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Hermes Investment Office Q3 2019

MARKET RISK INSIGHTSObjective danger in the investment environment

Eoin Murray Head of Investment

Looking back just 10 years from the dizzy heights of the latest Dow Jones peak could easily induce vertigo. The US stock market hit a record 27,000 in June, more than tripling in size from its trough in February 2009.

Yet while investors may marvel at how far they’ve come in a decade, a fuller historical vista provides a better guide for what lies ahead. From a 100-year perspective, the Dow Jones – or any equity index for that matter – resembles the outline of a mountain range, the jagged lines mapping out the multiple peaks and troughs that investors have traversed over the climb.

But at these stratospheric levels, the air is pretty thin. Previously, I have outlined how investors need special tactics to survive in today’s rarefied markets – similar to the ‘mountain fitness’ that serious climbers develop to increase their chances of staying alive in the extraordinary, elevated worlds they plan to conquer. It is this kind of readiness that will help us overcome the investment world’s equivalent of altitude sickness.

In this edition, I turn to another mountaineering concept. Mountaineers use the term ‘objective danger’ to describe the risks – from rockslides to storms – that lie beyond their control once they have committed to climbing a certain path.

After making the decision to allocate capital to particular assets, investors face many situations that could fall under the ‘objective danger’ label. And just as serious climbers do their best to understand and prepare for the risks ahead, investors also need to arm themselves with knowledge and equipment to deal with objective dangers as they arise.

Equity markets rebounded strongly in the first quarter of this year, following the short, sharp stumble at the end of 2018. Over the second quarter, equity indices edged ever-higher – albeit at a slower pace – to reach successive new record peaks.

Despite the strength of the recovery rally, we urge investors to remain structurally bearish in this late-cycle phase. The International Monetary Fund (IMF) has called the current environment the ‘new mediocre’, which aptly sums it up for us. We live in strange times when risk assets are buoyed by news that central banks are considering a resumption of quantitative easing (QE) in response to looming uncertainty.

For now, investors are relying on the oxygen supplied by central banks to sustain elevated share prices. We could still see further short-term tradeable moves, with indices possibly surpassing record highs. But the risk (and opportunity set) is firmly skewed to the downside. Sooner or later monetary authorities will have nothing left in the tank, which could prove fatal for investors stranded in alpine regions.

Back at ground level, the geopolitical environment remains fraught with peril. Much attention is given to the growing threat of US protectionism, although we feel this is actually a battle for technological dominance with China, rather than anything to do with trade – see this commentary from our Global Emerging Markets team).

But other flashpoints abound: Brexit, Hong Kong, Taiwan, Japan and Korea, Iran and Turkey, to name just a few. Markets have been able to absorb the simmering tensions so far, but investors should be aware that should these objective dangers materialise, there may be liquidity demands across their portfolios in the future.

On a three-month view, equities have generally produced the highest absolute returns, beaten only by crude oil (see figure 1). Even so, corporate bonds have clocked up better risk-adjusted returns than shares, while US high-yield bonds have performed the best on a Sharpe-ratio basis. The strong-yet-volatile track record of oil means the asset class has a similar Sharpe ratio to US and global equities.

Figures 1: Three-month risks and returns

BondAsset Class

Risk – Std Dev (Ann. %)

Low Sharpe Ratio

High Sharpe Ratio

2520155 100

$ re

turn

(%)

Commodity Equity

Crude Oil-Brent

S&P GSCI Commodity

S&P GSCI Ind Metals

GSCI Precious Metal

MSCI EM Latam

MSCI Japan

MSCI NordicMSCI UK

MSCI EMUMSCI USA

MSCI ACWI

MSCI EM

MSCI Australia

MSCI Asia Pac ex JP

UK 10yr

US 10yr

Japan 10yr

Swed 10yr

Switz 10yr

Ger 10yr

JPM GBI-EM Bd

JPM EMBI GLB.DIVERS

JPM Global Gov Bd

BofAML US TIPS

BofAML US$ EM Sov+

BofAML ML US CorpBofAML ML US HY

Aus 10yrCan 10yr

LME-Copper

CCI Softs Index

CCI (CRB)

Gold Bullion LBM

CCI Grains & Oilseed

CCI Industrials

CCI Precious Metals

LIBMA Silver

-15

-10

-5

0

5

10

15

Source: Absolute Strategy Research, Hermes, as at August 2019.

But over a 10-year period, fixed-income assets have delivered lower volatility and similar returns to equities, which for emerging-market and credit bonds has led to higher Sharpe ratios (see figure 2). Meanwhile, commodities underperformed equities despite experiencing similar levels of volatility.

