When Is Risk On Or Risk Off Really Asset Class Reallocation?

The views expressed in this column are solely those of the author and do not reflect the views of SVB Financial Group, or Silicon Valley Bank, or any of its affiliates.

In our daily updates we often talk of the markets switching in a very polarized fashion from risk on (having more risk appetite) to risk off (suffering from risk aversion). What do these terms really mean?

More often than not, these actions are the trade-off between greed and the consequence of greed, which is the risk of losing some of the value or devaluing the principle in return for a higher return: fear. When the risk of the latter seems more likely to overtake the advantage of the higher return, then there is a flip from risk appetite to risk aversion.

In currency terms, this usually means that in times of risk appetite the currencies with the higher yields will benefit or strengthen against the U.S. dollar. These currencies can be divided into two main classes. The first is the commodity currencies, which typically have higher yields. Due to higher demand from countries that now consume a lot more than previously, the central banks in these countries have raised their interest rates to try and slow inflation while commodity prices are rising in US$ terms. China is, of course, the largest of these commodity consumers. The result is that the economies in the commodity based countries of Australia, Canada, South Africa, Russia, Brazil and New Zealand have higher interest rates and, therefore, attract the higher risk investment funds. They are the beneficiaries of risk on. The second group of currencies that benefit are those with interest rates higher than the U.S. that do not have commodity based economies.

The currencies that are the beneficiaries of risk off when fear takes over from greed are the yen, the Swiss franc and the US$ because money flows to U.S. Treasuries (at least this used to be the case). The reason I say the US$ used to be the beneficiary is that there has been an acceleration this year of more central banks and sovereign funds, due to the Far East investing in euros rather than in USD, as they diversify their foreign holdings from such a high ratio of U.S. holdings. This is the reason why the euro has maintained its current level despite the euro zone debt problems.

The reason they are moving away from investing in USD is that they are concerned about the amount of US$ we are printing. The theory is that the more currency you have in circulation the less the currency is worth. The foreign countries investing their excess funds created by large trade surpluses have sensibly decided that unless the number of US$ is decreased, the buying power of the US$ is impacted. The result is that it will take more dollars to buy ALL other assets.

The fact is, the way we look at the dollar is slightly different from everyone who is outside the U.S. because it is our currency. The way this devaluation of the dollar affects us is that we see everything else going up in price. Other currencies are more expensive making your foreign vacation in Switzerland this summer cost twice as much as it would have done in the year 2001.

Over the same time period gold has risen from $275 per ounce to over $1,500 per ounce a 550 percent gain in price. Silver was $3.50 per ounce it is up 1,000 percent, but these are precious metals and we all know there are other driving forces behind their rise. Although that is true, let us not forget that there has been a massive amount of gold purchases by the same Far East central banks and other sovereign funds that have been diversifying into other currencies as these metals are de facto currencies.

If we look at other more basic commodities;
 

• Cotton is up from 40 cents per pound to $1.40 per pound. 350 percent higher
• Maize (corn) is up from $100 to $320 per metric tonne 320 percent higher
• Beef is up from $2.40 per kilo to $4.50, up 188 percent percent
• Wheat is up from $140 to $360 per metric tonne up 257 percent

Allowing for inflation compounded over a 10-year period and a pickup in demand, the buying power of the dollar has decreased considerably even taking into account the other factors when compared to the buying power of the other currencies.

Using the euro as the obvious alternative, the above commodities are only higher in euro terms calculating the value difference basis as the euro was 0.9 to the dollar in 2001 compared to 1.43 now: a 158 percent increase.

• Cotton would be 88 cents so only 220 percent higher
• Maize would be $202 or 101 percent higher
• Beef would be $2.85 or only 19 percent higher
• Wheat would be $228 only 162 percent higher

I think this gives us a broad-based idea of how much buying power the dollar has lost. If we were to make the comparison against when the euro was formed at about 1.18 and use that as a more realistic average compared to the 90 cents the euro was worth in 2001. We have to halve the value of the savings for the goods in euro terms showing that while these goods would be higher in parse in euro terms, they would still be much less when compared to the rise in price in U.S. dollar terms.

Let's bring this back to a more domestic focus for us here in the U.S. The Dow was 10,112 at the end of August 2001, (the date used for the above data); it is now 11,690. That means in euro terms — using our average value of 1.18 compared to 1.43 where the euro is today — the Dow is now worth 9,661 in euro terms. To put it another way, if you had euros, bought dollars, invested them in the Dow index for 10 years and sold them today, you would have taken a 20 percent loss due to the erosion of the dollar's value. If you had owned stocks over this same time period, the value of your asset in global terms would have declined.

This illustrates the impact of what happens when a country prints too much (a relative term) money. Not only do commodities and currencies cost more, but its own domestic equities cost more.

Bring on the end of the Fed's QE II policy and hopefully a slight reprieve from this weak dollar policy. Of course, this only shifts the market's global focus to who has the most bad debt out there. Long term we must have Europe beaten on this one, unless the euro splits!