The Great Debate: “Should you be risk-on or risk-off?”

Investor appetite for risk rises and falls over time. According to Investopedia, 'risk-on' and 'risk-off' refer to changes in investment activity in response to global economic patterns. When risks are perceived to be low, investors tend to favour higher-risk investments such as equities, and when risks are perceived to be high, they favour more traditionally defensive assets.  

The challenge today is that yields are so low that investors are being forced against their will to hunt returns from riskier asset classes. Geopolitical tensions, unconventional monetary policy and the duration of the current bull market are just a few of the everyday items on the list of reasons to worry.

Many of these risks have been present for some time and investors that have been parked on the sideline have missed out on good returns. Despite a bleak outlook at the start of the year, the S&P ASX200 is up ~19% this calendar year before including dividends, for example.

There is a trend towards alternative assets to diversify away from equities and bonds in professionally managed portfolios. This includes investments in hedge funds, infrastructure, private equity and private credit.

For self-directed investors, cash plays a significant role in portfolios. As interest rates fall, these investors are needing to go hunting for income, even if they believe that risks are elevated.

It's a tricky situation. Nearly everyone I speak with is trying to come to terms with the current environment and debating how much risk they should be taking right now. 

That's why we decided to run a live debate during our recent Livewire Live event focused on this topic, pitching two teams of experts against each other and taking a 12-month view. Below is a summary of some of the points presented, with the full video below.

What the 'Risk-Off' camp said

Speakers: Dr Philipp Hofflin, Lazard Asset Management: Giselle Roux, Escala Partners; Jay Sivapalan, Janus Henderson 

The core of the risk-off argument is that the duration of the current bull run has stretched valuations, and prices no longer reflect fundamentals. 

Giselle Roux said chasing returns today is like picking up pennies from in front of a bulldozer. After a decade of ~10% per annum returns, she said it was now prudent to bank some of those gains.

"There'll be no warning bell to tell you that things are about to change. You'll get all kinds of false signals; you are going to get little calming rallies."

Jay Sivapalan from Janus Henderson encouraged investors to reflect on the distortions that were being created in markets. In the 500-year history of bond markets, there has never been a negative yield, he said.

Jay acknowledged that elevated price to earnings ratios could be propped up by low bond yields. However, he argued that earnings are a more powerful driver of valuation and relying on low bond yields alone is dangerous.

From a fixed income perspective, the message was simple,... recognise the distortions, don't hunt for yield.

"Be fearful when others are greedy and greedy when others are fearful."

Dr Philipp Hofflin from Lazard Asset Management presented the case for risk-off from an equities perspective. His argument focused on the premise that assets are expensive. Quoting Buffett, he said that now is not the time for investors to get greedy.

Hofflin has been around long enough to know what frothy markets look like. He highlighted a handful of signals that were catching his eye.

• Top line revenues are up 50% with prices up 400% in the current bull run
• Multiples are at levels that have not been seen outside of 1999 and 2000 – the peak of the dot com boom
• There is a new record for the percentage of loss-making companies listing in the US
• In the S&P, company gearing is at record highs as companies pay out more than 100% of their free cash flow in buybacks and dividends

Hofflin concluded by saying that recession is not a prerequisite for investors to lose money, really expensive stock markets are dangerous just by themselves.

What the 'Risk-On' camp said

Speakers: Charlie Jamieson, Jamieson Coote Bonds; Ben Griffiths, Eley Griffiths Group; Brigette Leckie, Koda Capital

Ignore the noise and focus on the fundamentals. That was the opening message from Brigette Leckie who laid out the case for being risk-on. She says that central banks are wiser from experience and are being proactive with their policy settings.

Leckie highlighted that none of the three leading causes of recession presents a threat in 2019; Inflation is present but not being suppressed, energy prices are being kept low through shale oil, and war is unlikely as self-interest from politicians will likely drive a resolution on trade disputes.

In December 1996 Alan Greenspan gave a speech that labelled equity markets as being in a state of "irrational exuberance". The NASDAQ was trading at 1300 and proceeded to rally to 5000 by March of 2000. Leckie says the risk of missing meaningful returns is real.

Charlie Jamieson highlighted that we had a glimpse of risk off at the end of 2018. Credit markets, the oil that keeps the financial system moving, seized, and it terrified central bankers. The narrative and action from Jerome Powell flipped 180 degrees from a tightening bias to one of enormous accommodation.

At the time of the debate there had been seventeen interest rates cuts in developed markets in 2019, providing 1,100 basis points of stimulus. Jamieson says that there is more to come, and this stimulus is only just working through financial markets.

"All around the world this year we are enjoying enormous accommodation well ahead of any kind of crisis moment. It is that fact that will keep risk on for the next 12-month period."

Goldman Sachs maintains an indicator that measures investor sentiment in markets. Ben Griffiths says that it continues to show that a bearish mood resides in markets and that equity markets are set to continue climbing a wall of worry.

Griffiths says that before any investor looks to invest in equities, it is necessary to check that credit markets are functioning in a healthy manner. Across a comprehensive range of checks, he says that all indications point to smoothly functioning credit markets.

Another indicator that Ben draws on is correlations. In short, he is looking to see that a high proportion of stocks are contributing to the gains in equity markets. Correlations currently sit at the top end of the range.

With equity risk premiums at around 8% in Australia and 5% in the United States, Griffiths says the outlook for stocks remains positive. 

What's your view?

I'm a glass half full person and tend to lean towards the risk on camp. However, I fully acknowledge that there is some pretty crazy stuff (negative yields) out there.

I'd love to hear your views via the comments below. Are you feeling risk on or risk off right now? Why?

Watch the full video below