MARKET RISK INSIGHTS - hermes-investment.com · ‘Trump of South America’, Jair Bolsonaro, assumed power this year – have flashed warnings that the post-Soviet globalisation

For professional investors only

www.hermes-investment.com

Hermes Investment Office Q4 2018

MARKET RISK INSIGHTSConstellations and corrections: asset-gazing in the risk universe

Eoin Murray Head of Investment

Space changed the world on October 4, 1957

The successful launch of the Soviet Union’s Sputnik 1 into earth’s orbit 61 years ago added an extra-terrestrial edge to the ground-based Cold War between the world’s then two greatest superpowers. Sputnik, the 83.6 kg ball of aluminium-magnesium (with a hint of titanium), undoubtedly ushered in an era of new political, military, technological, and scientific developments.

Stung by the Soviet stratospheric achievements, the US embarked on an ambitious program to dominate space highlighted five years after Sputnik by President John F Kennedy’s famous “We choose to go to the moon” speech.

Laying out US plans to put a man on the moon within the decade, Kennedy said the pace of technological change “cannot help but create new ills as it dispels old, new ignorance, new problems, new dangers”.

“Surely the opening vistas of space promise high costs and hardships, as well as high reward,” he said in 1962.

Although he didn’t live to see it, the US met Kennedy’s moon-landing deadline – albeit with just over five months to spare.

But if Kennedy’s speech marked a high point of US chutzpah and outward-looking optimism, the Sputnik spark has long-since lost its luminance in world affairs. Sputnik itself only orbited for three weeks before its batteries died ahead of a two-month-long, silent descent and disintegration in the earth’s atmosphere.

Likewise, the US today appears to have gravitated back from the outgoing, risk-taking, moon-shooting nation epitomised in Kennedy’s rhetoric to one concerned with more insular objectives. Instead of cold war we have a trade war, and a new presence at the superpower table in the shape of China.

Across the world, events from Brexit to Brazil – where the so-called ‘Trump of South America’, Jair Bolsonaro, assumed power this year – have flashed warnings that the post-Soviet globalisation trend is breaking up in the atmosphere of populism: we are at a point of political schism.

As the various bodies spinning in the global geopolitical realm continued to deviate from their hitherto stable orbits during the September quarter, however, investment markets tracked smoothly on, apparently unperturbed by chaos ascending in the Zodiac.

Investors scanning for signs of the ‘rolling bear’ constellation, which popped briefly into view this February after years of absence, found nothing to report over the three months to September 30. The February spike in equity market volatility faded from view; calm descended once more.

Barring a few other isolated observations – such as a rare incidence in June where all factor strategies glowed red – the year to the end of September was largely omen-free.

Since September 30, of course, rolling bear has made a few more sustained appearances on the investment horizon with significant equity market volatility over October and November. Risk is back in business – as millennial asset-gazers found when bitcoin crashed below $4,000 in November for the first time since 2017, 80% off its high.

For seasoned observers of the investment universe, the return of rolling bear comes as no surprise – except, perhaps, that many felt it was long overdue. Market pressures have been building for some time.

The US Federal Reserve, for example, is hoping it can pull off a near-miracle with its current programme of quantitative tightening (QT); mixing modest rate rises and a measured reduction of its balance sheet. As figure 1 shows, the Fed’s projections amount to an historical outlier that counts on a perfect outcome of close to full employment with good growth but little inflationary pressure.

Figure 1. Is it different this time? The Fed’s projections of inflation and unemployment

Low inflationand lowunemployment

The Lonely QuadrantThe Fed’s projections for low unemployment and inflation have few precedents in the past six decades

Yearly Fed projections 2018-21

2 4 6 8 10 12

Monthly rates since 1960Unemployment rate (%)

2

4

6

8

10

12

-2

0

Inflation (%)

January 1966

Source: US Federal Reserve, Bureau of Labour Statistics, Bureau of Economic Analysis, Hermes as at November 2018.

Against an environment of mounting trade tensions and slowing growth elsewhere in the world, this particular anti-gravity trick may be extremely difficult for the Fed to pull off, despite its optimistic projections.

As we have noted in previous editions, corporate debt is also a rising concern. US corporate non-financial debt rated BBB is now more than triple the level it was at the outset of the global financial crisis (GFC), accounting for roughly 49% of the investment-grade bond market.

We meet in an hour of change and challenge In a decade of hope and fear In an age of both knowledge and ignoranceThe greater our knowledge increases, the greater our ignorance unfolds. Public Service Broadcasting, ‘Race for space’ (also President John F Kennedy, 1962)

MARKET RISK INSIGHTS Q4 2018

2

Figure 2. The BBBurgeoning high-yield market

($bn

) (%)

92 94 96 98 00 02 04 06 08 10 12 14 16 18

BBB Par HY Par BBB Par % of HY

2,000

50

300

1,500

1,000

500

0 0

4,000

2503,500

200

150

3,000

100

2,500

Source: Morgan Stanley Research, FTSE Fixed Income LLC, Hermes as at November 2018

The main cause of the BBB-rated increase stems from net issuance, which has been topped up by debt downgraded from the safer tranches. Of particular note, more than 30% of current BBB-rated debt is leveraged at four-times or greater, with interest coverage steadily declining.

