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Markets struggling to price risk

Anthony Rayner, co-manager of Miton’s multi-asset fund range, discusses how markets are struggling to price risk

Central banks are no longer focused on the world’s economies exiting a global recession in a synchronised fashion. Economies are on different growth paths and so central bank policy has diverged. In that sense, global monetary policy is less coordinated and economic risk is perceived to have fallen. However, central banks are still unified in their desire for a stable financial system, which remains fragile as it continues to bear significant debt. Currently, the short term known challenges to a healthier financial system are the cracks in the Eurozone project, Chinese asset bubbles bursting and the raising, at some point, of US rates.

These challenges are very different but they have a number of important factors in common. At the centre of them all lie the authorities, whose key short term objective is to avoid material capital loss to the extent that it threatens financial contagion in the first order and economic contagion in the second. These evolving issues are, to varying degrees, the primary reasons behind the very recent elevated market volatility. The Eurozone and China have the additional dimensions of political risk, which markets typically struggle to price. However, one thing is ‘normalised’ volatility and another is when markets dislocate. So far, financial markets have responded to events in Greece and China in a fairly localised way, with contagion pretty limited.

Has volatility been encouraged by QE?

Volatility is not a bad thing in itself. Arguably, the powerful and numerous Quantitative Easing (QE) programmes have been dominant in keeping volatility capped during a period when economic and financial risks have been elevated. Volatility increasing across a number of asset classes might not be so bad, as some of these programmes are exited and economic risk is perceived to have subsided in certain countries, such as the US and the UK.

However, maybe central banks are increasingly contributing to financial market stress. Some of the more recent surges in volatility, rather than being dampened by QE may well have been encouraged by QE, as market participants position themselves to benefit from well-flagged QE policy to the degree that it leads to herding behaviour into crowded trades and, ironically, instability in markets.

Examples of this would be euro weakness seen in the second half of last year and the early part of this year and, more recently, the volatility spikes in government bonds. In effect, we have seen ‘rolling’ volatility across certain asset classes.

In summary

The mix of risks has shifted from economic health to financial market health, whether this will remain the case is unclear, but central banks remain very much under the credibility spotlight. What does this mean for our portfolios? In an environment where markets are lurching from ‘risk-on’ to ‘risk-off’ on an almost daily basis it can be difficult to make sense of how asset class behaviour is changing and the degree to which the relationships between asset classes are changing. However, understanding the risk environment in this way forms a very important part of trying to ensure we have a truly diversified portfolio. More generally, ahead of the dust settling a little, we’re happier observing, rather than acting.

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