Monday 7 September 2020

Q&A with Marie Brière

How can investors cope with volatility risk and inflation hedging in these unprecedented times? Marie Brière, Board Member of Inquire Europe, provides her in- depth insight. 

1. Given that we remain in the midst of a financial crisis and are coping with unprecedented uncertainty, it is very difficult for investors to predict what will transpire in three months, let alone ten years. Do you have any words of wisdom for institutional investors in Europe who have no choice but to engage in long-term asset allocation? 

The Covid crisis will certainly have long-lasting consequences for investors. This dramatic episode reminded us that certain risks are difficult to quantify. It also served as a wake-up call that natural disasters can happen suddenly and unanticipated1,  and that we are more vulnerable than we could imagine. An immediate consequence of the shock is that environmental and social concerns have taken on particular importance for long-term investors. It becomes impossible to argue that investors do not have to worry about the environmental externalities generated by companies2.  Also, the Covid-19 crisis has brought social issues back to the forefront of ESG. Business decisions affecting employees (in particular their health and social protection, teleworking or unemployment policies) have become essential. 

This has resulted in investors’ appetite for ESG products to increase. In the midst of the crisis, funds and companies benefited from better financial performance due to ESG, have outperformed their competitors. This outperformance is in part due to the exposure of these funds to sectors less impacted by confinement or social distancing measures, such as but not limited to, tech or telecoms. Inflows to ESG funds have also been much more robust during the crisis3.  In the end, the crisis might permanently change the way we invest.

The Covid crisis has also led investors to question if financial globalization can be taken for granted. In 2007, globalization reached its peak with global cross-border capital flows amounting to $11.8 trillion. The Global Financial Crisis (GFC) that followed contributed to a trend reversal. Foreign direct investment has decreased by 60% since 2007 and cross-border financial flows experienced a similar trend4.  The recent Covid-19 pandemic is likely to be an enormous stress test for globalization. It already forced firms and nations to limit traveling and trade, and it could lead to a reevaluation of the interconnected global economy. This can have important consequences for investors looking for diversification opportunities. It could entail more segmented markets, increased idiosyncratic risks and, and in the long run potentially increased transaction costs. 

In recent research5,  we examined linkages between 17 international stock markets from a long-term, historical perspective to determine how the correlation structure changed over time. We experienced two globalized periods: a period of “moderate” globalization during the Gold Standard Era (1880-1914) and a period of “extreme” globalization, which we have been in since 1972. In between, there was a period of deglobalization, with the implementation of capital controls (1918-1971). Interestingly, our results show that the intensity of stock market contagion (re-correlation of  international markets during financial crises) varies with the degree of financial market globalization. Contagion was absent from stock markets in the period of deglobalization and of “extreme” globalization but was present in the period of “moderate” globalization. Without globalization, contagion cannot exist. But if cross-market correlations are very high, globalization kills contagion. Contagion happens during periods of moderate globalization. If one of the consequences of the Covid crisis is that the economic deglobalization we are experiencing leads to less financial market integration, we could expect improved diversification benefits for international investors during quiet times, but also increases in correlation during financial crises. Investors should thus be very careful about the consequences of financial crises on the risks of their portfolios.

2. 2020 has proven to be a dramatic year for markets (equity, fixed income, commodity); what are currently the best tactics to use to manage volatility risk? How do these tactics compare to what you employed during the Great Financial Crisis? 

The recent fluctuation in financial asset prices has revived investors’ awareness of the risks of exposure to capital markets. Not only do risky assets underperform during periods of market stress, they also become more volatile and lose their diversification properties because of contagion mechanisms. This phenomenon is repeated during all periods of stress and provides fertile ground for identifying ways of protecting a portfolio against the adverse effects of crises, and was especially acute during the GFC and the recent Covid crisis.

Investors must therefore seek ways to shield their portfolios from the extreme swings that occur during a crisis. Of the conventional asset classes, only government bonds seem to fit the bill, benefiting from a flight to quality and offering excellent returns (8% on US Treasuries from September to December 2008, 10% from January to April 2020). That said, an alternative solution emerged as a simple and attractive way of protecting portfolios: volatility. At first glance this might seem strange - volatility is usually seen as a risk indicator. However, the development of standardised products on volatility has provided investors with access to a new range of possibilities. 

For example, exposure to the implied volatility VIX or VStoxx futures provides excellent protection if equity markets fall. Investors can thus mitigate the tail risks of their portfolio, making it less risky than a traditional diversified portfolio. Considered as a long-term investment, it makes it possible to build more efficient portfolios than the traditional equities / bonds mix6 .

3. For the last 10 years, inflation has averaged less than 2 percent annually. However, due to central bank stimulus and rising sovereign debt levels, is it wise for investors to prepare for that possibility? What are the inflation hedging tactics that are most logical to consider at this juncture in the crisis?

