For professional investors only www.hermes-investment.com Excellence. Responsibility. Innovation. Q4 2016 Hermes Investment Office Market Risk Insights In cinematic terms, the third quarter offered investors more tension-building moments than over-the-top action scenes. As our previous Market Risk Insights suggested was likely, the three-month period played out against a backdrop of apparent calm, disturbed only by brief spikes of volatility and risk aversion. Recognising that we must bear some risk to generate returns, we should take care to ensure that those risks are of our choosing. To do so, we need to build as full a picture of market risk as possible, going beyond traditional measures. As the third quarter demonstrated, investors have rapidly reverted from brief moments of terror to a prevailing level of calm. Their jumpy behaviour indicates how torn the market is between the offsetting effects of unconventional monetary policies – with their positive impact on the prices of risk assets – and the increasing economic and political uncertainty that we face. For that reason, we continue to believe that risk is best considered as a multi-headed hydra, one that is highly time-variant and can manifest itself in different, unexpected areas. We watch with bated breath. We group our thinking into five key aspects of market risk: 1. Volatility 2. Correlation risk 3. Stretch risk 4. Liquidity risk 5. Event risk While investors must also consider the full gamut of risks, in this commentary we will focus on financial risk, leaving our analysis of the wider context for another day. Even the surprise twist of the June Brexit vote turned out to be more red herring than plot developer as the onset of the northern summer apparently eased investor nerves. However, early in September the first aggressive global stock sell-off for some time alerted the market audience to the danger lurking below the serene summery surface. If September woke investors once again to risk – triggering some significant bouts of cross-asset liquidation and sharp deleveraging – the effect was short lived with the fourth-quarter reel opening to familiar scenes of market torpor. But despite the lack of drama over the previous quarter, there are plenty of potential scenarios that could inject a greater sense of urgency into the current stage of the story. For example, the US presidential elections have triggered endless media and market speculation. We will be devoting a separate piece of analysis to the potential outcomes and impacts from the result. Ultimately, we believe the US vote will, at most, prove to be a temporary diversion from the true perils about to come into frame. Liquidity and market depth in general remain weak, and political risk is not confined to events in Washington – the Italians head to the ballot box soon to vote on constitutional change, Brexit negotiations are yet to begin and the Germans and French go to the polls next year. Meanwhile, the Federal Reserve will opine on US interest rates shortly before the Christmas break. These events have the potential to cause severe ructions, and investors should position their portfolios accordingly. In fact, the eerie calm currently projected by markets makes it more difficult than ever for fund managers and investors to discern when, and where, the real villains will appear. We think it is as important as ever to gauge forward-looking ex-ante risk from as many angles as possible. Of course, we can draw on lessons from the past and historical data. History, however, only offers a rough guide to the probable future outcomes that we can prepare for. He who goes gently, goes safely; he who goes safely, goes far. Joseph Thomson – geologist and explorer The Hermes Investment Office Independent of investment teams, the Hermes investment Office continuously monitors risk across client portfolios and ensures that teams are performing in the best interest of investors. It provides rigorous analyses and attributions of performance and risk, demonstrating Hermes’ commitment to being a transparent and responsible asset manager. Summary Key risks highlighted in this report: Risk is restless – it is not as low as volatility measures would have us believe Liquidity risk could spread from credit markets into others With a number of potentially seismic events on the horizon, political risk remains high
Transcript
For professional investors only www.hermes-investment.com
Excellence. Responsibility. Innovation.
Q4 2016
Hermes Investment Office
Market Risk InsightsIn cinematic terms, the third quarter offered investors more tension-building moments than over-the-top action scenes. As our previous Market Risk Insights suggested was likely, the three-month period played out against a backdrop of apparent calm, disturbed only by brief spikes of volatility and risk aversion.
Recognising that we must bear some risk to generate returns, we should take care to ensure that those risks are of our choosing. To do so, we need to build as full a picture of market risk as possible, going beyond traditional measures.
As the third quarter demonstrated, investors have rapidly reverted from brief moments of terror to a prevailing level of calm.
