Market Risk Monitor – January 2018

Edward Fishwick |Jan 17, 2018

The latest issue of the Market Risk Monitor assesses how the risk environment has changed over the last quarter of 2017 and whether the current market environment is still conducive to risk taking.

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Capital at risk: all financial investments involve an element of risk. Therefore, the value of the investment and the income from it will vary and the initial investment amount cannot be guaranteed.

Still a low volatility/ low risk environment

Our end of 2017 metrics suggest that the low volatility/ low risk environment we have observed for a considerable time is pervasive across asset classes. Implied volatility in equity and bond markets tracks the bottom end of their historical range, while correlations in weekly returns across asset blocks appear to be relatively low. While getting more expensive, valuations of equity markets are still within historical ranges. Furthermore, except for the outperformance of some technology stocks, we do not observe strong thematic trends across different market segments, suggesting a lack of major economic risk. This is a change from previous years when low volatility, short indirect oil exposure or expensive stocks were driving relative returns.

While it is true that the duration of the current period of low volatility is unusual in a historic context, an analysis of time series volatility of the S&P 500 going back to 1872 shows that low volatility regimes are significantly more common than high volatility regimes. The same analysis also shows that high volatility has historically been related to sustained periods of instability such as war or real economic distress. In the absence of such a negative real economic background, volatility has historically been subdued.

In other words, the absence of volatility in itself may not necessarily be a concern. However, we note that valuations across several industries/sectors are now quite expensive relative to longer-term data, with technology being a prime example. Similarly, event risk remains in our view an important area of concern.

What does this mean from a risk management perspective?

On balance, our metrics suggest that the current market environment is still conducive to risk taking. However, our analysis also underscores the need for a risk management process that complements standard measures of risk with systematic scenario analysis that reflects the scale, the duration and the potential for each identified scenario to cause broader market stress. This exercise, we believe, arms the investor with the ability to map each scenario to their specific portfolio construction process.

Any opinions, forecasts represent an assessment of the market environment at a specific time and is not intended to be a forecast of future events or a guarantee of future results. There is no guarantee that any forecasts made will come to pass.

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