RiskInterest Rate RiskVolatile Markets, but a Relatively Calm Risk Landscape

Volatile Markets, but a Relatively Calm Risk Landscape

Investor concerns about central banks have
grown in recent weeks, especially since the US Federal Reserve tightened up its
monetary stance and indicated it will no longer flood the markets with
liquidity. It appears as though equity markets have suddenly shifted, from the
relatively benign, low-risk environment they experienced over the past 12 to 18
months to one that is much more uncertain. This tightening
by the Fed
, combined with slowing growth in China, fears about the impact
of Japan’s new economic policies, declining mining activity and many other
measures of economic health, seem to have put the brakes on many stock markets.

The increased economic uncertainty has translated to higher risk in
some markets, but the impact has been uneven. Axioma’s own ‘Quarterly Risk
Review’ assesses the state of risk in global publicly-traded equity markets and
the discussion of risk in this context reflects how volatile the group expects
indices to be over the next few months, expressed as an annual standard
deviation of returns in eight different markets: Asia Pacific ex-Japan;
Australia; China; Japan; Emerging Markets; Europe; Global Developed; and the
US. Axioma’s risk models combine moves in factors such as industries, countries
and currencies with correlations across factors.

Axioma currently
sees an environment in Europe and the US that has become just a bit more risky.
After bottoming out in March and April this year, predicted risk in these
markets is currently modestly higher than it was at the end of 2012. Risk
spiked sharply for the FTSE Developed Europe Index – which represents the
performance of 500 large and mid-cap companies in 16 developed European
markets, including the UK – in April along with the strong surge in stock
prices, but both risk and the market have levelled off since then.

While risk over and above that of the market for most countries within Europe
has gone up, in general the increase has been small – typically one percentage
point or less since the beginning of the year. Despite the announcement of its
upcoming removal from the investment decision support tools specialist MSCI’s
Developed Markets Index, Greece’s risk has actually gone down. However,
Greece’s risk remains significantly higher than that of most other markets,
both emerging and developed.

No Further Crisis on Horizon
for the Euro

One factor that has kept the FTSE Developed
Europe Index’s risk from rising, even as the markets tossed and turned, is the
recent relative calm of the euro. While country risk has increased slightly in
aggregate, currency risk has fallen over the past few weeks.

risk picture for Europe is not dramatically different from that of large-cap US
stocks, as measured by the Russell 1000 Index, where Axioma sees risk as also
roughly equivalent to where it was at the beginning of this year. Another
commonly-used measure of market expectations of future volatility is the
option-implied volatility indices VIX. The VIX index is currently at around the
same levels as it began 2013, and well below its long-term average level,
although it has rallied from the lows reached in March this year.

Figure 1: Median 60-day Asset-Asset Correlations.
Axioma Figure 1 Asset-asset Correlations
Source: Axioma.

correlations are a further risk-related measure that investors keep a close eye
on. When correlations are high, it suggests that stock returns are being driven
by a single unifying factor. When they are low, individual assets are more
likely to be moving based on their own fundamental characteristics.
Correlations of individual stocks within markets neared, or reached, all-time
highs in mid-2012 and have since fallen substantially. So far this year
correlations have increased somewhat, but have not approached their high levels
of a year ago. We view this positively, as it suggests there is not a global
theme driving all stocks in the same direction.

Concerns in Japan

Asian markets are perhaps more
interesting from a risk perspective. Risk has almost doubled in Japan so far
this year, mirroring the giddy enthusiasm and then substantial concerns about
the impact of new economic policies being put into place in the country. Japan
has gone from being one of the least risky major markets to one of the most
risky, in a very short period. Similarly, the Japanese yen (JPY) stands out as
being by far the most risky and worst-performing of the major currencies
relative to the US dollar, despite recovering some of its losses most recently.
In addition, the yen has been a diversifying factor, somewhat reducing Japanese
market risk for foreign investors.

Figure 2: Predicted
Risk: Axioma Short-Horizon Fundamental Forecast.

Axioma Figure 2 Predicted risk chart
Source: Axioma.

Risk for Australia’s ASX
200 index, up almost six percentage points since January, has climbed notably
as well.

Concerns about China’s economy have been bubbling to the
surface all year, and after peaking in February the level of the market is
roughly the same as it was at the start of 2013. However, risk in China has
actually been trending down along with the market itself.

Overall Risk Landscape: The Worst May be Over

what does all of this mean and what are the repercussions for corporate
treasury? Axioma believes that a few takeaways can be gathered from analysis of
the risk environment:

  • Both volatility and correlation are important
    components in determining market risk. If countries, currencies or individual
    stocks are volatile, but moves are uncorrelated with other factors or stocks,
    overall market risk does not necessarily have to rise. In other words,
    correlation can provide a strong diversification benefit.
  • Although
    there has been a pickup in volatility and correlations recently in most
    regions, it is important to note that expectations of risk remain quite low
    relative to what the markets have experienced in recent years. From 2008
    through mid-2012 the overall level of risk was much higher than it is now.
  • Given the ongoing concerns about central bank actions and their impact on
    the global economy, as well as the potential for rising interest rates, the
    expectation is for risk to continue to increase relative to where it started
    the year. However, Axioma does not anticipate levels rising back to anywhere
    near the levels reached at the height of the global financial and European
    sovereign debt crises.

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