Axioma Relaxed on Risk Outlook

Mid-year anxiety over both tapering by the US Federal Reserve and slowing growth in China, plus worries about the impact of the US government shutdown, drove market risk to a peak in the second quarter of 2013, but it was all downhill after that according to Axioma.

The risk management software firm, in its webinar analysis of 2013 trends in risk, reports that levels of risk in most markets ended the year lower than where they started.

“Although it was ‘risk off’ for many investors at mid-year, large cap US stocks ended up having their best year since 2003, despite the government shutdown, with consumer discretionary stocks leading the way,” said Melissa Brown, senior director of applied research at Axioma. “Relatively safe utilities brought up the rear of US sectors, albeit with positive return that might have looked quite strong in a different environment.”

The year was characterised in part by a shift in risk from west to east, though the change had more to do with trends in the west rather than the east.

“One of the most significant trends of 2013 was the continued decoupling of developing markets from emerging markets,” said Brown. “We saw it across the board, in equity, bond, currency and credit default swap [CDS] markets. The divergence of risk and return had major investor implications in terms of stock and country selection in emerging markets.”

After several years in which economic concerns revolved around certain countries and the euro, European markets saw their risk fall, especially after the second quarter. US and North American markets also experienced a decline in risk, while risk in Asian markets, with the exception of Japan, was flat-to-up over the past year. Emerging markets fared less well, with even the historically better-performing markets underperforming developed markets.

“Europe shook off many of its recent woes, as returns in both Greece and Ireland both soared,” added Brown. “Spain and Italy also had strong returns, and with less volatility than Ireland and Greece.”

Domestic economic concerns in Japan drove risk sharply higher, though as worries faded the fall-off was equally dramatic.

Low-Risk Outlook

Lower factor correlations and asset correlations also contributed to the decline in risk developed markets. Individual asset-asset correlations fell to levels not sustained since the mid-to-late 2000s. Factor correlations also fell in emerging markets, but the impact of the decline was largely offset by higher factor volatility.

“Lower correlations, along with the changes in risk geographically, resulted in investors becoming much more discriminating,” said Brown. “In the absence of a single overarching theme driving returns, investors placed their bets based on the individual merits of countries and individual assets within countries.”

Although low correlations often suggest a good environment for stock pickers, when combined with low volatility, it frequently means a difficult year for active managers. “Decent factor returns, especially for momentum, may have made the environment a little more conducive to quant manager outperformance in 2013,” said Brown.

“Of the regions we track, only the US saw lower-than-average monthly momentum returns in 2013, although on a risk-adjusted basis even in the US performance looked quite good,” said Brown. “Overall, on a risk-adjusted basis, momentum was far stronger than average in every region for the last 12 months.”

From a historical perspective, despite the second-quarter blip, risk in 2013 overall remained much closer to historically low levels than to high levels, noted Brown.

Looking ahead, while low risk often prompts concerns among investors about an impending increase, nothing on the horizon – based on Axioma’s risk data – suggests an uptick ahead, said Brown. In fact, short-horizon forecasts were below medium horizon for most of the year, suggesting that a decline in medium-horizon forecasts may be ahead for many countries, particularly Japan.

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