Their jumpy behaviour indicates how torn the market is between the offsetting effects of unconventional monetary policies – with their positive impact on the prices of risk assets – and the increasing economic and political uncertainty that we face.
For that reason, we continue to believe that risk is best considered as a multi-headed hydra, one that is highly time-variant and can manifest itself in different, unexpected areas.
We watch with bated breath.
We group our thinking into five key aspects of market risk:1. Volatility2. Correlation risk3. Stretch risk4. Liquidity risk5. Event riskWhile investors must also consider the full gamut of risks, in this commentary we will focus on financial risk, leaving our analysis of the wider context for another day.
Even the surprise twist of the June Brexit vote turned out to be more red herring than plot developer as the onset of the northern summer apparently eased investor nerves.
However, early in September the first aggressive global stock sell-off for some time alerted the market audience to the danger lurking below the serene summery surface. If September woke investors once again to risk – triggering some significant bouts of cross-asset liquidation and sharp deleveraging – the effect was short lived with the fourth-quarter reel opening to familiar scenes of market torpor.
But despite the lack of drama over the previous quarter, there are plenty of potential scenarios that could inject a greater sense of urgency into the current stage of the story.
For example, the US presidential elections have triggered endless media and market speculation. We will be devoting a separate piece of analysis to the potential outcomes and impacts from the result. Ultimately, we believe the US vote will, at most, prove to be a temporary diversion from the true perils about to come into frame.
Liquidity and market depth in general remain weak, and political risk is not confined to events in Washington – the Italians head to the ballot box soon to vote on constitutional change, Brexit negotiations are yet to begin and the Germans and French go to the polls next year. Meanwhile, the Federal Reserve will opine on US interest rates shortly before the Christmas break. These events have the potential to cause severe ructions, and investors should position their portfolios accordingly.
In fact, the eerie calm currently projected by markets makes it more difficult than ever for fund managers and investors to discern when, and where, the real villains will appear. We think it is as important as ever to gauge forward-looking ex-ante risk from as many angles as possible.
Of course, we can draw on lessons from the past and historical data. History, however, only offers a rough guide to the probable future outcomes that we can prepare for.
He who goes gently, goes safely; he who goes safely, goes far. Joseph Thomson – geologist and explorer
The Hermes Investment OfficeIndependent of investment teams, the Hermes investment Office continuously monitors risk across client portfolios and ensures that teams are performing in the best interest of investors. It provides rigorous analyses and attributions of performance and risk, demonstrating Hermes’ commitment to being a transparent and responsible asset manager.
SummaryKey risks highlighted in this report:
�� Risk is restless – it is not as low as volatility measures would have us believe
�� Liquidity risk could spread from credit markets into others
�� With a number of potentially seismic events on the horizon, political risk remains high
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Q4 2016
Volatility: indicators point low but risk remains highLooking solely at volatility has its pitfalls, but it remains a reasonable starting point for all risk analysis. The key is to consider forward-looking volatility through several different lenses, across multiple asset classes and across various geographies.
We retain our usual collection of measures for analysis. Figure 1 shows the 52-week moving average of the VIX, the Merrill Option Volatility Expectations (MOVE) Index, the Deutsche Bank FX Volatility (Currency VIX) Index and the expected volatility of the Bloomberg Commodity Index (Commodity VIX). These measure the implied volatility of equity markets, government bond markets, currency markets and commodity markets respectively, and have been standardised to make them directly comparable. They each represent the market’s expectation of future volatility, and are often viewed as a benchmark of risk appetite.
Figure 1: Moving averages of selected volatility measures
Nor
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inde
x
VIX MOVE Currency VIX Commodity VIX
20082007 2010 2012 2014 20162009 2011 2013 2015-2
-1
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Source: Hermes, Bloomberg, Chicago Board Options Exchange, Deutsche Bank, Bank of America Merrill Lynch as at 30 September 2016
Across the board, long-term implied volatility measures fell for all asset classes. Of course, we should expect a degree of correlation across our four measures as they are all influenced by the level of systemic risk in the market environment.
