MARKET RISK REPORT Creeping Upwards May 2018
Executive summary Volatilities in general declined again their very elevated levels of the prior months. Asset volatilities were mixed relative to their 12-month averages, with equities mostly high but FX and bonds mostly low. Realised volatility (of the Eurostoxx index over 30 days) fell from 15.2% to 11.6% (high). Equity market price moves returned to positive on the month. Volatility trends were all downwards again. Sector volatilities ended at 10-2 and were mostly high relative to the last 12 months. Sovereign bond price moves were again small. Volatility moves were small and mixed, ending at 3-4% (but 0.9% in Japan). All were low. FX moves were moderate. Volatility moves were mixed and ended at 5-7%. Volatilities relative to the euro were again low to medium. Option volatility will have been lower than recently as underlying prices during the month were small and volatility of volatility dropped back for the US to 119% (medium). Commodities price moves were small, with the exception of a rally in oil. Volatility moves were also small e.g. Oil fractionally down to 24.4% (high down to medium), and Copper up to 19.3% (low back to high). Real Estate (equity) price moves were positive again. Volatility moves were mixed and finished at 7-1 (ranging from low to high). PE Funds fell fractionally as did hedge funds, with volatility moves mixed. Niall O Connor
Table of contents 1. Summary volatility matrix p. 4 2. Key News p. 5 3. Kurtosis & correlation in the equity markets p. 6-7 4. Equities p. 8-9 5. Equity Implied Volatility p. 10 6. Fixed Income p. 11 7. Foreign Exchange p. 12 8. (Equity) Options p. 13 9. Commodities p. 14 10. Real Estate (Real Estate Share Prices) & Alternatives p. 15-16
Summary volatility matrix Continuing subdued inflation figures assisted with moderating growth, and coupled with plenty of M&A proved supportive for equity markets. However, in the background, the US 2 year bond yield continued to creep upwards, rising from 2.3% to 2.. We use this as our proxy for riskfree (and minimal duration risk) assets, especially for dollar assets. The impact of a stronger dollar and higher short rates is already being felt in emerging markets, most notably in Argentina and Turkey. We continue to see a potential tipping point as risk-free money becomes more and more attractive, and growth less so. We can t be sure where the tipping point is, but we can t help but feel that at some point risk-free will look at least as attractive as risky (i.e. the reversal of the QE trade forcing investors to go longer duration and lower credit quality). That could well be the source of additional volatility in risk assets. ASSET CLASS EQUITIES VOLATILITY OF VOLATILITY GOVERNMENT BONDS FX VS $ COMMODITIES PROPERTY ALTERNATIVES KURTOSIS CORRELATION AREA LATEST VOLATILITY LATEST Z-SCORE REGIME North America 16.2% 1.1 high Asia ex-japan 11.3% 0.4 medium Europe 10.9% 0.5 high Japan (Nikkei) 9.1% -0.8 low Energy 16. 0.9 high Consumer Staples 11.6% 1.2 high Financials 10.2% -0.0 medium IT 19. 1.0 high Volatility of VIX 119% -0.3 medium Volatility of VSTOXX 9-0.6 low Germany 3.2% -0.8 low US 3.1% -0.6 low Japan 0.9% -0.6 low Italy 3.6% -2.2 low /$ 5.2% -1.9 low /Yen 4.6% -2.2 low /CHF 2.9% -1.3 low / 6.8% 0.1 medium Oil (Brent) 24.4% 0.3 medium Gold 11.3% 0.6 high Copper 19.3% 0.5 high US 14.7% 0.6 high Europe 6.9% -1.1 low Japan 11.7% 0.1 medium HFRX Global HF 3.4% 0.4 medium Avg PE Fund 117.4% 4.1 high ZCF 1% left (vs -2.33 for normal curve) Average market correlation with euro equities -2.84-1.1 HIGH 10.4% -0.6 low Note: Throughout the text we refer to volatilities as being "low", "medium" or "High". We define this by defining three equal "sized" regimes over the last 12 months. i.e. High volatility implies that volatility is in the upper third of its statistical range over the last 12 months. The table shows the "z-score" of the volatility of each market, i.e. how many standard deviations above (or below) the mean over the last 12 months each market's volatility is. 4
Key News Major Volatility-Driving Events There was plenty of volatility inducing news this month, with geopolitics and high levels of M&A. The US continued to push towards a trade war with China, including banning companies from doing business with the Chinese telecoms equipment manufacturer ZTE American sanctions against Russia caused several large stocks to sharply sell off, and also hit the Ruble. Geopolitical tensions, especially around Syria, caused the oil price to continue to rise. The US 10 year bond yield rose up through 3% and the 2 year through 2. Argentina upped rates to 30.2 to bolster the Peso The Turkish lira also continued to fall The IMF warned on continuing rises in global debt, to a new all-time high of $174trn Facebook s Q1 net profit grew by 63% y/y. Alphabet s grew by 73%. Tesla results showed continuing high levels of cash burn. Its shares were largely unchanged on the month though CBS bid for Viacom. Alibaba bought Ele.me for $10bn. Novartis agreed to pay $9bn for AveXis. Comcast bid $22bn for Sky. Shire looked to be recommending a bid of $64bn from Takeda. T-Mobil announced another merger attempt with Sprint. Sainsbury s said it was merging with Asda. Marathon said it was buying Andeavor. UK inflation surprisingly fell to just 2. GDP ESTIMATES FOR 2016, DEVELOPED COUNTRIES 3. 2. 2. 1. 1. 0. Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 2018 GDP estimates for developed countries were increased for Japan but reduced for the Euro area. GDP ESTIMATES FOR 2016, DEVELOPING COUNTRIES 8% 7% 6% 4% 3% 2% 1% US UK Spain Germany Euro Area Japan France Italy Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 China India Turkey Russia Brazil 2018 GDP growth forecasts for developing countries were increased for Russia, Brazil and Turkey. 5
