Excellence. Responsibility. Innovation. Q2 2016 Hermes Investment Office Market Risk Insights Each social formation, through each of its material activities, exerts its influence upon the civic whole; and each of its ideas and ideals wins also its place and power. Patrick Geddes – sociologist and urban planner In our second Market Risk Insights of 2016, we again try to add some colour to the current environment. The markets were skittish in the first quarter, as we predicted. Even the sociologist quoted above, as familiar as he was with human interaction, would have been shocked by the speed with which the mood of the market changed, seemingly much faster than in the past. Oil alone fell nearly 30%, rallied some 27%, dropped over 22%, recovered This makes it even more challenging for investors and fund managers to almost 60%, before falling a final 8%; an exhausting time for market navigate the markets. We cannot underestimate the risks of real-world observers. Oil volatility spiked 81% by mid-February, while collapsing scenarios. But as investors we must bear some risk in order to generate back below its starting level of 48% towards the end of the quarter. returns, and must broaden and deepen our understanding of risk But it wasn’t just oil, all risky assets were chucked about. beyond traditional measures to capture the full picture. Risk is best considered a multi-headed hydra, one that changes shape Figure 1: Oil: price v volatility dramatically through time depending on market conditions. As such, 50 100 understanding the impact of market risks requires close analysis of the risks at hand. 45 90 40 80 index volatility Oil Summary 35 70 Key risks highlighted in this report: Oil price 30 60 Volatility will spike again this quarter Correlation risk has not disappeared 25 50 Liquidity risk could easily progress from being a concern 20 40 to a problem 14 Jan 16 14 11 Feb 16 11 Feb 28 Jan 16 28 25 Feb 16 25 Feb 31 Dec 15 31 31 Mar 16 31 10 Mar 16 Oil price (LHS) Oil volatility (RHS) We group our thinking into five key aspects of market risk: Source: Hermes, Bloomberg, CBOE as at 31 March 2016. 1. Volatility 2. Correlation risk Recent work by UBS supports the notion that sentiment was much 3. Stretch risk more persistent in the pre-financial crisis era than it is today, with the regularity of nervous peaks shrinking from nine-to-12 months 4. Liquidity risk to as little as three months today. 5. Event risk While investors must also consider the full gamut of risks, beyond pure financial-market risks, in this paper we will leave our analysis of the wider context for another day. For professional investors only www.hermes-investment.com Q2 2016 Volatility Figure 3: The volatility of volatility Looking solely at volatility has its pitfalls, but it remains a core building block for all risk analysis. The key is to consider forward-looking volatility through 16 several different lenses and across multiple asset classes. 14 Figure 2 shows the 52-week moving average of the VIX, the Merrill 12 Option Volatility Expectations (MOVE) Index, the Deutsche Bank 10 FX Volatility (Currency VIX) Index and the expected volatility of the Bloomberg Commodity Index (Commodity VIX). These measure 8 the implied volatility of equity markets, government bond markets, 6 currency markets and commodity markets respectively, and have been VVIX index values standardised to make them directly comparable. They each represent 4 the market’s expectation of future volatility, and are often viewed as a 2 benchmark of risk appetite. 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Figure 2: Moving averages of selected volatility measures VVIX reading 1-year moving average 4 Source: Hermes, Bloomberg, CBOE as at 31 March 2016. 3 Forward-looking volatility predictions rose in two distinct spikes during the quarter, the first during January and the second in late February 2 and early March, before returning to the longer-term moving average 1 level each time. Forward-looking volatility has not reached the heights of that first spike since 2011, aside from a short peak last August. We 0 expect further spikes at a higher frequency as 2016 unfolds, a reflection Normalised index of growing uncertainty. -1 We also look at cross-sectional dispersion as a volatility measure. It can -2 be thought of as a measure of the various opportunities available for 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 stock pickers in equity markets, reflecting the best-to-worst range at VIX MOVE Currency VIX Commodity VIX particular points in time. Source: Hermes, Bloomberg, CBOE, Deutsche Bank, Bank of America Merrill Lynch as at Figure 4: Cross-sectional dispersion of stock returns 31 March 2016. 