Figure 2: 10-year risks and returns

BondAsset Class

Risk – Std Dev (Ann. %)

Low Sharpe Ratio3525 3020155 100

$ re

turn

(%)

Commodity Equity

-5

0

5

10

15High Sharpe Ratio

Crude Oil-Brent

S&P GSCI Commodity

S&P GSCI Ind Metals

GSCI Precious Metal

MSCI Japan

MSCI Nordic

MSCI UK

MSCI EMU

MSCI USA

MSCI ACWI

MSCI EM

MSCI EM Latam

MSCI AustraliaMSCI Asia Pac ex JP

UK 10yr

US 10yr

Japan 10yr

Swed 10yr

Switz 10yr

Ger 10yr

JPM GBI-EM Bd

JPM EMBI GLB.DIVERS

JPM Global Gov Bd

BofAML US TIPS

BofAML US$ EM Sov+

BofAML ML US Corp

BofAML ML US HY

Aus 10yr

Can 10yr

LME-Copper

CCI Softs Index

CCI (CRB)

Gold Bullion LBM

CCI Grains & Oilseed

CCI Industrials

CCI Precious Metals

LIBMA Silver

Source: Absolute Strategy Research, Hermes, as at August 2019.

The devil whispered in my ear: ‘You’re not strong enough to withstand the storm.’ I whispered back: ‘I am the storm.’ Leg tattoo of Azara Garcia, champion ultra-endurance runner

MARKET RISK INSIGHTS Q3 2019

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In our view, the late 2018 selloff was largely driven by market perception (rather than reality) that central-bank tightening – in particular from the US Federal Reserve (Fed) – was about to drain liquidity from capital markets. With the punchbowl removed, investors decided that trouble lay ahead and acted accordingly. When Fed chairman Jerome Powell appeared to halt the policy shift, confidence came roaring back.

But the financial sector struggled, particularly during the end-of-year selloff, and systemically important banks haven’t recovered with the rest of the market (see figure 3).

Figure 3: Relative performance of Systemically Important Financial Institutions

75

80

85

90

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100

105

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Asia ex Japan FSB G-SIBsUS Eurozone Japan

M J J A S O N D J F M A M

Source: Absolute Strategy Research, Hermes, as at August 2019.

This suggests to us that the global-banking system faces its own objective dangers. This does not surprise us, given that falling interest rates threaten banks’ profitability models. If banks do suffer, that does not augur well for the financial system as a whole.

Meanwhile, the buyback boom has continued apace, driving equity markets ever higher. Buybacks are expected to top $1trn in 2019, further distorting equity markets. The US economy also recently reached a significant milestone, posting the longest recovery in modern times (see figure 4).

But the mood is dominated by concerns that policymakers do not have the tools to deal with the next downturn. One currently favoured solution would be to return to unconventional monetary policy (UMP) methods like QE, despite considerable unease about its adverse side effects such as inequality and populism.

Figure 4: The longest US economic expansions since World War II

Months from start of recovery1949-53 1954-57 1958-60 1960-69 1970-73 1975-801980-81 1982-90 1991-01 2001-07 2009-?

Reco

very

in U

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al G

DP

(pre

-rec

essio

n pe

ak =

100

)

0 12 24 36 48 60 72 84 96 108 120

135

155150145140

115

130125120

105110

95100

Source: RBC Capital Markets, as at August 2019.

Another idea is to turn to fiscal measures. But there are concerns that this could push government debt – already at record levels in some countries – even higher. The US Congress and the White House have just agreed on a budget deal for the next two years which is the equivalent of boosting fiscal spending by roughly 0.6% of GDP. In early 2018, the Fed indicated that stimulus like this was a reason to raise interest rates faster. One imagines their thinking has changed somewhat now.

The spike in volatility over the fourth quarter ensured that 2018 ended on an exciting note. But since then, volatility has returned to extreme lows. Using data from the volatility index (VIX), our long-running ‘complacency’ chart covers three jittery market periods: the 1998 Long-Term Capital Management collapse and Russian default crisis, the end of the dotcom boom in 2001 and the three-to-four years starting just before the financial crisis and ending in 2011.

Our complacency indicator considers the impact of ‘jumps’ – or sharp spikes in volatility – and ‘long memory’, which tracks the slower retreat of anxiety as calm returns to markets. We measure this by comparing volatility high points to the sum of the volatilities for the days from the start of the jump to its conclusion. Using this technique, the higher the read-out on the complacency indicator, the more fragile markets appear to be.

Figure 5: Complacency indicator: volatility eases off

VIX

& C

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Long memory VIX LT average Complacency indicator (RHS)

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Source: Hermes, Bloomberg, The Chicago Board Options Exchange, as at August 2019.

Based on historical trends, the surge of volatility in the fourth quarter of last year appears to be a normal response. This suggests to us that not only should we expect more spikes as the current cycle rolls on, but that these jolts will be increasingly sustained as the long-memory component of volatility kicks back in.