Kurtosis in the equity markets Despite the big moves in markets this year, particularly to the downside, both tails of the distribution have still remained quite well behaved. The left tail ended at -2.84 vs -2.33 theoretical, and the right tail at +2.65 vs +2.33. 5 4 3 2 1 0-1 -2 CORNISH-FISCHER EXPANSION OF EURO STOXX 50 The left tail ended at -2.84 vs - 2.33 theoretical, and the right tail at +2.65 vs +2.33. -3-4 ZCF 1% left Z 1% left ZCF 1% right Z 1% right Methodology To capture a measure of both Skewness and Kurtosis we look at the Cornish-Fischer expansion, which gives a good measure of the tails of the equity market. (We use a 60-calendar day rolling basis). The underlying market we plot is the Eurostoxx 50, but other equity markets normally show very similar results. We plot on the chart the expected Z-scores for 1% left tail (i.e. a 99% VaR) and a 1% right tail assuming a normal distribution: +/- 2.33. We also show the Cornish-Fischer expansion result for the same market. This indicates how far from a normal distribution each tail was. On a long term basis on average the tails are slightly fatter than the normal distribution would suggest, which should not come as a surprise. What is perhaps more surprising is how much variation in fat-tailedness there has been: a daily 99% VaR has varied between -1 and -4.5 standard deviations over time. The biggest variationsfrom +/-2.33 came in 2008 and2010. 6
Inter-market correlations with EU equities 10 INTER-MARKET CORRELATIONS 1 AVERAGE CORRELATION 8 6 4 2-2 -4-6 -8 North America Japan Bunds (negative) /$ Average Average correlation dropped again to just 1 (medium down to low), as FX correlation fell again. Equity correlations fell slightly again on the month. 1 MULTI-ASSET PORTFOLIO 1 - -1 Average asset Multi-asset portfolio Diversification impact 3. AVERAGE VOLATILITIES We also look at a hypothetical multi-asset portfolio consisting of equities, bonds, gold, oil and hedge funds. Average asset volatility fell from 13.2% to 10.2%, but the benefit of (multi-asset) diversification reduced from -6.6% to -4.. In combination portfolio volatility dropped fractionally from 6. to 5.7%. 0.8% PORTFOLIO VOLATILITY Note: The chart shows 30-day correlation over time between different markets and the pan-euro equity market. Higher levels of correlation will in general lead to less ability to diversify risks, and higher portfolio volatility for given position holding volatility. 7
Equities Stock price STOCK PRICE PERFORMANCE: REGIONS (LOG SCALES) 2600 26,000 4.3 % Europe 1300 13,000 North America Europe Asia ex-japan Japan (rh axis) Major equity indices performance returned to positive across the board. North America was +0.4%, Asia ex-japan was +1.2% while Europe rebounded +4.3%%, and the Nikkei was +4.7%. STOCK PRICE PERFORMANCE: SECTORS (LOG SCALES) 250 240 230 220 210 200 190 180 170 Energy Consumer Staples IT Financials, rh axis Sector price moves were again very mixed. Energy was +9.4% on rising oil prices, Financials +0.6%, while IT was +0. and Consumer Staples -2.4% 150 145 140 135 130 125 120 115 110 105 100 0.6% FINANCIALS 0. IT 9.4% ENERGY 2.4% CONSUMER STAPLES 8
Equities Volatility EQUITY VOLATILITY: REGIONS 2 2 1 1 North America Europe Asia ex-japan Japan (Nikkei) 10.9% EUROPE Regional volatility moves were all downwards, sharply so for most regions and especially so for Japan. North America fell to 16.2% (high), Asia ex-japan fell to 11.3% (high to medium), Europe fell to 10.9% (high) and Japan (Nikkei) fell from 24.8% to 9.1% (high to low) EQUITY VOLATILITY: SECTORS 3 2 2 1 1 Energy Consumer Staples IT Financials Sector volatility moves were also downwards, but remained elevated relative to 2017. Energy fell to 16. (high) Consumer Staples rose to 11.6% (high), Financials fell to 10.2% (high to medium) and IT fell to 19. (high). 9