If any type of shock causes further downgrades, the high-yield or junk portion of the market could be swamped. With outstanding BBB issuance some 250% of the high-yield market, we will be keeping a close eye on this metric.

Elsewhere, the zombie firms are plodding along as the long era of low interest rates continues. Previously, we have highlighted a potential link between zombie firms – or those kept alive by unnaturally low borrowing costs – and the low-productivity puzzle that has been troubling economists for some time.

Figure 3. Staggering: zombie firms in OECD countries

Share of Zombie firms

87 89 91 93 95 97 99 01 03 05 07 09 11 13 15

%

%

Probability of staying zombie (RHS)

10

70

80

85

75

0 50

60

55

65

2

4

6

8

14 90

12

Source: TS Lombard, Hermes as at November 2018.

The growing trend of firms that struggle to meet their interest payments is clear; rising interest rates will only exacerbate this issue. Figure 3 depicts a worrying rise in the likelihood that zombie firms can never return as self-sustaining corporate entities.

Despite the looming threats to market stability, investors for the most part kept calm and carried on during the first three quarters of 2018. Excluding the February jolt of equity-market volatility, the first nine months of the year were virtually trouble-free.

However, as our regular Complacency Indicator (see figure 4) shows, volatility has a nasty habit of catching investors unaware – and leaving long-lasting psychological damage in its wake.

The Complacency Indicator captures two key characteristics of volatility: it typically ‘jumps’ after long stretches of calm to create ‘long memory’, or an extended period of time before it subsides. We track these effects 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 4. Jumps and memories: the Complacency Indicator

VIX

& C

ompl

acen

cy in

dica

tor

Long memory VIX LT average Complacency indicator (RHS)

1992

1993

1990

1991

1998

1997

1996

1995

1994

1999

2001

2000

2005

2003

2002

2004

2008

2006

2007

2010

2009

2012

2013

2014

2011

2016

2017

2018

2015

0

20

40

60

80

100

120

Source: Hermes, Bloomberg, Chicago Board Options Exchange as at November 2018.

While we refer to equity markets (via the VIX) in this analysis, the trend holds equally for other asset classes. We expect the recent surge in volatility will make it increasingly harder for investors to shrug off market jitters as ‘long memory’ sets in, disrupting the calm.

Overall, we strongly believe that markets remain in a period where all asset classes are vulnerable to a change in sentiment. As noted in previous issues, complacency does not guarantee negative outcomes but we believe that investors should continue to be cautious, remain flexible with their investment strategy and be prepared for any eventuality.

Big-picture themes such as the transition from crisis-level monetary settings to more-normal interest-rate conditions continue to play out. Investors everywhere are grappling with geopolitical tensions, whispers of inflation, climate change and divergent global growth.

But risk can lurk in unexpected places or hide in plain sight. We have applied our usual collection of forward-looking, evidence-based tools to the latest quarterly data in order to tease out many of these latent risks that could present investors with their own ‘Sputnik shock’.

Coincidentally, as the world paid a brief tribute to the 61st anniversary of Sputnik 1 this October, two other astronomical discoveries burned bright across the headlines. Scientists, searching for the as-yet mythical ‘Planet 9’ stumbled across a new dwarf planet beyond Pluto, dubbed ‘The Goblin’.

HERMES INVESTMENT OFFICE 3

At the same time, astronomers released the first evidence of the existence of a moon beyond our own solar system. The ‘exomoon’, estimated to be the size of Neptune (making it by far the biggest moon on record), is thought to be orbiting a giant planet some 8,000 light years away.

Tellingly, though, both the assumed exomoon and Planet 9 have not been observed directly but inferred by the behaviour of surrounding known objects and light. As each data point accumulates, scientists either become more confident of their hypotheses or develop new ones.

The Goblin, for example, appears to be moving in concert with a handful of other dwarf planetoid objects around a mysterious region of the outer solar system known as the Oort Cloud. Along with its celestial dance partners, The Goblin seems to move under the gravitational influence of a giant unseen object, adding to astronomers’ certainty that Planet 9 is out there: somewhere in an ever-changing space.

SummaryKey risks highlighted in this report:

�� We urge investors to give serious consideration to carbon, water and plastic pollution – three of the most pressing ESG risks

�� Debt is at unsustainable levels globally – eventually there will need to be a reconciliation

�� Protectionism is a political and the associated economic risk and could easily spiral out of control given the personalities involved

�� Liquidity is drying up outside the US – it will eventually be the conduit for contagion risk

In this issue, we group our thinking into six key aspects of market risk:

1. Volatility

2. Correlations

3. Stretch

4. Liquidity

5. Events

6. ESG

We have long recommended that investors consider the full gamut of risks, beyond pure financial-market risks, and take a long-term perspective.

VOLATILITY: SET FOR LAUNCHAsset price instability is the primary measure of risk for investors; and the rocket fuel of returns. But traditional measures of volatility – denominated in standard deviations from the norm – alone don’t tell the whole story.

We need to consider volatility from many perspectives across asset classes, geographies and time scales.

This quarter we again turn to our dashboard of volatility indicators to gauge risk. For example, figure 4 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 5. Moving averages of selected volatility measures

-2

-1

0

1

2

3

4

Currency volatility Commodities volatilityEquity volatility Debt volatility

2010 2012 2014 2016 2017 20182008 2009 2011 2013 2015

Source: Hermes, Bloomberg, CBOE, Deutsche Bank, Bank of America Merrill Lynch as at November 2018.

