I recently went to a business lunch where I had a long conversation with someone about the flow of money around the world. And then we started talking about the market being “risk on” and the market being “risk off”.

Later that day, this article: “Emerging Markets Crack as $3.9 trillion Funds Unwind“.

And then I heard one of the CNBC ladies drop the “risk-off” comment in a highly-pretentious-but-attempting-to-sound-nonchalant kind of way.

Which are all clear signs from the Universe that this blog post was required.

When the Market is “Risk On”…

Ironically, “Risk on” does not mean that there is a lot more risk happening; rather, it means that the market is feeling generally more optimistic about taking on more risk. So capital (money) flows into the more risky investments.

And when it’s “Risk Off”

Warren Buffett would call this that day when Mr Market comes to greet you with a sullen look on his face and a Chicken Little attitude about life. And Mr Market would be busy transferring his capital into low risk investments.

Why It’s Important

Economists love to start small, by making key assumptions (constraints), and then evaluating how we would behave if faced with those constraints. And we like to start with the assumption of a “closed economy”. That is – a domestic economy that pretends that it is the only economy that exists.

In a single country’s economy, here is the rough list of “high” risk investments:

1. Equity (stocks and shares – both listed and unlisted);
2. High-risk bonds (I struggled to come up with another name for these – but they are what they are: monies owed by people with a less-than-stellar credit rating); and
3. Derivatives – being a bet taken on any other type of investment (ie. the instrument “derives” its value from another).

And here’s the rough list of “low” risk investments:

1. Cash
2. Government bonds
3. Large Corporate bonds
4. Most types of property
5. Gold

You get other commodities, and the alternative stuff like art and antiques, but the above are the large asset classes.

Of course – in some situations, some of the “low” risk investments can turn out to be quite high risk in the short term. For example, if there has recently been a real estate bubble (as happened just before 2007), then property would probably shift up into the high risk investment category.

But the exceptions aside, this is the general idea behind the capital* flows:

Now let’s extend those assumptions…

In the real world, the IMF and the First World have done a fairly solid job of encouraging freedom of capital flows (almost any IMF loan comes with the explicit understanding that the recipient governments will be “liberalising” their economies – step 1 of which is removing obstacles to foreign inflows and outflows of capital).

So what happens?

Well when the market is “risk on“, global investor money flows out of the low risk developed economies (in blue: America, Europe, Australia and Japan), and invests in the high risk assets of the high risk emerging markets (Latin America, India, China, Russia, South East Asia, and South Africa [to an extent]):

Domestic emerging market investors, who have just sold some of their investments off to the incoming global investors, are now left with a bit of a story around what to do with their money. So they start buying up local real estate and the smaller equities. And eventually, this excess money reaches the consumers, who respond by doing a bit more consuming. Also, rather happily, this inflow of funds has strengthened the exchange rate, making imports cheaper, which results in even more consuming (and shrieks of pain from the export sector).

All this extra consumption leads to inflation pressure in the emerging markets. Which is exactly why Brazil and Co were raising interest rates when Europe and America were driving theirs down. As the money flowed in, there was an excess of investment, meaning that inflation was on the rise.

Awkwardly, this increase in interest rates just made the emerging markets even more attractive to the global investors. So they engage in more “carry-trades”.

Carry trade: borrow at cheap interest rates in one country (eg. the US) to invest at higher interest rates in another (eg. Brazil).

And so on until the market panics and we all go “risk-off“. At which point, the flows reverse themselves, and the emerging market currencies crash, followed swiftly by their markets.

Which is what seems to be happening right now. To summarise what’s in that article that I linked to above:

1. The US and European central banks have indicated that they’re going to start suspending their quantitative easing programs (the “tapering off” everyone is talking about);
2. Which is making everyone a bit jittery about the low interest rates of the US and Europe bottoming out.
3. In response, global investors are slowing the volume of carry-trades – if not reversing those trades altogether (by liquidating their emerging market investments and taking the money home to repay their loans).
4. As of June 12, global investors had dumped a record $5.6 billion of Brazilian stocks and $3.2 billion of Indian bonds in the preceding three weeks. In Brazil, that’s ±0.5% of the total market. In 3 weeks!
5. But this is only the tip of a $3.9 trillion iceberg that cruised into emerging market town over the past four years…

They’re calling it “the perfect storm” for emerging markets.

Ah – brace yourselves?

*Just so that we’re clear: “Capital” refers to wealth/funds/money. If I take my savings and invest them in Apple shares, my “capital” has flowed from physical cash and into equities.