While much has been written about the increase in VIX over the past few days, factor risk models—which can look at the risk of any index as well as the sources of the changes in risk—can provide substantial additional insights.
As we observed for VIX, risk model volatility shot up around the globe as the Dow’s biggest point-drop ever rippled through the markets on Monday, following on a smaller, but still substantial drop the prior Friday. Risk increased in all regions Axioma monitors closely, but the magnitude of the rise in volatility in the US was by far the largest. Following the abrupt market fall, Axioma’s short-horizon fundamental US4 model recorded an increase in its risk forecast of about 500 basis points over the past five days. Risk jumped a total of 455 basis points on Friday and Monday alone.
Even before the market rout of the last few days, as the US market posted new records in 2018, its risk had started to climb. By Monday, Russell 1000 short-horizon risk reached 12.42%, a level not seen since August 2016. Despite the jump, risk is still relatively low compared with historical levels, although it can perhaps be in the incipient phase of an upward trend. Volatility in the US has risen 720 basis points since the Russell 1000 hit a 35-year low of 5.25% on November 27, 2017.
After the US, the FTSE Global Developed index, Canada’s TSX Composite and the FTSE Emerging Markets index exhibited the biggest spikes in volatility over the past five days, their short-horizon risk surging 390, 200 and 190 basis points, respectively. China, as represented by CSI 300, showed the lowest increase in risk (of 20 basis points) over this period.
The US and Japan are now tied as the second-riskiest markets after Emerging Markets, while Australia (as measure by the ASX 200) became the least risky country.
In the US, the dramatic increase in overall risk was largely the result of higher market risk. Other components—industry, style and specific—have seen a slight upward drift, but that would not have driven the overall forecast higher.
The decomposition of the change in risk from the factor model perspective revealed that the increase in factor volatility drove 100% of the rise in US risk over the past five days. Factor volatility was also responsible for the positive change in risk in the other regions Axioma tracks closely, and, in most cases, it was boosted by an increase in factor correlations.
From the standpoint of the full covariance matrix, the rise in both stock volatility and asset-asset correlations spurred the increase in risk in all regions, with the exception of China, where almost half of the positive contribution of increased stock volatility was offset by a decrease in stock correlations.
See our daily risk monitors for more detail. Will risk come down just as sharply as it went up? History suggests it is more likely to remain elevated for a while, especially if investors view the drawdown as related to broader economic issues, such as potentially higher inflation and interest rates. This would likely keep asset correlations higher than they have been for some time, which will, in turn, give a boost to overall risk.