December 12, 2017
After almost a decade of weak inflation and low or even negative interest rates, some of the world’s central banks are actively pursuing a return to conventional monetary policy. With macroeconomic change, however, will come tests that may no longer feel familiar. Could 2018 be the year to revise approaches to risk management?
For the first time since the global financial crisis, interest rates and inflation are slowly starting to rise. The great quantitative easing experiment, credited with driving up asset prices and saving fragile economies, is gradually winding down. But in the meantime, the world’s financial markets have changed significantly.
Towards the end of the last decade, quantitative easing helped emerging markets benefit from what was essentially a kind of carry trade. As central banks focused on buying up bonds, investors were driven to look for yield in growing economies such as China and Brazil. Concerns about overpricing may have slowed down the once rapid flow of funds into emerging economies, but these markets remain a riskier proposition – and greater potential sources of yield – than conventional markets.
In fact, across developed economies, it is hard to find much evidence of risk at all. Just a glance, for example, at the supremely straight-lined plot of the S&P 500 over the past two-and-a-half years will tell you that major markets have rarely been less volatile. Central banks, quite simply, have done a sterling job of eliminating economic risk, by both supporting and heavily regulating their too-big-to-fail financial institutions – suppressing their profits but also making them and fellow blue-chip companies a safer investment.
Now, times are changing yet again, raising questions that haven’t tested economies – or risk practitioners – for many years.
Lately, investment managers and risk analysts have barely had to consider how macroeconomic shocks will affect their portfolios. As central banks helped make markets more predictable, certain subjects that used to be key to competent risk management became irrelevant and redundant. For those who study and model the impacts of market events, questions about inflation, interest rates and even liquidity have effectively disappeared from the day-to-day curriculum. So, what happens when risk analysts are examined on these issues once more?
Let’s take the case of inflation. Certain stocks and corporate bonds are more sensitive, because of the fundamentals of their businesses, to inflation shocks than others, or will perform better in inflationary scenarios – and investment managers will soon need to use more discretion in their allocation strategies.
It may also be necessary to re-examine approaches to liquidity. With long-only strategies working well across many asset classes in recent years, investors have had less need to be concerned about liquidating their investments. But in a faster-shifting market where funds are reallocated more frequently, we could shortly see more widespread concern about liquidity risk – another concept that hasn’t been much tested for a while.
How, then, can risk managers prepare for the return of the old normal?
To continue the examination analogy, there are no recent past papers to look at for guidance on managing macroeconomic shocks. After a period of more predictable questions, the exams are about to get stiffer and cover a greater range of trickier subjects that haven’t come up for some time. Just to pass forthcoming tests, risk practitioners will need to get down to some serious homework.
In the context of risk management, doing your homework means being able to use research tools that take you beyond simple reviews of recent history. In other words, risk models will need the ability to really dig into the macro fundamentals that are set to reshape the investment environment – through sophisticated scenario analysis.
Think of scenario analysis as a combination of reading up on the right textbooks and conducting the most appropriate experiments, in advance of the exam. When applied to funds under management, it addresses all the uncertainties that underlying investments face.
The smooth incline of indexes such as the S&P 100 cannot be expected to continue. Rockier times are on their way, and all kinds of macro shocks and “bad news” – from political upheaval to new monetary policies and market events – are set to have a greater impact on a fund’s wealth and how it should be allocated across different strategies.
Scenario analysis models the potential impacts of macro shocks at multiple levels, to the financial markets, industry sectors and to individual funds, long, short or hedged. It therefore allows risk managers to understand their assets’ exposure to certain risks – and, ultimately, how the value of their funds could fluctuate as a result.
With new tests for risk managers will come greater complexity. Economies and financial markets are increasingly interdependent and one shock may lead to another. Hence, rather than just deterministically looking at yield curve, risk management must also focus on how events propagate through different asset classes and markets. But these impacts will be far from uniform, creating fresh challenges for scenario analysis.
Consider this exam-style question: Will your funds benefit from an inflation shock? The answer is far from straightforward. If inflation were to more than double, and interest rates rose too, some companies would struggle to meet their debt obligations. However, although inflation and interest rates are clearly related, certain firms – and funds – may be reasonably insulated against an inflation shock but not a sharp rise in rates.
Alternatively: How could a rise in oil prices affect inflation? Again, there will not be a single outcome. A significant price-per-barrel increase could have a positive growth effect on economies that have been held back by low energy prices, and a deflationary impact on others. There’s also the balance between developed and emerging markets to factor in.
Advanced scenario analysis systems are designed to anticipate and help manage these complex interdependencies, and to investigate the impacts of such shocks. For large banks, this powerful technology can be used for mandatory stress tests against major shocks – the kind of events that affect credit conditions widely, and drive some companies to the wall. For investment managers, it can help take an informed view on less dramatic but still critical market trends, producing results that are easy to digest and will support day-to-day as well as longer-term investment decision-making.
In recent meetings with highly experienced risk managers around the world, most of them in North America, Europe and Asia Pacific have asked the same question – how best can we model the coming inflation, interest rate and liquidity shocks? Here, at least, the answer is simple. Volatility may come and go, but scenario analysis remains the most effective approach to managing its impact.
Naturally, fund managers themselves must take responsibility for their own risk mitigation strategy. However, the best possible starting point for each manager will be a standardized approach to risk reporting, together with the adoption of coherent multi-asset-class risk models and scenario analysis methodologies. And this is where fund administrators can make an essential contribution.
As money flows from one asset class to another in the search for yield, and with the rise in “passive” products such as index-based exchange traded funds, the fund administrator is in a good position to provide effective risk reporting across all asset classes. Armed with such insight, the administrator is also well placed to inform all the stakeholders within an asset management firm how the new/old normal is likely to bear on their performance.
So, instead of a patchwork of partial and incomplete risk views, fund administrators should be able to offer a complete overview of the new risk landscape. In turn, this service can become integral to the relationship of trust which binds managers to their administrator.
The key will be to provide the highest quality of reporting on the inflation- and rates-sensitivity of funds under administration. In so doing, fund administrators can prepare their customers in the best possible way for the new risk examination questions to which regulators and end-investors will need answers in 2018.