Opinion

James Saft

Risk-on, risk-off may be ending: James Saft

January 29, 2013

By James Saft

(Reuters) – The after-effects of the Great Crisis may still be with us, but the great correlation in global financial markets may be coming to an end.

After years of seemingly disparate markets all going up or down in concert, recent weeks have shown signs of assets actually trading on their own merits. If sustained, this would be an important sign not just of a return to normality in financial markets, but that investors see a more stable world.

Then again, it might be a giant head-fake.

Sometimes called “risk-on, risk-off”, or Ro-Ro, this has been the dominant trade since the financial crisis broke, with commodities, stocks and especially currencies moving very tightly together in predictable ways, mostly driven by major economic news and global events.

When investors felt things were good, everything “risky”, like equities or commodities tied to economic growth, rallied together, sometimes almost without reference to regional or individual differences. At the same time, good news was bad for the dollar, which would rally instead on disappointing or negative developments.

Now there are signs this is ending, especially in the currency markets, which, as the biggest, most liquid and frenetic market often leads the way in setting trends.

Correlation in currency markets is as low as it has been in five years by some measures, according to JP Morgan currency strategist John Normand. Instead, trading is being driven by local issues, from radical new economic and monetary policy in Japan to the prospect of a triple-dip recession in Britain.

Similarly stock markets are no longer trading in lockstep, with Japan, notably, rallying sharply. A key measure of global stock market correlation is down more than 30 percent since June, according to Societe Generale, and is as low as it has been since 2007.

The important thing here isn’t the news that is driving individual markets in different directions, it is that investors are now calm enough to be able to actually think, consider and deal with an individual currency or stock on its own merits. We seem, thankfully, to be moving away from the kind of adrenalin-fueled, fight-or-flight state we’ve been in since the fall of Lehman Brothers in October of 2008.

THE WORLD THE CENTRAL BANKS MADE

Since Lehman we’ve been in a world in which the signal issue for all markets and assets has been whether or not things, well, are going down the tubes. That central issue has been in various guises, first the banking crisis and then the euro zone crisis, but all of the issues have been big enough and ugly enough to deeply impact the prospect of almost any asset you care to name.

In that kind of scenario the two key questions are how bad a given piece of news is, and what will be the reaction of governments, particularly central banks. That makes sense because governments and central banks are the only entities big enough to respond forcefully to a huge crisis, and frankly it was going to matter very little if a particular Italian company was well managed or if its products were in demand if Italy exited the euro zone.

What is hard to tell is if the new discernment we are seeing in financial markets is a sign things are genuinely better, or if central banks have so anesthetized investors that they can no longer fret over the big issues.

One group who will definitely benefit from a fall in Ro-Ro trading is professional investors. High correlations, markets in which everything goes up and goes down, are ones in which many investment techniques simply don’t work. The benefit from diversification, long believed to be the market equivalent of a free lunch, has been scant or absent entirely.

It has also been tough times for stock pickers, and everyone has turned into a global macro hedge fund manager, regardless of job description.

The fall in global correlations may also be a sign that we are entering a period where globalization is on the defensive, making local politics, economics and other factors much more important.

Japan, from that perspective, is a good example of this. Japan’s stock market has rallied and the yen has fallen because of a political development – the rise again of Shinzo Abe to the office of prime minister. That in turn has driven new radical monetary policy which is likely to be out of proportion to what is being done elsewhere.

As well, a China-Japan dispute over uninhabited islands in the East China Sea actually drove a contraction in Japanese exports last year, the kind of thing which should give pause to anyone in a risk-on moment blindly bidding all global equities up at the same time.

It is genuinely too early to know, but if it lasts, a world in which investment has more than two speeds, risk-on or risk-off, would likely be a healthier one.

(At the time of publication, Reuters columnist James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. For previous columns by James Saft, click on)

(James Saft is a Reuters columnist. The opinions expressed are his own)

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