Can systemic risk come back in 2023?

In the latest instalment of Simply put, where we make macro calls with a multi-asset perspective, we analyse the outlook for systemic risk using an established measure of market turbulence over time. 

 

Need to know The 2022 rates shock has impaired markets’ ability to cope with new shocks The currently challenged disinflation trend could push central banks to tighten more With the lower capacity for shock absorption, this could trigger a harder landing for markets – a current risk for investors

 

Measuring resilience

The disinflation trend that emerged in Q4 last year offered breathing room for markets and investors until January. With a fresh batch of numbers putting disinflation to the test, markets have started to doubt that it can continue. Should the Federal Reserve (Fed) and the European Central Bank decide to increase the pressure they are already exerting on their respective economies and markets, financial stability could be at risk.

The next question is: where do we stand in terms of systemic risk? To answer that, we need a financial stability measure. We turned to the method presented by Kritzman et al. in 2010, which differentiates between the shocks that challenge financial stability and the capacity of markets to absorb them – their resilience capability. When computing these measures today, shocks are reemerging but the resilience of markets looks impaired.

Let us look at the numbers.

 

Absorption vs turbulence

In 2010, Kritzman et al. proposed a novel approach to gauging systemic risk, alongside an innovative yet simple methodology to measure it. Their approach separates market shocks from the capacity of markets to absorb them. The key idea here is to make a clear distinction between what is thrown at markets to digest and their coping ability.

The first notion is captured through the ‘turbulence ratio’, which computes as returns in excess of their trends, squared, and weighted by their underlying risk. A turbulent episode means that returns depart significantly from their recent trend and dwarf their recent volatility. September 2008, February 2018 and June 2022 are examples of when such turbulence affected markets – equities for the first two, and equities and bonds for the latter.

The second concept – absorption – is probably what makes this approach the most interesting. When markets receive a shock, it does not necessarily put financial stability at risk. For that, the authors see a second necessary condition: markets need to be in a situation where they are unable to absorb the shock. How do they propose to measure that absorption capacity? By comparing how much of markets’ total risk is explained by the largest common factors to markets, as extracted through ‘principal component analysis’, a statistical technique.

For example, in equity markets, when the first three to five factors explain an unusually high share of the total risk, the absorption capacity is clearly impaired. In other words, for markets to absorb shocks, they must be able to price in a large cross-section of risk factors.

Think of rates: when the first factor (the level of rates) explains an unusually large part of rates’ variance, it simply highlights how the pricing of rates is saturated by one common factor (usually monetary policy). Should this factor endure a shock, systemic risk could rise significantly. In their paper, the authors propose the rather intuitive approach, running a principal component analysis over 50 equity sector indices extracted from the S&P 500, retaining the first five factors and gauging their explanatory power over the total risk of that market. Their method clearly highlights how 2008 showed a rise in the absorption indicator prior to the Lehman Brothers collapse, highlighting the fragility of markets at that point in time. What can it say about today’s situation?

 

FIG 1. Absorption ratio across asset classes (top) vs turbulence (bottom) across two periods: 1994-2023 and 2021-2023

Source: Bloomberg, LOIM

 

Today’s systemic risk

Figure 1 shows the outcome of running these computations over different types of universes: US equities (as a replication of their results), government bond rates, credit spreads, currencies and commodities. We ran the methodology on these universes over the 1994-2023 period, using a 250-day look-back window and retaining, as recommended in the paper, one factor for every five series. The figure shows the absorption ratio and the turbulence measure separately.

Starting with the turbulence ratio, the chart clearly indicates how 2022 was marked by widespread  turbulence. The shock originated in bonds, peaking in that asset class in December 2021 before spreading to others. After a second bond shock in August 2022, the turbulence indicator then declined continuously until today. From that angle, today’s rates shock seems more likely to be behind us than ahead.

From today’s standpoint, the interesting part is the absorption ratio. Between summer and winter 2021, most absorption ratios fell to one of their lowest historical points, showing how the consistent pricing of Covid risk was quickly evaporating in markets and investors were starting to focus on other risk factors. In late 2021, as the bond turbulence peaked, the rather good absorption capacities of markets started deteriorating. This has impacted most markets, but credit seems to be where the deterioration is most visible.

Being based on credit-default swap indices, today’s situation in credit markets cannot be compared with 2008, but we can probably use the authors’ results regarding equities. The findings call for caution in 2023: when the absorption ratio increases by one standard deviation, equity returns are on average equal to approximatively -3% in the month that follows (based on the 1998-2010 period).

The analysis of such metrics remains a call for caution for now: with the 2022 rates shock, the capacity of markets to absorb new shocks is probably depleted today. This could limit the capacity of central banks to fight rather sticky inflation without harming markets profoundly. From that standpoint, a resumption of the disinflation trend would be more than welcome.

 

Simply put, the 2022 rates shock has impaired the capacity of markets to cope with new shocks. Disinflation now would avoid a situation where the Fed put this coping capacity to a further test – with unwelcome consequences.

 

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Macro/nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for world growth, world inflation surprises and world monetary policy surprises are designed to keep track of the latest macro drivers making markets tick. 

Our nowcasting indicators currently point to:

• Our growth indicator declined again this week, essentially with the US data. Our indicator is clearly entering into low zones
• Inflation surprises should remain negative, as the Eurozone indicator has fallen again this week
• Our monetary policy indicator has crossed the 45% threshold and remains below this level for now. Some status quo from our central bankers should be expected from that angle
   

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicators gather economic indicators in a point-in-time manner to measure the likelihood of three macro risks – growth, inflation surprises and monetary policy surprises. The nowcasters vary between zero (low growth, low inflation surprises and dovish monetary policy) and 100% (high growth, high inflation surprises and hawkish monetary policy).

 

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