With the stock and bond markets remaining highly volatile and in search of a bottom, a concept born in more recent times may serve as a qualitative signpost as to where we are in the current cycle: “risk-on, risk-off.”
When I entered the investment industry in the latter half of the 1990s, investors did not speak of risk-on or risk-off markets. The markets were always a place of risk-on, there was no risk-off mode. Prior to the recent cycle, risk was generally everywhere at all times, which is the natural state of markets.
Following the 2008 crisis, markets became dominated by global central bank policies and passive investing generally. If central banks ‘had your back,’ risk-on, and if not, it was risk-off. As risk-off markets are bad for business, policy makers naturally favored risk-on markets. This has been especially true following the financial crisis.
The challenge with a prolonged period of risk-on is that it was not just stocks that were risk-on investments. The global zero interest-rate policy turned everything into risk-on ─ stocks, bonds, real estate, etc. Diversification became increasingly difficult as highlighted by the following quote from my March 2022 market outlook, “SPY: The death cross and what you need to know.”
In essence, stocks and bonds are now positively correlated leading to synchronized gains and losses. This is problematic from a systemic risk perspective as there is less ability to diversify portfolios…
Phase Change
Central banks are well advanced in transitioning from the above conditions. The absolute size and velocity of the change in interest rates has been historic.
Continue reading this report with a stoxdox membership.