Despite the brief hiatus in September, equity volatility remains at low levels relative to history: this picture is consistent across bond, currency and commodity markets.
However, such low implied volatility can induce investors to increase the notional size of their positions, often directly through explicit portfolio construction techniques and frequently through gearing.
Ramping up market exposure is fine as long as implied volatility remains low. But those same investors will be forced to cut their positions, leading to self-reinforcing position-shedding, given the further shocks and sharp volatility surges we anticipate.
So while we expect a relatively calm environment to continue through to the next Federal Reserve decision on interest rates, markets will be at their most vulnerable to volatility shocks.
Expectations of future volatility can be seen in the VVIX, a risk-neutral forecast of large-cap US equity index volatility.
Figure 2: The volatility of volatility
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VVIX One-year moving average
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2008 2010 2012 2014 20162009 2011 2013 2015
Source: Hermes, Bloomberg, Chicago Board Options Exchange as at 30 September 2016
Forward-looking volatility predictions rose during the quarter, according to our longer-term metric, and given the likely uptick in political uncertainty in the fourth quarter, we see that trend continuing. We expect the Fed’s decision in December to be significant, with any decision to raise rates clouding the expected volatility picture even further, while a decision to hold rates could lead to a drop in future volatility expectations.
The term structure of volatility can help predict the state of the market, as well as shed light on constructing profitable investment strategies. With respect to the VIX, the term structure is easily captured by comparing the price levels of different futures expirations. Since volatility is a measure of systematic risk, in that sense the VIX term structure suggests the trend of future market risk. If the VIX is upward-sloping, it implies that investors expect to see the volatility (risk) of the market going up in the future. If the VIX is downward sloping, it indicates that investors expect to see the volatility of the market going down.
Figure 3: Term structure of volatility
Term structure of VIX futures contracts
12.5
15.0
17.5
20.0
22.5
12 Oct16
12 Feb17
12 Mar17
12 Apr17
12 May17
12 Jan17
12 Dec16
12 Nov16
12 June17
Inde
x
Source: Hermes, Reuters, CBOE as at 30 September 2016
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Last quarter we looked at the prices of a near and a further away futures contract, but this time we offer the full term structure based on all available contracts extending to the middle of next year. It is worth noting that the liquidity in the more distant contracts will not yet be great. Nonetheless, we can safely conclude that the market appears to be anticipating higher volatility in the coming months, although the upward-sloping term structure as a whole is lower than it was last quarter.
We also like to look at the cross-sectional dispersion of equity returns as a volatility metric. It can be thought of as a measure of the various opportunities available for stock pickers in equity markets, reflecting the best-to-worst range at particular time periods. We track the measure through time.
Figure 4: Cross-sectional dispersion of stock returns
Source: Hermes, Bloomberg, FTSE as at 30 September 2016
Other things being equal, elevated levels of cross-sectional volatility speak to higher return dispersion across assets. The levels that we witnessed after the Brexit decision around the globe have largely subsided, with dispersion in most markets dropping to as low as the fifth percentile based on data since January 2007.
The exceptions are: the UK, perhaps unsurprising given the continuing levels of uncertainty around the eventual Brexit outcome; Japan, also unsurprising in light of the Japanese government’s desperate attempts to boost economic growth; and Australia, perhaps slightly more surprising, but reflecting an uncertain environment in China.
Stock pickers everywhere will be hoping for an increase in cross-sectional volatility, and we feel that there should be sufficient uncertainty in this quarter to deliver this.
The variance risk premium (VRP) measures the difference between market-implied volatility and realised risk. It is essentially a contrarian indicator: when it is high and positive (low and negative), it suggests that market participants are overly pessimistic (optimistic) about market risk. The example below relates to US equities.
Figure 5: Variance risk premium
Risk
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Variance Risk Premium Z-score
-400
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-200
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0
100
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2012 2014 20162008 2010 2013 20152009 2011
Source: Hermes, Deutsche Bank as at 11 October 2016
It was another subdued quarter for the VRP measure, despite a brief jump part-way through September. On this measure alone, market participants do not appear particularly optimistic nor overly pessimistic as we head into the final quarter of the year.