In an environment where all asset classes remain highly sensitive to sentiment shifts, we caution investors to prepare for the ‘objective dangers’ that lie in the months and years ahead.

As usual, we update our risk indicators in this issue, providing investors with the best forward-looking tools at our disposal as we trek on through the atmosphere. Further summits may beckon at these elevations, but it is long, long way down.

HERMES INVESTMENT OFFICE 3

SummaryKey risks highlighted in this report:

�� Policy uncertainty is on the rise as the trade war re-escalates and Brexit comes to a head

�� Central-bank liquidity keeps markets breathing easy for the moment, but free oxygen is not limitless

�� Plastics and climate change are high on the environmental, social and governance (ESG) agenda

�� Liquidity pressures are increasing in debt markets

�� Pent-up volatility is due to flare out

In this issue we update our views on six key aspects of market risk:

1. Volatility

2. Correlation risk

3. Stretch risk

4. Liquidity risk

5. Event risk

6. ESG risk

VOLATILITY: WEATHER WARNINGThe transition from blue sky to blizzard can take even the most seasoned climbers by surprise. But at the very least, risk-conscious mountaineers will check weather forecasts before setting out from base camp.

In markets, volatility is the weather. Investors need to keep a close eye on volatility as they venture out, but it should not be considered in isolation. We refer to several volatility measures in order to build up a multi-dimensional picture of this fundamental risk parameter.

We have measured the implied volatility of equity, government bond, currency and commodity markets, standardising the metrics to make sure they are directly comparable (see figure 6). Each represent the market’s expectation of future volatility and are often viewed as a benchmark of risk appetite.

Figure 6: 52-week moving averages of selected volatility measures

Currency volatility Commodities volatilityEquity volatility Debt volatility

2010 2012 2014 2016 2017 201920182008 2009 2011 2013 2015

Nor

mal

ised

inde

x

-2

-1

0

1

2

3

4

5

Source: Hermes, Bloomberg, Chicago Board Options Exchange, Deutsche Bank, Bank of America Merrill Lynch, as at August 2019.

Our longer-term, rolling measures show that volatility picked up sharply in the fourth quarter of last year and has been steadily declining since then. When combined with poor liquidity and low trading activity, this low level of volatility is more indicative of inaction and complacency than genuine ease within markets.

As we have warned repeatedly, the apparently endless calm conditions could tempt investors to use more leverage as a fast track to higher returns. This is fine so long as implied volatility remains low, but given that we anticipate further shocks, over-leveraged investors could be taking on more than they bargained for.

We expect volatility to increase over the year, which will ripple further down the line as shocks trigger ‘long memory’ anxiety among investors who may scramble for safer ground. But an orderly retreat may not be possible for investors weighted down by leverage.

Historically, treasury spreads have been a useful warning sign of impending volatility. As figure 7 reveals, there is a strong relationship between treasury spreads with a three-year lead and the VIX. With a healthy correlation of 0.52 between the two measures, we expect volatility to rise over the next few years.

Figure 7: Treasuries as a predictor of equity volatility

VIX

inde

x 2s10s

10yr-2yr US Treasury spread, inverted and advanced by 3 years (RHS)VIX Volatility Index

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-0.5

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31/01/1990 31/01/1996 31/01/2002 31/01/2008 31/01/2014 31/01/2020

Source: Hermes, Federal Reserve Bank of St Louis, as at August 2019.

Inevitably, forward-looking volatility expectations spiked late last year as equity markets stumbled heavily. Investors have subsequently revised down expected volatility as equities resumed their ascent during the first half of 2019.

We suspect that rising equity markets have once again lulled investors into a sense of complacency, leaving many ill-prepared for a potentially larger reprise of the late-2018 tumble.

Cross-sectional dispersion is another way to view changing volatility conditions (see figure 8), showing the spread between the best and worst equity returns at any one time. If cross-sectional dispersion is compressed, investor returns fall across a tighter band; conversely, a higher cross-sectional dispersion provides more opportunities for stock-pickers to exercise their skills.

The Hermes Investment OfficeIndependent of the investment teams, the Hermes investment Office continuously monitors risk across client portfolio and ensures that teams are performing in the best interest of investors. It provides rigorous analyses and attributions of performance and risk, demonstrating our commitment to being a transparent and responsible asset manager

MARKET RISK INSIGHTS Q3 2019

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Figure 8: Cross-sectional dispersion of stock returns

%

Cross-sectional volatility Cross-sectional volatility (moving average)

0

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2008 2010 2012 2014 2017 201820162007 2009 2011 2013 2015

Source: Hermes, Bloomberg, Financial Times Stock Exchange, as at August 2019.