Our longer-term, rolling VIX measure shows that equity volatility continued to rise in the third quarter, falling back slightly towards its end. Commodities followed the shaking shares trend but bond and currency markets stayed flat. We expect volatility across all asset classes will inevitably experience a concerted rise sooner rather than later on the back of increasing protectionism and diverging regional economic fortunes.

Nonetheless, the still low implied volatility measures could encourage investors to leverage up their exposure to markets in an effort to capture apparently low-risk returns. We urge caution on gearing strategies given the anticipated further volatility shocks ahead, which would turbo-charge leverage into loss.

As per the Complacency Indicator, sustained bouts of volatility will likely create negative feedback loops as ‘long memory’ keeps investors ready to quickly react (or over-react) to any perceived price fluctuations. Life is precarious for geared-up investors in trigger-happy markets.

Experienced volatility metrics simply reveal what happened in markets but investors are more interested in what lies ahead. On that score, the ‘Volatility of volatility’ – or VVIX – measure provides a glimpse of how investors view the immediate future: it offers a risk-neutral forecast of large-cap US equity index volatility, still a proxy for global markets.

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


4

Figure 6. The volatility of volatility

Inde

x

VVIX Moving average

2010 2012 2014 2017 201820162009 2011 2013 201501

2

3

4

5

6

7

8

9

10

Source: Hermes, Bloomberg, CBOE as at November 2018.

Forward-looking volatility expectations spiked significantly in the first quarter, fell back in the second, and remained subdued throughout the third. We believe the market has it wrong: there is too much complacency in the system, which can lead to misallocation.

Resurgent equity market volatility during October and November indicates that markets are possibly coming around to our view.

Cross-sectional dispersion is another of our favoured volatility measures. The metric captures the various opportunities available for stock pickers in equity markets, reflecting the best- to-worst range at particular time periods.

All things being equal, elevated levels of cross-sectional volatility speak to higher return dispersion across assets.

Figure 7. Cross-sectional dispersion of stock returns

%

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

0

2

4

6

8

10

12

14

16

18

20

2008 2010 2012 2014 2017 201820162007 2009 2011 2013 2015

Source: Hermes, Bloomberg, FTSE as at November 2018.

While the data shows the long-term trend for cross-sectional volatility is on the rise, active managers will be hoping that heightened dispersion lingers longer than the single spike we witnessed during the September quarter.

Active managers will struggle if all markets track sideways, or rise or fall in unison.

Most of our metrics suggest volatility subsided over the September quarter after a more fractious first quarter of 2018. But we believe risk measures will ultimately reflect underlying global tensions – including economic and political factors as well as financial leverage concerns – as we move through the final quarter of 2018 and into next year.

Indeed, as post September 30 events have demonstrated, market volatility is poised for lift-off.

CORRELATION RISK: REGIME CHANGE COUNTDOWN BEGINSFollowing the GFC most assets have tracked in one direction – fortunately that was upwards. However, the lock-step behaviour of asset classes is historically unusual and counter-productive for investors looking to ride out volatility on diversified portfolios.

Asset class correlation, though, is a tough concept to pin down: we need to clearly define the meaning and closely monitor its behaviour over time.

For instance, two variables with the same long-term trend could have a negative, short-term correlation coefficient, over-emphasising the level of diversification available between them.

Information regarding the long-term trend should be taken into consideration when assessing diversification. Given that correlation is typically measured with respect to mean values, we must also account for sample trend in our analysis.

Figure 8. Correlation heat maps

Correlation: September 2018US NonFin HY ConstrainedEU N-FinaFixed&Float HYCGlobal HYMSCI EMMSCI EUROPEMSCI JAPANMSCI NORTH AMERICABBG EnergyBBG AgricultureBBG LivestockBALTIC DRY INDEXJapan 10 YEAR JGB FLOATGermany Generic Govt 10YEuro Generic Govt Bond 10YAustralia Govt Bonds GenericBBG Industrial MetalsBBG Precious MetalsGlobal Broad Market

Glo

bal.B

road

.Mar

ket

BBG

.Pre

ciou

s.Met

als

BBG

.Indu

stria

l.Met

als

Aust

ralia

.Gov

t.Bon

ds.G

ener

ic.Y

Euro

.Gen

eric

.Gov

t.Bon

d.10Y

.Yie

ldG

erm

any.G

ener

ic.G

ovt.1

0Y.Y

ield

Japa

n.10.

YEAR

.JGB.

FLO

ATIN

G.R

ABA

LTIC

.DRY

.IND

EXBB

G.L

ives

tock

BBG

.Agr

icul

ture

BBG

.Ene

rgy

MSC

I.NO

RTH

.AM

ERIC

AM

SCI.J

APAN

MSC

I.EU

ROPE

MSC

I.EM

Glo

bal.H

YEu

.N.F

inaF

ixed

Floa

t.HYC

US.

Non

Fin.

HY.

