Investors need to consider factors such as the withdrawal of unconventional monetary policy, which assets have risen for an extended period of time and changing correlations between different parts of the market if they want to understand the health of the ongoing bull run. 
That’s the view of Eoin Murray, head of investment at Hermes Investment Management, who argues in his Market Risks Insights report that investors need to remain mindful of the fact that markets could be heading into a period of increased volatility – even in the months ahead.
“The year may be almost at an end, but 2017 still has the capacity to shock,” the report said. “The shift from one monetary regime to another is unlikely to progress without convulsions in the market.
“In our consistently-held view, the current calm – reflected in low volatility and generally benign conditions – may hide deeper market vulnerabilities that could catch complacent investors.”
Performance of stock markets over 2017
Source: FE Analytics
Of course, a number of investors maintain that the ongoing bull market has plenty of room to keep going. Recent articles on FE Trustnet have highlighted the views of fund managers and strategists such as Charles Stanley’s John Redwood and Royal London Asset Management’s Trevor Greetham, who said there are few reasons why the bull run should end anytime soon.
However, Murray added that investors should be consider the “full gamut of risks beyond pure financial market metrics” and pointed to the risk metrics matrix used by Hermes Investment Management to assess the health of markets.
Until recently, this matrix considered five factors but the asset management house has now added a sixth that investors need to be aware of. In this article, we take a closer look at the factors that Hermes believes can help prepare for changing market conditions.
Volatility risk: Why markets may get the ‘UMP’
The past quarter has seen long-term implied volatility measures for all asset classes continue to drop, with currency and commodity volatility being the areas seeing the most rapid declines. However, this may not continue to be the case as central banks start to scale back on unconventional monetary policy (UMP).
Murray said: “How the markets react to the unwinding of unconventional monetary policy is crucial. This, alongside rising global political unrest, means we can expect forward-looking gauges such as the VVIX [a risk-neutral forecast of large-cap US equity index volatility] to flicker upwards over the rest of 2017. We also anticipate markets will retain the effects of volatility shocks more deeply in their collective conscience (long memory will return).”
The head of investment added that one danger of sustained low implied volatility is if investors are lulled into a false sense of security and gear up their portfolios as a result – as this can lead to them being hit hard when volatility returns in earnest.
Stretch risk: Why investor can’t be sure of the floor
While implied volatility is one of the most obvious ways to identify rising market risks, stretch risk allows investors to identify assets that have trended in one direction for a considerable period of time. A ‘stretched’ asset typically features suppressed headline volatility that obscures true underlying risks, Murray added.
Stretch risk – high yield in Europe
Source: Hermes, Reuters as at October 2017
Murray highlighted the European high yield market as one area that stretch risk can be seen – as the hunt for yield continues and suggest an element of complacency within credit markets – although he added that it can be found in plenty of other areas.
“Overall, we can find examples of stretch risk in both equity and bond markets, either from a momentum or extreme valuation perspective,” he said. “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 and well into next. In the face of greater leverage as a result of lower volatility, we can only hope that the inevitable unwind will be orderly.”
Correlation risk: Prepare to be surprised
Most asset allocation and investment strategies are underpinned by correlation assumptions, as understanding the perceived relationship between asset classes is essential to managing overall portfolio volatility risk.
However, Murray noted that correlation is not a fixed quality. Since 2007, correlations have tended to be high with assets, asset classes and geographies largely moving together; this appears to have eased more recently, suggesting investors might have to deal with an environment different to that of the past 10 years.
“Over the last few decades the range of investment options has multiplied across asset type and geography. While the expanding investment universe has brought the benefits of diversification, portfolio construction and risk management, techniques have become increasingly homogenous,” the investment head continued.
“As their strategies conform investors tend to react in a similar fashion when faced with the same new information, increasing the gap risk in correlations. We anticipate sharp movements in correlation, which investors will need to handle by combining different portfolio construction and risk management methods.”
Liquidity risk: Contained but under pressure
Hermes Investment Management believes that understanding liquidity risk is key to carrying out a health check of the market, as liquidity is often the transmission mechanism for contagion from significant shocks to current market conditions.
“Liquidity is often the first casualty of any market dislocation. Dislocations can occur even in highly-liquid markets. By identifying ‘crowded’ trades, we are better able to identify potential trigger sources of liquidity risk. We believe concerns over liquidity risk in the corporate debt market remain highly relevant,” Murray said.
Where fund managers see the most crowded trades
Source: Hermes, Bank of America Merrill Lynch as at October 2017
The chart above shows the rotation in fund managers’ most-crowded trades during the latest quarter. Hermes’s analysis of the Hui-Heubel ratio for bund futures suggests liquidity conditions remained relatively stable during the quarter with a usual number of illiquidity spikes, although the group added that it remains to be seen if years of low rates and quantitative easing have damaged the ability of central banks to counter downturns.
Event risk: Mood moderates despite the radicals
Event risk, which includes political and policy uncertainty, is a constant feature of financial markets. However, the past couple of years have seen markets “almost casually” shrug off numerous instances of political upheaval.
Murray said: “Our global policy uncertainty indicator reached a 16-year peak around Brexit, only to be surpassed by a new high around the time of the US election. The metric has declined substantially since then, as the prevailing view appears to be that markets can remain immune to political uncertainty but not so to its economic cousin.
“Despite the sanguine market take on geopolitics, there are flashpoints aplenty – notably North Korea and Brexit, while populism is back on the agenda in Europe”
ESG risk: Are monetary incentives undermining carbon targets?
The latest factor to be added to Hermes’ risk matrix is environmental, social & governance (ESG) risk. Although ESG has been an important element of the firm’s research process for many years, it has held off making it an official part of the matrix until now.
“ESG analysis offers investors another, potentially lucrative, method of managing portfolio risk. By introducing ESG into our risk mix we aim to help investors adapt quality research insights to practical portfolio solutions,” Murray said.
A recent study that grabbed the team’s attention was a novel dataset compiled by the Carbon Disclosure Project, which examined efforts by firms to meet ambitious carbon emissions targets. It found that using stretch goals alone was effective in helping meet these targets, but said the addition of monetary incentives/bonuses seemed on the whole to undermine the achievement of those targets.
Murray added that studies such as this give investors “strong clues” about how they can analyse the relative riskiness of company strategies to address climate change through corporate behaviour modification.