Unfortunately, the long-term trend for cross-sectional volatility has stalled after rising over the past couple of years. Active managers will be hoping the gauge resumes a steady rise.

All our volatility measures ticked up strongly at the end of last year, before settling down during the first half of 2019 to previous low levels. In our view, the preternatural calm throughout the first half of the year masked a tense market mood, prone to relapse into bouts of anxiety at any time.

Events following the end of the second quarter confirmed this diagnosis, as global equity markets slipped downwards and we witnessed the worst single-day slide for US stocks so far this year. We expect further volatility spikes as increasingly changeable weather conditions buffet markets for the rest of the year and beyond.

CORRELATION RISK: SEARCHING FOR ANCHOR POINTSMountaineers typically use an intricate series of screws, carabiners, ropes and pulleys to traverse difficult terrain and prevent falls. The choice of roping techniques will naturally depend on the geography, as well as the climber’s experience, skill and temperament. But ultimately the performance of these safety systems hinges on the strength of the anchor point that the ropes thread through.

Safety-conscious climbers seek to diversify this risk by applying the concept of redundancy – that is, using more than one anchor point. As one mountaineering website, Mountain Knowhow, describes it: “Your points must be redundant. If one anchor fails, the anchors should not fail automatically too. Use always two, better more solid anchor points. Three is a good number. Ensure to keep redundant carabiners and slings too. I cannot stress this enough: Redundancy is the number one rule that will save your life if applied right.”

Clearly, how the anchor points are secured and arranged will make a big difference to how they perform under pressure. Investors also have to carefully consider whether their portfolio anchor points – or their asset allocation – are actually spreading risk as per specifications, or whether they are prone to simultaneous failure.

We rigorously monitor correlation risk across a number of statistical measures including our regular asset-class heat map (see figure 9). The heat map provides a graphical representation of various asset-class correlations – as measured by mean values – at a point in time.

Figure 9: Correlation heat maps

Correlation: March 2019Global HYUS NonFin HY ConstrainedEU N-FinaFixed&Float HYCMSCI EMMSCI EUROPEMSCI NORTH AMERICABBG Industrial MetalsBBG EnergyMSCI JAPANAustralia Govt Bonds GenericBBG AgricultureBBG LivestockBALTIC DRY INDEXJapan 10 YEAR JGB FLOATBBG Precious MetalsGlobal Broad MarketGermany Generic Govt 10YEuro Generic Govt Bond 10Y

Euro

.Gen

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t.Bon

d.10Y

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Correlation: June 2019Global HYUS NonFin HY ConstrainedEU N-FinaFixed&Float HYCMSCI EMMSCI EUROPEMSCI NORTH AMERICABBG Industrial MetalsBBG EnergyMSCI JAPANAustralia Govt Bonds GenericBBG AgricultureBBG LivestockBALTIC DRY INDEXJapan 10 YEAR JGB FLOATBBG Precious MetalsGlobal Broad MarketGermany Generic Govt 10YEuro Generic Govt Bond 10Y

Euro

.Gen

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t.Bon

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G.R

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Aust

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Source: Hermes, Bloomberg, as at August 2019.

A cursory glance at the March and June quarter-end heat maps reveals little change over the period. Given that asset classes resumed their upwards trajectory after the fourth-quarter shock, the lack of diversification opportunities is perhaps not surprising.

Of course, the point-in-time heat maps don’t tell the whole story: the history of asset correlations does not unfurl in straight lines. In times of severe market dislocation – including the late-2018 plunge – only a handful of portfolio ‘anchor points’ have usually provided much protection. In the past, allocations to cash, gold and one or two safe-haven assets have been the reliable anchors of a last resort for many investor portfolios.

Digging a little deeper, the Morgan Stanley Global Correlation Index aggregates correlations across asset classes, geographies, sectors and factors and intra-markets into a single metric (see figure 10). The measure plainly fell at the end of 2016 and has remained at relatively lower levels since, including during the most recent quarter.

HERMES INVESTMENT OFFICE 5

Figure 10: Morgan Stanley Global Correlation Index

Inde

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Source: Morgan Stanley, Bloomberg, Hermes, as at August 2019.

But overall, cross-asset global correlation has remained stubbornly high since 2007, with assets, asset classes and geographies largely moving together. While the Morgan Stanley data has showed some signs that asset-class performances were diverging, the measure recently nudged above 0.35 for the first time in several years. This dashed our hope that a healthier, low-correlation environment was emerging.

Yet this is not surprising, given that central banks seem willing to underwrite riskier assets with ever-sinking rates and the promise of further ‘unconventional’ liquidity support. Until markets question the wisdom of rebooting unconventional monetary policy, we expect all asset classes to move in concert.

