Equity Risk Monitor Insights

This week we noted that financial stocks in the Russell 1000 fell sharply following last week’s comments by the Fed’s governor urging caution regarding the raising of interest rates. Falling insurance company shares due to Hurricane Harvey and now Irma added to the decline in the Financials sector fortunes. Financials had a hard time throughout August, but last week’s losses pushed its cumulative year-to-date return to just 3.43% (down from 9% for the year-to-date period ended July). Financials is the third-worst-performing sector in the Russell 1000 year to date, after Energy and Telecommunications (the two losers in the index). Financials also experienced an increase in risk over this period. Financials’ risk of 13% last Thursday kept it the third-riskiest sector in the index, after Energy and Telecommunications, a position it has held since May. However, Financials’ contribution to benchmark risk decreased recently. Its contribution to benchmark risk climbed after the US presidential election, reaching 20.5% in May, when the gap between its contribution and weight in the index widened to 6%. Since May, however, the sector’s contribution to risk has followed a declining trend, as its weight remained relatively flat, and therefore the gap shrunk. Still, the sector’s risk contribution is higher than what one might expect given its index weight. As of last Thursday, Financials’ contribution to risk of about 17% exceeded its weight in the Russell 1000 by about 3 percentage points.

Since early August the median pairwise realized 20-day stock correlation in the Russell 1000 has skyrocketed in the US. After dropping to 0.06 (a level not seen since 2001) in the beginning of August, the 20-day median shot up five-fold in only four weeks, reaching 0.30 last Thursday. The 60-day median pairwise asset correlation rose slightly over the same period. Higher asset correlations typically reflect concerns that economic and market events will drive stock prices rather than companies' individual characteristics, perhaps a reflection of the uneasiness created by the current geopolitical turmoil and the potential impact of Hurricanes Harvey and Irma on the US economy (although short-term correlations have risen in other markets as well). When looking at the decomposition of the change in risk from a stock-level perspective, the increase in stock correlations was entirely responsible for the one-month 40-basis point increase in risk for the Russell 1000. Lower stock volatility offset the increase in risk by 10 basis points, while the effect of changes in index composition was nil.

In contrast to what happened in other regions, equity risk in Australia’s ASX 200 dropped abruptly and substantially last month. At the end of July, Australia (in local currency) was the riskiest country among the regions Axioma tracks closely, after a sharp increase in its market risk over the prior three months. The increase came at a time when most other markets saw a decline. Since then, the situation reversed, with all four variants of Axioma’s Australia Model showing lower risk in the index over the past month. In particular, the short-horizon fundamental and statistical models recorded dramatic monthly drops of over 150 and 180 basis points, respectively. In just the past five days, the short-horizon fundamental model shed about 100 basis points, as risk remained flat or marginally declined in most other regions Axioma monitors closely (except in Japan where risk rose). By last Thursday Australia’s risk had dipped below that of Developed Europe, Japan, China, and Emerging Markets.

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Melissa Brown, CFA

As Managing Director of Applied Research, Melissa Brown generates unique insights into risk trends by consolidating and analyzing the vast amount of data on market and portfolio risk maintained by Axioma. Brown’s perspectives help both clients and prospects to better understand and adapt to the constantly changing risk environment.