BlackRock Investment Institute | October 2021

Market risk monitor

  • The story

    • Risk sentiment remains robust and asset correlations relatively low – keeping the environment constructive for risk-taking.
    • Yet we see the path narrowing for further gains in risk assets. Traditional valuation metrics show only median levels compensation for risk in U.S. and European equities at a time of heightened uncertainty on the growth and inflation outlook. We see little compensation for risk in fixed income broadly.
    • Current valuations depend on low interest rates even as inflation has risen. Our pro-risk stance is based on a view that central banks will respond much less to higher inflation than in the past, keeping the rise in nominal government bond yields in check – our new nominal theme. But the risk to our view is a change in their reaction function away from that implied by new policy frameworks.
    • We see less risk of an individual equity driver causing a sharp unwind. The value factor is not nearly as much of a drag on performance as before. Equity pullbacks have been shallower compared with 2020, keeping the resulting volatility spikes milder.

    Risk assets are still benefitting from the vaccine-driven restart that has spread beyond the U.S. Our indicators confirm that risk sentiment remains robust. Lingering nervousness over what lies beyond the economic restart continues to drive periodic bouts of volatility and jumps in the pricing of expected market volatility – but the spikes are less striking than earlier in the year. Interest rate volatility remains at historically rock-bottom levels, even with the rise in long-term government bond yields.

    Investors continue to be well rewarded for taking risk, but the path is narrowing for further gains in risk assets and valuations show little compensation for taking risk in fixed income more broadly. We maintain our tactical pro-risk stance but acknowledge risks of markets and policymakers misreading the current inflation surge. This could result in a surge in inflation expectations, central banks tightening policy prematurely or markets trying to anticipate a sharp tightening of monetary policy.

    Within equity drivers, the importance of both the value and volatility factors has reduced, partly reflecting the rebound in value and small cap shares this year. Oil remains a limited driver so far – despite the big gains in crude oil prices.

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Introduction

Investors often need to tread a careful path between taking sufficient risk to meet their goals and having the appropriate tools in place to manage that risk. Our Market Risk Monitor – powered by the work of BlackRock's Risk & Quantitative Analysis team in collaboration with the BlackRock Investment Institute – aims to help investors by providing insights for five metrics we deem essential to the management of portfolio risk. These are volatility, concentration, regime, persistence and risk premia. In our view, monitoring these five elements of risk can help investors build positions that are deliberate, diversified and appropriately scaled to conviction and market conditions.

Market risks change through time, sometimes smoothly but sometimes very rapidly. These changes usually have important implications for the appropriate positioning of many types of investment portfolios. BlackRock’s risk management philosophy is underpinned by a belief that risk positions should be deliberate, diversified and appropriately scaled to conviction and market conditions. Investors should tread a careful path between taking sufficient risks to meet their goals and having the appropriate tools in place to manage sudden and pronounced reversals in risk sentiment, in our view.

Our Market Risk Monitor demonstrates some of the key elements of market risk that we keep a close eye on. The table below details which areas show an elevated level of risk, according to our analysis.

 

Element of risk Level Direction of change
Volatility High High
Concentration High
Regime High
Persistence High
Valuation / Risk-premia

High High/rising       Neutral/unchanged     High Low/falling

Notes: This material represents BII's assessment of the market environment as of October 2021 and is not intended to be a forecast of future events or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any funds, strategy or security in particular.

Volatility

Expected volatility is a strong indicator of the risk of an asset. Volatility can be measured in different ways, but most often it involves tracking the standard deviation of returns over some sample period and capturing the dispersion – or potential dispersion of returns – over time. The biggest challenge in forecasting volatility is the speed with which it can change. Sometimes it surges rapidly, and the magnitude can be very large. As a result, the risks of assets and portfolios can change significantly, even when the underlying holdings are static.

The volatility chart shows the evolution of S&P 500 and U.S. Treasury implied volatility – the VIX and the MOVE indexes respectively. Implied volatility is the option market’s pricing of future volatility. The two markets have historically been correlated during periods of systemic risk, such as in 2008.