If history has taught us one thing, it is to expect the unexpected. Over time, asset-class relationships have been subject to sharp changes, which we analyse through our ‘correlation surprise’ tool. Correlation surprise has long been associated with ensuing negative global equity-market returns (see figure 11).

Figure 11: Correlation surprise and returns

Russell3000

MSCIEmergingMarkets

MSCIEmerging

Asia

MSCIEurope

MSCIChina

Subsequent one-month annualised return

-0.30

-0.25

-0.20

-0.15

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-0.05

0.00

Source: Hermes, Bloomberg, as at August 2019.

Figure 12: Correlation surprise in the global equity universe

Inde

x

2007 200920052001 2003 2011 2013 2015 20192017

Correlation Surprise Index

0

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Source: Hermes, Bloomberg, as at August 2019.

The correlation-surprise indicator spiked higher during the late 2018 market sell-off, followed by another brief blip coinciding with the terse meeting of global powers at the G20 symposium in Osaka this May.

Occasionally, the correlation-surprise gauge does flash false-positive signals, but we think the Q4 result is a harbinger of further instability in asset-class linkages that will materialise this year.

Investors counting on time-honoured diversification techniques for downside protection should, therefore, closely analyse their asset-class correlation assumptions. Some traditional portfolio anchors may well have come adrift and different fixing points could offer more security as the balance between asset classes shifts.

STRETCH RISK: LEVERAGE ON THE EDGEAsset prices can vary across incredible ranges, often defying reason and mathematics for long periods of time. Even more curiously, some assets priced at irrationally high levels can take on the appearance of ‘low risk’ when measured by volatility. With a little digging, investors can sound out the true identity of these seemingly immovable objects before gravity eventually prevails.

As in previous editions, we highlight this so-called ‘stretch risk’ in relation to a specific asset. This quarter, we look at the ratio of different ‘buckets’ of leveraged-loan debt to earnings (see figure 13).

Figure 13: Leveraged loans by debt-to-EBITDA ratio

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2001 2004 2007 2010 2013 2016 2019

Percent

Debt multiples ≥ 6xDebt multiples 5x−5.99x

Debt multiples 4x−4.99xDebt multiples ≤ 4x

Q1

Source: S&P Global, Federal Reserve Bank of New York, Hermes Investment Management, as at August 2019.

MARKET RISK INSIGHTS Q3 2019

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The data show the market share of loans with the highest leverage (6x or more) has increased over the last two years, suggesting that credit standards for new debt have slipped. To date, though, default rates remain low – but we closely monitor this metric for any sign of change.

Like leveraged loans, non-performing loans (NPLs) in China have experienced a dramatic rise. Beijing has probably taken steps to reduce the stock of NPLs, by, for example, encouraging write-downs out of the gaze of the public eye. But efforts to deleverage the Chinese banking system seem to be of little avail as the pace of NPL creation has outpaced disposal (see figure 14).

Figure 14: China NPLs

Per c

ent o

f GD

P

Excluding NPL disposals2002 2004 2006 2008 2010 2012 2014 2016 2018

Excluding NPL disposals & write-offs via the People's Bank of China

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Source: Fathom Consulting, Hermes, as at August 2019.

Unsurprisingly, two months after China shocked investors with the government’s first seizure of a bank in several decades, market confidence in smaller lenders is low. But the action against Baoshang Bank could be a net positive for investors if the move triggers a wholesale repricing of risk in the Chinese financial sector.

For now, the risks surrounding both the leveraged loans and Chinese NPL markets remain skewed to the downside. They are not alone on that score – the ongoing pressure of central-bank liquidity is pumping into virtually all global markets, stretching many assets beyond their natural forms. As the year goes on we think that investors will need to make doubly sure of their ground before stepping forward.

LIQUIDITY RISK: HIGH AND DRYINGWe have consistently held the line that liquidity measures offer investors the best indication of impending danger. Renewed monetary-policy easing may gloss over some of the risks, but we must still refer to reliable sources of information for any early warning signs.

Today, both the ‘TED spread’ – a measure of the gap between US interbank and short-term treasuries – and the differential between corporate and government bonds, as reflected in the credit spread, provide solid footholds as we launch into an investigation into liquidity conditions (see figure 15).

Figure 15: Funding and credit risk

%

TED spread Credit spread

-2

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2007 2008 2010 2012 2014 2016 2017 2018 20192009 2011 2013 2015

Source: Hermes, Bloomberg, as at August 2019.

We can see a brief but intense tightening of liquidity during the late 2018 market slump, with both the TED and credit-spread indicators spiking higher. Like many of our risk gauges, the return to business-as-unusual in rising markets during the first half of 2019 has seen these two liquidity measures settle once again to a gentle trickle.

But with some $14tn-worth of negative-yielding debt sloshing around markets, there is undoubtedly pent-up risk building behind these idyllic scenes of tranquillity. And even extremely liquid markets can quickly freeze up if investors turn direction en-masse.

