Crisis - what crisis?

While the markets feel risky, the perceived risk has not been matched by a spike in market levels of implied volatility

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The sell-off in risk assets in February/March resulted in the VIX (a measure of implied volatility for the S&P500) jumping above 30; so far the recent market declines have seen only a brief spike in the Vix above 19 following the disappointing headline US unemployment report, although at the time of writing the index had already declined quickly back below 18.

Other measures are also more sanguine, such as the COTW, which shows the implied five-year probability of default in EM debt, based on CDS data (the arithmetic average of the constituent universe of the EMBI Global Diversified Index).

This risk measure is heading back to the lows seen in 2007 and certainly adds to the sense that there is not a more generalised concern on the macro outlook. Leading indicators, such as the yield curve in developed markets, equity markets themselves or the OECD series, are also not yet suggesting that the end of the cycle is nigh.

Portfolio construction challenges

We note that over the last 10 days or so the volatility of correlations has increased, which reduces the diversification benefits of any portfolio and therefore increases the forward looking risk profile. While this is a short-term observation it is in line with our medium-to-longer term views that cross asset class correlations will increase on trend, suggesting that any given portfolio is likely to be riskier over the next five years than the same portfolio’s realised risk was over most of the last 20 years or so.

This development argues for increased breadth in decisions as well as flexibility in approaching asset allocation and portfolio construction challenges.

David Shairp June 2011

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