Download risk appetite renaissance - RBC Global Asset Management

Economic Compass
Global Perspectives for Investors
ISSUE 22 • MARCH 2013
HIGHLIGHTS
Eric Lascelles
Chief Economist
RBC Global Asset Management Inc.
ƒƒ As earnings growth has slowed, the stock market rally has increasingly relied
upon a rising risk appetite.
ƒƒ We calculate that risk appetite has finally returned to a neutral stance, and still
has room for further moderate improvement.
ƒƒ Of the underlying contributors to this action, risk tolerance in particular can
afford to continue normalizing and an attractive return proposition should
remain a positive catalyst.
ƒƒ While there is always the risk of a reversal, it is comforting that risk appetite
looks much more normal than it did the prior two times the stock market
reached current levels.
RISK APPETITE RENAISSANCE
What has enabled this impressive comeback? To answer this
question, we need to understand what drives stocks (Exhibit 2).
The first and most durable driver is rising corporate earnings.
Profits have indeed rebounded admirably from the worst of the
financial crisis, though in recent quarters they have become
less of a central contributor (Exhibit 3). The earnings outlook is
adequate, but admittedly unexciting given an economy mired in
sluggish growth.
Exhibit 1: S&P 500 on Upward Trend Since 2009
S&P 500 Index
Financial markets have plugged doggedly higher for several
months. The S&P 500 is flirting with its all-time record, as are
several other indexes (Exhibit 1). This has been a long time
coming: investors have spent 13 years wading through the
detritus of the dot-com bubble and global financial crisis to
reach this point.
1700
1600
1500
1400
1300
1200
1100
1000
900
800
700
600
2000
Flirting with all-time high
Latest
surge
Long
recovery
2002
2004
2006
2008
2010
2012
Source: Haver Analytics, RBC GAM
The second source of stock-market gains is rising risk appetite.
Loosely speaking, a resurgent risk appetite encourages
investors to transition into traditionally riskier assets such
as equities, resulting in higher valuations (Exhibit 4) and,
consequently, a rising stock market.
Exhibit 2: Source of Stock Market Gains
Recent equity gains have come in sizeable part from the
second of these drivers – renewed risk appetite – which has
fluttered higher from a position of extreme risk aversion to risk
reluctance, and now to risk neutrality. Future stock-market gains
– should they occur – will have to come in large part from this
wellspring until such a time as the economy and earnings are
able to more boldly assert themselves.
In this context, what are the chances that the risk-appetite
wellspring runs dry? In contrast to the prior market peaks of
2000 and 2007, risk appetite is not obviously overblown this
time.
Stock Market Gains
Rising
Earnings
Source: RBC GAM
Rising Risk
Appetite
Many times, the term “risk appetite” is bandied about in an
overly loose fashion, for instance as shorthand for whether the
stock market is rising or whether businesses are hiring. These
phenomena can indeed respond to (and thus reflect) higher risk
appetite, but they do not move solely at its behest.
At other times, the term is used more precisely – but too
narrowly – for instance by probing the risk appetite of just a
single sector of the economy, be it households or businesses or
some aspect of the credit market.
Other proxies for risk appetite are theory-heavy and anchored
in impressive math and statistics, but lack a reliable real-world
connection.1
Each of these riffs on risk appetite has its value, but none
captures the entire melody.
We define risk appetite as a greater willingness to engage in
what are traditionally considered risky endeavours, such as
rotating into more volatile investments, undertaking a new
enterprise, expanding an existing business or leaping from one
employer to another.
Even with this clarification in hand, there is a further
complication: risk appetite is an unobserved variable. Unlike
GDP growth or a dividend yield – for which official figures exist –
risk appetite can only be guessed at.
Gauging risk appetite
In an effort to obtain the best guess possible, we combine 46
different measures of observable proxies for risk appetite into a
single risk appetite index (Exhibit 5).2 The full set of variables is
sorted by category and listed in Appendix A.
1
These also tend not to be maintained for long by their publishers, as
demonstrated by discontinued series from the International Monetary Fund, Bank
of International Settlements and Bank of England.
2
The components are normalized and weighted equally in the survey, and
variables are excluded for periods earlier than their first data point. Inevitably,
there is some duplication of variables, especially given the inclusion of thirdparty risk appetite indexes that in turn rely upon several of the primary indicators
we include. Principal component analysis was rejected as an option due to the
extreme limits placed on the output by a large number of inputs, and because the
length of the resultant series would be restricted to the shortest input.