The majority of our volatility measures continue to point to a low-risk environment. However, we believe that indicators are masking considerable amounts of fragility and that a watershed moment might not be far away. Much of the uncertainty centres on the political environment, but we see enough worrying signs with respect to volatility’s influence on leverage to feel that the risk goes beyond the corridors of power.
Correlation: surprise signalsLooking at volatility in isolation runs the danger of interpreting risk through a single lens: we must also consider correlation.
Correlation, which measures the relationship between assets in a portfolio, is the second building block upon which the notion of diversification is grounded and, much like volatility, it is highly time-variant.
As investors, we must be careful about our use of the term correlation: two variables with the same long-term trend could have a negative, short-term correlation coefficient, over-emphasising the level of diversification that they can offer.
Information regarding the long-term trend should be taken into consideration when assessing diversification. Given that correlations are typically measured with respect to mean values, we also need to account for sample trend in our analysis.
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Figure 6: Correlation heat maps
Correlations: June 2016Global HYUS NonFin HY ConstrainedEU N-FinaFixed&Float HYCMSCI EMMSCI EUROPEMSCI NORTH AMERICABBG Industrial MetalsBBG EnergyBBG AgricultureMSCI JAPANAustralia Govt Bonds GenericEuro Generic Govt Bond 10YGermany Generic Govt 10YBBG LivestockBALTIC DRY INDEXJapan 10 YEAR JGB FLOATBBG Precious MetalsGlobal Broad Market
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Correlations: September 2016Global HYUS NonFin HY ConstrainedMSCI EMEU N-FinaFixed&Float HYCMSCI EUROPEMSCI NORTH AMERICABBG Industrial MetalsBBG EnergyBBG AgricultureBBG LivestockBALTIC DRY INDEXMSCI JAPANAustralia Govt Bonds GenericEuro Generic Govt Bond 10YGermany Generic Govt 10YBBG Precious MetalsGlobal Broad MarketJapan 10 YEAR JGB FLOAT
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Source: Hermes, Bloomberg as at 30 September 2016
Consider the end of June and end of September heat maps of cross-asset correlations: it would appear that little changed over the quarter.
Looking at the heat maps alone, one would find it hard to imagine that we had experienced the cross-asset sell-off in September, even though calm has been once again restored. Average pair-wise correlations in equity markets are close to or just above their longer-term medians, except notably in Latin America and China. Correlations in the latter two regions are comfortably bedded down in the top quartile of historical data points from 2007 – this points to a fragility regarding future shocks for those markets.
The key correlation between equities and bonds is mid-range, but has been highly volatile, constituting an important metric to monitor for multi-asset portfolios.
Analysing correlation surprise allows us to capture the degree of statistical unusualness in current correlation levels relative to history. As with any statistical measure, its interpretation requires some caution. In general though, we can see that spikes in correlation surprise are more often than not followed by disappointing returns.
Figure 7: Correlation surprise and returns, 31 December 1998 to 17 April 2015
Russell3000
MSCIEmergingMarkets
MSCIEmerging
Asia
MSCIEurope
MSCIChina
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Average return after correlation surprise
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Source: Hermes, Bloomberg at 31 March 2016
Figure 8: Correlation surprise in the global equity universe
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20011999 2003 2005 2007 2009 2011 2013 20162015
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Source: Hermes, Bloomberg as at 30 September 2016
The significant spike in our measure during the quarter suggests highly unusual statistical behaviour across global equities. Even when other risk metrics have reverted to ‘normal’ levels, our index of correlation surprise remains more elevated than during the global financial crisis and the dotcom bubble and bust.
In addition to remaining stubbornly on alert, this measure actually began to rise before the brief market ructions in September – telling us to anticipate something unusual. From time to time we would expect false positive signals, but we think it is wise to remain cautious about any portfolio assumptions with respect to cross-asset relationships.
