Betting on Red or Black in Global Financial Markets
Those who support “risk on” at a particular moment are expressing economic optimism by being in a buying mood. The converse, those who are embracing a “risk-off” mode, take a much gloomier view, foreseeing economic contraction or even disaster scenarios. Like placing the bet on the right color at the casino, choosing the most realistic interpretation of current risk sentiment can make all the difference in a portfolio.
Changes in risk tolerance
We constantly swing between the twin financial emotions of fear and greed. When greed is dominating, we enter a risk-on mode, which is reflected in our choice of asset types. When fear prevails, we refocus on preserving capital rather than amplifying profits. If the risk balance is aligned, new economic data can impact the overall trend, so traders can use the next countertrend to increase their initial positions.
Investment outlooks seesaw between rosy and bleak. Risk-on, risk-off attitudes, soon christened RORO, gained traction around 2012, a few years after the great financial crisis. Investors noticed that assets were moving more than usual in tandem all across the world and no longer just on a specific country basis. After the 1997 Asian “contagion” and other so-called unanticipated events, traders tended to move in lockstep in a herd response. Now, however, they had a name for it, and RORO has stuck for over a decade.
Shifts in sentiment can rapidly alter broad investment activity, often as a reaction to global economic patterns. When a crisis such as a war or terrorist attack strikes or a recession looms, traders typically react by closing all their more-liquid positions. They want to be ready to unload the riskiest ones ASAP. Commodities in particular, which often have higher standard variations, can careen wildly. In more normal periods, when the crisis is over, signs of changing sentiment can be monitored through corporate earnings, macroeconomic data and global central bank policies.
Keeping an RORO scorecard
Since asset classes tend to move increasingly en masse, it becomes a fairly straightforward exercise to line up which ones gravitate together according to the risk-on or risk-off temperature. Although there are exceptions, it is remarkable how much these investments trade as a bloc.
During risk-on phases, investors load up on:
- High price-to-earnings stocks.
- Small caps.
- Emerging market securities.
- High-yield, lower-rated and junk bonds.
- Commodities such as crude oil, copper and aluminum.
- Higher-yielding currencies such as Australian and New Zealand dollars.
- Leveraged derivatives such as futures and options on futures.
- Call options.
Risk-off safe haven assets represent the other side of the coin. Investors flee to safety in:
- High-grade bonds.
- Treasurys and other government bonds.
- German bunds.
- Cash and cash-like instruments.
- Money market funds or accounts.
- Utility and consumer staple securities.
- Currencies such as the U.S. dollar, Japanese yen and Swiss franc.
An interesting snapshot of the transition from risk-off to risk-on groups occurred on the night of the presidential election in 2016. The transition was unusually abrupt. Until the evening of the election itself, risk off seemed to be ascendant while the world awaited a Clinton victory. When it became apparent that Trump would win, tables flipped and risk-on assets surged, including the U.S. dollar versus Swiss, Japanese and Canadian currencies, while gold and interest markets stumbled.
While RORO signals alone are not enough for making investment decisions, you might use the composite information for gradual shifts, such as rebalancing, purchasing undervalued assets or selling inflated ones. You might increase your liquidity as power for spending at a later moment if assets become distressed.
Sophisticated investors also use a carry trade to sell low-yielding “funding” currencies in exchange for higher yielding “target” counterparts. For example, the U.S. dollar, Japanese yen and Swiss franc are used for funding targets such as the Brazilian real, South African rand or Australian dollar.
Your financial advisor can help you recognize and interpret sentiment changes as they occur. Have that conversation now and be prepared for whatever the spin of the roulette wheel may bring.