Market risk management & analytics: Relationships matter

Market risk management & analytics: Relationships matter

The negative relationship between stock and bond prices has been a solid portfolio diversifier over the last 20 years. If you go back to 1998, when the “Greenspan Put” was introduced (the attempt of the Federal Reserve Board to boost the securities market by lowering interest rates and help money flow into the markets), you notice that the traditional positive relationship between stocks and bonds flipped to negative. Up until that time, the fear of inflation was dominant. From 1998 onwards, the concern changed and markets started to have a fear of deflation or disinflation. Every time the equity markets showed structural weakness, the Fed and the other major global central banks would lower rates. They could certainly afford to do so as inflation was on the decline.

Because of the most extraordinary monetary policy initiatives of the last few years, government bonds, to this day, carry a tiny inflation risk premium and an inflation shock is completely discounted. Being long duration has been an effective portfolio hedge, while being long equities for yield enhancement and long duration for capital appreciation worked well as a strategy in the last few years, especially for private wealth portfolios. An investor wonders, however, how could the relationship between two such asset classes evolve in the future and how this should influence one’s portfolio positioning?

Whilst it is in the human nature to extrapolate what we have experienced in the recent past, investors should continuously assess the relationships between the different asset classes held in their portfolio. Correlations (the statistical measure indicating the extend to which two measures or variables fluctuate together) change over time, often performing dramatic changes from positive to negative and vice versa. Investors should therefore employ risk management analytics which enables them to identify, measure and mitigate such risks across all possible dissections of a multi-country, multi-asset, multi-sector, multi-currency portfolio, both on an individual and consolidated portfolio levels. Such measurements should be based on both ex-post and ex-ante methodologies and on both an absolute and relative basis.

Investors (and anyone else for that matter) cannot predict the future with certainty. What a sophisticated risk management system can do, however, is to assist an investor in assigning probabilities to various possible scenarios and thus enable its user to position a portfolio in a way that potentially mitigates the worst probable outcomes in a multi-option world. A lack of such a systematic investment approach would resemble more speculation than investing.

 

Posted on October 31, 2017Makis Ioannou, CEO KlarityRisk