What does waning risk appetite mean?

The first week of January is usually a positive one for markets, and this is mainly due to various reallocation flows. However, the first week of 2024 followed two months of high returns on equities and bonds. A moment's pause is probably in order to take stock of recent valuations. Is the Federal Reserve's (Fed’s) pivot and the long-predicted soft landing already fully priced in? In this weekly edition of Simply put we ask whether declining risk appetites point to a weaker outlook.

Are we still bullish?

These are difficult questions to answer. An indirect approach can perhaps provide an answer: after this global rally, is market sentiment still as bullish as before? 

Our 'nowcast' indicator of risk appetite currently offers an interesting perspective. While sentiment remains positive, demand for hedging has recently increased, as shown by the change in direction of credit spreads in particular, but also by the rise in implied volatility on the foreign exchange market. 
 

Risk appetite is falling

One of the indicators of risk appetite that guides our investment choices is a combination of different markers of investor demand for hedging. These include TED spreads (for liquidity), credit default swap (CDS) index spreads (for credit), implied volatilities on equity indices (volatility) and implied volatilities on various foreign exchange markets (for FX volatility). From these different metrics, we extrapolate the probability of being in a risk appetite phase, which provides us with the indicator shown in the upper part of figure 1. The lower part of the same figure shows the percentage of each category of these indicators that has risen over one month - the diffusion index. 

A genuine bull market is normally reflected here by a high and rising probability. The recent trend in our indicator is therefore consistent with a period of falling risk appetite: the aggregate indicator is high, but the percentage of its component indicators that are rising is less than 50%. Risk appetite is therefore high but showing signs of receding. Its various sub-components also show certain disparities, both in terms of risk appetite and in terms of the diffusion index. In particular, credit has recently provided very positive signals, while forex and equity volatility have been at lower levels. FX volatility in particular has been reflecting a declining appetite for risk for several weeks. 

Is a more cautious approach therefore advisable? The answer lies in the historical performance of the markets over such periods. 

Figure 1. Nowcasting indicator of risk appetite (top) and diffusion index (bottom) in 2023-2024

Source: Bloomberg, LOIM. For illustrative purposes only. Past performance is not a guarantee of future results.

Standing at a crossroads

Figure 2 shows the performance of different asset classes according to risk appetite regimes between 2011 and 2023. The performance during periods of high and rising appetite or when appetite is low and falling should come as no surprise. Whichever sub-indicator is considered, the performance of equities and excess returns on credit is generally positive in the former and negative in the latter. 

Currently, the message is much less clear. Our indicator identifies a period of high but declining risk appetite, particularly with regard to the volatility of the currency markets. From the point of view of figure 2, the underlying message is therefore as follows:

• If we consider the aggregate indicator (that impacts our portfolio allocation), risky assets perform poorly over such periods, but not necessarily negatively 
• If we look at the volatility of the foreign exchange market or credit spreads, the conclusion is no different: the performance of the equity markets has historically been negligible during such periods 

The environment we currently find ourselves in can therefore hardly be called a ‘bear’ period, but rather a crossroads. Since 2011, 48% of equity returns and 47% of credit excess returns are positive in periods such as these. It therefore seems that we are experiencing a pause rather than a more significant decline in valuations. The likely outcome therefore remains uncertain for the time being, and it is far too early to start shouting wolf - especially with real interest rates back below long-term real growth in the US and Europe. 

Figure 2. Annualised performance of the main risk premia as a function of risk appetite regimes

Source: Bloomberg, LOIM. For illustrative purposes only. Past performance is not a guarantee of future results.

Nowcasting corner

The most recent evolution of our proprietary nowcasting indicators for global growth, global inflation surprises, and global monetary policy surprises are designed to track the recent progression of macroeconomic factors driving the markets.

Our nowcasters indicators currently show:

• Growth continues to rise, notably in the US and China. World growth for Q1 could deliver a positive surprise if this trend continues
• Inflationary pressures continue to build up, slowly but surely. The US inflation report is consistent with this trend, and we need to see a moderation in it for the Fed to gain sufficient confidence to cut rates
• Monetary policy continues to show dovish messages, especially in the US 
   

World growth nowcaster: long-term (left) and recent evolution (right)

World inflation nowcaster: long-term (left) and recent evolution (right)

World monetary policy nowcaster: long-term (left) and recent evolution (right)

Reading note: LOIM’s nowcasting indicator gather economic indicators in a point-in-time manner in order to measure the likelihood of a given macro risk – growth, inflation surprises and monetary policy surprises. The Nowcaster varies between 0% (low growth, low inflation surprises and dovish monetary policy) and 100% (the high growth, high inflation surprises and hawkish monetary policy).

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