Market risk monitor. Assessing current risks RISK MANAGEMENT REGULATORY MARKETS INVESTMENT ACTIONS PORTFOLIO DESIGN

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1 FOR PROFESSIONAL/ INSTITUTIONAL/QUALIFIED INVESTORS AND PROFESSIONAL/PERMITTED CLIENTS ONLY RISK MANAGEMENT REGULATORY MARKETS INVESTMENT ACTIONS PORTFOLIO DESIGN Market risk monitor Assessing current risks

2 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. We seek to achieve that by measuring and calibrating risk through a number of key metrics. 2 ASSESSING CURRENT RISK

3 Content This quarterly update provides an overview of the market risk environment as at 30 ember 2017 through the analysis of six key components: 1 Volatility risk 2 Correlations and concentration 3 Persistence risk 4 Liquidity risk 5 Valuation risk 6 Event risk It is our belief that understanding the market risk environment and its implications for portfolio positioning may lead to better investment outcomes. In particular, a greater understanding of market risk may allow better calibration of portfolio risk for the purposes of targeting alpha and achieving return objectives. More detail on our approach and methodology can be found in our introductory publication: The elements of risk: analysing changing market conditions. MARKET RISK MONITOR 3

4 Overview The low-risk environment we have witnessed for an extended period has continued over the quarter with virtually all our risk metrics indicating an absence of major risk. This risk-on market regime across all public markets reflects a supportive macro-economic backdrop with an increasingly synchronised global economic upturn. While substantial geopolitical risk remains with the North Korean crisis being the most worrying example there appears to be no obvious catalyst that would trigger a significant risk reversal. 4 ASSESSING CURRENT RISKS

5 Looking at our metrics in more detail, we observe that volatility readings still track the bottom end of their longterm ranges and that our multi-asset concentration index still shows low correlation (high diversification) across different assets. There is neither notable persistence risk nor obvious signs of crowding. While some shorter-term valuation measures suggest that investors may not receive a sufficient rate of return for the risk taken, on a longerterm basis, (Cape-Shiller ten-year rolling PE) valuations do not appear stretched. Event risk, as mentioned, remains significant from both a geopolitical and a monetary policy transition perspective. However, over the quarter, markets have shown significant resilience when faced with negative, geopolitical news flow. What are key risks to watch? North Korea European politics, including Brexit China US tax reform The low risk environment described above is not new. In fact, in the years since the Global Financial Crisis it has become familiar. Yet it has proven to be an environment that many investors have found hard to navigate. Calibrating portfolio risk in current market conditions is challenging and warrants, in our view, significant stress testing of portfolios. We believe such scenario analysis can help investors deal better with the high levels of short-term volatility that we have seen in the aftermath of unexpected events. This counter-narrative has received increasing prominence in recent months and we believe it to be a major consideration in the calibration of portfolio risk. However, while it is undoubtedly true that there have been significant flows into these markets and that risk has increased in some of those segments, it remains, in our view, an open question whether this represents a serious, systemic risk. In this context it is also important to acknowledge the existence of a strong counter-narrative to the measured risk is low argument, relating to differences between public and private markets and the potential build-up of risk in areas such as private loans and high yield. This argument asserts that low interest rates in conjunction with the resulting search for yield create the preconditions for an excessive build-up of risk. While this risk is not visible in the volatility of public assets and thus does not manifest itself in the behaviour of asset prices, it nonetheless represents an important issue. The concern is that while markets may appear benign, and indeed the returns to risk assets may be positive for extended periods, there may come a point at which this hidden build-up of risk induces a significant correction in the price of risk assets. Consequently, it is still the case that based on the risk metrics presented here markets enjoy benign risk conditions, in which risk taking appear largely supported. Nevertheless, we note those counterarguments, and observe that close attention to economic variables such as interest rates and inflation may well be important in respect to ongoing decisions about portfolio risk taking. MARKET RISK MONITOR 5

6 MOVE Index (%) 1 Volatility risk Remarkably low What does exhibit 1 show? The time series of the VIX and the Merrill Option Volatility Expectations (MOVE) indices since January Note that these series are correlated as they are both influenced by systemic risk. Exhibit 1. Implied volatility VIX Index (%) VIX Index (%) VIX Index Quartiles 1-3 Median June MOVE Index (%) VIX MOVE Quartiles 1-3 Median June Source: Chart by BlackRock using data from Bloomberg. Merrill Lynch and Govt/FF&O Research data in USD as at end of ember Market volatility continues to be very low across equities and bonds. The box and whisker chart, above to the right, shows that even compared to a 12-month average, current implied volatility is very low. In the absence of any meaningful change in the macro-economic or geopolitical sphere, past history suggests that this low risk environment is likely to continue. However, the SKEW index is close to historical highs, indicating investors willingness to hedge against large market drawdowns. It points to increased nervousness about the withdrawal of QE and geopolitical event risk. 6 ASSESSING CURRENT RISKS

