First confronted with the somewhat esoteric terms risk-on and risk-off (or RoRo) typically (for those born in the 70s/80s) evokes childhood memories of the movie The Karate Kid – famous for its line ‘wax-on – wax-off’.
Regrettably, though, RoRo is slightly more involved than waxing Mr Miyagi’s car!
What does risk-on and risk-off mean?
- Risk-on is an investment setting in which market participants buy into riskier assets, normally to the effect of expanding corporate earnings, optimistic economic outlook and accommodative central bank policies.
- Risk-off is simply the opposite to risk-on whereby market participants readjust positions to take on less risk, usually to the effect of corporate earnings downgrades, contracting or slowing economic data and uncertain central bank policies.
At its simplest, one can view RoRo through the equity and bond market window.
Equities tend to yield a greater return than bonds. This, we believe, is well-documented through mainstream media.
So, generally, when the economy is optimistic it prompts investors to search for higher returns, and therefore one can expect to see the stock market rally. This is a risk-on scenario. The flip side to this is when risk appetite turns sour. Investors, in this case, commonly move capital from stocks to purchase government bonds. This would be a risk-off event. Government bonds are, for the most part, thought to be risk-free and thus boast a safe-haven value.
Safe-haven markets to watch
Countries with strong economies are deemed the safest place to store capital in times of economic uncertainty, as there is a lower likelihood of these currencies suffering devaluations amid market turmoil. Traditionally, safe-haven currencies are defined as the Japanese yen, the Swiss Franc and the US dollar.
- Japan sees strong safe-haven in flows in times of global uncertainty due to its large amounts of foreign investment.
- Switzerland’s historical position of political neutrality has made it a popular safe-haven destination for concerned capital holders.
- The US dollar is the most highly liquid and widely used currency in the world and is often an investor favourite amid rising global risks, with the safety of US bonds sought after by domestic and foreign investors alike.
Gold’s safe-haven value
Investors also tend to favour the precious metal gold as a safe haven. The behaviour of gold in risk-on or risk-off movement, however, is not easy to chart. We say this because a depreciating US dollar often, but not always, translates to a rise in the price of commodities. Thus, a falling US dollar due to positive risk-on sentiment can see the price of gold increase. Thus, it is not always possible to relate market sentiment directly to the movement in price of gold.
Another interesting point worth mentioning is that it is entirely possible to see both equity and gold markets rally side-by-side. When the economic cycle is positive (GDP is rising), stocks generally appreciate while gold falls. Yet, if inflation is rising along with GDP then both gold and stocks can rally, as gold is thought to be a hedge for inflation.
Risk-on markets to keep an eyeball on
In the presence of a risk-on environment, the idea is that the global economy is in recovery and safe-haven trades like long dollar, bonds, Swiss franc and Japanese yen are liquidated.
As such, the US dollar generally trades lower against most currencies, particularly commodity currencies. The rationale behind this is that fast-growing economies such as China will demand greater amounts of raw materials, and this generally increases the value of the stock market and higher-yielding currencies such as the Australian dollar (AUD) and New Zealand dollar (NZD).
At the same time, low-yielding instruments (Japanese yen and Swiss franc) tend to gain less on a relative basis or possibly even lose value. Low-yielding currencies are usually sold to fund the purchase of higher-yielding currencies. This selling of a low-yielding currency while simultaneously buying a high-yielding currency is called the carry trade. So, an effect of a risk-on sentiment is an increase in the stock market and demand for high-yielding currencies.
Using the S&P 500 or DJIA as a way of gauging inventor sentiment is (that is whether we are in a risk-on or risk-off scenario), in our book, a valid approach. This will help one select which markets are likely to rise (think commodity currencies) and those that are looking vulnerable to the downside (think yen and the Swiss franc).
Just to be clear, we simply view safe-haven flows as just that – flows between different markets – correlations if you will. For that reason, NEVER base a trade solely on your expectation of safe-haven direction.
A good trade should boast several converging elements!