• Liquidity risk measures currently reflect little of the turmoil in markets. Both funding and liquidity risk sit at pre-crisis levels, suggesting that liquidity is reasonably good in money markets and not critical in the credit markets – at least for now. However, trading volumes have been consistently low in the last year and liquidity, by its nature, is transient, meaning it can quickly evaporate when it is most needed. We believe that investors should be concerned about liquidity risk across asset classes in 2016, particularly since there is a possibility of contagion.
• Event risk has proved to be particularly prescient in the last month, as evidence of the slowing Chinese economy and the rise in interest rates in the US prompted successive falls in the markets. Event risk is best assessed by two measures: turbulence and absorption. Turbulence refers to ongoing periods in which all or almost all assets behave uncharacteristically, while absorption refers to the ability of the markets to absorb shocks, therefore gauging susceptibility to systemic risk.
In the last year, markets behaved fairly typically, with fluctuations similar to those in most other years. However, the absorption ratio rose steadily from mid-2015 onwards, peaking at the end of the year. This is problematic, as the lack of turbulence could mean that the market has failed to price in the risk of a sudden sell-off.
Contagion: A further complication is the correlations among crises in different regions. Historically, crises have usually emerged in one market before spreading to others and then abating slowly. In 2015, local shocks did not become global, with only the August panic showing some signs of contagion.
At the time, the policies of central banks were near-identical around the world throughout the year, which could have helped contain shocks.
However, further tightening of US monetary policy by the Federal Reserve and the resulting policy divergence could increase the risk of contagion.
Mixed picture for messy markets: The risk profiles of the markets are particularly mixed. While they have behaved relatively normally over the last year, and could continue to do so, it is clear that the risk of a sudden shock is high.
The current absorption ratio suggests that markets would be vulnerable to such an event, with liquidity risk potentially spreading across asset classes and correlations changing rapidly. From this analysis, the case that diversified portfolios are currently more risky than they initially appear to be is strong, particularly where they rely on negative correlations to reduce risk.