Similar problems can crop up at the top of the world. Mount Everest should not, in theory, suffer from traffic jams. Yet crowds commonly block the route to the legendary Himalayan summit. While there are about 20 routes to the top of the mountain, many are too dangerous to navigate, meaning that 8,041 of the 8306 Everest summits to date have followed the same route.1 But the increasingly crowded mountaintop can have fatal consequences: so far this year, 19 climbers have died in the queue to the summit.

We may have reached ‘peak Everest’. In a similar vein, investors can get caught out as others rush in and out of popular markets. Towards the end of last year, there was a sense that the market was heading in new directions. Unfortunately, our optimism appears to have been misplaced. The Bank of America Merrill Lynch survey reveals investors are once again flocking to the favoured haunts of ‘long big tech’ and ‘long US dollar’ (see figure 16).

1 ‘Comparing the routes of Everest’, published by www.alanarnette.com on 28 December 2017.

HERMES INVESTMENT OFFICE 7

Figure 16: Where do you think the most crowded trades currently are?’ Fund managers share their views

0% 5% 10% 15% 20% 25% 30% 35%

Other

Short Value

Short EuropeanEquities

Long EM

Long US T-bills

Long US Treasuries

Long S&P 500

Short EM equity

Long USD

Long Nasdaq(FAANG + BAT)

Mar 19 May 19 Jan 19

Source: Hermes, Bank of America Merrill Lynch, as at August 2019.

There is some justification for the latter, given that currency weakness abounds elsewhere, but the tech bet could easily come unstuck as regulatory pressure grows to rein in the so-called FAANGs.2

Corporate debt also remains highly susceptible to liquidity risks. Fixed-income markets in general are quicker to reprice risk than equity investors. Currently, we sense there is a large gap in liquidity conditions between credit and equity markets.

We also note that fixed-income liquidity trends typically lead other classes. Unsurprisingly, credit liquidity has deteriorated over the last few years as non-US dollar-denominated debt issuance has grown.

As in our previous Market Risk Insights we include once again the Hui and Heubel ratio for Bund futures: the ratio measures intra-day price movement relative to the ratio of traded volume to either market capitalisation or open interest.

The ratio shows that liquidity remained broadly elusive across the quarter, with much lower flows, and that institutional investors largely sat on the sidelines of the equity and credit markets (see figure 17).

Figure 17: The Hui and Heubel ratio for Bund futures

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Source: Hermes, Bloomberg, as at August 2019.

The hyperbolic increase in systematic investors – or those trading to rules-based strategies such as quantitative shops and index houses – has been blamed in part for distorting market-liquidity flows. In the normal course of affairs, investors following automated rules may not be a concern but if markets turn sharply this ‘mindless’ money could easily exacerbate trends, putting pressure on liquidity.

For example, the rapid growth of exchange-traded funds (ETFs) since the 2008 global crisis has allowed unprecedented access and ease of trading – but these strengths can quickly become weaknesses in the face of market trauma.

We turn once more to our Kyle’s lambda analysis that measures the liquidity conditions in equity markets. The sophisticated statistic compares the cost of market liquidity over time by estimating the price impact on a trade representing 2% of the daily volume (see figure 18).

Figure 18: Kyle’s lambda

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The latest Kyle’s lambda data indicates that liquidity became more costly towards the end of the second quarter, rising to levels seen late last year. While the current figure is above the five-year average, it remains well below the spike seen during the financial crisis.

2 Facebook, Amazon, Apple, Netflix and Google.

MARKET RISK INSIGHTS Q3 2019

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Central banks came to the rescue once more during the first half of this year after markets slid dangerously downhill in the final quarter of 2018. Generous helpings of monetary largesse – including from the previously hawkish Fed – did the trick again.

Whether this monetary stimulus will be enough to push economies over the hump remains very much moot. As later events have shown, global markets are hardly on a sound footing. Our indicators suggest that liquidity pressures are rising in certain asset classes, especially credit, which could quickly spread through the financial system if the market fall becomes precipitous.

EVENT RISK: SCALING THE WALL OF WORRYInvestors prefer risk to be neatly quantified. In a purely rational world, our statistically robust analyses of market data would provide a perfect route through risky regions.

Reality, of course, has different plans. The true ‘objective danger’ for investors usually arrives courtesy of chaotic world events unbounded by any notion of standard deviation. Currently, there is no shortage of potential off-the-Bell-curve candidates; any number of them could trigger a market rock-fall.

Some of the known macro risks include: trade wars by tweet; riots in Hong Kong; a looming ‘no deal’ Brexit; and UK oil tankers in Iranian custody. Undoubtedly, others will arrive out of left-field, but investors still need to develop a general sense of the scale of geopolitical uncertainty at any one time.

