The return of volatility to markets other than equities, a fall in correlations between asset classes and “an unstable floor for downside risk” are some of the issues that investors need to be attentive of in today’s market environment. 
These are the views of Eoin Murray (pictured), head of investment at Hermes Investment Management, in his latest report: ‘Spring of hope, or winter of despair? Investors face Dickensian conditions’.
In it, Murray argues that the famous opening lines to Charles Dickens’ A Tale of Two Cities – “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” – could set the scene for the current market and macroeconomic climate.
The Hermes head of investment said the current market backdrop is characterised by latent volatility, contradictory extremes appearing as equally likely realities and confusion over whether it is a time of inflation or disinflation, liquidity or illiquidity, growth or slump.
In the following article, we take a closer look at the six types of risk Murray and his team watch as part of their process and how they have developed over the opening months of 2018.
Volatility: Hard times ahead?
Equity markets witnessed an increase in volatility in the opening months of 2018 after spending several years at subdued levels. However, volatility did not tick up for other asset classes – although Murray expects this to happen eventually.
Moving averages of selected volatility measures
Source: Hermes, Bloomberg, CBOE, Deutsche Bank, Bank of America Merrill Lynch as at May 2018
“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,” he said.
“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.”
The head of investment noted that further price instability could lead leveraged investors to sell down positions, which may cause even more volatility. In light of this, he recommended that investors adopt a “conservative” approach to gearing in anticipation of rising volatility to come.
Correlation: Greater expectations
Murray also said that cross-asset correlations have remained “stubbornly” in a band since 2007, with assets largely moving together in a manner not often seen since before the financial crisis. However, he added that “investors can never take co-relationships for granted”.
“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,” he explained.
Morgan Stanley Global Correlation Index
Source: Morgan Stanley, Bloomberg, Hermes as at May 2018
In this environment, investors cannot simply use traditional portfolio diversification methods because they have been built entirely on historical correlation measures and could come unstuck if conditions change significantly – something that Hermes thinks could happen this year.
“Despite the wider array of asset classes offering potentially greater sources of diversification, investors are increasingly herding around common risk and portfolio management strategies,” Murray said. “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
While most investors focus on volatility as the main measure of market risk, Murray argued that asset price stability can sometimes mask underlying dangers. He gave the example of how fully-priced assets that exhibit low volatility can still present substantial downside potential.
Hermes uses ‘stretch risk’ to analyse apparently low-volatile assets or those that have trended in one direction for an extended period in order to monitor the risk that stretched valuations could suddenly snap back.
“The injection of liquidity from unconventional monetary policy – 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,” the head of investment said.
Liquidity: Bleak times ahead?
When monitoring potential trigger sources of liquidity risk, Hermes pays close attention to the Bank of America Merrill Lynch Global Fund Manager Survey. Each month, the bank polls fund managers across the world to find out what they think is the most crowded trade in markets.
These crowded trades have rotated in recent months, with long Bitcoin briefly appearing on the list before dropping off; there was a similar story when it came to being short volatility. Fund managers at the moment consider big tech to be the most crowded trade in markets.
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.
Where fund managers think the most crowded trades currently are
Source: Hermes, Bank of America Merrill Lynch as at May 2018
“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
Hermes monitors a number of non-standard models when attempting to stay on top of ‘event’ risk, arguing that a better understanding of possible outcomes can be gained by stress-testing portfolios in a number of different ways.
Within this, the group’s Turbulence Index climbed to its highest level for nearly eight years during the sell-off that hit markets in February 2018.
Murray said: “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.”
Furthermore, Hermes’ Policy Uncertainty Indicator has remained at its lower end, suggesting investors currently regard politics as less influential than economics. However, Murray cautioned that it would be “foolish” for investors to ignore the possible effects of a potential trade war between the US and China, real conflict in the Middle East and renewed uncertainty in Europe.
ESG Risk: Tale of two commodities
Environmental, social & governance (ESG) is a relatively new parameter that has been added to the risk analysis toolkit used by Murray and his team. Over the past quarter, this has focused on the issues surrounding water and concrete.
Communities around the world face a growing water crisis, meaning the need for lower-cost means to secure ample and clean water is growing in importance.
India’s water shortage
Source: Hermes
Hermes gives the example of India, which has 16 per cent of the world’s population but just 4 per cent of its fresh water supply. Half of the water supply in India’s rural areas is routinely contaminated with toxic bacteria; each year about 600,000 Indian children die from drinking unclean water.
“Natural infrastructure approaches have a major role to play in confronting the impending crisis,” Murray said. “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.”