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Five ways to measure market risk

27 May 2020 BlackRock Investment Institute

The story

• The coronavirus crisis crushed risk appetite in the first quarter. Unprecedented policy action then triggered a recovery in risk assets.
• Measures of market volatility soared past levels seen in the global financial crisis and remain at historically high levels.
• Attractive valuations have opened up in equity markets over the long term – yet the coronavirus shock is putting significant pressure on forward earnings.
• The underperformance of value stocks has become an ever-greater market driver.

The VIX – a measure of equity market volatility – has a median of 17 since 1991. Over the past five years, the VIX has spent most of the time below that median as we have experienced a period of remarkably low macroeconomic volatility. Yet as the coronavirus shock unfolded in March the VIX passed its peak value during the global financial crisis to rise above 82. Unprecedented global fiscal and monetary policy, as well as signs of coronavirus curves flattening, have since dampened volatility – but the VIX level is still comparable to other crisis periods such as the end of the tech bubble and the European sovereign debt crisis.

Both the speed and style of this crisis have been remarkable. The world has instigated an economic shutdown without historical precedent. The coordinated central bank and government action – of the sort we advocated in our August 2019 paper Dealing with the next downturn – eventually resulted in a sharp risk rally. Yet it remains to be seen if this injection of liquidity and government support will be enough to reassure markets if the second wave of infections hits developed markets. We also see the risk of the coronavirus shock morphing into more systemic financial pressures and potentially a financial crisis. But for now, we believe that the bold and broad policy response, especially in the U.S., is limiting this risk of a material escalation.

Our implied volatility charts show the huge spike in the uncertainty of equity and bond markets as they responded to the double whammy of plunging oil prices and the coronavirus pandemic. The regime map – which combines our measures of risk aversion and concentration in the market by pulling together information across asset classes – shows that markets were in a deep global risk-off regime as of April 13. Diversification between asset classes was almost non-existent. This represents an extreme, broad-based risk-off episode that is characteristic of sudden and deep shocks in financial markets – and is reminiscent of the global financial crisis.

The coronavirus shock has opened up the possibility of appealing equity returns on a long-term horizon. We highlighted before equity markets were reasonably valued relative to bonds. The recent selloff has made this risk premium higher for long-term investors – risk premia now look attractive because nominal yields are hovering near lows and they are based on cyclically adjusted earnings. It is important to note that the coronavirus shock is putting significant pressure on forwarding earnings and that this methodology – with interest rates so low – may be less useful as an indicator of valuation risk than it has been in the past.

In the near term, there is a risk of rotation in equity style factors. Value stocks – companies that are trading cheaply relative to fundamentals such as earnings – continued to underperform as investors sought safety in high-quality stocks. This trend leads to higher persistence risk and sets the scene for a factor rotation if there is an upside surprise in corporate earnings, the global policy response or inflation.

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