Is it time for Risk On or Risk Off?Posted:
Stock markets ebb and flow between times of heightened tolerance to risk and lessened tolerance to risk. Share prices are driven by these changes in risk tolerance. The timing of these conditions is determined by global economic patterns.
In times where global economic risk is perceived as low, investors engage in higher-risk investments, leading to a risk-on environment. When the global economic risk is perceived as high, stock market investors are more risk-averse and tend to engage in lower-risk investments, leading to a risk-off environment.
Factors that influence the risk appetite of investors in a market, and subsequently determine risk-on or risk-off conditions include:
- Corporate Earnings – Growing corporate earnings and forecasts tend to positively influence investor sentiment. Positive corporate earnings forecasts contribute to higher share prices and to risk on behavior.
- Economic Outlook – Expectations of strong economic growth and increased output contributes to corporate earnings and as a result encourage risk-on sentiment.
- Central Bank policy – Accommodative monetary policy boosts economic growth by expanding the money supply and by reducing the cost of borrowing by reducing the policy rate. These actions boost corporate earnings and reduce the real return of other asset classes outside of stocks, promoting risk-on behavior.
In 2020 when the pandemic caused shutdowns worldwide, global economic output sharply declined, and asset prices fell. In response to the sudden halt of economic activity, central banks lowered policy rates, lowering the cost of lending for the domestic banks in their respective economies. This resulted in a jump start of global economies. Central Banks also began a process called quantitative easing, which involves the central bank purchasing assets from the open market to increase the money supply and to encourage lending. The United States Federal Reserve has been purchasing $80Bn of US government bonds and $40Bn of Mortgage-Backed Securities each month since Q2 of 2020.
Central Bank policies led to the second half of 2020 characterized by a V-shaped economic recovery. While March saw a crash in economic output and share prices, the accommodative policy caused interest rates to fall allowing corporate entities and consumers access to low-cost funds, increasing capital expenditures, and increasing consumer spending. The economic outlook for 2020 and 2021 was very optimistic, and corporate earnings soared toward the end of 2020. This response to the pandemic created a risk-on environment for investors.
Stock markets benefited from the risk-on environment. By the end of the year, U.S. markets had appreciated by approximately 60%-70% from their March lows. With the level of central bank action, both sovereign and corporate bond markets saw yields shrink to levels barely beating inflation, as a result, stocks and real estate were the only places to generate real returns on investments. This explains the sharp rises in asset prices seen in the back half of 2020.
The momentum in markets in late 2020 slowed leading into 2021, with concerns about inflation, reduction in accommodative monetary policy, and slowing economic growth. The accommodative stance made by central banks has increased the money supply to the point where, in combination with the supply chain issues of 2021, inflation has been greatly elevated in 2021. As inflation seems to be a material issue, pressure is on central banks to raise rates and cut back on quantitative easing, ultimately slowing the economy down.
The US Federal Reserve has positioned itself to begin slowing down quantitative easing in November and begin to raise rates beginning in 2022. These actions have already resulted in U.S. treasury yields increasing and stocks sliding in September. These actions may spell a risk-off environment for investors in Q4 leading into 2022.
Investors who have profited from the recovery during the risk-on period started in 2020, may consider the position to risk-off entering Q4 2021, by position as follows:
- As long-term US treasury yields are expected to increase as the Fed eases back on quantitative easing, investors can reduce exposure to stocks that have values dependent on great future earnings growth. These include growth companies and the big tech who have far outperformed markets in the previous 18 months of risk on conditions.
- Investors can rotate into companies that benefit from rising rates such as financials, small caps, and staples.