Coping with high risk velocity
Even before Covid-19 started to rock markets, a new era of heightened volatility was unfolding. By Win Phromphaet
In today’s economic landscape, we have been seeing more late-cycle volatility, spurred by geopolitical tensions and slowing global growth — and this was before the spread of the coronavirus began to rock financial markets worldwide.
Prominent in any discussion of market risk is one question — how to mitigate it? Where does it actually exist in the current financial system?
As an asset manager, it is crucial that we respond promptly to any market uncertainties and volatilities to protect the interests of our customers and stakeholders. Understanding both the global and local context is essential.
After all, the way in which global investors think about asset allocation, identify yield opportunities and make decisions about risk management will alter the pace of growth.
In Thailand, we have observed heightened risk velocity in the stock market in recent years, largely driven by increasing dominance of three instruments: exchange-traded funds (ETFs), derivatives (especially single-stock futures) and algorithmic trading.
When coupled with external geopolitical risks, such as the trade war,
Brexit, US-Iran conflict, and now the global coronavirus pandemic, movements of more than 2-3% in the SET index within a few hours have become more common.
In the era of fast-paced online and algorithmic trading, when investors panic in the face of external shocks, they tend to react extremely quickly.
That is not to say markets are more volatile than they have been in previous cycles. However, the pace at which risks can transition has never been more rapid. This heightened risk velocity requires greater understanding.
PRICES VS EXPECTATIONS
Observable market dynamics currently at play include the disconnect between the price of assets and the expectation of the underlying economy. We are also seeing a migration towards lower-rated bonds as investors seek yield, and the proliferation of risk-sensitive investors.
Investors’ cognitive dynamics are also changing. The preferred medium for potentially market-moving politics and economic information is shifting from planned addresses to unplanned pronouncements on social media, such as the unfiltered Twitter lens of Donald Trump.
Innovation plays a part in this too — the evolution from a market peak driven by financial and industrial stocks to a tech-driven peak. We are seeing far greater scope for rapid disruption where economies have become systemically reliant on the prospects of the major tech companies.
These factors have undoubtedly contributed to heightened risk velocity. Principal believes the investors’ playbook must be adjusted by understanding the current heat map.
We view this as an opportunity to analyse risk velocity more comprehensively. First, let’s look at the dichotomy between asset prices and the underlying economy: How far and fast did markets move compared to the past year?
Principal’s latest publication on risk velocity noted that a growing disconnect between asset prices and the expectations for the underlying economy fuelled the potential for risks to be realised more rapidly than in previous cycles.
The equity and credit markets, for example, were defying both the weakening global backdrop and previous monetary tightening. The entry of new investment vehicles such as ETFs and systematic investment funds, coupled with perfection-priced markets, collectively quickened the pace at which those markets feel risk.
A glance at the bond market, on the other hand, reveals that in the past four years alone, the market for investmentgrade US corporate bonds increased from around US$4 trillion to $5.8 trillion. Unfortunately, there has been a decrease in overall credit quality.
‘‘ Tech giants not only carry an outsized risk in terms of their index weighting but also, in a tech-enabled economy, the reliance that all businesses have on their products.
TECH EFFECT
Picking up on the theme of the tech peak, we see that US growth stocks, particularly tech stocks, performed spectacularly well in the long bull market since March 2009. The IT sector of the S&P500 index surged nearly 600% since the March 2009 low versus about 330% for the underlying index.
The tech giants not only carry an outsized risk in terms of their index weighting but also, in a tech-enabled economy, the reliance that all businesses have on their products.
We are seeing this global trend spill over into the Thai market. Hence it is imperative to put in place measures to mitigate volatile and uncertain market sentiment and movement.
We believe the growth of the technology sector creates investment opportunities in many asset classes. For example, like many of their US peers, tech companies in Asia-Pacific are also generating double-digit profit growth. Examples are Samsung Electronics, Tencent Holdings and Taiwan Semiconductor.
In response to heightened risk velocity, we recommend clients remain calm, stay diversified and focus on asset allocation. Instead of putting all their eggs in Thai equity or Thai fixed income, we recommend adding three more asset classes: global equity, REITs and gold.
For clients who do not have time to construct their own portfolio, balanced-income funds are available in the market to help. Other useful products include target-date funds, which change asset allocation gradually as workers approach retirement. Some of these funds contain all five of the asset classes mentioned above, reducing risk and providing peace of mind, even in volatile markets.