing policy uncertainty in the UK and around the globe, we err on the side of caution. In our view, event risk is greater to the downside.
The markets are not currently adverse for disciplined risk takers. Adaptive risk-management strategies remain the order of the day, and active managers capable of implementing them while seeking investment opportunities should be well suited to this environment.
Figure 1. Global policy uncertainty peaked at the Brexit vote and remains high
Source: Economic Policy Uncertainty, Hermes as at January 2017.
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