We attempt to do this through a variety of non-standard tools that provide a useful insight into the likelihood of the objective dangers materialising. Tracking market turbulence offers a powerful clue for investors looking to understand how chaotic events could affect future investment returns.

Figure 19: Turbulence index – future returns

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Source: Hermes, Bloomberg, as at August 2019.

We measure market turbulence by examining the ‘statistical unusualness’ of the current risk backdrop, in terms of both volatility and correlation data. Our analysis shows that financial turbulence can linger for a long time and is often followed by periods of low returns in many markets.

Interestingly, the Hermes turbulence index did not pick up anything historically out of kilter in global equity markets over the first half of 2019 or even during the bump in the final quarter of last year (see figure 20).

Figure 20: Turbulence index – global equities

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In fact, turbulence in equity markets has settled down since a jump towards the end of 2017. We interpret the market volatility experienced during the dog days of 2018 as a likely dress rehearsal for more dramatic performances ahead. While the Fed’s newly accommodative stance could stave off an end-of-cycle correction, this will probably not be for long.

But even if a market shock does hit, our absorption-ratio indicator suggests that investors should still be able to cushion the impact. The measure – an aggregate of data-points covering 17 different asset classes – reveals the extent to which risk is concentrated in just a few factors.

In a particularly fragile period, the absorption ratio would rise as risks centre on fewer underlying factors that investors in aggregate would not be able to dodge.

Figure 21: Absorption ratio

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Our absorption ratio barely flickered as markets tumbled in the closing months of 2018, while little changed during the placid first half of this year (see figure 21). But we still maintain a close watch on our gauge of market fragility, given that following the end of the second quarter volatility has continued to roll on.

While not standard risk measures, our turbulence and absorption indicators do, nonetheless, reference well-known market statistics such as volatility and correlation.

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Geopolitical risk, though, is more difficult to capture in the financials. We need to assess these dangers with alternative methods, such as our policy-uncertainty indicator that is based on the prevalence of ‘bad’ economic news.

The increasing frequency of gloomy economic news can foreshadow actual rises in equity-market volatility as policy uncertainty flow through into lower growth and higher unemployment.

As policy uncertainty begins to dominate the global conversation, the trend can also focus investor angst on a single macro factor, which, as our absorption ratio shows, is associated with increasing market fragility.

Figure 22: Economic policy uncertainty

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Policy uncertainty has climbed sharply since the beginning of 2018 (see figure 22). And, despite a dip downwards as markets recovered from the December quarter rout, our index turned higher once again over the first half of 2019.

While trade tensions – which have flared up again – dominate the macro-worry agenda, in this issue we include a more detailed list of investor concerns. A survey by the New York Federal Reserve does confirm that trade wars are the number-one policy risk, but they also have some looming competition (see figure 23).

Figure 23: Potential shocks

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Source: Federal Reserve Bank of New York, Hermes, as at August 2019.

Uncertainty is without a doubt on the rise and is more prevalent than even just a year ago. Investors face a slew of accelerating macro distractions including, but not limited to, deteriorating US-China relations, a chaotic Brexit and civil unrest in Hong Kong

As our policy-uncertainty measures indicate, the ‘wall of worry’ is looking both higher and more complex than ever. Regardless, investors seem to have not yet adapted their climbing techniques to the changing conditions. Both the Hermes-turbulence and market-fragility indicators remained largely unmoved during the latest quarter, registering concerns at low-to-medium levels.

ESG RISK: IN A ROUGH PATCHAbout two years ago we introduced ESG as a new parameter in our risk assessments in this publication. At the time, the move may have seemed slightly controversial, but ESG has since shifted decidedly to the mainstream as many investors now, at least nominally, take account of the factors in their research and client communications.

The subject matter devoted to ESG has expanded considerably across asset classes and industries, which is hard to condense into a single graph or metric. Because of this, we detail particular ESG trends each quarter, which this time around begins with a look at how climate change could impact the airline industry.

Figure 24: Climate-change impacts expected by the airline industry

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Figure 24 reveals that airlines expect the physical impact of climate change to primarily bring operational problems, as well as increasing the costs of business. But the data also show that climate change could trigger more obscure risks to airlines concerning safety and infrastructure impairment (or even loss).

Airlines will have to address these evolving problems through a number of potentially expensive strategies, such as improving aircraft technical performance or working with airport providers to increase runway resilience to hotter temperatures.

Investors can use these insights to identify the airline operators that are responding the most quickly and efficiently to climate-change challenges. We think that these firms will most likely emerge among the most successful in the years ahead.

We also consider another ESG-related issue. Plastic pollution has accumulated in several huge areas of the world’s oceans. One of these is the Great Pacific Garbage Patch (GPGP), a zone about three times the size of France, located between California and Hawaii (see figure 25).