7 What does exhibit 2 show? The cross-sectional volatility seen in the S&P 500 since Elevated levels of cross-sectional volatility speak to higher return dispersion across assets. Other things being equal, active risk in a portfolio varies 1:1 with cross-sectional volatility, but not with absolute risk. Exhibit 2. Cross-sectional volatility in the S&P S&P 500 Index 14 Cross-sectional volatility (%) Cross-sectional volatility (%) S&P 500 Index Quartiles 1-3 Median June Source: Chart by BlackRock using data from MSCI and BlackRock data in USD as at end of ember Realised volatility continues to be low as well. We highlight this through the exhibits above. On the left hand side, we show the dispersion of realised returns of stocks in the S&P 500 on a monthly basis, while the whisker and box chart on the right hand side highlights that, as at quarter end, relative volatility was below its 12-month average. MARKET RISK MONITOR 7

8 2 Correlations and concentration A supportive background What does exhibit 3 show? The correlations across 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. Exhibit 3. Correlation across asset classes IL debt Dev sov debt IG debt EM sov debt HY debt Dev equity Dev sml cap equity EM equity Listed private equity Infrastructure Property Commodities ex energy Energy IL debt Dev sov debt IG debt EM sov debt HY debt Dev. equity Dev sml cap equity EM equity Listed private equity Infrastructure Property Commodities ex energy Energy N/A High Medium to high Low Source: BlackRock data as at end of ember Notes: Indices used are the Bloomberg Barclays World Govt Inflation Linked bonds TR USD for IL 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 US 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. The correlation matrix shows relatively low correlations in weekly returns across asset blocks, suggesting that there are significant diversification opportunities for multi-asset investors. It is noteworthy that while the high yielding debt block continues to behave like a single grouping, correlations across equities are relatively low. 8 ASSESSING CURRENT RISKS

9 What does exhibit 4 show? The time-varying relationship between risk and return as well as correlations between the different asset classes listed in exhibit 3 are as represented by their respective market index. On the X-axis, we measure diversification and on the Y-axis, the reward to risk. Exhibit 4. Risk premia and diversification opportunities November 2010 Less Return for risk More May 2002 August 2001 October 2008 High Diversification Low Source: BlackRock data as at end of ember The regime map combines the information from the correlation matrix, i.e. diversification in shortterm data, with the rank correlation between risk and return to plot the market to four potential regime types. The above chart echoes the stability in asset returns experienced over the quarter. The range of movement in our proprietary Risk Tolerance Index and across our multi-asset concentration map has been limited, suggesting a continuation of the risk-on, high diversification environment we have seen since the Trump election. MARKET RISK MONITOR 9

10 3 Persistence risk Subdued economic risk What does exhibit 5 show? It illustrates the ability of style factors to explain one-year price momentum in global equities, as measured by the MSCI All Country World Index. Higher values indicate concentration in the sources of return. Exhibit 5. Persistence risk (%) Oil Value Volatility Size Source: Chart by BlackRock using data from Reuters and BlackRock data in USD as at end of ember The exhibit above shows the correlation between price momentum and four prominent themes, value, volatility, size and oil, to help us tease out the macro-economic themes that may be driving the market. While there has been a significant dispersion in sector returns with information technology outperforming and energy underperforming the market, the quarter-end decomposition highlights momentum is at the bottom end of its historical range, reflecting subdued economic risk. 10 ASSESSING CURRENT RISKS

11 Market liquidity risk 4 Economic synchronisation What does exhibit 6 show? An aggregate score which combines positioning, flows and asset return data from EPFR Global. This measure is used to estimate crowding globally in government bond, credit, equity and foreign exchange markets. We focus on the scale and directionality of changes relative to the previous period. Exhibit 6. Crowding patterns 2.0 Less crowded Score More crowded Japan Emerging Eurozone US US Eurozone US Japan Emerging Eurozone Japan US Eurozone Emerging Government bonds Credit Equities FX 2017 June 2017 Source: Chart by BlackRock using data from EPFR Global, Bloomberg and BlackRock - data as at end of ember 2017 Notes: For all asset classes except commodities, aggregate level daily flow data into and out of mutual funds and ETFs is sourced from EPFR. Weekly open interest data for currency and commodities - published by the Commodity Futures Trading Commission - is sourced from Bloomberg. Overall crowdedness levels remain muted with z-scores staying comfortably within longterm distributions. The notable exception being the US dollar where changes in positioning have driven the score below -2. While the changes over the quarter have been muted, continued investor interest in EM rates and US credit is noteworthy. MARKET RISK MONITOR 11

