Autumn 2014

INSIDE VIEW: Moving variables everywhere

GymnastApart from in Japan, much of Asia has experienced consecutive periods of rapidly changing volatility and correlation levels over recent years in reaction to external events. Olivier d’Assier of Axioma discusses risk. Geopolitical events in Ukraine, Gaza and Iraq should not necessarily impact markets thousands of miles away in Asia.  Also, domestic policy changes by the central banks of the US, Europe or Japan should not be the main volatility drivers of Hong Kong, Korea or Singapore markets.  Yet, despite little change in their domestic fundamentals, markets in Asia excluding Japan have experienced consecutive periods of rapidly changing volatility and correlation levels over recent years in reaction to such external events. These reactions are attributable to the huge pool of excess liquidity that has washed up in Asia looking for yield following years of quantitative easing (QE) programmess in the West.  This liquidity pool is much more sensitive to US interest rate policies than to local valuation fundamentals, and hence takes the driver’s seat when it comes to volatility changes in the region. PREDICT THE FUTURE
For Asian investors, the need to accurately predict the future direction of this pool is a prerequisite for adjusting their valuation models. Additionally, because the information flow necessary to make these predictions comes in after Asian market hours, investing in Asia has become akin to driving while looking in the rearview mirror.  The uncertainty that comes from a lack of timely information on this critical influencer of future performance adds to the riskiness of investing in Asia. Risk has been commonly defined as the volatility of returns. This volatility is driven by varying degrees of uncertainty about the future distribution of these returns. Free of these external macro events, the volatility of Asian markets as a whole is on par with that of Europe and only slightly above that of the US market. Macro news can affect predicted volatility in the region: between May and December last year, fears of tapering in the US, which would essentially “recall” this large pool of liquidity to that market, caused volatility to increase in Asia.  Being unable to predict the content of a speech by the chair of the US Federal Reserve or the outcome of peace negotiations in the Middle East during market hours leaves investors in this region with a higher uncertainty level. This, in turn, translates into wider confidence intervals around the distribution of future returns post-event. Given this, most investors choose to avoid participating in a market with unknown outcomes. Once uncertainty has cleared, and due to the excess liquidity floating around Asian markets, trading activity pick ups as investors re-enter the market looking for yield. They are following the adage that if you take care of the downside, the upside will take care of itself. This situation is not about to end soon. Despite strong data from the US, the US Federal Reserve is adamant about keeping a lid on interest rates until at least the second quarter of next year. The European Central Bank is about to start its QE programme and with the rising possibility that Europe will dip back into recession, this additional liquidity could well end up in Asia looking for yield.  The Bank of Japan has also been pumping liquidity into its market and has recently hinted that more could be coming to counteract the dampening effects of the recent sales tax hike in April. So despite fears of US liquidity returning home next year, there seems to be plenty of new liquidity coming to Asia from Europe and Japan. HUGE FUND FLOWS
What does this all mean for Asia excluding Japan going forward? Huge fund flows and geopolitical events will continue to blur the results of fundamental valuation models, especially with a question mark around both Japan and China’s economic growth. And with real asset prices at new highs and volatility levels with nowhere but up to go, there is plenty of downside risk to worry about.  Investors have been focused on being nimble and every volatility spike has been accompanied by a switch from small caps to large caps. So much so that size is the most volatile style factor in Axioma’s models by far, overtaking volatility and momentum – last year’s leaders. The positive correlation between size and volatility has reached 0.42, and between size and value 0.44. A large cap/low volatility/high value strategy would have earned 8.87% over six months. With the US being the only engine of global demand showing any strength, earnings growth in Asia will remain below the historical norm, unable to benefit from Europe and Japan. News flow will continue to be dominated by macro events and the large pool of anxious liquidity floating around regional markets will keep systemic sources of risk in control.  Investors should keep an eye on factor exposures in their portfolios and track changing correlations between them for signs of increased concentration risks.  There is upside potential in a factor rotation strategy with a disciplined focus on changing factor correlation being the key determinant of success. For stock selection strategies, the need to ensure that unwanted style exposures do not detract from performance will be important. Asian markets will remain heavily influenced by external events in the US, Europe, and Japan for months to come. The extra liquidity from multiple QE programmes will be adding leverage, amplifying any market moves and punishing the slightest lack of discipline in exposure management. The low levels of volatility are misleading and more representative of a lack of risk-taking than a low-risk environment. Low volatility and minimum variance strategies have outperformed after a prolonged period of underperformance since the last quarter of 2012. One earnings report season remains this year, and apart from that three-week period in late October, macro sources of risk will be dominant. Investors need to adopt a top-down and a bottom-up style, and to switch when called for. Proactive risk management with a disciplined and nimble investment process around style exposure management will give the best chance. Investment performance is a function of investor skill, a little bit of luck and humility during uncertainty. Risk management is as much about the latter as the first. Olivier d’Assier is Asia Pacific managing director at Axioma ©2014 funds global asia

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