Update Magazine I/2019 › Download the complete magazine

1 Insight No. 1: The biggest long-term risk is not taking any risks

After a decade of unorthodox central bank policy, defensive investments in bonds offer investors little compensation for resurgent inflation. In the vast majority of developed countries, real yields on government bonds are negative, even for long maturities (see Chart A/).

Institutional investors in continental Europe that traditionally had invested heavily in defensive fixedincome securities increasingly felt compelled to switch to corporate bonds and other spread market segments, as well as alternative investments, in order to be in a sustainable position to satisfy long-term obligations. For some groups of investors, strategic investments in equity markets were also suitable vehicles enabling them to participate in risk premiums. This strategic focus will increase the risks faced by these investors in the event of another market crisis. This gives rise to a strategic need for efficient risk management in order to avoid overtaxing institutional investors’ risk-bearing capacity.

Source: Bloomberg, AllianzGI, taking into account country-specific consumer price inflation, HICP for Eurozone countries, figures as of 1/2/2019. Past performance is not a reliable indicator of future results.

2 Insight No. 2: Market liquidity is central, but not a constant

The hot phase of the Great Financial Crisis started on August 9, 2007 when BNP Paribas froze three of its money-market funds to bar redemptions. While this initially affected ABSs, the liquidity crisis increasingly expanded to corporate bond markets. Then, for a short time in September-October 2008, it was hard to trade even European government bonds. Investors were at least able to find adequate liquidity on the equity and bond futures exchanges, even in the fall of 2008. In this regard, investors’ risk management position was and is sustainable if they can draw on the full range of financial instruments.

The financial architecture has changed further in the 10 years since the financial crisis. The increasing percentage of trading based on electronic algorithms, the fragmentation of trading volumes on alternative electronic trading platforms and the uninterrupted success of passive investments using ETFs raise doubts as to whether sufficient mutual liquidity will actually be available in the event of a crisis. The dramatic impact that electronically orchestrated (bogus) sell orders can have was demonstrated by the flash crash of May 6, 2010, when the S&P 500 dropped by almost 6% within a few minutes, and individual shares lost more than half of their market value in the short term.

Even the most liquid markets in the world are vulnerable to distortions that are compounded exponentially by algorithms. That presumably applies even more strongly to the significantly less liquid corporate bond markets and other spread markets: strategic demand from institutional investors and the support provided by central bank purchases have resulted in corporate bond markets whose liquidity has hardly been tested for years. A highly respected study of global liquidity by PwC in 2015 also refers to the decreasing liquidity after 2010, in particular with regard to the corporate bond markets. For example, European corporate bond trading volumes dropped by up to 45% between 2010 and 2015. Further indicators of diminishing market liquidity are the investment banks’ smaller trading positions: as an example, trading portfolios of U.S. corporate bonds shrank by almost 60% between 2008 and 2015.

Conclusion: the financial architecture has changed significantly since 2008. Consequently, for risk management, there is an even stronger focus than before on asset classes and, in particular, derivatives, which offer high liquidity based on efficient electronic trading.

3 Insight No. 3: Global economy and financial markets are at a crossroads in 2019

The global economy is in the ninth year of a widespread upturn. However, there is a noticeable decrease in growth momentum. Even the U.S. equity market, stoked by Donald Trump's tax reform, is on increasingly thin ice, as a glance at the market valuation of the S&P 500 according to the cyclically adjusted price-earnings ratio (“CAPE”) shows. With a CAPE of over 30, the valuation of the U.S. equity market in 2018 reached a level similar to that preceding the global economic crisis of the 1930s. The valuation level had significantly exceeded 30 only in 2000, which in hindsight is regarded as the high point of the tech bubble.

Another factor acting as a brake on future economic growth is the global debt level: after the 2008 financial crisis, public debt increased significantly, while the private sector largely failed to deleverage. In China, the private sector was in fact the main driver behind a historically rapid increase in the debt ratio over the past decade.

