Market risk monitor

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.

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

High/rising       Neutral/unchanged      Low/falling

Notes: This material represents BII's assessment of the market environment as of February 2022 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.

Valuation

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.

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.