A key difficulty in investment management is understanding the variation in correlation levels as assets, or asset classes, that at one time appear to be uncorrelated often become highly correlated during periods of market stress.
Conversely, those assets that are highly correlated may decouple at a later time. This instability in the level of correlation is further aggravated by time dependency in the volatility of the correlation coefficient. At times, correlations appear to fluctuate within a tight range; at others, we see fluctuations in the sign of correlation in very short time periods.
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Figure 9: Correlation signal
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Much like our correlation surprise measure, our correlation signal provided us with a warning of instability through a dramatic spike in late July and early August, albeit this measure has also dropped back to more ‘normal’ levels now.
Correlation risk has been the category to watch most keenly of late. The yardstick provided some helpful indicators that markets were more fragile than various volatility measures alone suggested. We believe that future trouble remains most likely to reveal itself through correlation changes.
Stretch risk: why buybacks could lead to snap back Stretch risk allows us to identify assets that trend in one direction for a considerable period of time, suppressing headline volatility, and obscuring the true underlying risk.
Figure 10: Stretch risk: high-yield credit market
BofA Merrill Lynch Global High Yield Index
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Source: Hermes, Reuters as at 30 September 2016
In the past, we have illustrated this with reference to specific credit markets, and once again we take a look at a global high-yield index. Its inexorable rise from the end of 2008 ran out of steam mid-way through last year, but subsequently resumed its steady march in the first quarter of 2016.
Another example that we have looked at with respect to stretch risk in the past is commodity markets.
Figure 11: Stretch risk – commodity momentum
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Thomson Reuters/Core Commodity CRB Index Total Return
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Source: Hermes, Reuters as at 30 September 2016
After a rocky ride and strong downward trend over the last six years or so, commodity markets appeared to have broken that momentum and posted a strong recovery from the depths earlier this year. This expected mean reversion has flagged somewhat of late, and we await developments in the political spectrum to determine whether the commodity rally will regain some momentum or not.
Valuations can also become very stretched without the appearance of increased volatility. In this scenario, assets or markets become extremely cheap or expensive through continual small price movements. However, such valuations rarely persist and so it is likely that a snap back in value will occur, with the relevant asset or market returning to fair(er) value.
*Change from five years ago, in absolute percentage points**Jan-1 to Jul-16 annualised
Past 5-yr average Pre-financial crisis trend
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Source: Hermes, Federal Reserve, US Bureau of Economic Analysis, US Bureau of Labor Statistics, US Census Bureau, US Commerce Department, S&P DJGI, Robert Shiller, GMO as at 30 September 2016
Recently, many market commentators have claimed that developed-market equities, typically proxied by the S&P 500 Index, are not overvalued. On the basis of a range of valuation measures (forward P/E, Shiller’s cyclically adjusted price-to-earnings ratio (CAPE), dividend yield and price-to-book value), a comparison of the current level with a 25-year average suggests that equities are only modestly overvalued.
Against a considerably longer average, equities appear somewhat more overvalued (with a current CAPE of roughly 26 times against a 25-year average of nearly 25 times, but against a long-run average of 16 times). By way of comparison, figure 12 takes the return of the S&P 500 in real terms against a range of economic indicators – and here we see the mismatch that gives us cause for concern from a stretch risk perspective.
Over the past few years, corporate share buybacks have provided significant support for equity markets, particularly in the US. More recently, however, announced buybacks have slowed slightly, although a further pick up is expected in the coming quarter.
Source: Hermes, Reuters, S&P Dow Jones Indices as at 30 September 2016
This matters to the extent that buybacks have been highly supportive of the equity markets as a whole. Figure 13 shows that an index of the 100 firms with the largest buybacks has consistently outperformed the US equity market.
This source of demand has helped to stabilise equity markets, particularly during sell-offs such as those we witnessed in August last year, the early part of 2016, and this September. The resumption of buybacks over summer lends further stability to equity markets, yet is perhaps simply storing up problems for further down the road, particularly should the Fed decide to turn off the liquidity taps.
