Risk on-risk off can be defined as the ‘mood’ of investors in the global capital markets due to the ebb and flow of their risk tolerance catalyzed by macro-economic conditions. The investors in question are institutional investors who invest in the global capital markets by taking positions in markets such as equities, bonds and currencies for the purpose of making profit.
During periods where they perceive risk to be high, they tend to engage in lower-risk investments. On the other end of the spectrum, when risk is perceived to be low, investors tend to engage in higher-risk investments. In high-risk environments they tend to favor low-risk cash positions, low-negative interest rate economies with large bank balances like Japan and Switzerland, and bonds. During periods of risk on you may see inflows into higher-risk assets like stocks and cash outflow economies and commodity-linked currencies like Australian Dollar (Oil and Gold) and Canadian Dollar (Oil).
Different assets carry varying levels of risk and investors change asset classes depending on the perceived risk in the markets. In a market where stocks are outperforming bonds can be said to be in a risk on environment since stocks are generally perceived as a riskier asset than bonds. The inverse, risk off, is the case when there is a selloff in stocks and a rally in bonds. Some good examples, among many others, are the risk off year of the dotcom bubble crash, the financial crisis of 2008, the economic recovery of 2009 and the more recent stock market crash of 2021.
GAUGING RISK SENTIMENT
Investors mainly gauge market sentiment through factors like macro-economic data, global central bank action and corporate earnings. When they feel that the market is supported by strong fundamentals they perceive a positive outlook on risk. Some of the data points they focus on include;
• Expanding Corporate Earnings
• Optimistic Economic Outlook
• Accommodative Central Bank Policies (Quantitative Easing)
• Uptick in Speculation
Conversely, for a risk off sentiment, we have contracting earnings, a pessimistic outlook, quantitative tightening and drop in speculation. It is important to note that the market undulates between both sentiments and this ‘phasing in and out’ can be observed by watching the key asset classes involved in these rotations.
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Typically, risk off assets offer lower but more stable return on investment while risk on assets offer more returns but they can be volatile. Other interesting rotations to note are appreciation of financial stocks and the financial stocks ETF (XLF) in risk on environments due to their ties with Bank stocks. Investors usually swarm to Utility stocks and the utilities ETF in times of risk off. Investors also rotate in and out of instruments such as Real Estate Investment Trusts and commodity currencies depending on the risk sentiment. A useful ratio to calculate risk sentiment is BAC/REET (Barclays divided by Real Estate Investment Trusts). Due to the positive correlation between market health and financial stocks, the difference between gains and losses between Financial stocks and Real estate investment trusts is a useful measure.
Also worthy of note is the poster-child of currency carry trades the AUDJPY carry trade where investors borrow from a low-interest rate economy, Japan, and invest in a high-interest rate economy, Australia, to capture the spread.
In a nutshell, knowing the risk sentiment of institutional investors can be a very useful tool to have in addition to your other tools in your investment strategies. It helps retail investors gain an edge and puts you on the right side of the big order flows if utilized properly
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