Friday, October 11th, 2019

New Risk Conditions Indices

The asset allocation picture remains confused. Our models are clear that equities are unattractive, even though there have been occasions when it looked as though would rally. By contrast, the momentum behind fixed income returns has been strong for most of the year apart from a brief period of profit-taking in early September. So far, so simple, but this isn’t happening in the way it normally does – and it is certainly not a repeat of Q4 2018.

Normally when equities struggle, their volatility relative to bonds rises strongly. In other words, the excess volatility of equities vs bonds is inversely correlated with their excess return. In the year to date, both asset classes have done well in absolute terms, but equities are unattractive because they carry much higher risk. However, in recent months, equity volatility, which is already low in relation to history, has been falling, while the volatility of governments bonds has begun to rise, even though it is already at its long run average.

This is a puzzle, which may have important implications for the rest of the year. We don’t have a good answer at the moment, but we can set out the data, so that clients understand the situation and are prepared to act when necessary. Regular readers will be familiar with our risk conditions index, which looks at multi-asset volatility across a number of equity regions, fixed income categories and alternatives. This week, we introduce more detailed versions of the same thing, based on a selection of developed and emerging equity markets and their equivalent government bond markets. Everything is based on local currency returns and benchmarked to the median volatility of individual country/asset over the last 25 years, except in the case of EM bonds, where we do not have a complete data set.

The risk conditions index for DM equities is 77 (versus a 25-year median of 100). It got to a local peak of 103 in March 2019 as we recovered from the sell-off in Q4 2018. Both the correction and the recovery were high volatility episodes. After that, the index fell to a local trough of 68 in July, before rising slightly to its current level. On its own, this would normally support a significant position in equities. The reason it doesn’t at the moment, is that bond returns are so strong. The risk conditions index for DM government bonds is 100 – in line with its long-run median. More importantly, it is now at a 30-month high, having risen from a low of 73 in June 2019. If it rises another 10 points to 110, it will hit a new 5-year high. We would normally regard this trend of rising volatility as a sign that central banks were losing control of their domestic bond markets, but most investors regard their current policies as being positive for performance.

The bottom line is that bond markets are behaving as though a recession is imminent and equities aren’t. We are just about to start the Q3 results season in the US and then Europe. If the news is bad, we expect to see a spike in equity volatility and a decline in returns, which would remove most of the inconsistency between the two risk conditions indices. This is our base case. But if there is no significant reduction to consensus forecasts for 2020, there may be a sharp sell-off in government bonds. This would make their risk-adjusted returns look a lot worse in absolute terms and those of equities look a lot better on a relative basis. Equities can’t stay where they are at the moment. There has to be a big correction or a big rally.

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