Stretched valuations in certain equity factors continue to persist, with value stocks, for example, remaining cheap, yet they continue to suffer a malaise and remain out of favour. Similarly, low-volatility stocks are highly expensive and yet still keenly sought after.
Equity valuations as a whole appear most stretched relative to only the longest periods and less so in comparison with recent times, while bond yields remain at extremely low levels. The effects of central bank actions are plain for all to see – we feel that they cannot last forever and we continue to be wary of catalysts that have the potential to reverse equity highs and bond yield lows.
Liquidity risk: the shock transmission mechanismInvestigating the relationship between market risk, funding and monetary liquidity is essential in today’s markets. Funding refers to the ease of borrowing, whereas monetary liquidity reflects the ease of monetary conditions. They influence market liquidity, through market-making activity and bank funding respectively.
The two most closely followed metrics for funding and liquidity risk are the TED spread and the credit spread. The former focuses on the difference between interest rates available in the interbank market and on short-term US government debt (Treasury bills), typically at a one- or three-month view, whereas the latter generally focuses on the spread between corporate bonds and government bonds, again at a comparably short maturity.
The credit spread is thus an indicator of perceived credit risk, linked closely to the potential for default in the corporate bond market.
Figure 14: Funding and credit risk
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Source: Hermes, Bloomberg as at 30 September 2016
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Credit spreads have remained at the subdued levels that we have become accustomed to, and have sunk back after a brief and minor spike around the Brexit vote.
TED spreads, on the other hand, have moved substantially wider. Structural changes to money market regulations may well lie behind this phenomenon, with LIBOR rising as a result. This does not imply a funding crisis, as the new regulation has been known about for some time, but should it not stabilise this could indicate a deeper problem symptomatic of broader issues in offshore dollars.
Dislocations can occur in markets for even highly liquid assets, as liquidity is ephemeral. Moreover, the liquidity of an asset often depends on the direction in which you wish to trade and the direction that the rest of the market favours. Add to that the quantity of the asset to be traded, and we introduce another variable that influences liquidity.
By identifying crowded trades, we are better able to identify potential triggers for liquidity risk. To that end, the monthly survey conducted by Bank of America Merrill Lynch of global fund managers’ views provides some clues.
Figure 15: Fund managers answer the question: where do you think the most crowded trades currently are?
0% 5% 10% 15% 20% 25% 30% 35%
Long US dollar
Short EU stocks
Long quality
Long gold
Long US/EU IGcorporate bonds
Long EM debt
Long Nasdaq
Other
Sep 16 Aug 16 Jul 16
Source: Hermes, Bank of America Merrill Lynch as at 30 September 2016
Over the last quarter, we have seen some further rotation in fund managers’ most crowded trades. Long quality stocks and US and European investment grade corporate bonds have remained constant positions. It is interesting that some of those assets and asset classes that we note as being stretched do not yet feature in the crowded trade rankings.
We believe that concerns over liquidity risk in the corporate debt market remain highly relevant, and we continue to closely monitor this alongside our credit portfolio managers. We analysed the Hui and Heubel ratio for Bund futures in last quarter’s Market Risk Insights – this ratio measures intra-day price movement relative to the ratio of traded volume to either market capitalisation or open interest.
Figure 16: The Hui and Heubel ratio for Bund futures
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Liquidating sizeable portfolios remains extremely tricky with market depth being as fleeting as ever. It should come as no great surprise that we anticipate further spikes in the remainder of the year, signifying greater uncertainty around various political events and Fed action. We continue to believe that liquidity will be the most likely transmission mechanism for contagion should any significant shocks derail the current faux stability.
Here we introduce a new measure, Kyle’s lambda, that throws further light on liquidity conditions in the equity markets. Kyle’s lambda is a measure of liquidity resilience in the sense that it captures how much equity prices move with order flow, or effectively price impact. In that sense it is very similar to the Amihud illiquidity metric.
