Major surge in risk appetite is looming
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DESPITE the significant build-up of the second wave of the coronavirus in Europe and the infection tsunami facing the US, the outlook for the global economy received major boosts by the Biden/Harris victory in the US and the apparent successful development of a coronavirus vaccine.
The case for risk-on investment strategies is gaining impetus.
The normalisation of ties between the US and its former trade partners is expected to improve global trade and reduce the prospects of supply shocks.
Furthermore, the geopolitical environment will improve tremendously as the new administration is likely to rescind President Donald Trump’s withdrawal from agreements such as the Iran nuclear deal.
Early indications from China are that the trade war with the US may moderate somewhat as well.
It is still early days and the fight against the coronavirus is likely to be drawn out until vaccines are readily available.
Global economic activity in the fourth quarter may be under pressure, but will gain significant traction as the coronavirus threat wanes.
At this stage it is becoming increasingly evident that the global economy finds itself at the early stage of a major up-cycle and that investors may soon begin to assume additional risk.
The Barron’s Confidence Index is a useful ratio to calculate US investors’ desire to assume additional risk.
According to Investopedia, the ratio is the average yield of Barron’s Best Grade bond list relative to the average yield of its Intermediate Grade bond list. Since the coronavirus contagion rocked the markets in late March this year, the Barron’s Confidence Index fell to the lows experienced during the Global Financial Crisis in 2008/09 and has been range bound around the lows thereafter.
Investors, therefore, remained risk averse and focused on prime quality corporate bonds despite major rallies in developed market equities as represented by the main stock indices.
Investors also shunned emerging market bonds as the 10-year government bond yield spread to developed market government bonds increased.
It is no coincidence that a close relationship exists between the ratio of the gold price to the MSCI Emerging Market Index – my prime indicator of perceived equity market risk – and the Barron’s Confidence Index.
The gold price to emerging market ratio tested the highs of the past 15 years in April this year and has been weakening since then.
Further weakness in gold relative to emerging market equities is, therefore, likely to point to a surge in investors’ desire to take on more risk.
It can therefore be expected that the 10-year government bond yield spread of emerging markets to developed market government bonds will narrow as developed market bond yields rise and emerging market bond yields fall when the risk appetite of investors increase.
The stage in the global business cycle usually indicates what returns can be expected from various global asset classes.
According to my calculations covering the period 1995-2018, the oil price (Brent spot) and emerging market equities as measured by the MSCI Emerging Market Index were the top performing asset classes when economic growth bottomed and started to accelerate, producing monthly annualised returns of 37 percent in terms of US dollars respectively. Developed market equities (MSCI World Index in terms of US dollars) returned 25 percent plus, while metals as measured by the Economist Metals Index returned 15 percent.
The gold price and global bonds were the worst performers in this stage of the global business cycle with monthly annualised returns of 1 percent and -1 percent, respectively.
While down from the recent highs of 40-plus in the last week of October, the CBOE Volatility Index, or VIX, remains elevated at a level of 26 points, indicating continued anxiety among investors.
In previous articles I pointed to the narrow relationship between the gold price to emerging market ratio and the CBOE Volatility Index.
A surge in investors’ risk appetite could, therefore, lead to lower implied volatilities in the pricing of options as an increasingly number of investors are likely to write options to receive option premium income. Yes, a break below a neutral level of 20 points would indicate euphoria which is a typical reflection of investor emotions in a bull market.
Mr Market does not move in a straight line and hiccups can be expected.
The world has changed for the better though, and should underscore a risk-on strategy.
Ryk de Klerk is analyst-at-large. Contact [email protected] His views expressed are his own. You should consult your broker and/or investment adviser for advice. Past performance is no guarantee of future results.