2 ECONOMIC COMPASS Issue 22 • March 2013
S&P 500 Earnings Growth
(YoY %)
Risk appetite is a poorly understood concept, primarily because
the term is not consistently or clearly defined.
70
60
50
40
30
20
10
0
-10
-20
-30
-40
1999
Recent
deceleration
Initial
post-crisis
spike
2001
2003
2005
2007
2009
2011
2013
Note: Year-over-year % change of trailing 12-month earnings per share of
S&P 500 stocks. Source: Bloomberg, RBC GAM
Exhibit 4: Rising Valuations Contribute to Equity Performance
26
S&P 500 Price-to-Earnings (P/E)
Ratio
Defining risk appetite
Exhibit 3: U.S. Corporate Earnings Growing Only Modestly
23
20
Rebound as risk
appetite rises
17
14
11
8
2006
2007
2008
2009
2010
2011
2012
2013
Source: Bloomberg, RBC GAM
Exhibit 5: Reviving Risk Appetite
Risk Appetite Index (Average = 0)
In this report, we set out to better understand risk appetite,
gauge its current level, determine the likelihood of further
improvement and grasp its implications for the economy and
financial markets.
2.0
1.0
Loving
Seeking
0.0
-1.0
-2.0
Neutral
Reluctant
Averse
-3.0
-4.0
1991
1994
1997
2000
2003
2006
2009
Note: Measures risk appetite based on 46 normalized inputs.
Source: Bloomberg, RBC GAM, and as listed in Appendix A
2012
Economic Compass
Why bother including the fast-moving variables? They can be
useful for timing short-term market movements. To this end, the
fast movers have recently soured a little, suggesting a shortterm downside risk to markets this spring.
Breadth check
The overall risk appetite index also exhibits good breadth. We
decompose it into six buckets, sorted by type of input. These
are categorized according to price, flow, volatility, correlations,
surveys and third-party risk indexes (refer again to Appendix A
for details).
3
Higher risk appetite
2
1
1
0
0
-1
-1
-2
-2
-3
Lower risk appetite
-3
1991
1994
1997
2000
2003
2006
-4
2009
2012
Risk Appetite Index (Average = 0)
4
Low Frequency Data (RHS)
2
-5
Source: Bloomberg, RBC GAM, and as listed in Appendix A
Exhibit 7: All Elements of Risk Appetite Have Improved
3
1
0
-0.51
-1.00
Correlationn
4
-0.38
Flow
5
2
0.44
-0.20
Volatility
6-1
0.33
Price
0.25
Survey
1
70
Third-Party Risk Indices
Another interesting observation is that risk appetite spends very
little time around its average level. On the contrary, it typically
spends brief periods at well-below average levels (such as
when in the jaws of the financial crisis), then long periods at
moderately above-average levels, in risk-seeking mode. This
latter area constitutes the true “normal.” This suggests some
further progression is probable without risk appetite venturing
into unsustainable territory.
5
High Frequency Data (LHS)
Aggregate
The slow movers are generally of greater use because we seek
to identify trends that will endure for years, not ones that burn
brightly for a few months only to fizzle out. Promisingly, the
slow-moving index exhibits an even more pronounced upward
trend and reveals a level of risk appetite that is actually smack
on the average, rather than slightly worse (Exhibit 6). All of
this bolsters our confidence that risk appetite may manage to
continue rising, or at least sustain its recent gains.
Risk Appetite Index (Average = 0)
One way to extract even more insight from our risk appetite
index is to deconstruct it into slow- and fast-moving parts. Some
inputs move more slowly and with greater persistence than
others. They take years to swing from their lows to their highs,
compared to several times a year for faster-moving inputs.
3
Current
Level
Persistence check
Exhibit 6: Risk Appetite Normalizing
Change in Risk Appetite
We find that risk appetite has indeed revived, progressing from
the weakest reading in the history of the series in late 2008
to the strongest reading since the onset of the financial crisis.
What’s more, we calculate that risk appetite is now firmly into
“risk-neutral” mode, meaning that the era of risk reluctance and
the extreme risk aversion that preceded it seem to have come
to an end. Risk appetite is finally near its historically average
reading.3
Note: Change in risk appetite from the trough since January 2008.
