As individuals and businesses, we all encounter risks in various forms. The ability to understand and assess risk is an important discipline for any investor, and particularly important when considering investing in the financial markets.
Many major equities have started the year in a surprisingly positive fashion. Sentiment has been particularly optimistic driving global equity markets to, or close to, all time highs. There are many reasons why equity markets have reached these lofty levels. Many of the economic indicators have ticked up globally, showing a reasonably healthy picture, GDP growth forecasts have been revised up, leading to an expectation of corporate earnings growth, while business and consumer confidence surveys also point towards a positive outlook. In the US, speculation surrounding tax cuts, infrastructure spending and deregulation of financial services, all of which could boost the economy, has contributed to this positive sentiment. The economic landscape in the US is hugely significant for the state of the global economy, so it is perhaps unsurprising that the positive sentiment in the US has invigorated markets globally.
A cursory look at the headline numbers understates the current levels of risk in the market and may even be lulling investors into a false sense of security. The VIX (CBOE Volatility Index), sometimes referred to as the “fear Index”, measures the implied volatility of the market and is, therefore, a reflection of investors’ perception of future volatility or market risk. This year the VIX has averaged 12 which is well below its long-term average and suggests there is a little fear in the market today. Even looking at the term structure of the VIX, volatility is expected to rise but still remain below the long-term average. There are perhaps several reasons why the VIX is abnormally low but it does raise the question as to whether it is an adequate reflection of market risk?
Since the financial crisis, ultra-loose monetary policy was introduced by Central Banks and was predicated on generating growth and inflation in the underlying economy. The twin forces of Quantitative Easing (QE) and near-zero interest rates have done wonders for financial markets and been a significant boost for asset prices over the last few years, helping to suppress volatility. A consequence of ultra low interest rates is that investors’ appetite for risk is artificially increased as investors hunt for yield and returns. The opportunity cost of holding cash is such that investors are inclined to take on more risk than they are ordinarily comfortable taking on.
There is a well-known relationship between risk and reward which compares the expected rate of return of particular investment with the amount of risk taken to generate those returns. The starting point for this relationship is the so called “risk-free-rate” which is the theoretical return on an investment with zero risk. For US investors, the return on a three-month Treasury bill is often used as the risk-free-rate. Ever since the financial crisis, Central Banks have manipulated the risk-free-rate to record low levels and have kept it there for several years. It is, therefore, logical to suggest that if the risk-free-rate has been artificially low (mispriced) over this period, then the whole risk term has been distorted (mispriced).
What is apparent is that certain indicators do not seem to reflect the risks that are inherent in the markets. That is not to say that markets can’t trend higher from here, but as markets do trend higher they become riskier. Monetary policy has supported risk assets, but with valuations at elevated levels, equity markets remain vulnerable for a sell-off, particularly in the event of sentiment changes. We are also entering a period of interest rate “normalisation” in the US as the Federal Reserve has set its sights on raising interest rates back to normal levels. The unwinding of loose monetary policy and changes to the risk-free-rate could lead to an unravelling in volatility.
We know that markets can stay irrational longer than investors can stay solvent, therefore it is important for investors to understand the inherent risks associated with financial markets and recognise the distorting effect that ultra loose monetary policy has had on asset prices ever since the financial crisis.
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