Cons

trai

ned

Correlation: June 2018US NonFin HY ConstrainedEU N-FinaFixed&Float HYCGlobal HYMSCI EMMSCI EUROPEMSCI NORTH AMERICABBG Industrial MetalsBBG EnergyMSCI JAPANAustralia Govt Bonds GenericBALTIC DRY INDEXBBG LivestockJapan 10 YEAR JGB FLOATBBG AgricultureGermany Generic Govt 10YEuro Generic Govt Bond 10YBBG Precious MetalsGlobal Broad Market

Glo

bal.B

road

.Mar

ket

BBG

.Pre

ciou

s.Met

als

Euro

.Gen

eric

.Gov

t.Bon

d.10Y

.Yie

ldG

erm

any.G

ener

ic.G

ovt.1

0Y.Y

ield

BBG

.Agr

icul

ture

Japa

n.10.

YEAR

.JGB.

FLO

ATIN

G.R

ABB

G.L

ives

tock

BALT

IC.D

RY.IN

DEX

Aust

ralia

.Gov

t.Bon

ds.G

ener

ic.Y

MSC

I.JAP

ANBB

G.E

nerg

yBB

G.In

dust

rial.M

etal

sM

SCI.N

ORT

H.A

MER

ICA

MSC

I.EU

ROPE

MSC

I.EM

Glo

bal.H

YEu

.N.F

inaF

ixed

Floa

t.HYC

US.

Non

Fin.

HY.

Cons

trai

ned

Source: Hermes, Bloomberg as at November 2018.


Taking the end of June and end of September heat maps, correlations remained broadly stable between asset classes over the quarter. If volatilities rise as we anticipate, the prevailing correlation paradigm could well be challenged. As correlations change, investors will need to reassess their diversification assumptions.

Digging a little deeper, the Morgan Stanley Global Correlation Index below aggregates correlations across asset classes, geographies, sectors, factors, and intra-markets into a single metric: it plainly fell at the back end of 2016 and has remained at lower levels since, including during the September quarter.

Figure 9. Morgan Stanley Global Correlation Index

Inde

x

2004

2006

2008

2010

2012

2014

2003

2005

2007

2009

2011

2013

2015

2016

2017

2018

Global Correlation Index

0

10

20

30

40

50

60

Source: Morgan Stanley, Bloomberg, Hermes as at November 2018.

Cross-asset global correlation has remained stubbornly in a high band from 2007, with assets, asset classes and geographies largely moving together. Over the September quarter the Morgan Stanley measure stayed below 0.35, offering further evidence that asset class correlations were decoupling across the board.

Historically, surprise correlation changes have often preceded periods of poor returns (see graph below). We analyse correlation surprise by comparing recent statistical behaviour against long-term data in an effort to pick up early warning signs of asset class relationship changes.

Figure 10. Correlation surprise and returns

Russell3000

MSCIEmergingMarkets

MSCIEmerging

Asia

MSCIEurope

MSCIChina

Subsequent one-month annualised return

-0.30

-0.25

-0.20

-0.15

-0.10

-0.05

0.00


Figure 11. Correlation surprise in the global equity universe

Inde

x

2007 200920052001 2003 2011 2013 2015 20182017

Correlation Surprise Index

0

1,000,000

2,000,000

3,000,000

4,000,000

5,000,000

6,000,000


Our correlation surprise indicator experienced another quiet quarter. In some ways, we could make the case that a lack of cross-market unusualness against the current difficult macro backdrop is a sign of concern.

Correlation surprise is a critical signal to monitor as the cycle nears its end. From time-to-time the correlation surprise metric will give false-positive signals, but we think investors should remain cautious about any portfolio assumptions based on stable cross-asset relationships.

The fickle nature of asset class correlations is a constant worry for investment managers who must build assumptions into diversification models. But asset classes don’t always follow model behaviour. For instance, market stress can quickly end seemingly inseparable asset class relationships while bringing former opposites closely together.

Furthermore, the instability of correlations is itself highly unpredictable. Correlations can move in a tight band for long periods while sometimes we see rapid dislocation of asset class relationships. Our correlation signal below captures the degree to which asset classes are shifting behaviour relative to each other.

Figure 12. Correlation signal

Correlation Correlation signal

2004 2006 2008 2010 2012 2014 201820172016-1.0

-0.8

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

0.8

1.0

Corre

latio

n st

abili

ty

Correlation Correlation signal

0

20

40

60

80

100

120

140

Correlation signal



6

And during the September quarter the correlation signal has picked up signs that asset class relationships are under stress. The data shows periods of correlation instability are becoming more frequent, indicating investors should be cautious about asset class assumptions based on the recent past. We expect instability to pick up again over the remainder of this year and through 2019.

As we have argued repeatedly, stock-standard methods of portfolio diversification based on historical correlation data are likely to lose their effectiveness in a fast-changing investment environment. True, investors today have many more diversification options at their disposal as new asset classes and jurisdictions open up but at the same time portfolio construction and risk management approaches have converged across the industry.

Given most investors are following the same diversification recipe, any change in the underlying correlation ingredients could lead to systemically disappointing outcomes.

In our view the potential for regime change in cross-asset correlations remains at elevated levels, which the following chart supports:

Figure 13. Equity-bond correlation

2y downside beta of 10Y Treasuries to S&P 500Downside correlation (10Y Treasurie, S&P 500)

1986

1970

1974

1978

1982

1962

1966

1990

1994

1998

2002

2006

2010

2014

2018

-1.00

-0.67

-0.33

0.00

0.33

0.67

1.00

-0.6

-0.4

-0.2

0.0

0.2

0.4

0.6

Source: Bank of America Merrill Lynch, Hermes as at November 2018.