Source: Bloomberg, RBC GAM, and as listed in Appendix A
Fortunately, all six measures agree with the overall risk appetite
index (Exhibit 7). Each has improved substantially from its
worst reading. Three of the six are now above their historical
average and three remain below it. Within the context of our
qualitative classification scheme, two of the six measures are in
risk-seeking mode, one is in risk-neutral mode and three are in
risk-reluctant mode.
Notably, our collection of third-party risk indexes – measures of
risk appetite constructed by other organizations – is somewhat
more optimistic than the historical average, whereas our
own risk appetite index is still slightly below the average.
Consequently, markets may wrongly think there is little upside
left for risk appetite, whereas we suspect there is still some
room for improvement.
3
Within the risk appetite index, some measures are of course already well into
risk-seeking mode (such as credit spreads) whereas others (such as the real U.S.
10-year yield) are still mired in risk-averse mode.
3
Justifying rising risk appetite
Exhibit 8: Risk Appetite Underpinnings
Why has risk appetite reanimated, and what might permit
further gains?
We believe swings in risk appetite are induced by the
locomotion of three underlying variables: “risk tolerance”, the
“return proposition” and the “risk proposition” (Exhibit 8). Each
of these elements has lately contributed to the resurgence in
risk appetite, and two of the three look capable of supporting
further gains.
Risk tolerance
The first concept is risk tolerance, which is the most
straightforward, and arguably comes closest to what most
people envision when they think of risk appetite. Simply put,
rising risk tolerance means that a party is willing to tolerate a
higher level of risk, all things being equal.
Risk Appetite
Risk Tolerance
 Greater willingness to
tolerate risk
 Moves slowly
 Considerable room for
future improvement
Exhibit 9: Depicting Rising
Risk
Tolerance
Depicting
Rising
Risk Tolerance
Risk
Available risk-return profile
B
Resultant Mix
4 ECONOMIC COMPASS Issue 22 • March 2013
Initial Mix
A
The frequency with which U.S. workers voluntarily change
jobs (the “quit” rate) also provides a useful estimate of risk
tolerance. Switching jobs is an inherently risky proposition given
Desired risk-return profile with
greater risk tolerance (2)
Initial desired risk-return
profile (1)
Of the three components, risk tolerance usually moves the most
slowly and exhibits the greatest persistence in the direction
of its movement. As an extreme example, the generation that
lived through the Great Depression never fully recovered its
risk tolerance after the trauma of the 1930s, favouring less
risk throughout their lives despite the repercussion of inferior
returns.
Impact:
 Significantly more risk
 Somewhat better return
Return
Source: RBC GAM
Exhibit 10: Cross-Asset Correlation Declining
0.7
0.6
Asset classes highly correlated
0.5
Correlation
We can get a taste for the level of risk tolerance in a few ways.
The correlation between different financial assets has declined
from its highest levels. This hints that investors are becoming
somewhat less lemming-like in their investment choices and
again capable of distinguishing between the idiosyncratic
possibilities in different markets and among different securities.
Exhibits 10 and 11 reveal this diminished co-movement. These
offer classic evidence of rising risk tolerance, though it is equally
evident that risk tolerance is still far from normal and has the
most room for further improvement of the three components.
 Perception that
risks have shrunk
 Can move quite quickly
 Limited upside/possible
downside
returns have improved
 Moves at a middling
pace
 Room for future
improvement
Source: RBC GAM
In the context of an investment portfolio, rising risk tolerance
usually motivates a shift into more volatile assets, resulting in
the expectation of a somewhat better return in exchange for
substantially more risk (Exhibit 9).
As the 2008 financial crisis fades from memory, the question is
whether risk tolerance has been completely severed, as it was
for the Great Depression generation, or just frayed. Fortunately,
it appears to be the latter, likely because the economic decline
did not cut as deeply and a raft of economic, market and social
safety nets diminished the pain.
RiskRisk
Proposition
Proposition
Return Proposition
 Perception that available
0.4
0.3
0.2
0.1
0.0
2001
Asset classes less correlated
2003
2005
2007
2009
2011
2013
Note: Cross-asset correlations of U.S. Dollar Index, U.S. dollar 10-year interest
rate swap, S&P 500 Index, WTI crude oil price and gold spot price.
Source: Bloomberg, RBC GAM
Economic Compass
Risk tolerance is slowly beginning to revive. Given past evidence
of persistent movements and ample room for further gains, it
can probably continue its ascent.
