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The mood of global markets continues to change…how can we generate tactical short-term indicators?

Risk appetite, the overall mood of the global markets has been changing rapidly since December 2018. Asset managers, regulators and central bankers are making significant changes to their expectations on global growth, long-term interest rates and inflation outlook. Just last week, US Federal Reserve (FED) announced it was to keep its rates constant – an action that was broadly expected. However, the unexpected came from the dot-plots - the median FOMC member forecast is now signalling no change in rates for the whole of 2019. This year might be the first since 2014 that sees no rate hikes from the FED.

On the other side of the Atlantic German manufacturing data, released on Friday, triggered a stock sell-off and a significant rally in global rates. US 10-year rate decreased below US three-month rate for the first time in 12 years – increasing fears of a US recession.
The global risk appetite barometer is changing at speed. In this environment , how can we capture the changes in the overall risk appetite dynamically? How does fund flows might help us to generate tactical indicators in short-term? To answer these questions we generate three sub-risk appetite indices capturing different kind of risks in global markets.

Equity vs. Bond Risk Appetite – to capture short term rotations between equity and bonds we calculate fund flows as a percentage of the total AuM invested in each market using EPFR fund flows using only institutional funds flows. We then calculate the spread between these two and investigate 4 week rolling averages historically. Figure 1 shows the overall changes in the index since 2012. Higher values mean rotation into equities and lower values mean rotation to bonds. Dashed lines show average and one standard deviation levels of the overall index. As we can identify cyclical changes through the whole period, the recent rotation from equities to bonds seems quite significant.

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Figure 1 : Equity – Bond Rotation Index

Credit Risk Appetite - to capture rotations between high yield credit funds ( US, Europe High Yield and Emerging market Hard Currency Bonds) and US treasuries, we calculate fund flows as a percentage of the total AuM invested in each market using EPFR fund flows. Again, we only use institutional funds flows. We then calculate the spread between these two and investigate 4 week rolling averages historically. Figure 2 shows the overall changes in the index since 2012. Higher values mean rotation into high yield credit and lower values mean rotation to US treasuries. Dashed lines show average and one standard deviation levels of the overall index. The rotation out of high yield credit to US treasuries at the end of 2018 has been a significant one. The reversal was also significant and large.

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Figure 2 : High Yield Credit – US Treasury Rotation Index

High Yielding Currency Risk Appetite - to capture rotations between high interest currencies vs low interest rate currencies, we calculate fund flows as a percentage of the total AuM invested in each currency using EPFR country allocation database. We use institutional funds flows and calculate the spread between these two and investigate 4 week rolling averages historically. Figure 3 shows the overall changes in the index since 2012. Higher values mean rotation into high interest rate currencies and lower values mean rotation to lower interest rate currencies. Dashed lines show average and one standard deviation levels of the overall index. There was a short-lived interest on higher yielding currencies at the start of 2019. This has reversed in the last 4 weeks.

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Figure 3 : High Yield FX vs Low Yield FX Rotation

These three distinct types of indices have a relatively lower correlation – confirming their orthogonal nature. As changes in the risk appetite effect asset prices significantly in the short term, it is crucial to capture also the overall risk appetite to make better tactical asset allocation decisions. To generate this we take a simple average of these indices.  

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Figure 4 shows the overall changes in the index since 2012. Higher values mean rotation into risky financial assets vs lower values which signals rotation out of risky assets. Dashed lines show average and one standard deviation levels of the overall index. In late 2018, the risk-off was mostly triggered by equity to bond and high yield credit to US treasury rotations. After mid-December we saw a reversal in risk appetite towards high-yield credit but not towards equities. Currently, the overall index shows a reversal to risk-neutral levels, even after the dovish statements by most central banks. One thing is for sure -as incoming macroeconomic data and other important political events might move the needle towards one-side in the coming weeks, it is important to know where we are before deciding what to-do.

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