Figure 17: Kyle’s lambda
Effect of a trade equalling 2% of average daily volume
%
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21 Oct00
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13 Apr06
7 Jan09
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30 Jun14
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Source: Hermes, Bloomberg as at 30 September 2016
By estimating the basis point impact of a trade of 2% of the average daily volume traded, we can compare the cost of accessing liquidity at any point in time in our data history, irrespective of changes in the underlying market structure. Our model picks up some of the major market dislocations in recent decades, and demonstrates the difficulty of trading during the September volatility spike in global equity markets.
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On that basis, we expand our concerns about liquidity to encompass all markets, not just the bond markets. Should local shocks occur around the world, lack of liquidity will be the transmission mechanism, in our view. A sustained upturn in market impact increases the risk of a stock market correction becoming severe.
Event risk: turbulence, absorption and what the smart money thinksNo discussion of risk would be complete without consideration of the events that determine the degree of uncertainty prevalent at any one time.
We recommend the use of non-standard models when attempting to quantify risk, and feel strongly that a better understanding of possible outcomes stems from stress-testing of portfolios and detailed scenario analysis. These represent the minimum standard for risk management in today’s investment world.
During the financial crisis, unusually high market volatility and financial turbulence affected the entire economy. If we can successfully identify periods in advance in which asset prices behave uncharacteristically, then we may be able to minimise portfolio drawdowns by adjusting portfolios appropriately in advance.
Figure 18: Turbulence index – future returns
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Full sample annualised returnAnnualised return following most turbulent periodAnnualised return following most non-turbulent period
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-0.2
0.0
0.2
0.4
0.6
0.8
Source: Hermes, Bloomberg as at 31 March 2016
Here, we analyse market turbulence by identifying the statistical unusualness of the current risk environment, in terms of both volatility and correlation. This demonstrates that most turbulent periods typically precede significant drawdowns across a number of asset classes and markets.
Times of financial turbulence are typically persistent and provide lower rewards for risk-bearing than normal times. As such, this measure could be used to construct portfolios that would be relatively resilient to turbulence through a conditioning process.
Figure 19: Turbulence index – global equities
Inde
x
2000
2002
2004
2006
2008
2010
2012
2014
2001
2003
2005
2007
2009
2011
2013
2015
2016
Turbulence
0
5
10
15
20
25
30
Source: Hermes, Bloomberg, MSCI at 30 September 2016
Much as in the second quarter, global equity turbulence remained at broadly subdued levels, having fallen from a near-term peak at the beginning of February earlier this year. This implies that markets behaved normally relative to their recent past, which appears to be at odds with our interpretations of correlation risk measures.
Another tool that allows us to estimate market fragility is the absorption ratio, which captures the market’s ability to absorb shocks. It is perhaps best thought of as a measure of systemic risk.
We use principal component analysis to determine the extent to which the largest risk factors dominate the entire risk factor set. When markets are particularly vulnerable to shocks, a handful of factors will explain the vast majority of risk, whereas when markets are less fragile, we see the absorption ratio fall.
Figure 20: Absorption ratio – global equities
Abso
rptio
n Ra
tio
1999
2000
2002
2004
2006
2008
2010
2012
2014
2001
2003
2005
2007
2009
2011
2013
2015
2016
Absorption ratio
0.80
0.82
0.84
0.86
0.88
0.90
0.92
0.94
0.96
0.98
1.00
Source: Hermes, Bloomberg, MSCI at 30 September 2016
The absorption ratio for global equities clings to elevated levels, but interestingly did not experience the Brexit boost (ie. move lower) associated with so many of our other risk metrics. This suggests a continued fragility that the other event risk indicators we have discussed have not identified.
Political risk and its impact on markets should never be ignored, even if it is difficult to measure quantitatively. One way to tackle this problem is with a metric based upon the frequency of economic policy
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uncertainty coverage. Using an unstructured data approach, policy uncertainty appears to lead increases in equity market volatility. At a macro level, increases in policy uncertainty tend to foreshadow declines in economic growth and employment.
