Dickensian conditions
Q2 2018
In response, investors must watch for familiar patterns and new disruptions amid streams of financial indicators.
Models based on statistical history can serve as useful, if inexact, guides. But we need to use all the tools at hand, going beyond number crunching to consider geopolitical tensions and sustainability concerns, to separate meaningful signals from the noise.
We recommend tracking the following six indicators to recognise risk in its current form – and identify where opportunities lie.
Volatility of volatility
Source: Hermes, Bloomberg, CBOE as at May 2018
Equity markets returned to their historical, volatile form as 2018 began. Our range of risk indicators suggest that this was no mere blip. While volatility in other asset classes remains subdued, we expect that to change in the year ahead.
Forward-looking risk gauges edged higher, with the Volatility of Volatility Index (VVIX) spiking in February to levels not seen for at least two years and the long-term trend rising. The worm has turned.
Correlations
Source: Hermes, Bloomberg as at May 2018
Our multiple measures of correlation risk largely held steady during the first quarter of 2018 in spite of rising equity-market volatility. However, asset class relationships seemed to be shifting, with a slight lift in equity-bond correlations during the period.
Meanwhile, our correlation-stability signal reached a 12-month peak early in the year, suggesting that long-standing asset class relationships could be strained.
Correlation regime change, which we expect to occur in 2018, can happen at speed.
S&P 500
Source: Reuters, Hermes as at May 2018
Assets can hold historically unusual valuation levels for various reasons and for extended periods, but should eventually snap back. We have no difficulty in finding examples of such ‘stretched assets’ in today’s markets.
For example, European credit markets and US equities look tense relative to historical valuations. Passive investors in those assets may be walking a tightrope.
Which trades are the most crowded?
Source: Hermes, Bank of America Merrill Lynch as at May 2018
Money is plentiful for now, with global financing and liquidity conditions stable over the quarter. But a number of offshore US dollar funding risks loom on the horizon, including: ‘quantitative tightening’ by the Federal Reserve, tougher banking regulations and money-market reforms.
Financial trauma is usually transmitted by liquidity stress, which can pop up anywhere, however fund managers’ consensus views of crowded trades, shown in the chart above, can signal the most likely pressure points.
Absorption ratio across 17 asset classes
Source: Hermes, Bloomberg, MSCI as at May 2018
Global political tensions abound in 2018, with a populist Italian government and further US-instigated trade disputes making headlines at the time of publication.
Regardless of the simmering geopolitics, our main event risk gauges – the Turbulence Index and the Absorption Ratio – do not suggest a market boil-over. Both indicators are at a moderate level, with the Absorption Ratio – which measures the potential vulnerability of markets to external shocks – trending upwards.
Water stress on the Indian subcontinent
Source: WRI Aqueduct 2014
Emerging-market investors are no doubt wary of water stress in India, and should consider the impact of China and Pakistan’s agreement to build two new dams on the Indus River.
More than half of India already experiences high-to-severe water stress, exacerbated by contamination and a low volume of rain in 2017, but this could intensify further if the new dams are built upstream. The Indus is already considered to be one of the world’s most endangered water bodies, along with the Ganges.
In conclusion
The first quarter of 2018 was characterised by turbulence: it was the best and worst of times. While we can never know the true distribution of asset returns and gauge risk with 100% accuracy, our metrics increasingly indicate downside risk in the coming quarter, warranting a note of caution.
