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Hermes: Journeying through ongoing uncertainty

“There are as many worlds as there are kinds of days, and as an opal changes its colours and its fire to match the nature of a day, so do I.”

In 1960, Nobel Prize-winning US author John Steinbeck set out on a road journey around his home country to see what he could see; to note any changes in the vast nation he hadn’t observed up close for decades.  Aged 58 and in ill-health, Steinbeck was nonetheless willing to confront the reality of a rapidly-changing US from the driver’s seat of a jerry-built house truck and only a ‘middle-aged poodle’ called Charley for company.

While his best-selling recount of the trip was tinged with nostalgia and tips for poodle maintenance, the writer didn’t let the past blot out a clear-eyed view of the present. “A journey is a person in itself; no two are alike,” Steinbeck wrote.

Investors would do well to bear this advice in mind as they venture through the second half of 2018. In the latest Hermes Market Risk Insights report, Journeying through a changing risk environment, Eoin Murray, Head of Investment at Hermes Investment Management, explores the six key risks investors must navigate through during the latter part of the year.

Volatility: conditions are brittle

Given the expectation of increased volatility throughout the rest of 2018, Murray urges investors to remain cautious of leverage. Murray explains: “Ongoing low levels of implied volatility can encourage investors to increase leverage in their portfolios. As we have consistently stated, with market conditions likely more brittle than headline figures suggest, over-geared investors will be forced to unwind positions rapidly as volatility returns – an outcome that would only amplify any market downturn.”

Correlation risk: inability to pick up

Correlation instability is also likely to pick up again over the remainder of this year and through to 2019. Murray said: “Our indicators suggest portfolio diversification strategies based primarily on historical correlation assumptions have become less effective. We anticipate regime change in correlation within the next 12 months. Investors will need to adapt to that new environment by combining different portfolio construction and risk management methods.”

Stretch risk: Debt weight could snap late

Hermes’ stretch risk analytical tools seek to identify assets that – while judged ‘safe’ under volatility terms – are priced at historical extremes with the potential to snap back at any moment. There are concerns a central bank error could lead to a snap back.

Murray explained: “Investors are certainly pricing in a better than 50% chance of two further rate hikes this year; and we can’t discount the possibility that central bank policy error could trigger a self-reinforcing downturn. 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.”

Liquidity risk: investors squeeze credit

The report has identified several areas vulnerable to a liquidity squeeze, such as credit. “We observed a couple of illiquidity spikes in the most recent quarter, suggesting that liquidity conditions remain vulnerable to shocks. There is mounting anecdotal evidence of liquidity pressures in the credit markets. As per the last quarter, our credit traders are still finding it necessary to break up larger orders into smaller blocks to complete deals,” Murray said.

Event risk: absorbing politics

The trend of rising global political uncertainty was confirmed again over the latest quarter. Populist movements continue to garner headlines in Eastern Europe, as well as in the UK and US – while trade tensions became increasingly entrenched. In addition, Iran replaced North Korea as the pariah of the year. However, markets are looking through these risks.

Murray stated: “In general, though, the gap between policy uncertainty and implied volatility appears to have narrowed suggesting markets have priced-in, to a certain extent, geopolitical 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: Milk and meat emitters

In terms of ESG risk, this quarter we again considered a wider ESG trend: the surprisingly large impact of agriculture on climate change. “The five largest meat and dairy corporations combined – JBS, Tyson, Cargill, Dairy Farmers of America and Fonterra – are already collectively responsible for more annual greenhouse gas emissions than ExxonMobil, Shell or BP. Or looking at the data from another angle: the top 20 meat and dairy firms produce more emissions than entire nations such as Germany, Canada, Australia, the UK or France,” Murray said.

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