The unwelcome return of risk-on, risk-off
By James Saft
(Reuters) – After ebbing for most of the year, correlations are creeping back into financial markets.
Many investors, especially stock pickers, hoped they’d seen the last of “risk-on, risk-off”, a pattern in which commodities, stocks, currencies and bonds move very tightly in predictable ways and which has been the dominant trade in the post-financial-crisis landscape.
That certainly was the way the world looked even a month ago, with more assets going up or down on their own merits and prospects rather than in a lemming-like flight from risk towards safety or vice versa.
But with a simmering financial crisis in emerging markets, and with seemingly growing chances that the Federal Reserve is just weeks away from beginning to taper its bond purchases, some data shows risk-on, risk-off correlations are again on the rise.
First off, let’s look at how risk-on, risk-off worked, what caused it and who it hurt and helped.
The great correlation took off during the financial crisis when investors realized that a) the global economy and markets were in deep trouble and b) only central bankers and governments were in any position to make a meaningful impact.
When investors felt authorities were taking the right interventionist steps, 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 news for the dollar and Treasuries, which would rally instead on disappointing or negative developments.
Bad news, or the fear that authorities wouldn’t do enough, were good for the dollar and for Treasuries, both of which were seen as most insulated from any disaster.
One group for whom this was a disaster was stock pickers, or really anyone who added value chiefly by analyzing a given security or company. What is the point of poring over the books of an Italian dairy company, for example, if the value of its shares was going to be driven more by ECB chief Mario Draghi than by its own products and strategy? For several years the skills that mattered were risk management and the ability to gauge policy-makers’ commitment to the status quo.
RETURN TO NORMALITY?
All of this seemed to be changing for the first seven months of this year, and it had to be seen as good news. One of the easiest ways to see this was that stocks weren’t all going up or down at the same time. Instead, for the first time in years, they were being driven by their own prospects, or of course, by the way in which their specific business model would be driven by economic developments.
According to Deutsche Bank data, correlations within the Russell 1000 index of stocks dropped to 30 percent over the summer from nearly 60 percent a year ago. Or consider what Bespoke Investment Group calls “all or nothing days” on the S&P 500, a day in which at least 80 percent of the index is up or down. In the 1990s, a whole year could pass without an all or nothing day, but during the crisis the number spiked to 70 in 2011, which is more than 25 percent of all trading days in the year. So far this year, we are on track for 25 or fewer.
In the last month, however, we’ve seen an increase in correlation, especially in relation to emerging markets. Emerging markets are suffering a sort of mini-crisis due to the prospect of tighter global liquidity when the Fed begins to taper. That has hit countries like India and South Africa which need to import capital. Countries like those have seen strong sell-offs, but more to the point their sell-offs have begun to drive other assets, such as commodities and even developed market stocks. HSBC notes that three-month rolling correlations between emerging market currencies and the S&P 500 have about doubled in recent months.
As we approach the Fed’s meeting in two weeks, at which it is expected it will announce some form of taper, there is every chance that these correlations rise and spread, not just from emerging to developed markets but more deeply among developed markets.
That has to be a huge frustration to the average investor, who doubtless would simply like to return to being rewarded for allocating capital well among companies and borrowers.
And that’s the real danger here: that risk-on, risk-off represents a kind of failure of capitalism, in which investors get paid simply for second-guessing official policy and thus do a much poorer job of putting money where it will be best and most productively used.
For a while yet, it seems we are all sentenced to being Fed watchers.
Investors and Fed officials alike can probably agree this is a bad thing.
(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)