25 April 2019
Ongoing low levels of implied volatility can encourage investors to increase leverage in their portfolios. Photo: Reuters
Ongoing low levels of implied volatility can encourage investors to increase leverage in their portfolios. Photo: Reuters

Six key market risks investors should consider

In 1960, two years before he won the Nobel Prize for literature, US author John Steinbeck set out on a road journey across America 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 nation from the driver’s seat of a jerry-built house truck and with only a “middle-aged poodle” called Charley for company.

While his best-selling account of the trip, Travels with Charley, was tinged with nostalgia and tips on 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 well into the second half of 2018. The year to date has brought growing uncertainty as valuation concerns, rising interest rates, and geopolitical angst threaten to disrupt the long period of stability in capital markets.

But uncertainty almost always breeds opportunity for those who are prepared and willing to adapt.

Looking back, though, the stormy start to 2018 gave way to a second quarter that largely reprised the calm conditions of last year. History will record a somewhat different view of Q2 than market charts reflect: the period is likely to be remembered for the highs and lows of political uncertainty, and an escalation in global trade skirmishes.

Perhaps people basking in the sun don’t want to think about the risks, or when winter will come: but seasons change. As Steinbeck noted in his book, without change there is no adaption: “I’ve lived in a good climate, and it bores the hell out of me. I like weather rather than climate.”

We have long recommended that investors consider the full range of risks, beyond pure financial market risks, and the wider context should be fully explored. Here are six key aspects of market risk that investors should consider as, like the weather, the market conditions could potentially start to change:

Volatility: conditions are brittle

Investors look first and foremost to volatility as the bellwether of market risk. The key is to view forward-looking volatility through several different lenses, across multiple asset classes and geographies.

Given the expectation of increased volatility throughout the rest of 2018, investors should remain cautious of leverage.

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.

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 this new environment by combining different portfolio construction and risk management methods.

Stretch risk: debt weight could snap late

Our 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.

Investors are certainly pricing in a better than 50 percent 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

We’ve identified that several areas are vulnerable to a liquidity squeeze, particularly within credit. We believe that concerns over liquidity risk in the corporate debt market remain highly relevant. Credit liquidity has deteriorated of late, reflecting the predominance of non-US debt issuance over the last few years, and is patchy at best, isolated to the large capital structures.

Fixed-income markets in general are quicker than equity markets to re-price risk. We also note that fixed income tends to lead other asset classes in liquidity trends. And in our view there remains a wide gap in liquidity conditions between credit and equity markets.

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.

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.

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: farms’ greenhouse emissions 

In terms of environment, social and governance (ESG ) risk, one to highlight is 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.

What does this mean for investors? The key is to monitor this sector closely, as further evidence piles up suggesting a direct impact of climate change on global growth, which should be considered.

Conclusion: beginning at the end

“A journey is like a marriage. The certain way to be wrong is to think you control it.” Much of what Steinbeck says here is true of investing. You can’t control everything. But you can learn from the past and factor in this experience.

Risk appears in many forms, and not all of them are familiar. While the complete picture of the future will always remain elusive, investors need to consider potential imminent dangers from many different viewpoints to build up a mosaic of risk. This should help to minimize surprises, but it won’t eliminate them.

– Contact us at [email protected]


Head of Investment at Hermes Investment Management

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