16 June 2019
The market still offers opportunities for suitably skilled and risk-aware active managers who should pay heed to aligning risk settings with their investment horizons. Photo: Reuters
The market still offers opportunities for suitably skilled and risk-aware active managers who should pay heed to aligning risk settings with their investment horizons. Photo: Reuters

Should investors prepare for the ‘worst of times’?

“It was the best of times, it was the worst of times, it was the age of wisdom, it was the age of foolishness . . . it was the spring of hope, it was the winter of despair.”

Dickens’ opening words from A Tale of Two Cities could set the scene for current market and macroeconomic conditions: a world of latent volatility, where contradictory extremes loom as equally likely possibilities; where every change in political events could send markets either way. Is it to be a time of inflation or disinflation, liquidity or illiquidity, growth or slump?

The dramatic return of share-price volatility in the first quarter indicates some plot issues that may be resolved in 2018, but others remain hidden in the subtext. As investors face Dickensian conditions, there are six key risks to consider.

Volatility: Hard times ahead?

Volatility remains the popular measure for risk in financial markets. With the exception of February’s spike in equity volatility across the board, for all asset classes, long-term implied volatility measures have continued to drop. But going forward, it’s reasonable to expect other asset classes to follow the equity market into more volatile territory: anticipate both a steady rise in volatility as well as more frequent spikes in 2018.

It is a concern that current low implied volatility encourages investors to increase their market exposures, often through leveraging – and geared portfolios are particularly vulnerable to volatility shocks. In the event of price instability, leveraged investors unload positions, which can trigger further market volatility. Investors should consider adopting a conservative stance on gearing in anticipation of rising volatility ahead.

Correlation: Greater expectations

Cross-asset global correlation has remained stubbornly in a band from 2007, with assets mostly moving together – with the measure sticking below levels not often seen since before the financial crisis. This is a critical signal which needs close watching. If volatilities rise across the asset universe during 2018, the prevailing correlation pattern could be challenged: it’s best to remain cautious about portfolio assumptions with respect to cross-asset relationships.

Despite the wider array of asset classes offering potentially greater sources of diversification, investors are increasingly herding around common risk and portfolio management strategies. But in a changed investment environment, investors will need to adapt by combining different portfolio construction and risk management methods.

Stretch risk: The plot thickens

While volatility is the marquee measure of risk in financial markets, asset price stability can mask underlying dangers: fully-priced assets may exhibit low volatility but hide substantial downside potential. “Stretch risk” analysis identifies these apparently low-volatility assets and/or those that have trended in one direction or another for an extended period.

There are examples of stretch risk in both equity and bond markets, either from a momentum or extreme valuation perspective. The injection of liquidity from unconventional central bank monetary policies – now drying up – has created an unstable floor for downside risk, and this is likely to continue developing in unpredictable ways throughout the remainder of this year. As different market variables get tighter and tighter, with the growth of leverage built on lower volatility, investors should hope that the inevitable unwind will be orderly.

Liquidity risk: Bleak times ahead?

There has been further rotation in fund managers’ most crowded trades. As fast as “Long Bitcoin” appeared, it is now being replaced by “Long Big Tech” and Nasdaq stocks more generally.

Even before the latest rise, tech stocks were already popular with investors, who also show a persistent appetite to go long in the corporate bond markets. Short volatility, unsurprisingly, has suffered, but as volatility fell back, investors may have been tempted to reload. Based on this situation, concerns over liquidity risk in the corporate debt market remain highly relevant: don’t discount the chance of liquidity-sourced contagion.

Event risk: Further twists ahead

Political risk and its impact on markets should never be ignored, even if it is difficult to measure. Our own turbulence index rose to its highest level for nearly eight years during February’s sell-off, implying that markets were behaving less normally relative to their own recent past – driven by the return of normal volatility levels. Based on this pattern, the measure will experience further spikes during 2018.

Meanwhile, our measure of global policy uncertainty has remained relatively low with investors discounting politics as less influential than economics. It would be foolish to ignore possible knock-on effects from trade tensions between the United States and China, conflict in the Middle East and renewed uncertainty in Europe.

ESG risk: A tale of two commodities

Environmental, Social and Governance (ESG) risks require urgent action today. But rather than focus on the entire universe of ESG, two areas where there are many hard questions to be faced are around water and concrete.

As communities around the world face a growing water crisis, the need for lower-cost means to secure ample and clean water is increasingly urgent. Solutions require collaboration from a number of stakeholders (utilities, business, government and communities) – and considerable investment. For example, a recent memorandum of understanding between Pakistan and China commits to building two dams on the River Indus, as part of China’s One Belt, One Road initiative, to generate more than 11,000 megawatts of electricity at a forecast cost of US$27 billion. But the rivers of the Indus important to the sub-continent and these two dams may have unintended consequences for water safety in India.

At the same time cement companies – some of the major carbon dioxide emitters in the industrials sector – face risks in the transition to a low-carbon economy. Globally, these companies have reduced emissions intensity by roughly 1 percent per annum over the last four years – but more work is needed to help meet the global climate change target of keeping global temperature rises under the two-degree threshold.

Conclusion: A world of action

Objectively, these risk metrics show increasing indication of downside risks and signal that investors should maintain a note of caution. Even so, the market still offers opportunities for suitably skilled and risk-aware active managers who should pay heed to aligning risk settings with their investment horizons. For whatever the times, as Dickens puts it: “This is a world of action, and not for moping and droning in.”

– Contact us at [email protected]


Head of Investment at Hermes Investment Management

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