The high absolute valuation of equity markets and the expansion of global debt levels is not at all irrational, but rather is the result of the monetary policy pursued during the past decade. However, this policy of “quantitative easing”, conceived in response to the financial crisis, probably peaked in 2018, as a glance at the aggregate monetary base of the main central banks demonstrates (see Chart B/).

Source: Allianz Global Investors Global Economics & Strategy, Bloomberg (data as of 12/2018)

4 Sustainable risk management for the next 10 years

Clients view risk management as sustainably attractive if there is a reliable increase in stability in times of crisis, and opportunity costs remain manageable even in long bull markets. Risk management solutions based on the proprietary DMAP© (Dynamic Multi Asset Plus) investment approach of Allianz Global Investors focus on maintaining upside potential over a complete market cycle, while significantly reducing risks in poor fiscal years. This is made possible by applying the principle of “dynamic asset allocation”, which is efficiently implemented with futures and other derivatives.¹

Chart C/ and Chart D/ show the aggregate performance results for our mandates in the DMAP Asymmetric Total Return Composite. The chart on the left shows the dispersion in returns for rolling 12-month returns, illustrated by the average return and the respective maximum and minimum. Although under strategic asset allocation (SAA) the dispersion implies an almost symmetrical distribution around the mean value, for the DMAP Composite the realised dispersion in returns is asymmetric: the downside behaviour is significantly more attractive, which translates into a higher average return. At the same time, risk reduction in sharply negative market phases is not necessarily accompanied by a lower average return in positive market phases, as reflected by the chart on the right, where the rolling 12-month returns have been sorted into five quintiles in ascending order, and the average SAA and Composite quintile returns compared in phase. This clearly shows that the DMAP© strategy was able, on average, to generate added value both in the negative (Quintile 1) and positive market phases (Quintiles 2-5), whereas loss avoidance in bad times was significantly more pronounced than the generation of additional income in good times.

Risk management needs to consider two perspectives: first, a historical perspective in order to learn the lessons from past crises. Second, looking forward, crisis scenarios that have not yet occurred but are conceivable must also be taken into account. Algorithmic trading, which now has a dominant market share, and the reduction in trading positions by traditional market makers, are increasing the risk of discontinuities such as overnight risks. The dynamic hedging principle can be supplemented with option-based hedging features in order to reliably address such scenarios as well.

Source: IDS/Allianz Global Investors, as of 12/31/2018. Performance gross of fees in EUR.

Source: IDS/Allianz Global Investors, as of 12/31/2018. Performance gross of fees in EUR.

Scope recently gave Allianz Global Investors its highest rating, AAA, in recognition of its excellent quality and expertise as a provider of risk management overlay services. As the market leader with many years of experience in risk management overlays and in tail-risk management², Allianz Global Investors and our risk management experts at Risklab are exceedingly well positioned to provide efficient and innovative solutions for the next decade that meet the differing needs of institutional clients.

1) There is no guarantee that the strategy will succeed, and losses cannot be ruled out.

2) AAA (AMR) Asset Manager Rating by Scope, released on 9 August 2018. The analysis covered the aspects “Investment Professionals”, “Investment Process and Research”, “Market Position and Performance” and “Other internal and external Resources”. A ranking, a rating or an award gives no indication of future developments, and will change over time.

Investing involves risk. The statements contained herein may include statements of future expectations and other forward-looking statements that are based on management‘s current views and assumptions and involve known and unknown risks and uncertainties that could cause actual results, performance or events to differ materially from those expressed or implied in such statements. We assume no obligation to update any forward-looking statement. The value of an investment and the income from it may fall as well as rise and investors may not get back the full amount invested. There is no guarantee that the strategy will succeed and losses cannot be ruled out. Investors may not get back the full amount invested.

The volatility of fund unit prices may be increased or even strongly increased. Past performance is not a reliable indicator of future results. If the currency in which the past performance is displayed differs from the currency of the country in which the investor resides, then the investor should be aware that due to the exchange rate fluctuations the performance shown may be higher or lower if converted into the investor’s local currency.

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