by Christoph Schon, CFA, CIPM
Senior Principal, Applied Research
From changing inflation expectations to political instability, investment managers are constantly having to identify and manage market risk. Having a robust stress testing framework and tool to respond to an uncertain future is now – more than ever – a must-have in your arsenal.
Here, we look at two stress test results that may surprise you.
1. Some sectors benefit from high inflation
- In this stress test, we try to gauge the sensitivity of different asset classes to changes in inflation expectations through shocking up the Breakeven Inflation Rate (BEI) by 50bps.
- It is not surprising that it is bad news for Treasury and corporate bonds, but index-linked bonds also suffer losses, as the effect of higher interest rates offsets gains from higher inflation assumptions.
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But then, why are North American equity prices seemingly going up?
- Looking at this BEI +50bps scenario for the US in more detail, you can see that it is specific sectors that are responsible for the higher share prices.
- In this case, Consumer Staples, Healthcare and Utilities, with their high pricing power, are the ones that can offer protection in an environment of rising inflation.
Key takeaway: Ensure your stress testing tool allows you to drill down further into sectors.
2. One stress test can yield two significantly different results
- These are simulated asset-class returns for a 50bps rise in the 10-year US Treasury Yield in two different market environments.
- The second quarter of 2023 was characterized by concerns about banks going under and the US government defaulting. In this type of environment, equity and bond markets move in opposite directions, meaning that share prices will go up when yields rise.
- In the third quarter of 2023, investors focused once again on rising inflation and central banks raising rates in response. In this type of environment, stocks and bonds become increasingly correlated and will fall together.
Key takeaway: Ensure you have the right time period calibration for your stress test
Additional resources
Stress testing best practices
Stress testing should be part of an optimization framework that includes hedges and overlays. Whether embedded in a optimization framework or not, stress tests are critical from a risk management perspective.
Axioma multi-asset class risk monitor
This weekly report covers many of the components of risk in various asset classes, including government and corporate bonds, equities, currencies, etc. The report details volatilities and correlations of these components.
Axioma Risk
Our portfolio stress testing solutions have the flexibility to construct standard instantaneous shocks on single as well as multiple factors, varying each model parameter and selecting different lookback periods for correlated stress tests.