12 5 Absolute valuation risk Closer to fair value What does exhibit 7 show? It shows the current value and the long-term distribution of cyclically adjusted earnings yields for major global equity markets. In the same context, we also show spreads for high yield and emerging market bonds. Exhibit 7. Absolute valuation risk 10 Expensive (%) Cheaper S&P 500 TOPIX Japan MSCI Europe FTSE All SHARE UK MSCI Emerging Markets US high yield European high yield Emerging market bonds Interquartile range Median 2017 June 2017 Time period varies according to data availability. EPS is trailing 12-month averaged over 10 years. Source: Chart by BlackRock using data from Bloomberg and BlackRock data in local currency for each market as at end of ember While shorter-term valuation measures look somewhat stretched, our preferred long-term measure still indicates that valuations across equities and credit are within the interquartile range for most markets. Changes in those valuations over the quarter have been limited, reflecting the absence of valuation risk in broad equity markets over the longer-term Even US treasury valuations, which could be expected to fall given the likelihood of another Fed Rate hike, were largely static over the quarter as geopolitical tensions pushed prices back up. 12 ASSESSING CURRENT RISKS

13 Relative valuation risk 6 Within range What does exhibit 8 show? Exhibit 8 shows the distribution of the relative valuations of segments of the market (MSCI Europe ex- UK Index) that appear stretched against their long-term history. Exhibit 8. Valuation of different market segments 80 Expensive (%) Cheaper Momentum Volatility Value Growth Emerging Quality Interquartile range Median 2017 June 2017 Time period varies according to data availability. EPS is trailing 12-month averaged over 10 years. Source: Chart by BlackRock using data from Bloomberg and BlackRock data in euros as at end of ember Relative valuations allow us to focus on themes that look expensive compared to longer-term history. Specifically, the gap between the median and current level of forward PEs can be indicative of the price change expected in the event of a factor/sector rotation. Over the quarter, realised valuations have remained largely unchanged. This includes value and quality. Both have moved in line with revised earnings forecasts, meaning they are still a relatively long way from their mean. This is not surprising as stretched valuations can persist over long periods. Overall, however, long-term valuations look supportive. MARKET RISK MONITOR 13

14 7 Event risk A key concern in current markets What does exhibit 9 show? It shows, through principal component analysis, how different event risks are correlated to a small number of key factors. In this instance, the key factors are broad equity exposure and emerging markets. Exhibit 9. Principal component analysis Search for yield continues Fed surprise delay Brexit-adverse Financial pressure European populism makes gains Struggle continues for EU Banks Carry on Growth anxiety recedes Towards trade harmony Credible fiscal policy Tax reform compromise Factor 1 Additional abenomics works Real growth Ineffective spending Energy sell-off European Transitory spike in vol underperformance Run for blue chips and treasuries Tax reform derailed Stagflation policy growth Escalating military conflict Regime change in vol Full-on trade war China credit crunch Factor 2 NIRP works Yield trade unwind Trump grand tax deal Time period varies according to data availability. EPS is trailing 12-month averaged over 10 years. This chart is for illustrative purposes only. There is no guarantee that these scenarios will occur. Scenarios are subject to change. We highlight only what we believe to be the main scenarios, but these should not be construed as recommendations or advice. Source: Chart by BlackRock using data from Bloomberg and BlackRock data as at end of ember Using insights from the BlackRock Investment Institute, we monitor and analyse a wide range of event risks, i.e. future events that may impact financial markets, but are absent in historical data. However, at present, the following are particular areas of focus: North Korea European politics, including Brexit China US tax reform 14 ASSESSING CURRENT RISKS

15 Conclusion Two risk narratives currently exist, with dramatically different portfolio implications. In the first, the supportive risk environment we have now observed over an extended period remains largely in place and continues to provide a positive background to asset returns. In the second, the hunt for yield and the unintended consequences of quantitative easing cause excessive risk taking, particularly within the less transparent private and leveraged market segments. While these risks are harder to quantify, there are parts of the capital markets where it is possible to notice some impact. However, as long as there is no meaningful change in the central scenario of an increasingly synchronised global recovery, the benign risk environment may well continue to dominate. We therefore believe that monitoring deviations from this central scenario should be a key aspect of portfolio positioning and risk management. MARKET RISK MONITOR 15

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