Risk-On
| Asset Type | Behavior |
|---|---|
| Equity | In times of “risk-on” moods, investors want to take more risk, and equities generally rise. Higher beta companies and cyclical companies like technology and financials tend to outperform countercyclical companies like utilities and consumer staples. |
| Credit | Credit also reacts favorably in risk-on environments as prices of high-yield bonds rise. Investors chase yield instead of worrying about the ability of companies to pay them back. |
| Bonds | Safe haven assets like treasuries tend to sell off (yields rise as market prices fall) when investors want to take on more risk. The relationship is less clear though, because sometimes risk-on moods are a product of lower interest rates. For example, the Fed keeping interest rates low is stimulative to the economy and also good for bond prices. |
| Gold | Gold often sells off in risk-on environments because gold is considered a safe haven asset. Like treasuries, the relationship is less consistent because gold is also sensitive to interest rate and dollar currency movements. |
| Oil | Often times, the price of oil is representative of demand in an economy. When an economy is booming, manufacturing and transportation increase demand for oil. Thus, risk-on moods tend to be roughly associated with higher oil prices. |
Risk-Off
| Asset Type | Behavior |
|---|---|
| Equity | Risk-off sentiment often sees equities sell off as investors want to reduce risk. Higher beta companies and cyclical companies like technology and financials tend to underperform countercyclical companies like utilities and consumer staples. |
| Credit | Credit reacts negatively in risk-off environments as prices of high-yield bonds rise. Investors worry more about default risk instead of chasing yield. |
| Bonds | Safe haven assets like treasuries tend to rise (yields fall as market prices rise) when investors want to reduce risk. The relationship is less clear though, because sometimes risk-off moods are a product of higher interest rates. For example, a Federal reserve raising interest rates may upset the market if it doesn’t feel ready, and higher interest rates also result in lower bond prices. |
| Gold | Gold often rises in risk-off environments because gold is considered a safe haven asset. Like treasuries, the relationship is less consistent because gold is also sensitive to interest rate and dollar currency movements. For example, risk-off moods from higher interest rates and strong dollar will put downward pressure on gold, since gold in the U.S. is denominated in dollars. |
| Oil | The price of oil often times decreases if a risk-off mood is indicative of lower economic growth and demand, and thus less demand for raw materials like oil. |
Dollar and Inflation
| Asset Type | Behavior |
|---|---|
| Equity | Currency movements and inflation do not have obviously discernible effects on stock prices in the short term. Since we are buying and selling U.S. stocks in dollars, the net effect is zero. It does have some effect on international companies that derive a lot of their revenue from overseas. Inflation in theory does not have a huge effect on equities because the companies themselves gain more revenue from higher prices of goods and services. However, severe, prolonged inflation without growth in productivity will diminish equity returns. |
| Credit | Credit is a type of fixed income, and is negatively affected by high inflation. The interest payments that investors receive are worth less when their purchasing power is eroded by inflation. |
| Bonds | Treasuries are a type of fixed income, and is negatively affected by high inflation. The interest payments that investors receive are worth less when their purchasing power is eroded by inflation. Dollar strength is a byproduct of interest rates, so treasuries only have a indirect relationship with the dollar. |
| Gold | Gold is denominated in dollars, so stronger dollar is bad for gold and vice-versa. Gold is a hedge against inflation since gold prices rise with inflation. However, if the Fed raises interest rates more than that market thinks it needs to for combating inflation, this could lead to a negative impact on gold. |
| Oil | Oil is denominated in dollars, so stronger dollar is bad for oil and vice-versa. Oil is a raw material part of calculation of the consumer price index, or CPI, a popular measure of inflation, so they go hand in hand rather than being impacted by one another. |
Interest Rates and Yield Curve
| Asset Type | Behavior |
|---|---|
| Equity | The effects of interest rate and yield curve changes on stocks are complicated. All else equal, lower interest rates allow higher stock valuations because lower bond yields are less attractive by comparison. A steeper yield curve is indicative of higher growth expectations, which is positive for stocks, but especially positive for bank stocks. Keep in mind though that stocks are forward looking mechanisms, so often times it is not the steep yield curve itself that helps bank stock prices, but the transition from a flatter yield curve to a steeper yield curve that helps banks stocks. The deal with interest rates is complicated, because it is all about market expectations. Higher interest rates may depress valuations in a late cycle environment. However, a market that is accustomed to weak growth but all of a sudden sees higher economic growth and higher interest rate yields may react positively. It all depends on relative expectations rather than absolute rules of whether high or low interest rates are good or bad. |
| Credit | As mentioned in the inflation section, higher inflation expectations pushes interest rates higher, negatively affecting prices of high yield bonds. Opposite is true for lower inflation expectations. Steeper yield curves imply higher growth, which is good for high yield bonds in the sense that companies will be in better financial health, but bad for high yield bonds in the sense that higher benchmark interest rates will push down high yield bond prices. |
| Bonds | As mentioned in the inflation section, higher inflation expectations pushes interest rates higher, negatively affecting prices of treasuries. Opposite is true for lower inflation expectations. Treasuries make up the yield curve so it wouldn’t make sense to talk about the impact of the yield curve on treasuries. |
| Gold | Higher interest rates are a negative for gold because why own a non yielding asset when other assets pay us an interest rate? Steeper yield curves imply higher economic growth expectations, and higher growth makes gold less attractive compared to other assets like equities. |
| Oil | Higher interest rates often corresponds to stronger dollar, which is a negative for both gold and oil as non-yielding assets. Yield curve changes do not have an obvious theoretical relationship to oil since higher growth is good for oil demand, but also implies higher interest rates. |
Monetary and Fiscal Policy
| Asset Type | Behavior |
|---|---|
| Equity | Accommodative monetary policy and expansionary fiscal policy are good for equities from a broad high-level perspective. In a more fine-tuned examination, accommodative policy lowers interest rates, which help companies that benefit from lower interest rates (borrowers) more than companies that benefit from higher interest rates (lenders - banks). Expansionary fiscal policy helps cyclical companies like industrials, transportation, and financials more than utilities and consumer staples companies. |
| Credit | Accommodative monetary policy helps companies borrow and lowers interest rates, driving up high yield bond prices. Expansionary fiscal policy stimulates inflationary growth, which may drive yields up and prices down. |
| Bonds | Accommodative monetary policy helps companies borrow and lowers interest rates, driving up treasury bond prices. Expansionary fiscal policy stimulates inflationary growth, which may drive yields up and prices down. |
| Gold | Accommodative monetary policy is a positive for gold since lower interest rates makes gold look more attractive than under higher interest rate environments. Expansionary fiscal policy is a negative for gold because higher economic growth and higher interest rate yields make gold look less attractive. |
| Oil | Accommodative monetary policy, if leading to a weaker dollar, is theoretically good for oil prices, but the relationship in reality is not obvious. Expansionary fiscal policy is theoretically good for oil since higher economic growth leads to higher demand for raw input materials like oil. However this connection is complicated in real life by demand and supply dynamics like how much oil is being produced by drilling companies. |
Review
How assets move with regards to each other, macro trends, and sentiment is something useful to keep in mind when investing. In the long term, only the company fundamentals and economic growth matters. But in the short and medium term, keeping an eye on these types of trends and movements may allow the investor to find a mispricing in the market to buy or sell at. It may seem like a lot of trends to keep track of, but after some time investing, some of these start becoming built in our expectations. However, it is important to realize that there are always exceptions to theory, and managing risk levels to an appropriate level will allow us to deal with unexpected surprises.