Equity Implied Volatility Market-Implied Near Term Outlook Implied Volatility Implied volatilities dropped, but were still high compared with (the possibly artificial) levels of 2017. The VIX fell from 20.0 to 15.9, while European implied volatility (VSTOXX) fell again from 17.4 to 13.7 on the month. IMPLIED VOLATILITY 35 30 15.9 VIX 40 25 15 10 5 0 13.7 VSTOXX 20 VSTOXX VIX Implied vs. Realised Volatility Both (European equity) realised and implied volatility fell sharply on the month. The ratio of implied/realised was broadly unchanged at 119%. This ratio remains fractionally above a neutral level, suggesting that the market expected there wouldn t be too much volatility-inducing news over the next 30 days compared to the last 30 days. IMPLIED VS. REALISED VOLATILITY 119%IMPLIED/REALISED VOLATILITY 4 3 3 Bond selloff (Jun) US tax reform (Nov) Inverse VIX (Jan) 30 25 2 20 2 15 1 10 1 Good economic growth (Sep) Trade wars (Feb) 5 - Implied Realised Implied / Realised (rh axis) Note: Note: the implied/realised volatility ratio gives an indication as to whether the market sees an event in the next 30 days (the implied volatility period) which will increase realised volatility (implied/realised >10, e.g. within 30 days prior to the Greek elections during the Greek crisis) or a period of relative calm after high realised volatility (implied/realised <10, e.g. immediately after Draghi s calming whatever it takes comments). 10
Fixed Income 10-Year Government Bond Futures PRICES OF 10Y BOND FUTURES 165 155 145 135 Prices Government bond price moves were again quite small. They were all slightly negative on the month. German bonds were -0.4%, US bonds were -1.3% and Japanese bonds -0.1%. 125 115 Germany US Japan Italy SPANISH 10Y BOND YIELD 2.0 1.8 Spanish bond yields fell rose fractionally to 1.3%. 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 Spain Yield VOLATILITY OF 10Y BOND FUTURES 8% 7% 6% 4% 3% 2% 1% Volatility Volatility moves were small and mixed on the month, and remained well below those of equities. German bonds fell to 3.2% (high back down to low), US bonds fell to 3.9% (high) and Japanese bonds rose to 1.4% (low up to high, on a very compressed range, compared to the last 12 months). 11 Germany US Japan Italy
Foreign Exchange = stayed unchanged vs. 0.8 % vs. 1.8% vs. $ Prices FX moves were again relatively moderate during the month. The Dollar rose by +1.8% vs the euro. The Yen lost -0.8% and Sterling was unchanged. 1.00 1.10 FX RATES VS. 0.65 0.70 1.20 0.75 1.30 0.80 1.40 0.85 1.50 0.90 1.60 /$ /JPY /100 / (rh axis) 0.95 Volatility FX volatility moves were mixed. /$ fell to 5.2% (medium down to low), /Yen fell to 4.6% (medium down to low), but / rose to 6.8% on Brexit uncertainties (low up to medium, relative to 12 month averages). VOLATILITY OF FX RATES VS. 5.2% vs. $ 6.8% vs. 4.6% vs. 12% 1 8% 6% 4% 2% / /Yen /$ Note: The charts show currencies vs. the. Axes on the first chart are inverted to show conventional currency quotations, but with higher on the chart representing a stronger currency vs. the euro. 12
(Equity) Options Option volatility is mainly driven by the volatility of volatility and moves in prices of the underlying instruments affecting options deltas. Volatility of Implied Volatility Volatility of implied volatility dropped again towards more normal levels in a historical context: they fell in the US to 119% and in Europe to 9. Volatility of volatility is unlikely to have been a big driver of option volatility during the month. VOLATILITY OF VOLATILITY 45 40 119% US 35 30 25 20 15 10 5 9 EUROPE Major (Regional Equity) price moves (Equity) prices saw smaller moves during the month, although Europe and Japan rallied hard mid-month. Price moves could have been drivers of option volatility, in some equities at least; moves in other asset classes were much smaller. 1 Volatility of VIX Volatility of VSTOXX CHANGE IN PRICES OF EQUITY INDICES, 30 DAYS 1 - -1-1 North America EU Asia ex-japan Japan Note on Treatment: Options show more complex behaviour than the other instruments we look at in this report, so we make some simplifying assumptions. As Calls and Puts are in effect polar opposites and in and out of the money options behave very differently, it is hard to generalise all options behaviour. However, we look at the two key drivers: volatility of implied volatility and major price movements of the underlying security. Implied volatility (via an option's Vega) drives option prices, so a big indicator of option price volatility is the volatility of implied volatility. But usually the biggest driver of individual option prices is the movement of the underlying (via the option Delta): a move in either direction will cause the option to go more in or out of the money (and a corresponding change in the option s Delta and price volatility). As a proxy for this, we look at the 30-day price swing of equity market indices; options on bonds or FX could of course behave differently. The 30-day period is relatively close to the time to maturity of many options. Calls and Puts will respond in opposite fashions: calls becoming more volatile (relative to the size of the underlying notional) as prices rise. 13 Note on Convertibles: Convertibles are in effect a combination of a bond and a call option, with the bond portion usually making little contribution to the instrument volatility unless the option is significantly out of the money. As such, convertible portfolios volatilities will tend to behave similarly to call option portfolios, and this commentary can be applied to convertibles as well as options.
