Is Risk-On, Risk-Off in the Rearview Mirror?

Trump. Brexit. There were plenty of big stories last year. But the one that may matter most for your portfolio in 2017—and how you manage risk—is how markets responded to these surprises.

How to sum up that response? Maybe this: it took markets three months to process Japan’s negative-interest-rate policy, three weeks to get over the Brexit shock and about three hours to digest Donald Trump’s election (Display 1).

In each case, global stock markets and other risk assets initially sold off, only to recover swiftly—a trading pattern known as a V-shaped recovery for how the price move appears on a trading screen.

This kind of highly correlated trading, with risk assets moving in one direction and safety assets (such as government bonds) in another, isn’t new. As any investor active in recent years knows, risk-on/risk-off has been a recurring pattern in markets since the global financial crisis.

For investors, keeping pace with abrupt shifts in risk sentiment has been a challenge. For instance, when risk aversion spiked, investors typically tried to sell equities. But it’s been hard to get the timing right. Often, stocks would start to rebound just as investors were starting to sell. Being late to join the recovery, of course, would hurt portfolio returns.

CHANGING THE INVESTMENT PLAYBOOK

But what if this risk-on/risk-off pattern is breaking down? The risk-off periods certainly appear to be getting shorter. We think there are explanations for this. First, global growth is finally starting to gain traction—good news for many growth-sensitive risk assets, such as stocks and high-yield bonds.

Related to this, developed markets are moving beyond a singular reliance on monetary policy to boost growth. Japan is supplementing ultra-loose monetary policy with fiscal stimulus, and the US may soon do the same. As a result, risk-on/risk-off trading patterns may be fading away, to be replaced by trending markets.

What does this mean for investors in 2017?

For one thing, it changes the way they need to think about risk and return. Investors will want to be open to a wide range of market signals so they can decide which ones most accurately reflect the conditions of the day.