With most markets posting strong gains in Q312, Axioma reports that risk forecasts generated by its risk models dropped, paralleling a decline in the VIX to its lowest level since 2007, according to the latest edition of ‘Axioma Insight: Quarterly Risk Review’, a reference on the state of investment markets for portfolio managers, risk managers and other investment professionals.
“The data suggest an eerie calm in world financial markets, despite a raft of looming concerns, including the European debt crisis, the threat of a US ‘fiscal cliff’ and the slowing of growth in China,” said Melissa Brown, senior director, applied research and co-author of the report.
According to the report findings:
- Risk levels approached the levels observed before the financial crisis, and those that were sustained through the mid-1990s in the US as well.
- Risk dropped substantially around the globe during Q312, and short-horizon forecasts fell more than medium-horizon forecasts, in some cases a lot more. Since short-horizon forecasts tend to lead medium-horizon, the latter are likely to drop in coming months.
- The one major exception to this trend is China. Risk forecasts in the rest of Asia fell, but not as much as in Europe or North America. After the end of the quarter, risk continued to fall in many markets.
- Short-horizon risk was also sharply lower than it was a year ago, whereas medium-horizon risk was somewhat higher.
- Lower factor volatility drove the decrease in risk; decomposition of the full covariance matrix showed that lower correlations also contributed substantially. Again, China was the exception.
- Factor performance was quite muted during Q3, with few factors’ returns falling outside of a one-standard-deviation range. Low volatility fared well in some regions, but it did not do particularly well in the global benchmark. A region-by-region would have likely been more effective for low volatility strategies.
- Median correlations were generally lower at the end of the third quarter than at the end of the second, and well below recent peaks. Cross-sectional dispersion remained low, however, which may have impacted managers’ ability to outpace their benchmarks.
- There were a few significant changes in factor correlations.
- Falling risk and changing correlations may have necessitated more risk-related trading for managers to maintain expected levels of tracking error.
“The macro issues we are seeing in the headlines could already be baked into stock prices, and for that reason volatility has remained subdued,” said Brown. “Or, the extreme uncertainty in current markets may have simply paralysed investors, which would also have had a dampening effect on volatility. More ominously, this could also be the calm before the storm.”
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