The graph shows that since the late 1990s, bonds and equities have been mildly negatively-correlated, offering attractive hedging properties to one another: previously, the reverse held true.

Markets could be at a point of significant correlation change as the 30-year plus bond bull-run and 10-year equity splurge both draw to a close. We think the countdown has already begun with correlation regime change expected within the next 12 months. Investors will need to combine different portfolio construction and risk management methods in the altered correlation environment.

STRETCH RISK: ALL SYSTEMS ARE GOToo often investors are guilty of using volatility as the only or primary measure of portfolio risk. Very expensive assets often have very low volatility, and despite sizable downside tail risk, are deemed perfectly safe by traditional risk models.

Stretch risk allows us to identify assets that trend in one direction for a considerable period of time. A ‘stretched’ asset typically features suppressed headline volatility that obscures true underlying risks.

In previous issues we highlighted examples of stretch risk in the credit markets. The theme continues this quarter with an analysis of developed and emerging market high yield debt as illustrated in the graph below.

Figure 14. Stretch risk – EM HY vs DM HY

Corre

latio

n

EM HY vs DM HY

20182011 2012 2013 2014 2015 2016 20170.0

0.2

0.4

0.6

0.8

1.0

1.2

Source: Hermes as at November 2018.

The graph tracks correlation in weekly option-adjusted spread (OAS) changes for developed and emerging market high yield debt over the past seven years. Over the past couple of years the correlation between the two high yield markets has fallen as investors increasingly appreciate the different underlying macroeconomic drivers at play for emerging market debt issuers.

By investing in high yield beyond just developed markets asset owners get the benefit of improved risk-adjusted returns for their credit allocation.

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 – one of the reasons that equity volatility is so low at the moment. However, such valuations rarely persist, with the relevant asset or market likely to snap back to fair(er) value.


Figure 15. Stretch risk – 1937 reprise

1932

1933

1934

1935

1936

1937

S&P 500

0

2

4

6

8

10

12

14

16

18

200.89 correlation

1000

1200

1400

1600

1800

2000

2200

2400

2600

2800

3000

Source: Reuters, Hermes as at November 2018.

Investors often evoke the old saying that history doesn’t repeat but it rhymes. Over the last few years, Bridgewater’s Ray Dalio has been comparing the current period to the environment in the late 1930s, particularly the pre-eminence of rising global populism in both periods.

As we can see from the chart above, there is indeed an astonishingly-high correlation between the equity market then and now (greater than 0.94), but this is perhaps even more powerful when one considers some other fundamental parallels:

1. Debt limits were reached at a bubble top, causing the economy and markets to peak (true of 1929 and 2007);

2. Interest rates hit zero amid depression (both in 1932 and 2008);

3. Quantitative easing, including money printing started, kicking off significant deleveraging (1933 and 2009);

4. Stock markets and risky assets rally in the excess liquidity (1933-36 and 2009-17); and,

5. The economy improves on the back of a cyclical recovery (1933-36 and 2009-17).

In 1937, the Fed began to tighten rates, sending stocks tumbling: will we see a repeat this time? Markets are currently pricing in a rate hike in December and a further three next year – there has to be a possibility of a policy error that will turn into a self-reinforcing downturn.

Overall, we can find excellent examples of stretch risk in both equity and bond markets, either from a momentum or extreme valuation perspective. The injection of liquidity from unconventional monetary policy has led to an unstable floor for downside risk, which we see continuing to develop in unpredictable ways throughout the remainder of this year.

LIQUIDITY RISK: WE HAVE IGNITIONInvestigating 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.

Today, the ‘TED spread’ and the ‘Credit spread’ are the two most closely-followed metrics for funding and liquidity risk. The TED spread focuses on the difference between interest rates available in the interbank market and on short-term US government debt (T-Bills), typically at a one- or three-month view. Whereas the Credit spread generally targets the spread between corporate bonds and government bonds, again at a comparably short maturity – essentially an indicator of perceived credit risk, linked closely to the potential for default in the corporate bond market.

Figure 16. Funding and credit risk

%

TED spread Credit spread

-2

0

2

4

6

8

10

2007 2008 2010 2012 2014 2016 2017 20182009 2011 2013 2015


Having pushed up during the first quarter the TED spread continued its second quarter retreat to the end of September. We are somewhat surprised the TED spread has not moved higher given it is supposed to reflect a range of perceived risks covering economic, monetary liquidity, and bank credit quality conditions. While the credit quality of the global banking system appears in good shape, both economic and monetary liquidity risks have risen over the year. In particular, we expect the TED spread to widen as liquidity conditions continue to tighten.

We note disappointing performance from global SIFIs (systematically important financial institutions) in general.

Dislocations can occur even in highly-liquid markets. The liquidity of an asset often depends on whether the direction in which you wish to trade matches the broader market sentiment. We also must consider the quantity of the asset to be traded as another variable that influences liquidity.

By identifying ‘crowded’ trades, we are better able to identify potential trigger sources of liquidity risk. To that end, the monthly survey conducted by Bank of America Merrill Lynch of global fund managers provides some clues.