The VIX index has retreated after climbing in September during the equity market retreat. It still remains below the levels seen earlier this year and has gradually started to return to pre-Covid levels. The repeated, if short-lived, spikes during the year highlight the underlying nervousness about what comes beyond the economic restart and the potential for a wide range of outcomes. The MOVE index – a measure of bond market volatility – remains subdued even with the climb in U.S. Treasury yields in recent weeks. That perhaps reflects how central bank purchases of government bonds are helping limit interest rate volatility, helping underpin risk assets.

Concentration

The inter-relationship between assets is as important as the volatility of individual assets. Diversification is a key element of portfolio risk. Like volatility, correlations can change a great deal over time. Sometimes this change is slow; other times it can be very rapid and subject to jumps. This can induce enormous changes in portfolio risk.

The correlations chart shows a range of assets as represented by their respective indexes. These assets include bonds and equities of various kinds, and others such as commodities. In times of stress, returns of different asset classes tend to be highly correlated, implying a lack of diversification.

Correlations are generally medium to high. The correlation of EM and investment grade debt with DM government debt is on the high side, showing the duration risk from any push higher in long-term yields. That has been reflected in total returns this year. At the same time, the typically negative correlation in returns between DM equities and government debt is closer to zero now, suggesting reduced diversification for multi-asset portfolios.

The regime map

The regime map is a two-dimensional representation of the market risk environment in which we plot the market risk sentiment and the strength of asset correlations. Positive risk sentiment implies that, in broad terms, riskier assets are outperforming assets perceived as lower risk, such as government bonds. Negative risk sentiment implies that riskier assets are underperforming low-risk assets. Increasing correlations might suggest a market-wide response to a common underlying theme, such as the 2013 “taper tantrum.”

The possibility of rapid changes in short-term asset correlations can make it difficult for investors to ensure portfolios are appropriately positioned for the immediate future. When there is greater correlation among assets (represented by the right side of the regime map), it is harder to diversify and risk is greater. When asset prices are less correlated (the left side of the map), investors have more opportunities to diversify their portfolios.

When the location of both series – risk sentiment and asset correlation – on the map is relatively stable, forecasting risk and return is easier. But when market conditions are volatile and the location of both series varies rapidly, anticipating risk and return can be significantly more challenging. The map shows we remain in an environment of lower asset correlation and high risk sentiment overall, so investors are being rewarded for taking risk. This is in line our pro-risk stance on a tactical horizon, which is supported by a broadening global economic restart and still negative real interest rates. See our Global Outlook published in September 2021.

Persistence

Sometimes asset returns move far from where they started on very low volatility. When asset returns trend for an extended period, standard risk measures such as volatility fail to capture the risk associated with these moves. Monitoring trending market drivers – such as size and value, or oil prices – make it possible to gauge this risk over time.

The persistence chart shows the extent to which these market drivers explain one-year price momentum in global equities. For instance, it was the oil price that drove the equity market when crude prices plunged in 2015-2016 and again last year when oil prices went negative (see the green bars in the chart). Since 2018, it has been the systematic underperformance of value stocks and lately the outperformance of low-volatility stocks.

Higher overall persistence risk – when the bars in the chart are higher – shows that there is a greater amount of momentum behind a certain theme and the potential for a swifter fall in equity markets if that investment theme loses popularity. Overall persistence risk has dipped during the course of 2021. Value and volatility have been the main drivers of global equities over the last 12 months, though both fell in significance in the third quarter and are now some way below pre-Covid levels. Value is not nearly as much of a drag on performance as before. Oil grew in significance in September, although the size of the increase pales in comparison to the one experienced when oil prices turned negative in April 2020. Overall, the lack of a strong driver suggests less risk that one of these drivers could power a sharp reversal in risk assets.

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Valutation

Assets and securities that become expensive or cheap relative to their long-term norm can be risky simply because of valuation. Stretched valuations may be indicative of elevated conditional risk in the market, but the short-term correlation between valuation and return is inconsistent and therefore difficult to forecast. Valuation itself is sometimes an elusive concept to capture.

The chart illustrates this through the compensation for risk that investors receive as the earnings yield or credit spread relative to U.S. 10-year Treasury yield. The chart suggests that equity valuations are within or near the historical interquartile range, implying fair compensation for risk-taking. By contrast, relatively risky bonds show some stretched valuations with spreads at the narrow end of the long-term historical distribution. We see valuation risk overall as higher now compared with Q1 because of the wide range of potential outcomes beyond the restart. Potential returns in line with or below historical median levels is probably insufficient for such a wide range of outcomes.

