A few months ago, Benzinga published an article explaining the difference between risk-on and risk-off investing and how each strategy correlates to a particular economic, financial and geopolitical context.
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Put simply, when uncertainty reigns either in the world or in the markets or in both people tend to look for safe havens, investments that imply lower risk and inferior returns, like gold, U.S. Treasuries, a few strong currencies and some defensive stocks.
Lately, risk-off investing has been bandied about in financial press quite a bit, especially since Syrian and North Korean tensions started to bubble up.
Since April is Financial Literacy Month, Benzinga decided to ask Agecroft Partners Don Steinbrugge to better explain what risk-off investing is and if international affairs have made it a trending strategy nowadays.
Understanding Market Valuations And Risk
To understand risk-on and risk-off investing, one must first understand how market valuations work.
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Valuations are basically determined by two components: financials (like earnings or sales) and the sentiment of the market. And these fluctuate substantially over time, Steinbrugge explained.
When risk is on, the market as a whole does well and growth-oriented companies do exceptionally well, better than SPDR S&P 500 ETF Trust (SPY). On the other hand, when risk is off and people are scared, the market sells off and high-growth stocks dont fare very well, the expert continued.
This means that in risk-off contexts there is a sort of flight to quality. In this context, defensive stocks tend to outperform. However, stocks are not the only capital investments available; so, some investors resort to cash; others, to strategies that have low correlations with the market like CTAs or direct lending; others, to put options. Some people are even looking for strategies that are long volatility, which will do really well when the market sells off and offset the sell off of the market, Steinbrugge said.
The Situation Nowadays
The big question now is, is risk-off investing the strategy du jour, taking into account factors like the tensions in and with North Korea and Syria, or the Trump administration?
Now, whats surprising is that Steinbrugge sees the opposite happening at the moment.
In the second half of 2015 and the first 10 months of 2016, a lot of investors were taking risk off the table, looking for strategies that either were uncorrelated or would do well if the market sold off, he said.
Since Trump took office, the sentiment (partially driving the value of the market) became very bullish. Weve seen the capital markets do extremely well since he has been elected, despite the fact weve havent really seen earnings go up that much, he went on.
The reason the markets are going up is that there are a lot of people out there that think that Trump is going to implement policies that will be favorable to the capital markets: infrastructure spending, trade policies, cutting corporate taxes, and so forth.
In his first 100 days in office, Trump has seen a lot of opposition from the Democratic Party. This has made it difficult for him to implement policies he is trying to pass. And, so far, the market has not reacted to that; the sentiment has still stayed positive. Nonetheless, at some point, if he is not able to accomplish what the market is expecting, we could see a selloff in the marketplace.
Having said this, he appended, risk-off strategies continue to see demand. So, its not a black and white situation, but rather a "shades of gray" kind of thing.
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