The exceptional rise in government deficits and debt levels, coupled with massive central bank interventions does raise the question of whether a globally low and stable inflation environment can persist in the long run. This in turn raises the question of inflation hedging, a key concern for many investors who are considering how to build a diversified portfolio that effectively hedges inflation risk. 

An initial and important observation is that the inflation-hedging power of different asset classes changed significantly over time, depending on the nature of the macroeconomic regimes. The past 40 years can be divided roughly into two regimes. The 1970s and 1980s were marked by high macroeconomic instability and supply-side shocks (e.g. the 1973 and 1979 oil shocks), which tended to be countercyclical. This implies that inflation shocks had an unfavourable effect on equity markets, as they did on bond markets. In contrast, the prevailing environment of the 1990s and 2000s was totally different, with much weaker economic shocks (this was “the Great Moderation”), which were procyclical. Any rise in inflation during this period was a sign of overheating; it often coincided with a run-up in equity markets but a decline in bond markets, albeit less pronounced. This is because, throughout the period, the inflation risk premium priced into bonds yields contracted as central banks gained credibility and inflation expectations stabilised.

The fluctuating correlation between equity markets and inflation is highly symptomatic and is observable to a lesser extent in other assets. Accordingly, in the period of highly volatile economic environment in the 1970s and 1980s, an investor willing to hedge inflation should have been mainly invested in short term rates when her investment horizon was short, and increase her allocation to inflation-linked bonds, equities, commodities and real estate when her horizon increased. In contrast, in the more stable economic environment of the 1990s and 2000s, short term rates still played an essential role in hedging a portfolio against inflation in the short run, but in the longer run, they were replaced by nominal bonds, commodities and equities7.  The exceptional performances of short term rates and nominal bonds is linked to the monetary policy and disinflationary environment that occurred and cannot be expected to continue in the near future. The long period of the Great Moderation may be over. But this does not mean that we have slipped back into a regime identical to the one in the 1970 and 1980s. Going forward, the nature of macroeconomic shocks may be quite different. One key message could be retained: no individual asset classes can hedge inflation as efficiently as a diversified portfolio.

4. If you had the opportunity to start a new research project today, what would the primary research question be?

The investment management industry works to serve individual end investors. Understanding their needs, preferences and investment behavior is a key topic. For example, I am working with a colleague to research how the socially responsible fund offering impacts individuals’ risk taking8.  Another trend amplified by the Covid crisis is the digitalization of our industry. Robo advice is growing and if generalized, could have a key impact on the business. Does this lead to improved individual’s investment decisions? We started new research in this direction as well.

Finally, understanding investors’ role on the price formation process is crucial. What is the impact of changing investment practices and new regulatory constraints?  I am pleased that Inquire Europe has been following these topics very closely and recently funded a number of very promising research around those lines9.  I look forward to the presentations that will be made during the next Inquire seminars! 

1  Although epidemics are not without precedent in recent history (SARS in 2002, H1N1 in 2010, Ebola in 2014, and MERS in 2019), and pandemic risk had been identified in many prospective studies of national security agencies, the risk was largely neglected by financial markets. For ex, it was not on the list of the 10 most probable risks cited in the World Economic Forum’s 2020 “Global Risk Report” (Jan 2020). 

2  Brière M., S. Pouget and L. Ureche-Rangau, "Do Universal Owners Vote to Curb Externalities: An Empirical Analysis of Shareholder Meetings", SSRN Working Paper N°3403465, 2019. 

3  Barberis J.J. and M. Brière, “ESG Resilience during the Covid Crisis: Is Green the New Gold?, Amundi Day After Series, 2020.

4 Bordo, Michael D. 2017. The second era of globalization is not yet over: An historical perspective. NBER Working Paper No. w23786.

5 Accominotti O., M. Brière, A. Burietz, K. Oosterlinck and A. Szafarz, "Did Globalization Kill Contagion", SSRN Working Paper N°3534157, 2020. See also VOX column: 

6  Brière M., A. Burgues and O. Signori, "Volatility Exposure for Strategic Asset Allocation", The Journal of Portfolio Management, 36(3), Spring 2010, p. 105-116. 

7  Brière M., and O. Signori, "Inflation Hedging Portfolios: Economic Regimes Matter", The Journal of Portfolio Management, 38(5), Summer 2012, p. 43-58. 

Ang A., M. Brière and O. Signori, “Inflation and Individual Equities", Financial Analyst Journal, 68(4), July-August 2012, p. 36-55. 

8  Brière M., S. Ramelli, "Personal Values, Responsible Investing and Stock Allocation", forthcoming.