The last time Nomura talked ‘risk on/risk off‘ they thought it had ruptured.
Now they think the market phenomenon — which had seen correlations intensify in recent (QEased and crisis-ed) years — might be ruined for good.
Here’s why:
At the start of 2011, there is increasing evidence that risk-on/risk-off behaviour is starting to fade as financial markets increasingly focus on idiosyncratic stories instead of systemic themes. As we explained … risk and growth asset correlations have fallen markedly. A similar breakdown in interconnectedness can be observed in equity subsectors and long-end rates.
A closer look at risk sentiment provides further evidence. Our preferred measure of market sentiment, GRAM+, which combines different risk factors from across the capital markets, has been in neutral territory for some time. Focusing solely on the headline figure, however, can be misleading and hide important details underneath. A closer look at GRAM+ subcomponents reveals two diametrically different stories (Figure 1): while EM-related risk factors (such as MSCI EM and EM CDS) have deteriorated substantially since the beginning of the year and have dipped into risk aversion, G10 sentiment is firmly in risk-seeking territory.
Such a divergence is rare, but not unheard of. We saw a similar pattern in the middle of the QE2 trade in October … Back at the time, however, QE-induced valuations supported a rally in EM and commodities, while G10 risk sentiment remained pessimistic. Conversely, the current gauge of risk sentiment suggests a preference for developed markets over EM, with the spread between the two at its widest in the past 20 years.
Figure 2 illustrates this point in simple terms by solely looking at recent divergence in equity performance. While the S&P 500 is making new highs, emerging market equities have started feeling the effect of higher inflationary pressures and tighter monetary policy, in line with our expectations. Indeed, as part of our year-ahead de-correlation trades, we have been short a basket of EM equities against US, Japan and Europe …
While we expect the gap between EM and G10 risk metrics to moderate from its current extreme levels, we think the asset de-correlation theme is likely to continue dominating 2011, possibly in a broader way than the EM/G10 divergence we set out [previously] … As the economic recovery enters a mature stage, the market will likely move away from focusing on overall risk sentiment and look at idiosyncratic fundamentals. Thus, we expect 2011 to be the year of relative value when the old risk-on/risk-off market adage may appear overly simplistic.
Back to fundamentals then.
Can anyone remember how to deal with those?
Related links:
Quant crisis, the much more moderated sequel? - FT Alphaville
The latest ‘New Normal’ backlash(es) – FT Alphaville
Still riding the risk-on, risk-off see-saw – The Telegraph