Why 'Risk-On, Risk-Off' Trades Dominate Amid Major Uncertainty

A variety of asset classes, notably stocks, bonds, and currencies, have been more closely correlated in recent months than at any other time since mid-2016, according to analysis by The Wall Street Journal. The root cause of this phenomenon is high levels of uncertainty about the direction of macro drivers such as trade policy and interest rate policy, the Journal adds.

In essence, the article elaborates, investors have divided all assets into two broad categories. "Risk-off" assets are viewed as safe haven investments and they tend to advance in price when expectations turn bearish. By contrast, "risk-on" assets are growth-oriented, and rally when positive news sparks increased bullish sentiment and perceptions of a more attractive risk/reward ratio.

Significance For Investors

During a period when "risk-on" sentiment prevails, the S&P 500 Index (SPX) rises, the yield on the 10-Year U.S. Treasury Note rises (i.e., bond prices fall), the euro appreciates in value versus the U.S. dollar, and the U.S. dollar appreciates versus the Japanese yen. In a "risk-off" period, the opposite occurs.

The study looked at trading days so far in 2019 through June 21, identifying days in which either sentiment prevailed, and tying that sentiment to events that occurred either before or during trading. Events also include comments and data releases from key policy making figures or organizations such as President Trump, Federal Reserve Chair Jerome Powell, the European Central Bank (ECB), and the International Monetary Fund (IMF).

"Risk-on" characterized 13 trading days, and "risk-off" dominated during 14 days. "Risk-on" days were marked by optimistic tweets about the progress of trade negotiations by Trump, or by dovish signals from the Fed. By contrast, "risk-off" days correlated with threats of new tariffs by Trump, hawkish comments from Fed officials, or forecasts of lower global GDP growth by the ECB and the IMF.

To some investors, "risk-off" periods represent buying opportunities. Neil Dwane, a portfolio manager and global strategist at Allianz Global Investors, is among these. However, he looks for investments that are generally not correlated with broad market movements, with infrastructure financing for clean energy products being an example that he shared with the Journal. Indeed, the current market environment should be conducive to deft stock picking, given that the one-year correlation among stocks in the S&P 500 is 0.41, down from 0.75 in 2013, per data from Morgan Stanley and Bloomberg cited in the same report. A correlation of 1.0 would represent all stocks moving in complete concert.

While the Journal conducted a simplified analysis using just U.S. stocks, U.S. T-Notes, and the value of the dollar versus two other major currencies, Bloomberg cites other examples of "risk-on" or "risk-off" assets. For "risk-on," they include lower-rated, higher-risk, higher-yielding corporate and government bonds, emerging market currencies, and industrial commodities such as copper. For "risk-off," they add German government bonds (bunds), defensive stocks such as utilities, and products tied to the CBOE Volatility Index (VIX) that are used to hedge against stock price declines.

Looking Ahead

The S&P 500 is up by 7.0% for the month through the close on June 24, putting it on track for its best June since 1955, per Dow Jones Market Data cited in another Journal article. Whether this represents a lasting overall shift to "risk-on" sentiment remains to be seen.

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