It’s almost four months since lock-down began for most of us in the UK and finally there seems to be reason to feel a bit more optimistic about the future. Slowly but surely, the high street is beginning to reopen, pubs and restaurants are welcoming back customers, people are starting to travel and for those who have been fortunate to be able to continue working from home, a return to the office is no longer out of the question. In fact, this week a small number of Validus employees have returned to our offices in Paddington and Eton and there is scope for our North American colleagues to do the same in Toronto next week.

With the pandemic seemingly under control, there is clear justification for being a little more optimistic about the months ahead and the start of a broad economic recovery. Last week, Bank of England Chief Economist, Andy Haldane, said that the recovery in the UK was happening faster than he and his colleagues had anticipated and many economic indicators have surpassed analysts’ expectations.

Looking at the markets, FX volatility continues to fall (the JP Morgan FX Volatility Index shown below has fallen from a high of 15% in March to 7.7% today) equity markets across the globe have posted a significant recovery and oil prices have stabilised around $40 per barrel. Clearly there is some justification for being more optimistic than we might have been in April / May, but when we see the S&P 500 within 7% of its all-time highs, I can’t help but wonder if things have gone too far too quickly.

JP Morgan FX Volatility Index

Source: Bloomberg

Working in risk management, we are often guilty of focusing too much about the downside and forgetting about the upside. However, in the current environment, we see three very broad reasons for remaining cautious:

  • Risk of a ‘second wave’ – from the start of the pandemic, doctors and scientists all warned of a likely second wave that would be bigger than the first. Obviously, it is a risk that everyone is aware of, but many have seemingly forgotten about it in recent weeks. We have already seen secondary outbreaks in many parts of the world, and while the argument could be made that Governments and medical practitioners are better equipped to deal with it now than they were back in March / April, the general public are not. 
  • Economic consequences and monetary policy – Governments and Central Banks have taken extreme measures to cushion the blow to their respective economies. The UK Government has already spent more than £25 billion paying people’s wages in the hope that employers will be able to welcome back staff as things return to normal. While this is set to continue (albeit in a slightly different form) in the coming months, it will not last forever, and unemployment will undoubtedly rise. Meanwhile, central banks around the world have taken further unprecedented steps to offer support but again, questions must be asked about how long this can continue. The BoE and the Fed both have negative rates at their disposal but understandably, both are reluctant to use them. Additional QE may help keep the bubble inflated, but we all know what happens to bubbles…
  • Political Uncertainty – Readers in the UK will understand Brexit negotiations remain ongoing with little sign of a trade deal in sight. Businesses across the UK have been told to plan for no deal, but with everything else going on, Brexit has fallen down the list of priorities for most. Meanwhile, across the pond, there is the small matter of a Presidential Election for the markets to contend with. Joe Biden is currently the bookies favourite (56% probability) with Trump relegated to second place (38% probability). We will expand more on this in the coming weeks but for now, we can go with the premise that where there is uncertainty, there is risk.

How markets react will be dependent on which of the three risk factors above takes centre stage. We have long become accustomed to ‘risk off’ resulting in a stronger dollar at the expense of all its peers, particularly EM currencies and sterling. If Brexit becomes more of a focus, we still see some downside risk for the pound in the short term although given that the currency is already trading at a significant discount to fair value, there should also be some upside if a deal can be reached.

Whatever the catalyst, we are encouraging our clients to think about precautionary measures for when volatility rises again. Whether it is a case of reviewing hedge ratios and the direct risk facing underlying portfolios or the indirect liquidity risk arising from hedging portfolios, now is the time to be giving it consideration, before it becomes a problem.

Author: Marc Cogliatti