Exhibit 12: Reluctance to Quit Hints at Low Risk Tolerance
2.6
U.S. Quit Rate (% of Employed)
the possibility of a poor fit, but is rewarded by an average 9%
wage gain. Importantly, the risk doesn’t vary much across the
economic cycle. Thus, the fact that more American workers are
again moving to new employers is promising, though the rate
remains much lower than before the financial crisis (Exhibit 12).
The same can be said for risk tolerance – improving, but still
subpar.
Return proposition
At the other end of the spectrum, the future return on stocks
looks to be fairly good given inexpensive valuations
(Exhibit 15). To be clear, bonds are still likely to exhibit less
volatility than stocks, but the gap has shrunk, whereas the
1.6
1.4
Rising
1.2
2003
2005
2007
2009
2011
2013
Exhibit 13: Both Treasury Yields and Credit Spreads Have Declined
8
U.S. 10-Year Treasury Yield
7
U.S. Corporate Bond Spread
6
5
4
3
2
1
0
2000
2002
2004
2006
2008
2010
2012
Note: Option-adjusted spreads of 7–10 year U.S. corporate bonds.
Source: BofA Merrill Lynch, RBC GAM
300
Change in CDS Spread (bps)
1.0
Median Correlation of S&P 500
Stocks and S&P 500 Index
Room
for
more
1.8
Exhibit 14: Rising Sovereign Default Risks
Exhibit 11: Stock Correlations Down From Peak
0.8
0.6
0.4
0.2
250
200
150
100
50
0
1983
Source: Ned Davis Research, RBC GAM
2.0
Source: Bureau of Labor Statistics, Haver Analytics, RBC GAM
%
Today, the return proposition is indeed altered – in two ways.
Prospective returns for fixed income investments appear to be
more limited than usual over the coming decade, owing to very
low government yields, narrow credit spreads and the risk of
capital loss when interest rates eventually begin normalizing
(Exhibit 13). Compounding this shift, the risks have arguably
increased given the general deterioration of government
finances (Exhibit 14).
Pre-2008
historical average
2.2
1.0
2001
The second concept embedded within risk appetite is what we
call the return proposition. The idea is that markets and/or the
economy may occasionally contort themselves in ways that offer
returns at odds with the associated risks. Investors, businesses
and households eventually respond to this incentive, catalyzing
a change in risk appetite.
0.0
1973
2.4
1993
2003
2013
Italy
France
Japan
Germany
U.K.
U.S.
Note: Change in 10-year credit default swap (CDS) spreads on sovereign bonds
since January 2008. Source: Bloomerg, RBC GAM
5
Risk proposition
The third component of risk appetite is the risk proposition. In a
sense, it is the mirror image of the return proposition. The idea
is that economic and market conditions sometimes vary in ways
that present an across-the-board decrease in risks, without
compromising expected returns.
Investors, businesses and households understandably respond
to this incentive by pursuing more lucrative opportunities,
content in the knowledge that their risk of failure is no worse
than usual (Exhibit 20).
Arguably, the risk proposition has improved over the past year.
Big downside risks to the global economy and markets have
shrunk. Europe has found itself on firmer footing, as evidenced
by lower Spanish bond yields (Exhibit 21). China has managed a
soft landing (Exhibit 22); and American politicians have avoided
the most dangerous pitfalls, providing incrementally better
policy clarity along the way (Exhibit 23).
One useful way of confirming this improved risk proposition is
by determining whether volatility is expected to be tame in the
future. The volatility bucket within our risk appetite index says
“yes.” It has improved by more than most of the other elements
and now sports among the best absolute readings (Exhibit 24).
In a similar vein, we observe that corporate defaults are again
fairly tame (Exhibit 25).
S&P 500 Price-to-Earnings (P/E)
Ratio
37
32
Historical
average
27
22
17
12
7
1980 1984 1988 1992 1996 2000 2004 2008 2012
Source: Bloomberg, RBC GAM
Exhibit 16: Equity Risk Premium Is Attractive
20
Equity Risk Premium (%)
Markets are still some distance from fair value, suggesting that
the return proposition should remain a positive catalyst for risk
appetite. Our survey-based metric of risk appetite suggests that
investors, businesses and households have not yet fully woken
to this opportunity (Exhibit 19), allowing for some additional risk
appetite upside as this realization sets in.
