APRIL 2019

Market risk monitor

  • The story

    After a tumultuous end to 2018, marked by a generalised risk-off tone across both equity and bond markets, we saw a dramatic reversal in the first quarter. Across the board, our elements of risk, including implied risk measures, valuations and concentration, appear to support risk taking. On the other hand, we observe several factors that point to a less straightforward narrative.

    Since the US Federal Reserve and other central banks hit the pause button on policy normalisation, equity markets have recouped most of their losses, while bond spreads have tightened across investment grade, high yield and emerging markets. Our global regime map illustrates the extent of the reversal in risk sentiment and concentration and suggests that we are now in a market environment that supports risk taking. 

    The VIX index, which measures implied volatility in the S&P 500, fell as rapidly this year as it rose in the last quarter of 2018 and is currently close to its low (25th percentile). Similarly, the MOVE index, which measures implied volatility in US treasuries, is currently close to its historical lows suggesting that investors do not expect major moves in the risk-free rate. In addition, we observe relatively high levels of diversification between investment grade, high yield and dollar denominated EM debt as well supportive equity multiples across major market indices.

    However, there are parts of the equity market where we see stretched valuations and elevated levels of risk. We highlight these areas under the persistence tab where we show the concentration of momentum. This chart distils the characteristics of stocks that are dominating market leadership. We calculate the proportion of total returns of stocks within the same index that can be explained by common factors. The quarter-end reading of the chart shows the market becoming increasingly thematic, as cheap (value) stocks have underperformed expensive (quality) stocks over an extended period. As these quality stocks become more expensive, there is an increased risk of a sector rotation in the event of a junk rally, similar to the one seen in March – August 2009. This scenario is unlikely given the BlackRock Investment Institute’s central case for modest growth at best. However, previous episodes suggest that these rotations can be significant.

    While market risk does not appear to be elevated based on current data, the Q4 risk-off episode should serve as a reminder that sudden changes in volatility have been the standout feature of financial markets since quantitative easing began in December 2008. Empirical measurement of VIX data suggests that the magnitude by which the index moves from low to high levels has increased significantly since 2008. Another hallmark of markets since the financial crisis has been rapidly changing correlations between equities and bonds as witnessed in Q4 2018 and Q1 2019. The final element to consider is the heightened geopolitical uncertainty across markets, as captured by the BlackRock Geopolitical Risk Dashboard, which potentially has significant implications for risk management.

    Overall, our metrics suggest that investors still need to 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.

    Source: BlackRock, 29th March, 2019

    Note - 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. This material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action. There is no guarantee that any forecasts made will come to pass.

Risk regime map Concentration Volatility Persistence Valuation
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Concentration and risk appetite

What does this chart show? The relationship between risk and return as well as correlations between the different asset classes, as represented by their respective market index. On the horizontal-axis, we measure diversification and on the vertical-axis, the reward to risk. Assets used are listed on the concentration tab.

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Source: Blackrock Investment Institute, April 2019. Notes: Based on correlations between the assets listed on the concentration tab. Market sentiment is based on our Risk Tolerance Index and measures asset return versus risk. Concentration is based on our Multi-Asset Concentration index. Time series are smoothed 20-day averages.
 

Correlation across asset classes

What does this chart show? The upper diagonal shows the correlation between asset classes as represented by their respective market index. A low number (green) indicates weak correlation, a high number (red) indicates strong correlation of either sign. The lower diagonal is the percentile rank of this correlation over a 5-year period.

Index data provided for illustrative purposes only. Indices are unmanaged and it is not possible to invest directly in an index. Source: Blackrock Investment Institute, April 2019. 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 index-linked debt; Citi WGBI 7-10yr local currency for Dev sov debt; Bloomberg Barclays Global Aggregate Corporate Total Return Index USD for IG debt; J.P. Morgan EMBI Plus Composite USD for EM sov debt; Bloomberg Barclays U.S. Corporate High Yield Total Return Index for HY debt; MSCI World Gross Total Return Index local currency for Dev equity; MSCI Daily TR Gross Small Cap World USD for Dev sml cap equity; MSCI Daily TR Gross EM USD for EM equity; S&P Listed Private Equity Total Return Index USD for Listed private equity; S&P Global Infrastructure Total Return USD for Infrastructure; FTSE EPRA NAREIT Developed TR USD for Property; Bloomberg ex Energy subindex USD for Commodities ex energy; Bloomberg sub Energy Index USD for Energy.

Implied volatility

What does this chart show?The time series of the Chicago Board Options Exchange Volatility Index (VIX) and the Merrill Option Volatility Expectations (MOVE)© indices since January 1990. Note that these series are correlated as they are both influenced by systemic risk.

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, with data from Bloomberg and Bank of America Merrill Lynch, April 2019. Notes: Charts based on the Chicago Board Options Exchange Volatility Index (VIX) and the Merrill Option Volatility Expectations (MOVE)© indices.
 

Factor drivers of global equity performance

What does this chart show? It illustrates the ability of style factors to explain one-year price momentum in global equities represented by the MSCI All Country World Index. Higher values indicate concentration in the sources of return.

Index data provided for illustrative purposes only. Indices are unmanaged and it is not possible to invest directly in an index. Sources: BlackRock, with data from Thomson Reuters and Bloomberg, April 2019.
 

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 global equity markets relative to the risk-free rate in those markets. In the same context, we also show spreads for high yield and emerging market bonds.

Index data provided for illustrative purposes only. Indices are unmanaged and it is not possible to invest directly in an index. Sources: BlackRock, with data from Bloomberg and Thomson Reuters, April 2019. Notes: The chart shows the long-term distribution of cyclically adjusted earnings yields for major global equity markets relative to the risk-free rate 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. Time period used varies according to availability.

Key takeaways

The chart shows the remarkable recovery in risk sentiment  over the last quarter, almost the positive mirror image of the steep decline experienced during the last months of 2018. We highlight previous episodes of major risk aversion in recent history by way of comparison. It shows how the move in the regime map was as large as seen at the end of 2015 and the beginning of 2016.

The regime map also underlines that in weekly data, correlations have continued to be fairly high through the drawdown and the recovery that we have seen so far.  

Key takeaways

The correlation between asset classes calculated over a short term window (using a 40 day half-life) shows relatively low correlations between developed market fixed income, emerging debt and credit.

The percentile rank of the correlations – bottom half of the chart –  also indicates that the current correlation between government bonds and other asset classes has moved towards the lower end of the observed 5-year time series.

Key takeaways

At the end of March, the VIX and the MOVE had moved back below long-term medians. This is a significant reversal from the end of December 2018 when the VIX breached 35%, almost twice the average level of the VIX over the whole of 2018.

These sharp and sudden changes in the level of implied volatility in equity markets have been a stand-out feature of the market over the past few years.

 

Key takeaways

The commonality in characteristics that have dominated market leadership has increased steadily since 2017. In broad terms, our metrics imply persistent outperformance of low volatility, high quality stocks and, conversely, systematic underperformance of value stocks.

However, the extent to which these common characteristics can  explain the return of outperforming stocks is relatively low compared to periods in the past, which include the sharp rise in the price of oil in 2016 and the sharp fall in highly volatile stocks in 2011 and 2015.

 

Key takeaways

Valuation risk is by definition a slow moving measure given that we use cyclically adjusted earnings over ten years.

Based on that timeframe, equity multiples appear either in line or cheaper than their long-term medians.

Spreads across emerging markets, Europe and high yield fixed income, however, remain tight when compared to their respective time series