7. OIL Commodities Prices Commodity price moves were small with the exception of oil. Oil rose by +7. on US/Iranian geopolitics and lack of Venezuelan production. Copper rose +0.9%, and Gold was almost unchanged at - 0.3%. 0.3% GOLD COMMODITIES PRICES 0.9% COPPER 120 110 100 90 80 70 60 50 40 1,800 1,600 1,400 1,200 1,000 800 600 Volatility Oil (Brent) Copper (indexed) Iron Ore Gold (rh axis) Volatility moves were generally small. Oil fell fractionally to 24.4% (high down to medium), Gold was also fractionally down to 11.3% (high), while Copper rebounded to 19.3% (low back to high). COMMODITIES VOLATILITY 3 3 2 2 1 1 Oil (Brent) Copper Gold Note: all prices refer to near futures rather than spot with the exception of iron ore which is a spot price. 14
Real Estate (Real Estate Share Prices) REAL ESTATE (REIT) PRICES 2,300 2,250 2,200 2,150 2,100 2,050 2,000 1,950 1,900 1,850 1,800 3,400 3,300 3,200 3,100 3,000 2,900 2,800 2,700 2,600 2,500 2,400 3.8%EUROPE 1.1% US Europe Japan (rh axis) US (rh axis) Real estate equities price moves were again positive on the month. Europe was +3.8%, the US was +1.1% while Japan was +5.. 5. JAPAN REAL ESTATE (REIT) VOLATILITY 2 2 1 1 Europe Japan US Volatility moves were mixed during the month. US rose to 14.7% (medium up to high), Europe fell to 6.9% (medium down to low) and Japan fell to 11.7% (high down to medium) Note: Note that for property we look at indices of the share prices of REITs, and not the underlying property directly, for which little real-time data is available. This is usually consistent with funds which tend to invest in property indirectly, e.g. via REITs or property companies. As REITs are usually focused on commercial property, residential property may also follow a slightly different pattern to that discussed in this article. 15
Alternatives ALTERNATIVES PRICES 1,250 1,200 1,150 1,100 1,050 1,000 Global Hedge Funds (EUR) Avg PE Fund (indexed) UK PE funds fell -0., while the average hedge fund lost -0.1%. 3.4% HFRX volatility 8% 7% 6% 4% AI VOLATILITY 3% 3.9% AVERAGE PE FUND 2% 1% Global Hedge Funds (EUR) an average PE fund Volatility of hedge funds fell to 3.4% (high down to medium) while the average PE fund rose to 3.9% (low up to medium by the standards of the last 12 months). 16
Definitions To avoid repetitions, the term volatility refers to annualised, 30-day average realised volatility in local currency unless otherwise specified. As such, it may be lower than, and lag, shorter-term market volatility in times of high market volatility. Charts show data up until 30th April 2018, and the commentary was written on or before 12th May 2018. Disclaimer The commentarydoes not constitute, and is not intended to constitute, investmentadvice. Any views expressed in this report are based on historical market data and as such cannot be interpreted as being forward-looking, or to constitute forecasts. Past movements are not necessarily indicative of future movements. Employeesof IRML/ARKUS FS may hold positions in securities mentioned. All expressions of opinion reflect the judgment of IRML/ARKUS FS at this date and are subject to change. Information has been obtained from sources considered reliable, but we do not guarantee that the report is accurate or complete. This document is not for US clients or distribution to the US. Arkus Financial Services - 2016 Arkus is the brand under which IRML S.A. operates and provides services This document is the property of IRML/Arkus FS and should not be copied or distributed to any third party without the prior consent of IRML/Arkus FS please contact us regarding distribution rights.