Risk-on, Risk-off

In the last several years, markets have exhibited certain correlations that broadly conform to two different investor mindsets. The first of these two mindsets is that of confidence and a willingness to take risk.

This mindset has been colloquially dubbed 'risk-on' for the fact that during these times investors are willing to buy risk assets like stocks and sell defensive assets such as bonds and gold.

Commodity prices will generally benefit during periods of 'risk-on' sentiment as the market expects strong future economic growth that will benefit commodities. For this reason, certain currencies tend to benefit during these times, in particular commodity currencies like the Australian dollar and Canadian dollar.

The other side of this is the 'risk-off' mindset where investors tend to move into defensive assets and sell risk assets. Currencies like the US dollar, Japanese yen and Swiss Franc are typically considered defensive and therefore rise during a risk-off move.

These correlations have been particularly strong during the post-GFC period and can be used to gauge general market sentiment as well as judge how one particular asset class would be expected to move given certain moves in other asset classes.

For example, if you saw gold falling, the US dollar falling and bond prices falling, you would expect to see strength in equities (particularly 'growth' stocks) and strength in the Australian dollar.

Higher risk companies, such as miners, will often benefit during these periods, not just because the underlying commodity prices will tend to be rising but also because investors have increased appetite for higher returns (and therefore higher risk) that can be obtained from these companies.

On the other hand, a jump in the price of gold and a spike in bond prices would be expected alongside weak equities. Not all equities fall into the 'risk-on' bucket, however, and certain defensive stocks can benefit during periods of 'risk-off sentiment'.

Telstra (TLS), for example, is considered such a large and stable company that investors will tend to buy TLS shares when they are nervous. Other defensive stocks might include utilities, like Origin Energy (ORG) or infrastructure stocks such as Transurban (TCL).

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Generally speaking, the larger the move in the price of one particular asset class, the more likely it is that the correlations will hold. Particularly during the 'risk-off' periods the correlations can become very strong.

For example, immediately following the vote by Britain to exit the EU in June of last year the 'risk-off' trade was very noticeable. Gold had a huge intraday jump in price while equities were hit hard. The US dollar spiked upwards and bond prices rose.

Investors should be aware of these correlations to help understand how a particular event may impact a certain asset class. During times of economic crisis, such as the 2008 financial crisis, correlations between assets are at their strongest. This means that portfolios that seem well diversified during good times can suddenly seem not well diversified at all.

While these correlations won't always hold, they are useful as a guide and it is definitely useful for investors to understand the general relationships. A well-constructed portfolio should contain some defensive positions to provide some protection during 'risk-off' periods.

If you would like to chat about your portfolio please get in touch today via email: william.oloughlin@rivkin.com.au or by phoning +612 8302 3633.