Exhibit 15: Stock Valuations Still Modestly Cheap
15
Historical
average
10
5
0
-5
1971
1977
1995
2001
2007
2013
Depicting Improving Return Proposition
Available risk-return profile with
improved return proposition (2)
Initial available risk-return profile (1)
Initial desired risk-return profile (1)
Desired risk-return profile given
improved return proposition (2)
Initial Mix
A
B
6 ECONOMIC COMPASS Issue 22 • March 2013
1989
Exhibit 17: Depicting Improving Return Proposition
However, different from the prior two components, further
improvements in the risk proposition could be difficult to
achieve. This is partially because the risk proposition is already
fairly good, and partially because the world is still host to a
variety of brewing risks.
Europe looks safer than before, but must still contend with
political gridlock in Italy, bank bail-ins in Cyprus and the everpresent risk of renewed crisis. Chinese growth has stabilized,
but its housing, local-debt and shadow-banking sectors are as
yet unreformed. U.S. public policy could still go off the rails.
1983
Note: Defined as difference between trailing earnings yield of S&P 500 stocks
and real yield of U.S. 10-year Treasury bond. Shaded area denotes +1 and -1
standard deviation from average. Source: Barclays Capital, Haver Analytics,
Shiller, RBC GAM
Risk
disparity between prospective returns has grown (Exhibit
16). This new and improved return proposition motivates an
increase in risk appetite, and results in a shift toward higheryielding assets (Exhibit 17). That shift is already underway, with
investors deploying previously idle cash into equities (Exhibit
18).
Resultant Mix
Impact:
 Unchanged risk
 Better return
Return
Source: RBC GAM
Economic Compass
Exhibit 18: Investors Return to Equities Seeking Higher Returns
Exhibit 21: Substantial Decline in Spanish Borrowing Costs
7.5
10-Yr Treasury Bond Yield (%)
Weekly Equity Mutual Fund
Flows ($ Billions)
16
12
8
Inflow
4
0
-4
-8
Outflow
-12
Jan-12 Mar-12 May-12 Aug-12 Oct-12 Dec-12 Mar-13
Source: ICI, RBC GAM
5.0
Jul-11
Dec-11
May-12
Oct-12
Mar-13
Exhibit 22: Chinese Economy Has Picked Up Speed
Expansion
Still below
normal
0.5
-0.5
-1.5
-2.5
1991 1993 1995 1997 1999 2001 2003 2005 2007 2009 2011 2013
Source: Bloomberg, RBC GAM, and as listed in Appendix A
Exhibit 20: Depicting Improving Risk Proposition
Depicting Improving Risk Proposition
Initial available risk-return profile (1)
Available risk-return profile with
improved risk proposition (2)
Initial desired risk-return profile (1)
Desired risk-return profile given
improved risk proposition (2)
A
Initial Mix
B
Resultant Mix
Impact:
 Less risk
 Better return
Return
55
Manufacturing PMI
1.5
50
Contraction
45
40
2006
2007
2008
2009
2010
2011
2012
2013
Note: PMI refers to Purchasing Managers Index, a measure of economic activities.
Source: HSBC, Markit, Haver Analytics, RBC GAM
Exhibit 23: U.S. Policy Uncertainty High But Falling
250
Economic Policy Uncertainty
Index
Survey-Based Risk Appetite
Index (Average = 0)
5.5
60
-3.5
Risk
6.0
4.5
Feb-11
2.5
6.5
Source: Financial Times, Haver Analytics, RBC GAM
Exhibit 19: Sentiment Is Improving, But Below Average
Source: RBC GAM
7.0
220
190
160
130
100
70
40
1985
1989
1993
1997
2001
2005
2009
2013
Source: Economic Policy Uncertainty Index – Baker, Bloom and Davis, RBC GAM
7
Risk appetite matters a great deal. The fact that risk appetite
has finally returned to its historical average over the past few
months is quite an important development for economic growth
and financial-market performance, arguably no less notable
than the recovery in the U.S. housing market or financial
stabilization of Europe.
What could go wrong
To be sure, there is always the risk of a reversal of risk appetite.
Unlike the U.S. housing market’s solid foundation of attractive
affordability and demographic demand, risk appetite is built
on three potentially unstable pillars: the willingness to take
chances, the sense that future returns could be larger than usual
and the sense that future risks could be smaller than usual. All
are subject to change, some more quickly than others.
A series of adverse events could substantially worsen the
risk proposition, shift focus away from the attractive return
proposition and compromise the slow gains in risk tolerance
made so far. Indeed, our faster-moving series hints that risk
appetite could already be stalling out, though only temporarily.
What could go right
Despite this threat, we suspect risk appetite can continue to
tread somewhat higher. Among the three components, the risk
proposition is unlikely to become materially more favourable
given its heady gains so far and the reality of a risk-laden world.
But the return proposition should continue to act as a beacon
for additional risk appetite, especially as economic healing
persists.4 Lastly, risk tolerance has a great deal of room for
further improvement as the spectre of the global financial crisis
fades.
The fact that the slow-moving portion of our risk appetite index
is still trending higher and the overall index is still short of
its historically “normal” level means that market upside still
beckons. This risk appetite renaissance looks like it could be for
real.
4
This healing refers primarily to U.S. housing and credit market improvements,
stabilization in Europe and the exciting reforms in Japan.
8 ECONOMIC COMPASS Issue 22 • March 2013
2
Volatility-Based Risk Appetite
Index (Average = 0)
Implications
Exhibit 24: Volatility Tapers as Uncertainties Subside
Lower volatility
1
0
-1
-2
Higher volatility
-3
-4
1991 19931995 1997 19992001 2003 20052007 2009 20112013
Source: Bloomberg, RBC GAM, and as listed in Appendix A
Exhibit 25: Corporate Default Rate Back to Low Levels
9
Annual Corporate Default Rate
(%)
Japan’s bold experiment to re-inflate growth is worthwhile,
but could unleash nasty consequences for its debt burden.
Geopolitical tensions are on the rise in many corners of the
world. Finally, there is always the (unlikely) threat of a natural
disaster just when all else looks calm.
8
7
6
5
4
3
2
1
0
1921
1934
1947
1960
1973
1986
1999
2012
Note: Issuer-weighted default rate for all Moody’s-rated corporate issuers.
Source: Moody’s Investors Service, RBC GAM
Economy
Contrary to the admonishments of kindergarten teachers
everywhere not to run with scissors, risky behaviour can
sometimes be a very good thing. Economies cannot grow
without people inventing new things, conceiving of new
products and starting new companies. Most of these will be
utter failures. But a few will succeed, employing more people
and improving living standards.
Moreover, a rise in risk appetite can be a self-fulfilling prophecy.
Greater risk-taking permits greater growth, encouraging yet
more risk-taking. It can also be wonderfully contagious, leaping
from country to country. For these reasons, it is both exciting
and consequential to see risk appetite stage such a comeback.
We figure that the lack of risk appetite over the past several
years was subtracting as much as a percentage point per year
Economic Compass
from economic growth.5 As risk appetite improves, that drag is
fading and is on the cusp of generating forward propulsion. To
be clear, economic growth in the developed world should still be
restrained by public-sector deleveraging and a variety of other
idiosyncratic drags, but this should not obscure the importance
of eliminating one more obstacle.
Risk
Exhibit 26: DepictingDepicting
RisingCombined
Risk Appetite
Effect of Three Forces on Risk Appetite
Initial available risk-return profile (1)
Available risk-return profile with
higher risk appetite (2)
Desired risk-return profile
with higher risk appetite (2)
Initial desired risk-return
profile (1)
Initial Mix
Rising risk appetite is also very important for markets, resulting
in a greater willingness to take on risk in exchange for a greater
return (Exhibit 26).
B
A
Markets
Resultant Mix
Impact:
 Slightly more risk
 Significantly better return
Investors often adjust their asset allocations as their risk
appetite grows. A stylized depiction of this process is shown
in Exhibit 27. Broadly, the transition from risk aversion to
risk neutrality – the path trodden so far – is consistent with
a diminished appetite for gold, cash and government bonds,
and a greater appetite for credit and equities. Should risk
appetite continue to gear up into risk-seeking mode, additional
reallocation is possible, further diminishing fealty toward the
former three investments and stimulating additional demand
for more volatile forms of equities, such as growth stocks and
emerging market stocks.
Return
* Note: Combines rising risk tolerance, an improving return proposition and an improving risk
proposition
Note: Combines rising risk tolerance, an improving return proposition and an
Source: RBC GAM
improving risk proposition. Source: RBC GAM
There is evidence that the precipitous stock market decline of
2008 was presaged by sharply declining risk appetite (Exhibit
28). As such, recent gains in risk appetite could be a leading
indicator for further stock-market appreciation.
Whether or not risk appetite is truly a leading indicator, it is
certainly no worse than a contemporaneous indicator. This is
also a useful property. Our belief that risk appetite can afford
5
Note that this drag was manifested in other economic variables, such as housing
market weakness, sluggish hiring and anemic capital investments.
Fraction of Portfolio Allocation
Exhibit 27: Risk Appetite and Investing Behaviour
Popular
during
riskaversion
periods
Gold
Cash
Government
Bonds
Credit
Value
Stocks
High Yield
Growth
Stocks
Popular
during
risk-loving
periods
EM
Equities
Averse
Reluctant
Neutral
Seeking
Loving
Investor Risk Appetite
Source: RBC GAM
9
Overblown risk appetite
signalled market excesses
2
60
1
40
0
20
-1
0
-2
-20
-3
-4
1991
Risk Appetite Index
-40
S&P 500 Index Return
1994
1997
2000
2003
2006
2009
Note: Risk Appetite Index based on 46 normalized inputs.
Source: Bloomberg, RBC GAM, and as listed in Appendix A
10 ECONOMIC COMPASS Issue 22 • March 2013
2012
-60
S&P 500 Index Return (YoY %)
What of the concern that stock markets suffered major
corrections both times they previously inhaled this rarefied
air? Never say never, but without major bubbles waiting to be
pricked and lacking the arrogance of excessive risk appetite, the
context is strikingly different this time.
Exhibit 28: Risk Appetite and Stocks Moving in Tandem
Risk Appetite Index (Average = 0)
to edge higher over time – mostly on the back of improving risk
tolerance and an attractive return proposition for investors –
means that further stock market gains are possible.
Economic Compass
APPENDIX A: RISK APPETITE INDEX COMPONENTS
PRICE
U.S. 10-Year Treasury Real Yield
Yield of U.S. 10-year Treasury Inflation Protected Securities.
U.S. Corporate Bond Spread
Option-adjusted spread of the BofA Merrill Lynch (BofA ML) U.S. Corporate Index which is
comprised of investment grade corporate debt in U.S. dollar issued in the U.S. domestic
market.
U.S. High Yield Bond Spread
Option-adjusted spread of the BofA ML U.S. High Yield Index, which tracks the performance of
non-investment grade corporate debt in U.S. dollar issued in the U.S. domestic market.
Global Corporate Bond Spread
Option-adjusted spread of the BofA ML Global Corporate Index, which is based on investment
grade corporate debt issued in major domestic and eurobond markets.
Global High Yield Bond Spread
Option-adjusted spread of the BofA ML Global High Yield Index, which is comprised of noninvestment grade corporate debt denominated in U.S. dollars, Canadian dollars, British pound
and euros, issued in major domestic and eurobond markets.
Emerging Market Sovereign Bond Spreads
Option-adjusted spread of the BofA ML Emerging Markets Sovereign Plus Index, which tracks
the performance of emerging markets and cross-over sovereign debt denominated in U.S.
dollars and euro, issued in U.S. domestic, euro domestic and eurobond markets.
Sovereign Credit Default Swap (CDS) Spreads
CDS spreads – costs of insuring against loan defaults – on German, French, Italian and Spanish
sovereign debts are averaged to create a composite.
Price-to-Earnings (P/E) Ratio
P/E ratio of S&P 500 Index.
Put-Call Ratio
Ratio of trading volume of put options to call options on S&P 500 Index.
VOLATILITY
Euro-U.S. Dollar (EURUSD) Option Volatility 1 Year
The implied volatility of a 1-year EURUSD currency option is the market expectation of future
volatility of the exchange rate of the currency pair.
U.S. Swaption Volatility 1Y 5Y Normalized
The implied volatility of a 1-year option on 5-year U.S. interest rate swap is an estimate of
future bond market volatility.
CBOE Volatility Index (VIX)
Expected equity market volatility priced into S&P 500 Index options.
Consensus Economics Standard Deviations of
GDP Forecasts – U.S.
Measures the level of disagreement in analyst forecasts of real GDP for U.S.
Consensus Economics Standard Deviations of
GDP Forecasts – Eurozone
Measures the level of disagreement in analyst forecasts of real GDP for the Eurozone.
Consensus Economics Standard Deviations of
GDP Forecasts – U.K.
Measures the level of disagreement in analyst forecasts of real GDP for the U.K.
Consensus Economics Standard Deviations of
GDP Forecasts – Japan
Measures the level of disagreement in analyst forecasts of real GDP for Japan.
Survey of Professional Forecasters Real GDP
Forecast Dispersion
Similar to the standard deviation of GDP forecasts from Consensus Economics, but with a
longer history and only for the U.S. The forecast dispersion is measured as the percentage
difference between the 75th percentile and 25th percentile of the projections of level of real
GDP in 1 year.
Economic Policy Uncertainty Index
Monthly index of U.S. economic policy uncertainty, generated by assessing news with policy
relevant terms, tax code expiries and forecast dispersions for CPI and government spending.
CORRELATION
Cross-Asset Class Correlation
A composite of pairwise correlations of U.S. Dollar Index, U.S. dollar 10-year interest rate swap,
S&P 500 Index, WTI crude oil price and gold spot price.
Correlation of S&P 500 Stocks and S&P 500 Index
Median correlation of S&P 500 individual stocks to S&P 500 Index.
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APPENDIX A
FLOW
Net Speculative Long Positions in U.S. Treasury
Difference between speculative long (bullish) and short (bearish) positions in U.S. 10-year
Treasury futures.
U.S. Corporate Bond Issuance
Value of corporate bonds issued by U.S. corporations.
Eurozone Corporate Bond Issuance
Value of euro-denominated corporate bonds issued by Eurozone corporations.
U.S. Net Equity Issuance
Value of equity issuance by U.S. corporations.
Eurozone Net Equity Issuance
Value of equity issuance by Eurozone corporations.
U.S. Mutual Fund Flows Into Equities
U.S. net inflows into equity funds.
U.S. Mutual Fund Flows Into Bonds
U.S. net inflows into bond funds.
U.S. Mutual Fund Flows Into Emerging Markets
U.S. net inflows into emerging market equity and bond funds.
Credit Growth – U.S.
Year-over-year change in loans to households and non-financial corporations in the U.S.
Credit Growth – Eurozone
Year-over-year change in loans to households and non-financial corporations in the Eurozone.
SURVEY
Thomson Reuters/University of Michigan Consumer
Sentiment Index
Measures consumers’ assessment of current economic conditions and expectations on future
conditions in the U.S.
European Commission Economic Sentiment
Indicator –EU
Assesses consumer confidence for European Union on economic and financial conditions,
industry confidence and activities.
European Commission Economic Sentiment
Indicator – Eurozone
Assesses consumer confidence for Eurozone on economic and financial conditions, industry
confidence and activities.
Japanese Consumer Confidence Index
Measures consumers’ expectation on overall livelihood, income growth, employment and
spending on durable goods over the next six months.
National Association of Home Builders Housing
Market Index
U.S. Index is based on a monthly survey of builder perceptions of current and future singlefamily home sales and traffic of prospective buyers.
Market Vane Bullish Consensus Stock Index
Tracks the degree of bullish sentiment of traders for stocks.
Rasmussen Investor Index
Measures economic confidence of consumers who have a minimum of $5,000 invested in
stocks, bonds, and mutual funds.
THIRD-PARTY RISK INDICES
Bloomberg Financial Conditions Index – U.S.
U.S. Index is constructed using money market spreads, credit spreads, and equity indices.
Bloomberg Financial Conditions Index – Europe
European Index is constructed using money market spreads, credit spreads, and equity indices.
BofA Merrill Lynch Financial Stress Index
A composite of over 20 variables from five asset classes covering a number of geographies; the
index measures risk, hedging demand and investor appetite of risk.
Kansas City Financial Stress Index
A gauge of financial stress in the U.S. based on 11 variables, including yield spreads, crossasset correlation and equity market volatility.
St. Louis Federal Reserve Bank Financial Stress Index
Similar to the Kansas City Financial Stress Index, the index measures stress in the U.S. financial
system using various bond yields, yield spreads, equity and EM bond indices, bond and equity
market volatility.
Citigroup Macro Risk Index
An equal-weighted index of credit spreads and implied foreign exchange and equity volatility
that measures risk aversion.
Westpac Risk Aversion Index
Index is calculated using implied volatility of six major currencies against the U.S. dollars, VIX
Index, U.S. 10-year bond-swap spread, JP Morgan EM bond spread and USBB1 industrial bond
spread.
Credit Suisse Global Risk Appetite Index
Index is constructed based on the relationship of excess returns and volatility of safe assets
and risky assets including equities and bonds of developed and emerging markets.
State Street Investor Confidence Index
Derived based on the premise that changes in sentiments are reflected in the shifts in holdings
of risky assets by institutional investors.
12 ECONOMIC COMPASS Issue 22 • March 2013
Economic Compass
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