Hermes: Is it time for investors to prepare for the ‘worst of times’?

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

Dickens’ famous opening words in The Tale of Two Cities could set the scene for the current market and macroeconomic climate – a world of latent volatility; where contradictory extremes loom as equally likely realities; where the slightest change in political winds could send events either way.

Is it to be a time of inflation or disinflation, liquidity or illiquidity, growth or slump?

The dramatic return of share-price volatility in the first quarter of the year indicates some plot issues that may be resolved in 2018, but others remain hidden in the subtext. In the latest Hermes Market Risk Insights report, Spring of hope, or winter of despair? Investors face Dickensian conditions, Eoin Murray,Head of Investment at Hermes Investment Management, explores the six key risks facing investors in extreme financial conditions.

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Volatility: Hard times ahead?

The piece highlights volatility’s return and how it remains the ‘thematic touchstone’ for risk in financial markets. Murray explains: “With the exception of the observed spike in equity volatility, across the board, long-term implied volatility measures continued to drop for all asset classes over the quarter. But we expect other asset classes will follow the share market lead into more volatile territory.

“Overall, our view is that volatility will return to more normal historical levels across asset classes. We reiterate our long-held concern that the current low implied volatility environment encourages investors to dial-up their market exposures, often through leveraging.”

Correlation: Greater expectations

Moreover, cross-asset global correlation has remained stubbornly in a band from 2007, with assets largely moving together – with the measure sticking below levels not often seen since before the financial crisis. Murray says: “We continue to keep a close eye on this critical signal. From time-to-time, the correlation surprise metric will give false-positive signals, but we remain cautious about any portfolio assumptions with respect to cross-asset relationships.

“Despite the wider array of asset classes offering potentially greater sources of diversification, investors are increasingly herding around common risk and portfolio management strategies. We anticipate regime change in correlation this year. In a changed investment environment investors will need to adapt by combining different portfolio construction and risk management methods”

 Stretch risk: The plot thickens

Volatility is the marquee measure of risk in financial markets; but asset price stability itself can mask underlying dangers. Take, for example, fully-priced assets that may exhibit low volatility – but hide substantial downside potential. The report uses ‘stretch risk’ analysis to zero in on these apparently low-volatile assets and/or those that have trended in one direction or another for an extended period.

 Overall, there are examples of stretch risk in both equity and bond markets, either from a momentum or extreme valuation perspective. “The injection of liquidity from UMP – now drying up – has led to an unstable floor for downside risk, which and we see this continuing to develop in unpredictable ways throughout the remainder of this year,” Murray states.

Liquidity: Bleak times ahead?

The report underlines further rotation in fund managers’ most crowded trades. As fast as ‘Long Bitcoin’ appeared, it is now dropping off the radar to be replaced by ‘Long Big Tech’ and Nasdaq stocks more generally.

Murray says: “Even before the latest rise, tech stocks were already a popular trade with investors also showing a persistent appetite to go long the corporate bond markets. Short volatility, unsurprisingly, took a bullet, but as volatility fell back, investors may have been tempted to reload. We believe concerns over liquidity risk in the corporate debt market remain highly relevant.”

 Event risk: Further twists ahead

The report’s Turbulence Index rose to its highest level for nearly eight years during February’s sell-off. Murray explains: “The uptick in the Turbulence Index implies that markets were behaving less normally relative to their own recent past – driven by the return of normal volatility levels. We anticipate that the measure will experience further spikes during 2018.”

Meanwhile, the report’s Policy Uncertainty Indicator has remained at the lower end with investors discounting politics as less influential than economics. It would foolish to ignore possible knock-on effects from simmering trade war tensions between the US and China, real conflict in the Middle East and renewed uncertainty in Europe.

 ESG Risk: Tale of two commodities

In terms of ESG risk, the report tackles hard questions of water and concrete. As communities around the world face a growing water crisis, the need for lower-cost means to secure ample and clean water is growing in importance. For example, half of India’s water supply in rural areas is routinely contaminated with toxic bacteria and each year about 600,000 Indian children die from drinking unclean water.

 Murray says: “Natural infrastructure approaches have a major role to play in confronting the impending crisis. Solving the problem requires interaction from a number of stakeholders (utilities, business, government and communities) – an approach that, unfortunately, does not prevail in all countries.”

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