Volatility, increased correlations, the potential for falling liquidity levels and potential contagion are among the major risks facing investors over the remainder of 2016, according to Eoin Murray, head of the investment office at Hermes Investment Management. 
While 2015 turned out to be a fairly topsy-turvy year for investors, the backdrop has seemingly worsened in the first seven or so weeks of 2016.
According to FE Analytics, all major regional equity indices have fallen more than 3 per cent in price terms in 2016 with some even dropping into double-digit loss territory prior to last week’s market snapback.
Price performance of indices in 2016
Source: FE Analytics
The headwinds to have hurt sentiment this year are effectively those that plagued markets in 2015 – a falling oil price and China’s growth slowdown. However, more uncertainty has been thrown into the mix of late as there are concerns that financial stress in the energy sector could spread to the banks while, at the same time, there are signs that investors are increasingly losing faith in central bankers.
The latter can be shown by the 20 per cent rise in the gold price since the end of 2015.
Murray says it is increasingly apparent that markets are now at a critical juncture following what has largely been a very fruitful seven-year period for risk assets since the global financial crisis.
“Global markets began this year by bucking a trend. Usually buoyed by the so-called ‘January effect’, this time markets around the world slid on growing concerns about China’s economy, the oil price and the future path of interest rates,” Murray said.
“Investors are anxious and fear that this rout, following the volatility of last August, marks the start of a bear market. In this environment, it is vital for investors to be aware of the risk in their portfolios, as the distributions of asset returns are likely to change.”
In this article, Murray highlights five major risks facing investors that he and his team have pin-pointed and how they may affect a portfolio.
Volatility
First and foremost, Murray says that while volatility been rising of late due to macro uncertainty, investors shouldn’t expect it to dissipate any time soon.
However, though increased price swings may prove painful over the shorter term, Murray adds that long-term investors can use it to their advantage by adding to their favourite holdings at lower valuations.
“Volatility has undoubtedly increased given recent events. Even before the turmoil began, key indices showed that volatility was rising in equity and commodity markets and that it was only falling among currencies,” he said.
“Forward-looking indices indicate that investors should expect more frequent spikes in volatility. While these surges create uncertainty, they could also present opportunities for active investors to take advantage of rapidly changing prices.”
Correlation risk
While there maybe opportunities in the previous risk, Murray says the potential for rising correlations between asset classes is likely to be a more painful outcome.
“Correlation risk can often be an imperfect measure, as it reflects either a long or short-term view, rather than a nuanced combination of the two. It is also problematic during periods of market stress of the kind being experienced now, in which correlation levels can change rapidly before reverting at a later date.”
Certainly, FE data shows investors have been able to fine non-correlated assets in the 2016 so far, with government bonds retaking their role as the natural hedge against equity market volatility.
Performance of indices in 2016
Source: FE Analytics
However, Murray questions how long this trend will last.
“One way to address this is to use the standard deviation of the correlations between asset classes, which shows the stability and, importantly, the historical reliability of correlations. This measure indicates that although correlation risk was relatively subdued throughout 2015, it appears to be very unstable and is likely to change rapidly as we progress into 2016.”
Many agree with Murray on this, with the likes of Seneca’s Peter Elston recently arguing that traditional ‘safe haven’ are now more risky than equities given the very low yields on offer.
Liquidity risk
Fears over falling levels of liquidity, particularly in global credit markets, have been present for some time now but hasn’t been at the forefront of many investors’ minds of late given the various global headwinds.
However, with the likes of the US Federal Reserve having now stepped away from quantitative easing and rising interest rates, Murray says it is a risk all investors need to keep an eye on.
“Liquidity risk measures currently reflect little of the turmoil in markets. Both funding and liquidity risk sit at pre-crisis levels, suggesting that liquidity is reasonably good in money markets and not critical in the credit markets – at least for now.”
“However, trading volumes have been consistently low in the last year and liquidity, by its nature, is transient, meaning it can quickly evaporate when it is most needed. We believe that investors should be concerned about liquidity risk across asset classes in 2016, particularly since there is a possibility of contagion.”
Event risk
This risk, according to Murray, is a much harder outcome to prepare for than the others mentioned so far given it revolves around so-called ‘black swan’ events.
“Event risk has proved to be particularly prescient in the last month, as evidence of the slowing Chinese economy and the rise in interest rates in the US prompted successive falls in the markets. Event risk is best assessed by two measures: turbulence and absorption,” he said.
“Turbulence refers to ongoing periods in which all or almost all assets behave uncharacteristically, while absorption refers to the ability of the markets to absorb shocks, therefore gauging susceptibility to systemic risk.”
“In the last year, markets behaved fairly typically, with fluctuations similar to those in most other years.”
Performance of index in H2 2015
Source: FE Analytics
He added: “However, the absorption ratio rose steadily from mid-2015 onwards, peaking at the end of the year. This is problematic, as the lack of turbulence could mean that the market has failed to price in the risk of a sudden sell-off.”
Contagion
The final risk is arguably the greatest of them all.
Indeed, much has been written over recent weeks about the potential risk of contagion spreading from commodity-related industries into areas such as the banks.
On top of that, there is also the concern that the recent market falls will become self-fulling – which translates as bearish investors possibly creating the bear market (by continued selling) that they are worried about in the first place.
Given the nervous backdrop, Murray says investors need to be very aware of such an outcome.
“A further complication is the correlations among crises in different regions,” he said.
“Historically, crises have usually emerged in one market before spreading to others and then abating slowly. In 2015, local shocks did not become global, with only the August panic showing some signs of contagion.”
“At the time, the policies of central banks were near-identical around the world throughout the year, which could have helped contain shocks. However, further tightening of US monetary policy by the Federal Reserve and the resulting policy divergence could increase the risk of contagion.”
All told, Murray is concerned that the backdrop for global markets is very uncertain and that all asset classes are sensitive to downside scares. Therefore, he says investors need to look over their portfolios to make sure they are as diversified as they first believed.
“The risk profiles of the markets are particularly mixed. While they have behaved relatively normally over the last year, and could continue to do so, it is clear that the risk of a sudden shock is high,” Murray said.
“The current absorption ratio suggests that markets would be vulnerable to such an event, with liquidity risk potentially spreading across asset classes and correlations changing rapidly.”
He added: “From this analysis, the case that diversified portfolios are currently more risky than they initially appear to be is strong, particularly where they rely on negative correlations to reduce risk.”
