By Saikat Chatterjee and Vikram Subhedar
LONDON (Reuters) - After this week's war of words between the United States and North Korea triggered the biggest fall in global stocks since the U.S. presidential election, investors are wondering what other off-radar shocks may be waiting to rock world markets.
Although there is little sign so far that investors are protecting themselves against a major sell-off, some say the current environment masks latent risks.
"Every day, our risk models tell us to take more risk because of falling volatility but with markets being where they are, we have to be very careful in not following them blindly," said James Kwok, head of currency management at Amundi in London.
"So we try to project scenarios on what can go wrong and where are markets not looking."
Such has been the extraordinary period of stability in financial markets in recent years that world stocks have hit a series of record highs while gauges of broad market volatility have plunged to record lows.
That benign investment environment has been fostered by central banks which have pumped vast sums of cash into economies since the global financial crisis that began a decade ago, lifting asset prices globally.
Flows into most asset classes have already overtaken peaks reached before the financial crisis.
For example, inflows into active and passive equity funds have nearly doubled to $10.9 trillion at the end of June 2017 from a September 2007 peak, according to Thomson Reuters Lipper data. Inflows into bonds have meanwhile increased nearly three-fold to $4.1 trillion in that period.
Broad market gauges of risk, such as the CBOE Volatility Index, better known as the VIX, and its bond market counterpart, the Merrill Lynch Option volatility index remain pinned near record lows despite a spike this week.
But analysts say low market volatility masks the heavy weight of options written on these gauges by investment banks betting that the calm conditions will persist for a long time.
That has been accompanied by the growing popularity of inverse-volatility ETF products, which have doubled in value this year as market volatility has cratered.
Morgan Stanley strategists say the volume of bets on volatility remaining low means even a small increase in price swings could force some of these leveraged bets to unwind, triggering shock waves in the financial system and sending stock markets tumbling.
Daily percentage changes are important in the volatility world because a lot of these exchange-listed products and notes are rebalanced daily based on these changes, so that any large change would automatically trigger selling pressure elsewhere.
"This is why lower volatility creates higher risk," said Christopher Metli, a Morgan Stanley quantitative derivatives strategist in a recent note.
He estimates that a 12 point rise in the VIX could send the S&P 500 index down by 3.5 percent. A move of that magnitude was last seen after Britain's shock Brexit vote in June 2016.
But a spike in volatility is not the only scenario worrying investors.
Other risks markets may be ignoring include the implications of a messy British exit from the European Union and the risks that the Qatar crisis could spiral out of control in the Middle East and hit oil prices. Even the prospect of a newcomer at top of the U.S. Federal Reserve when Janet Yellen steps down in 2018 could prove unnerving.
"Today's low volatility is the calm before the storm and doesn't reflect the real world in which companies are operating, or the major uncertainties that are developing," said Paul Hodges, chairman at International eChem, a consultancy.
Another variable is the expectation that central banks will soon start unwinding their massive post-crisis stimulus measures, with unpredictable results.
One of the biggest risks seen lurking is the rise and growing influence on the world's stock markets of passive funds, which aim to track rather than beat benchmarks and charge lower fees than their more actively-managed peers.
The proportion of stocks on the main U.S. benchmark equity index that are now owned by such passive investors has nearly doubled since the 2008 crisis to 37 percent.
But redemption pressures on large passive investors could exacerbate any market selloff.
Apple Inc, a stock market darling, has a fifth of its outstanding stock held by index funds with Vanguard, BlackRock and State Street making up the top three holders, according to latest Thomson Reuters data.
The head of sales of a large British-based bond fund said some of its clients are trying to put together pools of money with which to snap up beaten-down stocks if a large emerging market-focused ETF is faced with sudden redemption pressures.
"We get a lot of queries on what are some of the risks that markets may be overlooking, and that is what keeps us up at night," he said.
(Reporting by Saikat Chatterjee and Vikram Subhedar, Graphic by Saikat Chatterjee and Ritvik Carvalho; Editing by Catherine Evans)
Disclaimer: No Business Standard Journalist was involved in creation of this content
