Thursday, May 24, 2018

Volatility spike

The surprise return of volatility to stock markets worldwide this week may have implications for insurance portfolios.

A recent Pimco study of the top five Chinese life insurers showed that, although equities only represent 20% of their assets, equity risk drives 89% of portfolio volatility due to the turbulence of domestic stocks. But even in the US, equities represent 14% of health insurance assets, deliver 21% of the estimated total return and account for 41% of estimated volatility.

This sensitivity to equity volatility could be tested during 2018 after the stellar returns from risk assets last year, when global stocks gained 20%. Indeed, there are some fears that the second-longest bull market in history could come to an end this year as fears of inflation weigh on stocks.

After an utterly benign 2017, the The Chicago Board Options Exchange’s volatility index, VIX, which is known as the Fear Index spiked to its highest point since 2011 this week. Based on a scale of zero to 100, it was basically stable at around 10 for the whole of last year, but shot up to 50 on Tuesday.

There are certainly ways for insurers to mitigate such swings. “Sell programmes with futures can limit the amount of volatility that equity portfolios can contribute to the overall outcome of your total portfolio return in any one year so that when volatility is increasing you reduce some of that exposure to equity,” says one asset manager.

But doing this requires portfolio managers to be consciously managing it. This is not always the case. There are a broad range of elements that govern how an investment framework is created.

“Different health insurers focus on different sets of risk and return metrics when managing their portfolios,” notes Pimco.

Average volatility for each of the past six years has been below 20 and, while there have been fears for some time that markets were getting a bit frothy, nobody was forecasting the kind of turmoil that stocks have suffered this week.

It is far from clear why markets have been so wild this week. Most investors are overweight equity because of the continued strong growth fundamentals, benign inflationary environment and solid earnings.

Market commentators have pointed to data released last Friday that showed US wages were rising faster than expected. In any normal environment this would be just another data point supporting the positive momentum that got markets off to the best start to the year since 1987. Valuations in certain sectors might be a bit exuberant, but analysts say that we’re still below fair value at current interest rates — and considerably so after the drawdowns this week.

But the narrative that has gained currency is that investors are taking this wage rise as a portent of inflation. With unemployment at just 4% and company profits rising, perhaps the US Federal Reserve will hike interest rates more aggressively than the market has already priced in.

President Donald Trump’s tax cut might not have helped. With such strong underlying fundamentals, nobody in their right minds thought that corporate America needed a stimulus. The boost it has provided might have been enough to accelerate inflation fears, but most level-headed market participants see the sell-off as temporary — a buying opportunity for traders.

However, it is an indication of the level of nervousness — and therefore of more volatility ahead. After such a long period of low interest rates, rapid changes in rates and spreads are bound to result in a wilder ride in the capital markets.

And that means portfolio managers need to control their exposure to volatility. After a year in which investment returns contributed to good profits for many companies, 2018 is set to be a much trickier year.

 

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