Quantifying “unconventional” risks

TSAI

As we head into 2024, it may be worth paying attention to “unconventional” risks, including monetary policy risk, political risk, and geopolitical risk. This article explores one way to measure such risks and shows how they interact with stock prices and volatility.

 

Global equities appear to be off to a fairly positive start this year. Market participants may find optimism tempting amid a generally favorable macroeconomic backdrop in the U.S. and Europe, decent earnings growth, and realized volatility near 50-year lows. But they should also be cognizant of potential important sources of “unconventional” risk, i.e., risk that cannot be directly observed, particularly in monetary policy, politics, and geopolitics.

On the monetary policy front, the Federal Open Market Committee (FOMC) recently raised its growth forecast and lowered its unemployment forecast, and markets are pricing in back-to-back rate hikes.

Political risk comes in many forms, but the most relevant to public companies are those related to fiscal policy (about which uncertainty has been rising, as we recently noted), regulatory changes, changes in healthcare policy, infrastructure, and others. Geopolitical risk remains a perennial concern, whether it be armed conflict, trade disputes, or social unrest.

Do “unconventional” risks affect stock prices?

While the political and monetary policy risk indicators are U.S.-focused, their impact has the potential to impact markets and volatility around the world. Regressing the historical performance of global equity indices (the MSCI ACWI Index and the MSCI Emerging Markets Index) and the U.S. and European volatility indices against the risk factors provides a sense of their market impact. Each of these indices is negatively correlated with equity performance, with a greater impact on emerging market equities. They are positively correlated with broad market volatility, with increased geopolitical risk having a greater impact on European volatility.

Implications for Investors

If there is a silver lining to the apparent rise in geopolitical risk, it may be that U.S. stocks and the VIX have been able to defy it (at least to some extent). However, this is not the case for European volatility. While other “unconventional” risks appear to be rising, if not worsening, their impact – particularly on emerging market equities – is more pronounced. Allocators would therefore be wise to keep a close eye on these risk levels.