The simple reason why buy the dip rules the markets

How large the negative return is during a time of risk-off determines how much investors can make in positive return in the following months.By Ben Emons

Tensions on the Korean peninsula are intensifying almost by the hour, and yet markets appear relatively sanguine. What gives? There are a few reasons why, starting with data showing positive momentum in the global economy. Also, financial conditions have been exceptionally loose, in part because of the dollar’s weakness. And investors consider the nuclear threat from North Korea to be little more than saber-rattling.

But perhaps the main cause of the tranquil state in markets is the assumption that when things get to the point that the global economy is in jeopardy, central banks will come to the rescue. That’s been the case since the 1990s. Investors even have a term for it: the central bank put. They know that investing during periods of stress can be quite rewarding. So much so, that investor behavior these days is largely driven by a fear of losing out on big returns. As Warren Buffett likes to say, the best time to buy is when others are fearful.

The performance of major financial asset classes during the last four big crises reveals a consistent “flip sign” between returns during risk-off and risk-on periods. How large the negative return is during a time of risk-off determines how much investors can make in positive return in the following months.

Financial Effect

Source: Bloomberg. Daily Index data from MSCI World Index (Equities), Bloomberg Barclays Global Treasury Aggregate Index (Bonds), CRY (Commodities) and Deutsche Bank Currency Return Index in USD. Risk-off period taken from peak to trough. Risk-on period from the start through 12 months after.

The pattern of returns is closely tied to changes in gross domestic product and inflation in major advanced economies plus China, Russia, Brazil, Mexico and India. The data show when a risk-off event occurs, GDP activity declines and pushes inflation rates lower. Later, GDP activity tends to pick up as a result of a combination of monetary and fiscal stimulus, inventory rebalancing, and renewed investor confidence.

Economic Effect

Source: IMF. Annual GDP and inflation data of major advanced economies and BRIC countries. GDP and inflation change is from the annual GDP weighted average change from one year to the other.

Investors are better informed about what could happen because portfolio analytics nowadays include past crises and simulate severe financial meltdown scenarios. Although a nuclear conflict with North Korea would present what can only be called an unknown unknown, there is historic precedent in the Japanese earthquake and meltdown of three nuclear reactors at the Fukushima Daiichi power plant in 2011.

When it became clear the quake might cause a serious nuclear threat, investors flocked to haven assets, sending Japan’s yen higher by more than 5 percent, pushing 10-year U.S. Treasury yields lower by 30 basis points, and sending the S&P 500 Index down by 4.5 percent. The adverse market reaction was met with coordinated Group of 7 central bank intervention in the yen to calm markets, helping to set up an impressive rally in stocks in the following weeks.

The question is, what is the best hedge in the event of a serious conflict on the Korean peninsula? The past performance of a “risk-on” basket of stocks, bonds, commodities and currencies relative to the performance of a basket of “risk-off” assets comprised of the yen, gold, and U.S. Treasuries that have traditionally done well in times of crises can provide some clues.

Index Portfolio and Risk-Off Portfolio Returns

Source: Bloomberg. Monthly index data. Index Portfolio Return = 25% * return of MSCI Index + 25% * return of CRY Index +25% * return of DXY Index +25% * Global Aggregate Bond Index. Risk-off Portfolio = 33% * return of JPY + 33% * return of Gold + 33% * return of Treasury Index. Returns shown are six-month average of annual average.

In the past, when the returns of the “risk-on” and “risk-off” portfolios converged, that usually marked a tipping point. Markets are currently at such a juncture with the “risk-off” portfolio’s annualized return rising above that of the “risk-on” portfolio. So, could investors be getting ready to take advantage again of geopolitical tension by counting on the central bank put? Time will tell. But as history shows, stepping in when others are fearful is rewarding when the return of a risk-off portfolio is at its peak.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

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