8

Figure 17. Fund managers answer the question: where do you think the most crowded trades currently are?

0% 10% 20% 30% 40% 50% 60%

Other

Long S&P 500

Short Gold

Short EM equity

Long US banks

Long Oil

Long USD

Long Bitcoin

Long Nasdaq(FAANG + BAT)

Long IG credit

Short Govt Bonds

Aug 18 Jul 18 Sep 18

Source: Hermes, Bank of America Merrill Lynch as at November 2018.

The Merrill Lynch survey shows going long Big Tech remains the most popular trade by some margin despite declining since the July 2018 high point. But how long can the tech names continue to defy gravity? The significant narrowing of the market represented by the Big Tech bias is concerning.

On the short side, emerging market equity has seen a reprieve in the latest quarter, perhaps reflecting the feeling that the punishment inflicted by a strong US dollar on those jurisdictions is over for now.

During the September quarter investors also appear to be more upbeat about equity markets with long S&P500 ranking among the top three most popular trades. Unsurprisingly, long Bitcoin – one of the most popular picks in the January 2018 Merrill Lynch survey – has disappeared off the radar.

If liquidity risk is to reassert itself, we expect it would appear first in the corporate debt market rather than equities. Fixed income markets in general tend to re-price risk quicker than equity investors: we note the gap in the relative liquidity conditions of credit and equity markets remains wide.

Fixed income liquidity also typically leads that of other asset classes. Given the predominance of non-US debt issuance over the last few years we are not surprised to see credit liquidity has deteriorated of late.

In our previous Market Risk Insights we analysed the Hui and Heubel ratio for Bund futures – presented again here: the ratio measures intra-day price movement relative to the ratio of traded volume to either market capitalisation or open interest.

Figure 18. The Hui and Heubel ratio for Bund futures

0.00

0.01

0.02

0.03

0.04

0.05

0.06

0.07

0.08

0.09

0.10

Jan

10

Jul 1

0

Jan

11

Jul 1

1

Jan

12

Jul 1

2

Jan

13

Jul 1

3

Jan

14

Jul 1

4

Jan

15

Jul 1

5

Jan

16

Jan

17

Jan

18

Jul 1

8

Jul 1

6

Euro Bund 20-period moving average for the euro Bund

HH

L ra

tio


The analysis identified a couple of illiquidity spikes in the September quarter, suggesting that fixed income markets remain vulnerable to liquidity shocks: a process that could be intensified if cash-strapped investors are forced to sell into tightening market.

It is still a matter of debate whether global central banks retain the wherewithal to combat a liquidity crisis. Post GFC unconventional monetary policies featuring ultra-low (or negative) rates and quantitative easing have undoubtedly depleted central bank firepower. Bond markets, in particular, will react badly if monetary authorities fail to contain a liquidity crisis.

In fact, liquidity will be the most likely transmission mechanism for contagion should any significant shocks derail the current stability. This quarter we stick with our measure, Kyle’s lambda, which seeks to throw 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.

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 underlying market structure.

Figure 19. Kyle’s lambda

0%

5%

10%

15%

20%

25%

30%

2% ADV Market Impact Current 5yr average

2% A

DV

Mon

thly

Ave

rage

Impa

ct

31 S

ep 9

631

Sep

97

31 S

ep 9

831

Sep

99

31 S

ep 0

031

Sep

01

31 S

ep 0

231

Sep

03

31 S

ep 0

431

Sep

05

31 S

ep 0

631

Sep

07

31 S

ep 0

831

Sep

09

30 S

ep 1

831

Sep

17

31 S

ep 1

631

Sep

15

31 S

ep 1

431

Sep

13

31 S

ep 1

231

Sep

11

31 S

ep 1

0



Our model – as per the graph above – picks up some of the major market dislocations in recent decades. However, market impact for global equities was generally extremely low during the third quarter. Our credit traders, though, continue to find that they have to break up larger orders into smaller blocks to complete their trades.

Ultra-easy monetary policies have led to bloated central bank balance sheets in developed economies and have suppressed both volatility and interest rates, causing a rush in risky assets.

Global financing conditions appear stable, while liquidity is undoubtedly tightening. Fed QT aligned with current banking regulations and money market reforms could tighten offshore dollar funding further.

Investors generally appear to be balancing concerns about valuations and potential downside risks with the fear of missing out on more of the party, even as celebrations become more strained.

EVENT RISK: NO ESCAPE VELOCITYRisk in the real world is less easily captured in financial models than our previous numerically-based factors.

Consequently, we recommend the use of non-standard models when attempting to quantify event risk. We feel strongly that investors gain a better understanding of possible outcomes by stress-testing portfolios and running detailed scenario analysis. These represent the minimum standard for risk management in today’s investment world.

During the GFC, 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 20. Turbulence index – future returns

Russell3000

MSCIEmergingMarkets

MSCIEmerging

Asia

MSCIEurope

MSCIChina

Turb

ulen

ce in

dex

Full sample annualised returnAnnualised return following most turbulent periodAnnualised return following most non-turbulent period

-0.4

-0.6

-0.8

-1.0

-0.2

0.0

0.2

0.4

0.6

0.8

Source: Hermes, Bloomberg.