Historically low interest rates – especially real yields – are the core justification for current asset valuations. But whether low rates persist will depend crucially on the interplay between interest rates, inflation and debt following the policy revolution in response to the Covid-19 shock. For more see Testing debt tolerance from February 2021.

Event risk

Extreme events can destabilise markets. Government policy is a very big component of the risk mix. See BlackRock’s Geopolitical Risk Dashboard for a tracker of geopolitical risks and their market impact.

 

Concentration and risk appetite

What does this chart show?
The regime map is a two-dimensional representation of the market risk environment in which we plot the market risk sentiment (y-axis) and the strength of asset correlations (x-axis). Positive risk sentiment implies that, in broad terms, riskier assets (such as equities) are outperforming assets perceived as lower risk, such as government bonds. Negative risk sentiment implies that riskier assets are underperforming low-risk assets. Increasing correlations might suggest a market wide response to a common underlying theme, such as the 2013 “taper tantrum” when many asset classes were affected. When there is greater correlation among assets (represented by the right side of the regime map), it is harder to diversify, and so there is greater risk. When there is lesser correlation among assets (the left side of the map), there are more opportunities for investors to diversify their portfolios, and so there is lower risk. In stable market conditions, where the location of both series – risk sentiment and asset correlation – remain in a tight range towards the top left of the map, forecasting risk and return is easier. This was largely the case in 2017, when the line on our map stayed in a tight range in the top-left quadrant. But when market conditions are volatile and the location of both series varies rapidly, forecasting both risk and return can be significantly more challenging. See 2019.

Select year:
Highlight events:
Past performance is not a reliable indicator of current or future results. It is not possible to invest directly in an index
Source: BlackRock Risk and Quantitative Analysis and BlackRock Investment Institute, October 2021. Risk sentiment shows our estimate of reward to risk based on our Risk Tolerance Index (RTI). The RTI is calculated as the rank correlation between risk (measured by annualised volatility) and the return of the asset classes shown in the concentration tab. The return series for each asset class 2013-2020 is estimated as the weighted moving average of daily returns over a rolling 40-day window. We use a 40-day period because our work finds it has historically worked the best for our short-term risk management purposes. Asset correlation is based on our Multi-Asset Correlation (MAC) index in the concentration tab. The MAC gauges the level of diversification across asset classes – stronger correlations provide less diversification, and weaker correlations provide more diversification. This helps us uncover the relative importance of a common driver of returns across these asset classes. The data is then rescaled so it can be more directly compared.
 

Correlation across asset classes

What does this chart show?
The upper diagonal shows the current cross-asset correlation based on 252 days of data, with more weight put on the last 40 days because that timeframe is consistent with our models for measuring short-term risk. The closer the number is to zero (either positive or negative), the weaker the correlation (see numbers in green). A higher number (positive or negative) indicates a strong correlation between asset classes (see the numbers in dark red). The lower diagonal is the percentile rank of this correlation over a five-year period. A green percentage number indicates that the current correlation is close to its five-year average.

High Medium to high Low
Index data provided for illustrative purposes only. Indices are unmanaged and it is not possible to invest directly in an index. Source: BlackRock Risk and Quantitative Analysis and BlackRock Investment Institute, with data from Bloomberg and Refinitiv, October 2021. Notes: Correlation based on a short-term (40 day) half-life using 252 days of data. Indices used are the Bloomberg Barclays World Govt Inflation Linked bonds TR USD for inflation-linked debt; Citi WGBI 7-10yr local currency for DM gov debt; Bloomberg Barclays Global Aggregate Corporate Total Return Index USD for IG debt; J.P. Morgan EMBI Plus Composite USD for EM gov debt; Bloomberg Barclays U.S. Corporate High Yield Total Return Index for HY debt; MSCI World Gross Total Return Index local currency for DM equity; MSCI Daily TR Gross Small Cap World USD for DM small cap equity; MSCI Daily TR Gross EM USD for EM equity. For private markets, we use the S&P Listed Private Equity Total Return Index USD for listed private equity, the S&P Global Infrastructure Total Return USD for Infrastructure and the FTSE EPRA NAREIT Developed TR USD for property. For commodities, we use the Bloomberg Commodities Index.