Figure 21: Political risk in China
China Long-term smoothed average
0
100
200
300
400
500
600
2012 2014 201620112010200920082007 2013 2015
Inde
x
Source: Policy Uncertainty, UBS, Hermes at 30 September 2016
Our measure suggests that the trend in political risk for China is strongly upward, with the longer-term smoothed average at an almost 10-year high. Other things being equal, we would expect this to weigh upon Chinese equity markets over the coming quarter.
The smart money flow index is calculated by comparing trading activity in a US equity index across two time periods – the first half-hour of the trading day and the 30 minutes before its close. The assumption is that activity during the opening spell is dominated by retail investors, buying on emotion and overnight news, while the ‘smart money’ waits until the end of the day with a significantly greater quantity of assets traded on the back of institutional investor orders.
Figure 22: Smart money flow index
Inde
x
Smart money flow index
15,000
15,500
16,000
16,500
17,000
17,500
18,000
18,500
19,000
19,500
20,000
2012 2014 20162011 2013 2015
Source: Hermes, Bloomberg at 30 September 2016
Over the course of the most recent quarter, the amount of early activity relative to institutional activity later in the day has remained high. This suggests that the recent swings in markets are somewhat indiscriminate, with investors little concerned about the semantics of stock selection – perhaps not entirely surprising given the general uncertainty.
Event risk, incorporating political risk, is a constant feature of financial markets. Our principal metrics for capturing it – the turbulence index and the absorption ratio – are once again stubbornly at odds with one another, providing contrary signals as to the fragility of markets.
With the additional evidence of smart money flows and increasing policy uncertainty both locally and around the globe, we err on the side of the absorption ratio and contend that event risk is greater to the downside.
ConclusionFinancial markets combine the age-old themes of risk and return in a never-ending narrative. And while the story won’t – we hope – reach a stunning final conclusion, we’re always keen to know what might happen next.
By observing the interwoven threads of risk and return, we as experienced investors can identify some clues as to where the plot is likely to turn. Admittedly, we can never know the true distribution of asset returns and estimate risk with complete accuracy. However, by focusing the power of all our statistical and analytical tools on the effort we can determine a robust course of action.
Overall, our view of market risk for the coming quarter is as follows:
Volatility: we cannot over-emphasise the link between leverage and volatility, which at low levels emboldens certain investors to gear their portfolios. In the likely event that we see continued spikes in volatility for the remainder of this year, market corrections will be painful.
Correlation risk became the dominant source of risk in the last quarter and we think that will remain the case through the year-end.
Stretch risk continues to signal caution only as various asset classes could quite easily remain at current levels without some form of exogenous shock to cause disruption.
Liquidity risk has developed from a fairly localised issue affecting primarily the credit markets to one that could become far more significant and broader, potentially threatening all assets.
Event risk remains a mixed bag of signals, but we are inclined to hold the view that markets as a whole remain in a vulnerable state, still very much reliant on liquidity provided by central banks.
Based on all our observations, we have a sense that a climactic event is coming ever closer.
Whether the US election delivers that plot-turning moment, or the vote in the Italian constitutional referendum or the Fed rate decision in December, it seems possible that the fourth quarter will see some extreme market movements.
Uncertainty abounds. The comfort blanket of accommodative monetary policy cannot suppress fundamental market forces forever. In this environment, we would encourage investors to shy away from any complacency implied by benign risk measures. Objectively, our metrics show only small glimpses of extreme risk, but they are sufficient for us to voice a strong note of caution.
While it is not an adverse environment for risk taking, adaptive risk management strategies remain the order of the day. If market tension ramps up to unbearable levels, investors need to be ready for the coming action.
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Q4 2016
This document is for Professional Investors only. The views and opinions contained herein are those of Eoin Murray, Head of the Investment Office, 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. 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. Issued and approved by Hermes Investment Management Limited (“HIML”) which is authorised and regulated by the Financial Conduct Authority. Registered address: Lloyds Chambers, 1 Portsoken Street, London E1 8HZ. HIML is a registered investment adviser with the United States Securities and Exchange Commission (“SEC”).CM155702 T4915 10/16
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