We analyse market turbulence by identifying the statistical unusualness of the current risk environment, in terms of both volatility and correlation.

Our analysis 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 via a conditioning process.

Figure 21. Turbulence index – global equities

0

5

10

15

20

25

30

Turb

ulen

ce In

dex

2002

2003

2004

2006

2008

2010

2012

2014

2005

2007

2009

2011

2013

2015

2016

2017

2018

Turbulence

Source: Hermes, Bloomberg, MSCI as at November 2018.

Turbulence remained utterly subdued throughout the September quarter, with assets behaving as usual and relationships between them quite normal. Regardless of the current calm, we anticipate that the turbulence measure will experience further spikes during the rest of this year (as has played out during October and November) and into 2019.

The final fragility gauge, the Absorption Ratio, captures the market’s ability to cushion shocks and is perhaps best thought of as a measure of systemic risk. Our expanded multi-asset Absorption Ratio captures information for 17 different asset classes.

We use principal components analysis to determine how much 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 22. Absorption Ratio

Inde

x

1999

2000

2002

2004

2006

2008

2010

2012

2014

2001

2003

2005

2007

2009

2011

2013

2015

2016

2017

2018

Absorption Ratio

0.50

0.55

0.60

0.65

0.70

0.75

0.80

0.85

Source: Hermes, Bloomberg, MSCI as at November 2018.

As reflected in the graph above, there does appear to be some cross-asset vulnerability in the data. The result is unsurprising given the fraught global political and macroeconomic backdrop, but the signal strength is hardly cause for panic. We would expect to see further upward movement in this measure next year.

Political risk and its impact on markets should never be ignored, even if it is difficult to measure quantitatively. We tackle this problem with a metric based upon the frequency of economic policy uncertainty coverage.


10

Using an unstructured data approach, policy uncertainty appears to be a leading indicator of increases in equity market volatility. At a macro level, increased policy uncertainty tends to foreshadow declines in economic growth and in employment.

More explicitly, our policy uncertainty indicator chimes with the average correlation of stocks, in the sense that equities tend to be driven by a single macro factor when policy uncertainty is high.

Figure 23. Economic Policy Uncertainty

Inde

x

2002

2001

2000

1999

1998

1997

2003

2004

2006

2008

2010

2012

2014

2005

2007

2009

2011

2013

2015

2016

2017

2018

Global Policy Uncertainty Index

0

50

100

150

200

250

300

Source: Economic Policy Uncertainty, Hermes as at November 2018.

Investors are spoilt for choice when looking for examples of political uncertainty with the long list of candidates including:

�� Italian budget concerns;

�� Brexit;

�� rising trade tensions;

�� Syria and the Middle East more generally; or,

�� even the possibility of a Trump impeachment.

But while it is difficult to tell which geo-political drama is most vexing for investors one thing is absolutely certain – the political uncertainty index has been steadily rising throughout the year and doesn’t seem likely to turn south at any point soon.

The key question is when will investors incorporate the growing geo-political risk into their strategies?

Event risk, covering political and policy uncertainty, is a constant feature of financial markets. Our principal metrics for capturing it, the Turbulence Index and the Absorption Ratio, are at moderate levels and broadly in agreement. But steadily climbing policy uncertainty conditions could bring investor optimism back down to earth.


ESG RISK: BACK ON EARTHEnvironment, social and governance (ESG) officially entered our quarterly risk assessment orbit as a stand-alone feature just recently. However, we expect ESG risk to only increase in importance for investors.

ESG analysis is now an ingrained part of our investment process but it is also a broad, and expanding, topic. Rather than attempting to contain the entire ESG space within a statistical measure, each quarter we bring a couple of current issues into focus for investors.

This quarter our gaze turns towards plastic, which is attracting a growing consumer backlash as the environmental cost of the material’s convenience comes to light.

Plastic presents problems: far too little is recycled and far too much leaks into the natural environment, taking centuries to break down. Awareness of the issues, including damage to marine life and potential risks to human health, is on the rise. We think media headlines and emotive BBC documentaries have driven public opinion, which could threaten demand for virgin plastic. For example, campaigns against ‘single-use’ plastic bags have seen them withdrawn from many supermarkets around the world. In August this year New Zealand was the latest country to ban single-use plastic bags – joining a list of more than 40 nations already to have binned the bags. Collins Dictionary named ‘single-use’ as its word of the year in November 2018.

Figure 24. Plastic not fantastic

>99%of plastics are produced from chemicals sourced from fossil fuels

6%of total oil supply used for plastic production

>8.3BNtonnes of virgin plastics produced to date and...

6.3BNtonnes of waste generated

Regional production breakdown:

SourceOil & gas

ProductionChemicals

UseAutos,

beverages, retail & others

End of lifeRecycling & capital goods

Plastic production uses as much oil as the

aviation sector

Cosmetic products contain between 1 and 90% plastic

40-45%Landfill

12-14%Incineration

25-30%Land leakage

2-5%Ocean leakage

CHINAEUROPENAFTAREST OF ASIA

29%19%

18%11%

European consumption

by sector

20%

40%10%

6%

24%Building & construction

PackagingAuto

Electricals

Other

10-15%Recycling

Source: HSBC Research, Ellen MacArthur Foundation as at November 2018.


