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Equity Risk Monitors — October 3, 2023

Equity Risk Monitor Highlights | Week Ended September 29, 2023

  • Currency risk fell as US dollar strengthened
  • US Dollar’s strength drives high return for Exchange Rate Sensitivity
  • Short-Horizon model has risk down over the quarter, but the trading horizon model shows an 18% increase

Currency risk fell as US dollar strengthened

Most major currencies, in both developed and emerging markets, ended last week at or very near the low end of their 12-month volatility ranges and the high end of their return ranges over the same time period. The return data, however, masks the extraordinary strenth of the US dollar for the past few months, driven by higher interest rates in the US and an economy viewed as potentially more resilient to some of the economic forces buffeting other economies. We borrowed charts from our Multi-Asset-Class Risk Monitor to illustrate the six-month return and associated decline in risk.

While the decline in risk over the past year has been substantial, risk remains far above long-term low levels for most currencies. Risk for NOK, RUB and SEK remains at the high end of long-term risk estimates, whereas CHF and TRY arenearer the low end. Still, managers who are making currency bets may have seen currency-related changes to their active risk. Those who make deliberate active bets may be able to increase the size of the bets and maintain their target level of tracking error.

See charts from the Equity Risk Monitors for September 29, 2023:

Currency Risk and Return vs. USD

The following chart appears in our MAC Risk Monitor:

US dollar’s strength drives high return for Exchange Rate Sensitivity

As noted above, the US dollar has been strong relative to most major currencies since July. This strength has resulted in an unusually high return for the Exchange Rate Sensitivity factor in the US. Exchange Rate Sensitivity is a separate and distinct risk factor from a currency risk factor and, as the name implies, measures a stock’s sensitivity to movements in its home currency relative to a basket of currencies. If the stock fares well as the currency is appreciating (indicating a positive factor exposure), the implication is that it is an importer, although other company characteristics may come into play as well.

Over the past one, three and six months, the return of this factor in the US (both the US4 and US Small Cap models) has been two or more standard deviations above the long-term average return of about zero, reflecting the strength in the dollar. Given the magnitude of these returns (in US4, the 1 month return was 1.3%, 3 month was 2.0% and 6 month was 2.8%), a small exposure may have had a large impact on portfolio return.

See chart from the STOXX US Equity Risk Monitors for September 29, 2023­­:

Short-Horizon risk fell in Q3, but the trading horizon model shows an 18% increase

It has been a bit surprising to see the market fall in the third quarter and yet risk has continued its year-long decline in many regions. In general, risk has fallen as longer-term asset correlations have remained low, keeping risk down for both medium- and short-horizons. In the US, we are able to look at risk from an even shorter trading horizon, and here we see that risk has actually risen over the course of the quarter, from about 13.2% to 15.5%. The increase in ultra-short risk has come as the recent dynamics, especially since mid-September when the market has fallen in more than half the days, have sent the market tumbling. We expect to see short-horizon benchmark risk start to rise very soon, followed by medium-horizon. This also suggests that active risk is likely to increase as well.

The following chart does not appear in our Equity Risk Monitors but is available on request: