After the Financial Crisis of 2007–2009, several practitioners and academics argued that familiar refrains around crises – like “this time it’s different” – are invariably incorrect. These arguments mostly centered on the premise that, before financial crises, capital markets metrics (e.g., P/E ratios, credit spreads) trade outside of historical proportions signaling necessary corrections. In short, with front office discipline and robust risk management, the challenge to avoid the worst of a crisis should be less identifying it than Keynes’ adage that “markets can stay irrational longer
then you can stay solvent.”
Continuing COVID-19 related disruptions, to the real economy and markets, both remind us that not all crises are financial and belie the clarity that we hoped to have developed after the Great Recession. These disruptions also remind us that, while predicting events makes headlines, effective market risk management is more frequently the process of building portfolios that are resilient in crises. The best way to build that resilience remains the disciplined application of identified tools to best understand how your portfolio will incorporate new information. Today we take a deeper dive into two of these tools that may be of relevance as the initial wave of global government intervention matures while damage to the real economy persists; they are an understanding of:
1. Transmission pathways of risk between the financial sector and the real economy
2. The response of asset/portfolio volatility to material news.