Hermes' Murray: Five key risk factors to watch in 2017

A 'bumpy ride' ahead

Eoin Murray, head of investment at Hermes Investment Management, expects greater returns amid market volatility as he looks at the five key risks investors could face over the next 12 months. 

The ability of investors to digest uncertainty has never been stronger than in 2016, as equity markets moved serenely past Brexit and the ascent of Donald Trump. But does the current calm mask
underlying fragility?

Volatility - expect a bumpy ride ahead

Across the board in 2016, long-term implied volatility measures fell for all asset classes, excluding bond volatility. In the last quarter, we saw a modest spike around the US election, but that dissipated very quickly.

That is consistent looking at 2016 in its entirety, with each asset class choosing different times to have a short-lived volatility hiatus, but, in general, the volatility of all asset classes moved from low to lower.

Not only do we expect volatility to increase in 2017, we would urge investors to remain cautious of leveraging positions too far as the year progresses. Investors can expect a bumpier ride, but greater dispersion of returns will also lead to greater opportunity for active managers prepared to grasp it.

Correlation - are we set for a surprise?

Analysing correlation surprise allows us to capture the degree of statistical unusualness in current correlation levels relative to history. As with any statistical measure, its interpretation requires some caution. In general though, we can see spikes in correlation surprise followed, more often than not, by disappointing returns.

Our correlation surprise indicator began the last quarter at the highest level in the last 17 years. However, as the quarter progressed it fell back to more typical levels. We feel it is important to continue to watch the development of this signal. 

From time to time we would expect false positive signals, but we think it is wise to remain cautious about any portfolio assumptions with respect to cross-asset relationships.

Stretch risk - valuations on shaky ground

Stretch risk allows us to identify assets that trend in one direction for a considerable period of time, suppressing headline volatility to a reduced level, and giving an impression an asset is less risky than is the case. 

By and large, the fourth quarter of 2016 seemed to act as a turning point for certain assets which looked stretched either from a momentum or extreme valuation perspective.

One outlier is US equity markets which have risen strongly on the back of the US election result. It may seem very late in the cycle to many observers, but that alone will not stop equity momentum. 

While it dampened volatility, the extreme levels of intervention in certain key markets may well have hindered the mechanism of price discovery - creating a situation where investors' confidence in valuations has actually been weak and reliant on that intervention. This has led to an unstable floor for downside risk.

Liquidity risk - contagion still lurks

Over the last quarter, we have seen some considerable rotation in fund managers' most crowded trades. US equities are clearly much favoured over bonds, although the rotation is more nuanced than that, with bond-proxy stocks shifting significantly out of favour.
We believe concerns over liquidity risk in the corporate debt market remain highly relevant, and continue to closely monitor this liquidity alongside our credit portfolio managers. Liquidity in Bund futures reached a low for the year in December, having exhibited a number of illiquidity spikes during 2016.

It should come as no great surprise that we anticipate further spikes this next year, signifying greater uncertainty around various political events and Fed action. We continue to believe that liquidity will be the most likely transmission mechanism for contagion should any significant shocks derail the current stability.

Event risk - uncertainty to remain highly elevated

Our measure of global policy uncertainty reached a 16-year peak around Brexit, only to be surpassed by a new high around the time of the US election. This likely reflects global themes, as well as specific local concerns - rising debt levels in China will weigh on the outlook, alongside increased protectionism and the possibility of trade wars. We expect policy uncertainty to remain elevated throughout 2017.

Over the course of the last quarter, it is clear the optimists have held sway, but let's hope the market is not outweighing promise over fact. Given sentiment is an early warning for major market turns, we are concerned the percentage of bullish advisors has remained at a level which would normally suggest the taking of defensive measures for the sixth month in a row. 

So much of future market direction seems now to rest on the ability of the incoming Trump administration to deliver on their campaign pledges.

Event risk is a constant feature of financial markets. Our principal metrics for capturing it, the Turbulence Index and the Absorption Ratio, are both indicating relative lack of fragility. 

However, with the additional evidence of sentiment and increasing policy uncertainty both locally and around the globe, we err on the side of caution and contend that event risk is greater to the downside.

At an inflection point

While we might not agree with all the conclusions of the market, there is a real possibility we are at a point of inflection. The current calm may mask underlying fragility and makes it even more challenging for investors and fund managers to navigate the markets.

In this environment, we would encourage investors to shy away from any complacency implied by benign risk measures - objectively our metrics show only small glimpses of extreme risk, but they are sufficient for us to continue to voice at the very least a mild note of caution. 

While it is not an adverse environment for risk taking, adaptive risk management strategies remain the order of the day. Additional opportunities for active managers will be available to those that are capable of grasping them.