Implied volatility

What does this chart show?
We show the implied volatility of the S&P 500 and the implied volatility of U.S. Treasuries, the VIX and the MOVE respectively, over time at a monthly frequency. Implied volatility is the option market’s pricing of future volatility. The two series tend to be correlated during periods of systemic risk, such as in 2008. Yet in recent years VIX volatility has not translated into MOVE volatility. The historic distribution shows where the latest reading of implied volatility is compared with the past 30 years based on a range between the 5th and 95th percentiles, as well as the interquartile range (the band between the 25th and 75th percentiles).

Volatility through time

Historical distribution of volatility

Index data provided for illustrative purposes only. Indices are unmanaged and it is not possible to invest directly in an index. Sources: BlackRock Risk and Quantitative Analysis and BlackRock Investment Institute, with data from Bloomberg and Bank of America Merrill Lynch, October 2021. Notes: Charts based on the Chicago Board Options Exchange Volatility Index (VIX) and the Merrill Option Volatility Expectations (MOVE)© indices.
 

Market drivers of global equity performance

What does this chart show?
We break down the relative strength of global equity returns into broad themes - volatility, value, oil prices, quality and size - to assess how these themes explain the one-year price performance across stocks in the MSCI All Country World Index. Persistence in a market theme implies a widening gap between themes which is reflected in a higher number, creating the risk of a reversal and fragility in equity markets if investor sentiment changes. The chart shows how since the beginning of 2018, low volatility stocks (red) and value stocks (yellow) have both persistently been market drivers. Oil prices (green) have become much less a driver of global equities compared with the 2015-2016 oil price plunge when they were a significant driver of global equities. This chart does not tell us about market performance – just which themes are having the greatest influence on performance.

Index data provided for illustrative purposes only. Indices are unmanaged and it is not possible to invest directly in an index. Sources: BlackRock Risk and Quantitative Analysis and BlackRock Investment Institute, with data from Bloomberg and Refinitiv, October 2021. Our chosen drivers may change over time. Size is determined by measures such as market cap and total assets. Volatility is determined by measures such as the one-year price range and one-year standard deviation. Value is determined by traditional valuation measures such as book value to price and cash flow to price. Quality is determined by measures of profitability such as return on equity and return on assets. Oil’s persistence as a market driver is calculated using the oil price. Momentum identifies trends in asset prices. It is calculated as the 12 month minus 1 month return for each asset in the cross-section of the market.
 

Historical distribution of equity and bond yields

What does this chart show?
It shows the current value and the long-term distribution of cyclically adjusted earnings yields for major markets relative to long-term government bond yields in those markets. While this is a traditional method of judging equity market valuations in a longer term context, we use a different methodology in our capital market assumptions that adjusts for the structural decline in interest rates over the past four decades. We also show spreads for high yield and emerging market debt given their high correlation to equities.

Index data provided for illustrative purposes only. Indices are unmanaged and it is not possible to invest directly in an index. Past performance is not a reliable indicator of future results.
Sources: BlackRock Risk and Quantitative Analysis and BlackRock Investment Institute, with data from Bloomberg and Refinitiv, October 2021. Notes: The chart shows the long-term distribution of cyclically adjusted earnings yields for major global equity markets relative to the 10-year government bond yield in those markets. For fixed income we use yield spreads versus government bonds. Indices used are: S&P 500, Japan TOPIX, MSCI Europe, FTSE All-Share, MSCI Emerging Markets, Bloomberg Barclays US and European High Yield, JP Morgan EMBI Index. Valuation period is based on data since 2000.

Key takeaways

The volatility chart shows the evolution of S&P 500 and U.S. Treasury implied volatility – the VIX and the MOVE indexes respectively. Implied volatility is the option market’s pricing of future volatility. The two markets have historically been correlated during periods of systemic risk, such as in 2008.

The VIX index has retreated after climbing in September during the equity market retreat. It still remains below the levels seen earlier this year and has gradually started to return to pre-Covid levels. The repeated, if short-lived, spikes during the year highlight the underlying nervousness about what comes beyond the economic restart and the potential for a wide range of outcomes. The MOVE index – a measure of bond market volatility – remains subdued even with the climb in U.S. Treasury yields in recent weeks. That perhaps reflects how central bank purchases of government bonds are helping limit interest rate volatility, helping underpin risk assets.