12

Also this quarter, we came across an interesting tool designed to help investors get a better handle on climate scenario analysis. The Paris Agreement Capital Transition Assessment (PACTA) tool, developed by the 2o Investing Initiative (2Dii), is intended to help investors analyse exposure to transition risk across equity and fixed income portfolios under multiple scenarios.

Figure 25. The Paris Agreement Capital Transition Assessment (PACTA) tool

SCENARIOS

METRICS ASSET CLASSES

SECTORS

2O

4O

6O

Existingassets

Capacity additions/production forecasts

CAPEXplans

Locked-inemissions

Stocks Bonds Funds Privateequity/loans

Power Coal mining Oil & gasupstream

Automanufacturing

Cement Steel Aviation Shipping

80-90% of CO2 emissions associated with an index; 75% of CO2 emissions in the economy

10-20% of asset value of indices/funds

IEABNEFGreenpeaceSBTi

2017 20222018 2019 2020 2021

Source: 2o Investing Initiative, PRI as at November 2018.

PACTA joins our list of ESG analytical tools that we will continue to expand over the coming months and years. We look forward to sharing the growing ESG toolkit with portfolio managers and, ultimately, with our clients too.


CONCLUSIONInvestment risk is an elusive concept; it can never be completely described. But we can develop a reasonable sense of where risk is most likely to appear by applying the best range of indicators available.

Based on those multi-gauge readings, our view of market risk for the coming quarter is:

Volatility: We anticipate both a steady rise in volatility as well as more frequent spikes for the rest of 2018;

Correlation risk: We have a hunch that the correlation regime is on the point of a dramatic change – we will watch correlations closely as they are a principal determinant of the success of diversification strategies;

Stretch risk: Different market variables get tighter and tighter – in the face of greater leverage (as a result of lower volatility), we can only hope that the inevitable unwind will be orderly;

Liquidity risk: Unquestionably, liquidity is tightening around the globe, with very few markets immune;

Event risk: The global political backdrop continues to evolve rapidly – room for error (and the consequence of a misstep) grows ever-smaller;

ESG risk: We anticipate a direct impact from climate change on global growth.

Since the GFC most markets have rocketed higher fuelled by central bank largesse and increasing economic optimism. Just about all investors and asset classes have been aboard for the stratospheric journey to historical highs.

Until February this year, investment markets experienced a generally smooth ride up before being buffeted by an unexpected gust of volatility. Despite most risk gauges dipping since the February event until the end of the third quarter there are signs that the market is running out of rocket fuel. Post September 30 this year, volatility again hit equity markets, for example, but even beforehand investors faced many challenges.

For example, the HFHX Equity Hedge Fund Index shows just how difficult an investment environment 2018 has been.

Figure 26. Hedge fund difficulties

1200

12201230.16

1240

1260

1280

1300

1320

1340

2017Aug Sep Oct Aug Sep OctNov Dec Jan Jun JulFeb Mar MayApr

2018

Source: HFR as at November 2018.

When a highly-skilled group of managers – who have the ability to employ gearing and be either net long or net short the market – struggle to deliver returns it is perhaps a sign that all is not well with the world.

On the surface, with tech stocks soaring to record highs and a slump in volatility, it would appear that investors are brushing aside market risks, trade war concerns, and US Fed tightening. But life is not that simple, for we can also see a rise in equity skew, which suggests that investors are taking the opportunity to purchase crash protection.

Similarly, investment grade credit default swap turnover is significantly higher, hinting that investors are allocating to more liquid instruments in a bid to remain nimble should markets tumble, like Sputnik, back to earth.

If a correction is near, investors should prepare for the possibility according to their own circumstances: it could represent risk or opportunity depending on, most of all, their investment timeframe.

In justifying a huge budget increase for NASA to reach the moon, Kennedy said in his 1962 speech that the attempt was “in some measure an act of faith and vision, for we do not now know what benefits await us”.

We are, however, getting a better view of the risks.


14


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.

Issued and approved by Hermes Investment Management Limited (“HIML”) which is authorised and regulated by the Financial Conduct Authority. Registered address: Sixth Floor, 150 Cheapside, London EC2V 6ET. HIML is a registered investment adviser with the United States Securities and Exchange Commission (“SEC”).BD02776 0005123 11/18

For more information, visit www.hermes-investment.com or connect with us on social media:

Our investment solutions include:Private marketsInfrastructure, private debt, private equity, commercial and residential real estate

High active share equitiesAsia, global emerging markets, Europe, US, global, small and mid-cap and impact

CreditAbsolute return, global high yield, multi strategy, global investment grade, unconstrained, real estate debt and direct lending

StewardshipActive engagement, advocacy, intelligent voting and sustainable development

Offices London | New York | Singapore | Denmark

HERMES INVESTMENT MANAGEMENTWe are an asset manager with a difference. We believe that, while our primary purpose is to help savers and beneficiaries by providing world class active investment management and stewardship services, our role goes further. We believe we have a duty to deliver holistic returns – outcomes for our clients that go far beyond the financial – and consider the impact our decisions have on society, the environment and the wider world.

Our goal is to help people invest better, retire better and create a better society for all.

Documents

MARKET RISK INSIGHTS - hermes-investment.com · ‘Trump of South America’, Jair Bolsonaro, assumed power this year – have flashed warnings that the post-Soviet globalisation