20 Equity volatility rose dramatically as the first quarter unfolded, peaking 18 around the middle of February, before falling back to lower levels. However, 16 our normalised measure remains substantially above the average for 2015. 14 Bond volatility barely moved over the quarter, dipping modestly in the 12 second half, and remains well below its 2015 average. Currency volatility rose steadily as sentiment on the US dollar changed rapidly, while volatility 10 in the commodity and currency markets remained elevated at levels last 8 Correlation signal seen in 2013. A number of factors have led to an increase in market speed, 6 crowding, herding and short-term liquidity evaporation, and we would 4 anticipate that these will continue to lead to sudden drops and spikes in the 2 markets during the second quarter. 0 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Expectations for future volatility can be seen in the VVIX, a risk-neutral forecast of large-cap US equity index volatility. Cross-sectional volatility 12-month moving average Source: Hermes, Bloomberg, FTSE as at 31 March 2016. 2 Hermes Investment Office For European equities, dispersion rose above and then fell back to its longer- term moving average during the quarter, a move that was echoed in almost Correlation risk all regional equity markets. With a dampened risk environment taking hold Looking at volatility in isolation runs the risk of being both meaningless as the quarter progressed, dispersion decreased in most markets, even and misleading – we must also consider correlation, which measures though the long-term trend of increasing dispersion remains intact. Cross- the relationship between assets in a portfolio. Correlation is the second asset dispersion also continued its upward trend, suggesting an improving building block upon which the notion of diversification is grounded and, asset-picking environment all round. much like volatility, it is highly time variant. A new indicator for this quarter is the variance risk premium (VRP). It As investors, we must be careful about our use of the term correlation. measures the difference between market-implied volatility and realised Two variables with the same long-term trend could have a negative, risk. It is essentially a contrarian indicator, in that when it is high and short-term correlation coefficient, over-emphasising the level of positive it suggests that market participants are overly pessimistic about diversification available between them. Information regarding the market risk, and vice versa. long-term trend should be taken into consideration when assessing diversification. Given that correlation is typically measured with respect to mean values, we should also account for sample error. Figure 5: US equity variance risk premium 300 The markets appeared marginally more correlated at the end than at the beginning of the first quarter. However, the journey between those 200 two points was as traumatic as the trend in volatility. Across the quarter 100 we saw an increased correlation of all assets with oil. 0 Figure 6: Correlation of oil with US equities -100 Risk difference 0.5 -200 0.4 -300 0.3 -400 0.2 0.1 Correlation 1 Feb 08 9 Oct 15 11 Jun 10 9 May 13 17 Apr 15 27 Jun 08 29 Apr 14 21 Oct 14 31 Oct 13 21 Nov 11 23 Jun 09 31 Mar 16 31 May 11 17 May 12 12 Nov 15 Dec 09 03 Dec 10 22 Dec 08 0 Variance risk premium Z-score -0.1 -0.2 Source: Hermes, Deutsche Bank as at 31 March 2016. -0.3 When pessimism is highest, it could be an opportunity to buy risky 7 Jan 16 4 Feb 16 3 Mar 16 21 Jan 16 14 Jan 16 11 Feb 16 11 Feb 16 28 Jan 16 18 Feb 16 25 Feb 16 31 Dec 15 17 Mar 16 31 Mar 16 10 Mar 16 assets. During the quarter VRP spiked and then rapidly dropped, 24 Mar 16 highlighting the swings in market sentiment. Correlation (S&P500 Index,WTI Oil) We anticipated that 2016 could be a bumpy transition, but the start Source: Hermes, Bloomberg as at 31 March 2016. of the year was even rougher than we predicted. We expect the macro environment to remain fluid and volatile, so investors must stay nimble and able to take advantage of opportunities as they arise. With equity Early signs for the current quarter indicate a decline in the Oil/S&P 500 volatility falling to about 30% below its long-term average, things may correlation and a weakening of the US dollar/S&P 500 correlation too. appear too calm to be true. This will help to remove some market tail risk, but there is still a chance that the higher drift in correlations could resume. Analysing correlation surprise allows us to capture the degree of statistical unusualness in current correlation levels relative to history.