Key takeaways

The correlations chart shows a range of assets as represented by their respective indexes. These assets include bonds and equities of various kinds, and others such as commodities. In times of stress, returns of different asset classes tend to be highly correlated, implying a lack of diversification.

Correlations are generally medium to high. The correlation of EM and investment grade debt with DM government debt is on the high side, showing the duration risk from any push higher in long-term yields. That has been reflected in total returns this year. At the same time, the typically negative correlation in returns between DM equities and government debt is closer to zero now, suggesting reduced diversification for multi-asset portfolios.


Key takeaways

The regime map is a two-dimensional representation of the market risk environment in which we plot the market risk sentiment and the strength of asset correlations. Positive risk sentiment implies that, in broad terms, riskier assets are outperforming assets perceived as lower risk, such as government bonds. Negative risk sentiment implies that riskier assets are underperforming low-risk assets. Increasing correlations might suggest a market-wide response to a common underlying theme, such as the 2013 “taper tantrum.”

The possibility of rapid changes in short-term asset correlations can make it difficult for investors to ensure portfolios are appropriately positioned for the immediate future. When there is greater correlation among assets (represented by the right side of the regime map), it is harder to diversify and risk is greater. When asset prices are less correlated (the left side of the map), investors have more opportunities to diversify their portfolios.

When the location of both series – risk sentiment and asset correlation – on the map is relatively stable, forecasting risk and return is easier. But when market conditions are volatile and the location of both series varies rapidly, anticipating risk and return can be significantly more challenging. The map shows we remain in an environment of lower asset correlation and high risk sentiment overall, so investors are being rewarded for taking risk. This is in line our pro-risk stance on a tactical horizon, which is supported by a broadening global economic restart and still negative real interest rates.


Key takeaways

Sometimes asset returns move far from where they started on very low volatility. When asset returns trend for an extended period, standard risk measures such as volatility fail to capture the risk associated with these moves. Monitoring trending market drivers – such as size and value, or oil prices – make it possible to gauge this risk over time.

The persistence chart shows the extent to which these market drivers explain one-year price momentum in global equities. For instance, it was the oil price that drove the equity market when crude prices plunged in 2015-2016 and again last year when oil prices went negative (see the green bars in the chart). Since 2018, it has been the systematic underperformance of value stocks and lately the outperformance of low-volatility stocks.

Higher overall persistence risk – when the bars in the chart are higher – shows that there is a greater amount of momentum behind a certain theme and the potential for a swifter fall in equity markets if that investment theme loses popularity. Overall persistence risk has dipped during the course of 2021. Value and volatility have been the main drivers of global equities over the last 12 months, though both fell in significance in the third quarter and are now some way below pre-Covid levels. Value is not nearly as much of a drag on performance as before. Oil grew in significance in September, although the size of the increase pales in comparison to the one experienced when oil prices turned negative in April 2020. Overall, the lack of a strong driver suggests less risk that one of these drivers could power a sharp reversal in risk assets.

 


Key takeaways

Assets and securities that become expensive or cheap relative to their long-term norm can be risky simply because of valuation. Stretched valuations may be indicative of elevated conditional risk in the market, but the short-term correlation between valuation and return is inconsistent and therefore difficult to forecast. Valuation itself is sometimes an elusive concept to capture.

The chart illustrates this through the compensation for risk that investors receive as the earnings yield or credit spread relative to U.S. 10-year Treasury yield. The chart suggests that equity valuations are within or near the historical interquartile range, implying fair compensation for risk-taking. By contrast, relatively risky bonds show some stretched valuations with spreads at the narrow end of the long-term historical distribution. We see valuation risk overall as higher now compared with Q1 because of the wide range of potential outcomes beyond the restart. Potential returns in line with or below historical median levels is probably insufficient for such a wide range of outcomes.

Historically low interest rates – especially real yields – are the core justification for current asset valuations. But whether low rates persist will depend crucially on the interplay between interest rates, inflation and debt following the policy revolution in response to the Covid-19 shock. For more see Testing debt tolerance from February 2021.