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Figure 25: Major ocean gyres that are collecting plastic and other waste

Source: The Ocean Cleanup, Hermes, as August 2019.

The accumulated plastic heap in the GPGP is obviously a direct risk to marine life, but it also has significant downstream health and economic implications for humans: a survey found that 84% of the plastics were found to have at least on persistent toxic chemical which can enter the human food chain if ingested by animals.3

Overall, the UN estimates that the environmental damage to marine ecosystems that is caused by plastic is roughly $13bn. As far as ‘objective dangers’ go, the collapse of planetary life support systems is clearly one to watch. We believe that a continued focus on ESG research will be essential for investors as the world adapts to these existential challenges.

CONCLUSION: VIEW FROM THE MIDDLE OF ITAs markets headed steadily upwards through 2019, our multi-dimensional risk assessment process found most indicators at low-to-middling levels.

But despite a return to lower volatility this year in the wake of fourth-quarter trembles, markets exhibited a palpable sense of unease even as they scrambled to new record highs. The dissonance was perhaps best captured in our measure of policy uncertainty, which marched further upwards – and with good reason.

Until the end of June, though, investors were content to follow the rope anchored to central-bank liquidity and climb further into risk assets. But in the ensuing few weeks, the underlying market fragility was exposed as Trump’s trade tantrum triggered the biggest one-day fall in US equities this year.

We expect ongoing bouts of volatility to continue – and even more of them – as investors face up to the growing risks in a high-altitude market sustained only by dwindling supplies of central-bank oxygen.

Overall, our view of market risk for the coming quarter is:

Volatility – As central banks feed the market beast, volatility will, on average, remain muted, but with more frequent spikes throughout 2019;

Correlation risk – In our view, the correlation regime is on the point of a dramatic change, which could undermine the assumptions propping up many diversification strategies;

Stretch risk – Easy money has also carried many assets beyond naturally sustainable levels with credit sectors like leveraged loans liable to snap back to reality;

Liquidity risk – Liquidity is unquestionably tightening around the globe, with very few markets immune. Strong performance by most asset classes has been on very light flows and trading activity – markets will therefore be vulnerable if central banks disappoint increasingly demanding investor expectations;

Event risk – an expanding list of global flashpoints will give investors further pause for thought over the year as the falling rocks of trade wars, Brexit and other macro events bounce randomly through markets;

ESG risk – Our developing understanding of climate risk suggests it is the number one financial risk currently facing investors. This year the world celebrated the 50th anniversary of the Apollo 1969 moon landing and in retrospect, that momentous achievement of technical expertise and collective political focus will likely seem a breeze compared to combating our current environmental challenges. We anticipate that climate change will have an increasingly direct impact on global growth.

3 ‘Pollutants in plastics within the North Pacific Subtropical Gyre’, published by The Ocean Cleanup, as a December 2017.

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At the time of writing, equity markets have retreated somewhat from their second-quarter peaks. It remains to be seen whether the declines in equity indices (US shares fell almost 3% over the course of a day) are the start of a more serious fall or just another temporary setback before markets set atop higher peaks.

Tellingly, following the latest slide, markets recovered at least some lost ground in a matter of days. At any rate, central banks, including the all-important Fed, stand ready with rescue gear.

The Fed has already handed out one rate cut this year, with more expected as it encourages the US economy to ascend the wall of worry. Investors in risk assets will welcome this development.

Meanwhile, US-China trade relations took a turn for the worse and we don’t expect a final resolution any time soon. The US attitude to China has evolved over time from one of cooperation to containment. That was bound to happen irrespective of the administration; tensions will persist and the conflict will play out further in years to come.

Back in the UK, the now Boris Johnson-led government appears headed for a hard Brexit. While an agreement could still be negotiated, all likely options – including a rushed Brexit deal, a UK general election to settle the impasse or no deal – don’t augur well in the long-term for investors. In the short term, an election or no-deal outcome could hit risk assets particularly hard.

Regardless, the risks of monetary policy mis-steps are increasing by the day. If the current dose of oxygen fails to revive flagging economies, central banks will have little left in the tank. Investors might currently be appreciating the heights, but objective dangers lurk nearby.

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This document is for Professional Investors only. The views and opinions contained herein are those of Eoin Murray, Head of Investment, and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products. The information herein is believed to be reliable but Hermes does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. The value of investments and income from them may go down as well as up, and you may not get back the original amount invested. This document has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. This document is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Figures, unless otherwise indicated, are sourced from Hermes. The distribution of the information contained in this document in certain jurisdictions may be restricted and, accordingly, persons into whose possession this document comes are required to make themselves aware of and to observe such restrictions.

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