Investors generally kept calm and carried on during the third quarter, despite the shock of the Brexit vote, as market activity throughout the northern summer generally went according to script. But rising correlation and liquidity risks threaten the sunny mood.
Hiatus for the holidays
The prevailing atmosphere, however, was somewhat darker than the dialogue might have suggested. Any calm – if indeed that was the genuine mood – was threatened by strong underlying tensions, which flared up briefly in September.
With the exception of this blip – which saw sell-offs across markets and sharp spikes in volatility measures – investors could be forgiven for thinking nothing had changed by the quarter’s end. ‘Normal’ viewing resumed as the fourth quarter approached – order was restored, nerves soothed.
But, if anything, investors are more wound up than ever despite stubbornly low readings from volatility indicators. This slightly surreal scenario has undoubtedly been underwritten by ultra-accommodative monetary policies from the world’s major central banks, which have absorbed most of the pressure for the time being.
It is unlikely, though, that low-to-negative interest rates can keep the story plodding along in such an uneventful way. A number of potential plot-turning events could easily unfold in the current quarter.
Turn of the screw
Liquidity and market depth generally remain weak, political risk abounds in both the impending US election and Italian vote on constitutional change. Meanwhile, following consistent, if low, US growth throughout the year, the US Federal Reserve will opine on US interest rates shortly before the Christmas break.
Either or all of these events have the potential to swing the storyline from a tension-building phase to full-on action. Rather than simply sitting back and watching the scenes roll by in real time, though, we believe investors need to prepare for likely events based on the best evidence available.
Within the Hermes Investment Office, we continually analyse five prominent forms of risk, from volatility to event risk, with several indices contributing to each metric. Our latest research reinforces the cautionary positions we have advocated in recent quarters:
Volatility measures continue to point to a low-risk environment. However, we believe that indicators mask considerable fragility. Much of this uncertainty centres on political developments but we cannot over-emphasise the link between leverage and volatility, which at low levels emboldens some market participants to over-gear their portfolios.
In the likely event of continued spikes in volatility for the remainder of this year, resulting market corrections will be, as always, painful.
Correlation risk became the dominant source of risk in the last quarter and we think that will remain the case through to year-end. Both of our measures in this category – correlation surprise (see figure 1) and correlation signal – provide some helpful indicators that markets were more fragile than a range of volatility measures suggested.
Figure 1. Correlation risk: telling a story that volatility cannot
Source: Hermes, Bloomberg as at 30 September
Stretch risk retains a cautionary air as various asset classes could quite easily remain at current levels without some form of exogenous shock to cause disruption. However, we note that stock buybacks, in particular, have buoyed valuations in the equity markets for some time – whether that continues remains to be seen.
Equity valuations generally appear most stretched relative to only the longest periods of history, and less so when compared to recent times. Meanwhile, bond yields remain at extreme levels despite recent rises. We continue to be wary of catalysts that have the potential to reverse equity highs and bond-yield lows.
Liquidity risk has developed from a fairly localised problem affecting primarily the credit markets to one that could become far more significant and far-reaching, potentially threatening all asset classes.
We believe that liquidity – or the lack of it - will be the most likely transmission mechanism for contagion should any significant shocks derail the current storybook stability.
One measure of liquidity that we use, ‘Kyle’s lambda’, which assesses the resilience of liquidity by gauging how much equity prices move in response to order flow, demonstrated how difficult it was to trade global equities during the volatility spike in September (see figure 2).
Figure 2. Kyle’s lambda: stock prices spiked with orders in September
Source: Hermes, Bloomberg as at 30 September
Event risk remains a mixed bag of signals, with our turbulence and absorption ratio metrics, for instance, at odds with each other. But we hold the view that markets as a whole, given the range of political and economic risks, remain in a vulnerable state, still very much reliant on liquidity provided by central banks.
A cautionary tale
The broad range of indicators we monitor continue to suggest that investors should err on the side of caution. While these metrics don’t irrefutably point to extreme risk, we believe that the market story could easily take an unexpected, and unpleasant, turn.